SECTION 13. TAX PROVISIONS RELATED TO RETIREMENT, HEALTH, POVERTY,
EMPLOYMENT, DISABILITY AND OTHER SOCIAL ISSUES
CONTENTS
Introduction
Tax Provisions
Use of Distributional Analysis
Tax Provision Estimates
Net Exclusion of Pension Contributions and Earnings
Individual Retirement Plans
Exclusion of Social Security and Railroad Retirement Benefits
Exclusion of Employer Contribution for Medical Insurance
Premiums and Medical Care
Medical Savings Accounts
Cafeteria Plans
Health Care Continuation Rules
Group Health Plan Requirements
Tax Benefits for Accelerated Death Benefits and Long-Term Care
Insurance
Deduction for Health Insurance Expenses of Self-Employed
Individuals
Exclusion of Medicare Benefits
Deductibility of Medical Expenses
Earned Income Credit
Exclusion of Public Assistance and SSI Benefits
Dependent Care Tax Credit
HOPE Credit and Lifetime Learning Credit
Qualified State Tuition Programs and Education IRAs
Student Loan Interest Deduction
Exclusion for Employer-Provided Dependent Care
Work Opportunity Tax Credit
Welfare-to-Work Tax Credit
Exclusion of Workers' Compensation and Special Benefits for
Disabled Coal Miners
Additional Standard Deduction for the Elderly and Blind
Tax Credit for the Elderly and Certain Disabled Individuals
Tax Provisions Related to Housing
Owner-Occupied Housing
Low-Income Housing Credit
Tax Credit and Exclusion for Adoption Expenses
Child Tax Credit
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
References
INTRODUCTION
The preceding sections of this publication discuss direct
payments to individuals for retirement, health, public
assistance, employment, and disability benefits provided
through entitlement programs within the jurisdiction of the
Committee on Ways and Means. The Federal Government also
provides benefits to individuals through elements of the income
tax set forth in the Internal Revenue Code of 1986 (the Code).
The Code is entirely within the jurisdiction of the Committee
on Ways and Means.
Tax Provisions
Several different types of income tax provisions are
available to provide economic incentives. Examples include:
exclusions, exemptions, deductions, preferential rates,
deferrals and credits (see Joint Committee, 1996). 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 13-1 shows
the distribution of all tax returns for 1997 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 1996 forecast of the
Congressional Budget Office.
TABLE 13-1.--DISTRIBUTION OF TAX RETURNS BY INCOME CLASS, 1997
----------------------------------------------------------------------------------------------------------------
All returns Taxable Itemized Tax
Income class (thousands) \1\ \2\ returns returns liability
----------------------------------------------------------------------------------------------------------------
Below $10................................................... 21,496 1,642 130 -$5,364
$10-$20..................................................... 24,714 9,122 921 -4,029
$20-$30..................................................... 19,926 12,990 2,156 16,455
$30-$40..................................................... 16,441 13,966 3,399 33,817
$40-$50..................................................... 12,449 11,502 3,947 40,823
$50-$75..................................................... 19,605 19,397 10,041 108,548
$75-$100.................................................... 9,241 9,206 6,975 92,691
$100-$200................................................... 7,310 7,293 6,441 145,699
$200 and over............................................... 1,648 1,644 1,527 208,042
---------------------------------------------------
Total................................................... 132,830 86,763 35,537 636,683
----------------------------------------------------------------------------------------------------------------
\1\ The income concept is defined at the beginning 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.). Excludes individuals who are dependents of other taxpayers and
taxpayers with negative income.
Note.--Money amounts in millions of dollars, returns in thousands. Detail may not add to total due to rounding.
Source: Joint Committee on Taxation.
Tax Provision Estimates
Table 13-2 provides various estimates for 33 tax
provisions related to retirement, health, poverty, employment,
disability, and housing. These provisions are examined in
detail in this chapter including their legislative history, an
explanation of current law, and a brief assessment of their
effects.
NET EXCLUSION OF PENSION CONTRIBUTIONS AND EARNINGS
Legislative History
Prior to 1921, no special tax treatment applied to employee
retirement trusts. Retirement payments to employees and
contributions to pension trusts were deductible by the employer
as an ordinary and necessary business expense. Employees were
taxed on amounts actually received as well as on employer
contributions to a trust if there was a reasonable expectation
of benefits accruing from the trust. The 1921 Code provided an
exemption for a trust forming part of a qualified profit
sharing or stock bonus plan.
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.
TABLE 13-2.--ESTIMATED TAX BASE EXCEPTIONS AND CREDITS UNDER THE PRESENT INCOME TAX FOR VARIOUS ITEMS,\1\
CALENDAR YEARS 1998-2002
[In billions of dollars]
----------------------------------------------------------------------------------------------------------------
Year
Item ------------------------------------------------------------ Total
1998 1999 2000 2001 2002 1998-2002
----------------------------------------------------------------------------------------------------------------
I. Tax base exceptions related to:
Retirement:
Net exclusion of pension
contributions and earnings......... $320.0 $333.7 $348.0 $347.7 $342.1 $1,691.5
Keogh plans......................... 19.6 20.9 22.2 23.6 25.1 111.4
Individual retirement plans......... 49.8 52.3 55.2 58.4 62.8 278.5
Exclusion of Social Security and
railroad retirement benefits in
excess of employee share of payroll
tax \2\............................ 262.4 272.0 281.9 292.0 302.5 1410.8
Health:
Exclusions of employer contributions
for medical care, health insurance
premiums and long-term care
insurance premiums \3\............. 248.2 260.0 272.7 286.4 301.6 1,369.0
Exclusion of Medicare benefits:
Medicare part A................. 135.6 146.8 158.8 171.1 184.4 796.7
Medicare part B................. 63.2 70.5 78.5 86.2 94.6 393.0
Deductibility of medical expenses
\4\................................ 34.7 37.8 40.9 44.8 48.7 206.9
Deductibility of health insurance
expenses of the self-employed \5\.. 5.3 5.8 6.9 7.4 9.4 34.8
Exclusion of accelerated death
benefits........................... 1.1 1.4 1.7 2.1 2.5 8.8
Poverty:
Exclusion of public assistance and
SSI cash benefits.................. 51.1 52.5 55.7 54.6 59.1 273.0
Employment:
Exclusion of employer-provided
dependent care \6\................. 5.2 6.0 6.6 6.9 7.1 31.8
Employee stock ownership plans
(ESOPs)............................ 11.6 12.5 13.3 14.0 14.7 66.1
Exclusion for benefits provided
under cafeteria plans \7\.......... 29.6 33.3 36.6 40.2 44.2 184.0
Elderly and disabled:
Exclusion of workers' compensation
and special benefits for disabled
coal miners:
Workers' compensation........... 30.7 31.5 32.5 33.2 34.0 161.9
Special benefits for disabled
coal miners.................... 1.1 1.0 1.0 1.0 0.9 5.0
Additional standard deduction for
elderly and blind.................. 12.3 12.9 13.8 14.6 15.8 69.4
Housing:
Deductibility of mortgage interest.. 168.9 174.9 181.0 187.9 194.6 907.3
Deductibility of property tax on
owner-occupied housing............. 69.2 72.7 75.9 80.1 84.5 382.4
Exclusion of interest on State and
local government bonds for owner-
occupied housing................... 7.9 8.4 8.4 8.5 8.5 41.7
Depreciation of rental housing in
excess of alternative depreciation
system............................. 9.2 8.4 8.3 8.6 9.6 44.1
Exclusion of interest on State and
local government bonds for rental
housing............................ 3.6 3.7 3.6 3.5 3.4 17.9
Families:
Qualified State tuition programs and
education IRAs..................... 0.4 0.5 0.7 0.8 1.1 3.5
Student loan interest deduction..... 0.1 0.1 0.1 0.2 0.3 0.8
Employer-provided adoption expenses (\8\) (\8\) (\8\) (\8\) (\8\) (\8\)
II. Tax credits related to:
Poverty:
Earned income credit:
Nonrefundable portion........... 22.5 23.4 24.4 25.3 26.4 122.0
Refundable portion.............. 5.2 5.3 5.5 5.9 6.1 28.0
Employment:
Dependent care credit............... 2.7 2.8 2.9 2.9 3.0 14.3
Work opportunity tax credit......... 0.2 0.1 (\8\) (\8\) (\8\) 0.4
Welfare-to-work tax credit......... (\8\) (\8\) (\8\) (\8\) (\8\) 0.1
Elderly and disabled:
Tax credit for elderly and disabled. (\8\) (\8\) (\8\) (\8\) (\8\) 0.1
Housing:
Low-income housing tax credit....... 3.2 3.5 3.9 4.3 4.6 19.6
Families:
Child tax credit:
Nonrefundable portion.......... 16.6 20.5 20.4 20.2 19.8 97.5
Refundable portion............. 0.9 1.1 1.1 1.1 1.1 5.3
HOPE credit and lifetime learning
credit............................. 6.2 6.3 7.2 7.7 7.6 35.1
Adoption credit.................... 0.4 0.4 0.4 0.2 0.2 1.5
----------------------------------------------------------------------------------------------------------------
\1\ Estimates of exclusions and deductions represent changes in the tax base; they do not measure changes in tax
liability. Tax effects of provisions are not comparable.
\2\ In addition to OASDI benefits for retired workers, these figures also include disability insurance benefits
and benefits for dependents and survivors.
\3\ Estimate includes employer-provided health insurance purchased through cafeteria plans and health care
spending through flexible spending accounts.
\4\ Amounts reported on tax returns in excess of the medical deductions floor (7.5 percent of adjusted gross
income).
\5\ Amounts deductible from gross income: 45 percent of health insurance expenses in 1998 and 1999, 50 percent
in 2000 and 2001, and 60 percent in 2002. 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 dependent care 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.
Since ERISA, Congress has also acted to broaden the range
of qualified plans. In the Revenue Act of 1978, Congress
provided special rules for qualified cash or deferred
arrangements under section 401(k). Under these arrangements,
known popularly as 401(k) plans, employees can elect to receive
cash or have their employers contribute a portion of their
earnings to a qualified profit sharing, stock bonus, or pre-
ERISA money purchase pension plan.
An employee stock ownership plan (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 (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 40 percent of the employees of the employer or 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 100 percent of average
compensation, or $125,000 for 1997 (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). Section 4980A was repealed by the Taxpayer Relief Act
of 1997 for excess distributions received after December 31,
1996.
Failure to satisfy qualification requirements
If a plan fails to satisfy the qualification requirements,
the trust that holds the plan's assets is not tax exempt. An
employer's deduction for plan contributions is only allowed
when the employee includes the contributions or benefits in
income, and benefits generally are includable in an employee's
income when they are no longer subject to a substantial risk of
forfeiture.
SIMPLE retirement plans
The Small Business Job Protection Act of 1996 created a
simplified retirement plan for small business called the
Savings Incentive Match Plan for Employees (SIMPLE) (secs.
408(p) and 401(k)(11)). SIMPLE plans may be adopted by
employers with 100 or fewer employees and who do not maintain
another employer-sponsored retirement plan. A SIMPLE plan can
be either an individual retirement 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 13-3).\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.
---------------------------------------------------------------------------
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 between ages 40 and 60 before falling off
somewhat. 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 13-4).
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 13-5).
Coverage may be higher for higher paying jobs because of the
greater value of the pension tax benefits to workers in higher
tax brackets and because of the declining replacement rate of
Social Security at higher earnings levels.
TABLE 13-3.--EMPLOYER SPONSORSHIP AND EMPLOYEE COVERAGE UNDER PENSION OR
RETIREMENT PLAN, PRIVATE WAGE AND SALARY WORKERS
[Percent]
------------------------------------------------------------------------
Total Full time Part time
------------------------------------------------------------------------
Employer sponsorship:
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 coverage:
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.
TABLE 13-4.--COVERAGE UNDER EMPLOYER-SPONSORED PENSION OR RETIREMENT
PLANS FOR 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.
TABLE 13-5.--COVERAGE UNDER EMPLOYER-SPONSORED PENSION OR RETIREMENT
PLANS FOR FULL-TIME PRIVATE WAGE AND SALARY WORKERS BY WORKERS' WAGES
------------------------------------------------------------------------
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.
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 13-6).
Significant differences in coverage also are apparent
between full-time private wage and salary workers and other
wage and salary workers. Coverage is much lower among part-time
workers and much higher among public employees. Among part-
time, private wage and salary workers, 12 percent are covered.
Seventy-seven percent of public sector wage and salary workers
are covered including 85 percent of those who are full-time
workers (see table 13-7).
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.
TABLE 13-6.--COVERAGE UNDER EMPLOYER-SPONSORED PENSION OR RETIREMENT
PLANS FOR FULL-TIME PRIVATE WAGE AND SALARY WORKERS BY SIZE OF FIRM
------------------------------------------------------------------------
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.
TABLE 13-7.--COVERAGE OF WAGE AND SALARY WORKERS UNDER EMPLOYER-
SPONSORED PENSION OR RETIREMENT PLAN, BY PRIVATE OR PUBLIC SECTOR
------------------------------------------------------------------------
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.
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 to 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. The Health Insurance Portability and
Accountability Act provided that the early withdrawal tax does
not apply to withdrawals from IRAs: (1) for medical expenses
that would be deductible (i.e., to the extent that total
medical expenses exceed 7.5 percent of adjusted gross income);
and (2) for health insurance expenses of unemployed
individuals.
The Taxpayer Relief Act of 1997, effective for years
beginning after December 31, 1997, made the following changes
to the IRA provisions: (1) the income limits on deductible IRA
contributions that apply to active participants in an employer-
sponsored retirement plan were increased; (2) the nonworking
spouse of an active participant in an employer-sponsored
retirement plan may make a deductible contribution of up to
$2,000 to an IRA; (3) a new tax-free nondeductible IRA, the
Roth IRA, was added; and (4) the 10-percent early withdrawal
tax was waived for distributions from IRAs for education and
first-time home buyer expenses.
Explanation of Provision
Deductible IRAs
An individual who is an active participant in an employer-
sponsored retirement plan may deduct annual IRA contributions
up to the lesser of $2,000 or 100 percent of compensation if
the individual's adjusted gross income (AGI) does not exceed
certain limits.
The full $2,000 IRA deduction limit is phased out for
married individuals over the following levels of AGI: for 1998,
$50,000-$60,000; for 1999, $51,000-$61,000; for 2000, $52,000-
$62,000; for 2001, $53,000-$63,000; for 2002, $54,000-$64,000;
for 2003, $60,000-$70,000; for 2004, $65,000-$75,000; for 2005,
$70,000-$80,000; for 2006, $75,000-$85,000; and for 2007 and
thereafter, $80,000-$100,000. The phase-out range for married
individuals filing separate returns is $0-$10,000. A couple is
not treated as married if the spouses file separate returns and
do not live together at any time during the year. The phase-out
range for single individuals is: for 1998, $30,000-$40,000; for
1999, $31,000-$41,000; for 2000, $32,000-$42,000; for 2001,
$33,000-$43,000; for 2002, $34,000-$44,000; for 2003, $40,000-
$50,000; for 2004, $45,000-$55,000; for 2005 and thereafter,
$50,000-$60,000.
For years beginning after 1997, an individual who is not
an active participant, but whose spouse is, may make a full
$2,000 deductible IRA contribution if the AGI for the couple
does not exceed $150,000. The deduction limit is phased out for
AGI between $150,000 and $160,000. An individual who is not an
active participant in an employer-sponsored retirement plan may
deduct IRA contributions up to the limits described above
without limitation based on income.
The investment income of IRA accounts is not taxed until
withdrawn. Withdrawn amounts attributable to deductible
contributions and all earnings are includable in income. A 10-
percent additional income tax is levied unless the withdrawal:
(1) is made after the IRA owner attains age 59\1/2\ or dies;
(2) is made on account of the disability of the IRA owner; (3)
is one of a series of substantially equal periodic payments
made not less frequently than annually over the life or life
expectancy of the IRA owner (or the IRA owner and his or her
beneficiary); or (4) is made to pay medical expenses in excess
of 7.5 percent of AGI or for insurance premiums for unemployed
individuals; or (5) is made after 1997 for first-time home
buyer expenses (subject to a $10,000 lifetime cap) or for
qualified higher education expenses.
Roth IRAs
For years beginning after December 31, 1997, an individual
may make nondeductible contributions up to the lesser of $2,000
or 100 percent of compensation to a Roth IRA if the
individual's AGI does not exceed $95,000 for an unmarried
individual, or $150,000 for a married couple filing a joint
return. The maximum contribution is phased out between AGI
ranges of $95,000-$110,000 for unmarried individuals and of
$150,000-$160,000 for married individuals filing a joint
return. No more than $2,000 of contributions can be made to all
an individual's IRAs for a taxable year.
Qualified distributions from a Roth IRA are not includable
in income. Qualified distributions are distributions: (1) made
after the 5-year taxable period beginning with the first
taxable year for which a contribution is made, and (2) which
are made on or after the date the individual attains age 59\1/
2\, are made to a beneficiary on or after the death of the
individual, are attributable to the individual's being
disabled, or are for a qualified special purpose distribution.
A qualified special purpose distribution is a distribution for
first-time home buyer expenses, as described above.
Distributions that are not qualified distributions are
includable in income, to the extent earnings are included in
the distribution, and are subject to the 10-percent tax on
early withdrawal, unless an exception applies, as described
above for deductible IRAs.
Taxpayers with AGI of less than $100,000 may convert an
IRA to a Roth IRA at any time. If the conversion is made before
January 1, 1999, the amounts that would have been includable in
income had the amounts converted been withdrawn are includable
in income ratably over 4 years. The 10-percent tax on early
withdrawals does not apply to conversions of IRAs to Roth IRAs.
Nondeductible IRAs
An individual may make nondeductible contributions to an
IRA to the extent the individual does not or cannot make
deductible contributions to an IRA or contributions to a Roth
IRA. Earnings on contributions to a nondeductible IRA
accumulate tax free, and are includable in income when
withdrawn. The 10-percent early withdrawal tax applies to such
earnings, subject to the exceptions for deductible and Roth
IRAs as described above.
Effect of Provision
Use of IRAs expanded significantly when eligibility was
expanded in 1982 to all persons with earnings and contracted
correspondingly in 1987 when deductibility was restricted for
higher income taxpayers who were covered by an employer-
provided pension. The number of taxpayers claiming a deductible
IRA contribution jumped from 3.4 million in 1981 to 12.0
million in 1982 and 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 13-8).
TABLE 13-8.--USE OF DEDUCTIBLE IRAs, 1980-95
------------------------------------------------------------------------
Number of tax
returns Total IRA
Year deducting IRA deductions
contributions (billions)
(millions)
------------------------------------------------------------------------
1980.................................. 2.6 $3.4
1981.................................. 3.4 4.8
1982.................................. 12.0 28.3
1983.................................. 13.6 32.1
1984.................................. 15.2 35.4
1985.................................. 16.2 38.2
1986.................................. 15.5 37.8
1987.................................. 7.3 14.1
1988.................................. 6.4 11.9
1989.................................. 5.8 10.8
1990.................................. 5.2 9.9
1991.................................. 4.7 9.0
1992.................................. 4.5 8.7
1993.................................. 4.4 8.5
1994.................................. 4.3 8.4
1995.................................. 4.3 8.3
------------------------------------------------------------------------
Source: Internal Revenue Service, Statistics of Income, various years.
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 Internal Revenue Service, Internal Revenue Bulletin, 1938-
1, Income Tax Unit 3154, p. 114; 1938-2, Income Tax Unit 3229, p. 136;
and 1941-1, Income Tax Unit 3447, p. 191.
---------------------------------------------------------------------------
Under the Social Security Amendments of 1983, a portion of
the Social Security benefits paid to higher income taxpayers is
included in gross income. In 1993, the Omnibus Budget
Reconciliation Act increased the amount of benefits subject to
tax and increased the rate of tax for some benefit recipients.
The exclusion from gross income of benefits paid under the
Railroad Retirement System was enacted in the Railroad
Retirement Act of 1935. A portion of the benefits payable under
the Railroad Retirement System (generally, tier 1 benefits) is
equivalent to Social Security benefits. The tax treatment of
tier 1 railroad retirement benefits was modified in the Social
Security Amendments of 1983 to conform to the tax treatment of
Social Security benefits. Other railroad retirement benefits
are taxable in the same manner as employer-provided retirement
benefits. The Consolidated Omnibus Budget Reconciliation Act of
1985 provided that tier 1 benefits are taxable in the same
manner as Social Security benefits only to the extent that
Social Security benefits otherwise would be payable. Other tier
1 benefits are taxable in the same manner as all other railroad
retirement benefits (for further details, see section 5).
Explanation of Provision
For taxpayers whose modified 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 50 percent of the Social
Security and tier 1 railroad retirement benefits or 50 percent
of the excess of the taxpayer's combined income over the base
amount.
The second tier applies to taxpayers with modified 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 85 percent of Social Security benefits or 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). In addition, the fund is subject to
income tax relating to any set-aside to provide postretirement
medical benefits.
Effect of Provision
The exclusion for employer-provided health coverage
provides an incentive for compensation to be furnished to the
employee in the form of health coverage, rather than in cash
subject to current taxation. For example, an employer designing
a compensation package for an employee would be indifferent
between paying the employee one dollar in cash and purchasing
one dollar's worth of health insurance for the employee.\4\ On
the other hand, because the employee is likely to pay Federal
and State income taxes and payroll taxes on cash compensation
and no tax on health insurance contributions made on his
behalf, the employee would likely prefer that some compensation
be in the form of health insurance. Employees subject to tax at
the highest marginal tax rates have the greatest incentive to
receive compensation in nontaxable forms.
---------------------------------------------------------------------------
\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 1996, for 58 percent of the
population, employment-based health insurance was the primary
source of health coverage, while 5 percent purchased insurance
privately, 13 percent received Medicare benefits, and 9 percent
received Medicaid benefits. According to a special analysis of
data from the Current Population Survey conducted by the CBO,
15 percent of the population had no health insurance.
Health coverage through employer-based plans tends to be
more prevalent in the finance, government, manufacturing, and
mining sectors of the economy, among medium and large firms,
for more highly paid workers, and among those over age 30 (see
table 13-9).
MEDICAL SAVINGS ACCOUNTS
The Health Insurance Portability and Accountability Act of
1996 included provisions for medical savings accounts (MSAs),
effective for years beginning after December 31, 1996. Within
limits, contributions to an MSA are deductible if made by an
eligible individual and are excludable from income and
employment taxes if made by the employer (other than
contributions made through a cafeteria plan). Earnings on
amounts in an MSA are not currently taxable. Distributions from
an MSA for medical expenses are not includable in gross income.
Distributions from an MSA that are not for medical expenses are
includable in gross income and are subject to an additional tax
of 15 percent, unless the distribution is made after death,
disability, or age 65.
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 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.
TABLE 13-9.--PRIMARY SOURCE OF HEALTH INSURANCE FOR WORKERS UNDER AGE 65 BY DEMOGRAPHIC CATEGORY, MARCH 1996
----------------------------------------------------------------------------------------------------------------
Percentage distribution by source of insurance
Number of -----------------------------------------------
Category workers Own or
(millions) other Individual Public No
employer policy insurance \1\ insurance
----------------------------------------------------------------------------------------------------------------
Industry:
Agriculture..................................... 3.0 45.4 15.5 3.6 35.5
Construction.................................... 8.0 61.2 6.8 2.0 29.9
Finance......................................... 7.8 83.6 5.0 1.4 10.1
Government...................................... 5.6 92.3 1.8 0.8 5.1
Manufacturing................................... 20.4 82.9 2.2 1.6 13.3
Mining.......................................... 0.6 81.8 3.1 2.0 13.1
Retail trade.................................... 18.0 63.3 5.4 4.7 26.7
Services:
Professional................................ 28.6 83.0 4.5 1.9 10.7
Other....................................... 13.9 61.7 7.4 4.1 26.8
Transportation.................................. 8.5 81.9 3.2 1.4 13.5
Wholesale trade................................. 4.7 78.6 4.8 1.4 15.2
Wage rate \2\:
Below $5.00..................................... 5.4 50.2 4.5 6.8 38.5
$5.00-$9.99..................................... 39.1 68.7 3.8 3.6 24.0
$10.00-$14.99................................... 25.8 85.6 3.1 0.8 10.5
$15.00 or more.................................. 29.6 92.9 1.8 0.1 5.2
Family income as percentage of poverty level:
Under 100....................................... 8.9 25.6 5.0 20.1 49.2
100-199......................................... 19.4 52.6 5.9 5.9 35.6
200-299......................................... 22.3 72.3 5.5 1.9 20.3
300 or more..................................... 75.4 86.5 4.4 0.5 8.6
Firm size (number of employees):
Fewer than 10................................... 25.2 51.0 14.1 4.0 30.9
10-24........................................... 11.7 63.7 5.7 3.5 27.0
25-99........................................... 16.1 74.0 3.1 3.2 19.8
100-499......................................... 17.6 81.2 2.0 2.5 14.4
500-999......................................... 7.5 82.9 2.4 2.6 12.1
1,000 or more................................... 48.0 85.8 1.8 2.4 9.9
Age (years):
Under 30........................................ 31.1 62.9 3.9 5.7 27.5
30-39........................................... 37.5 75.4 4.1 2.8 17.7
40-49........................................... 33.3 80.0 4.9 1.8 13.2
50-64........................................... 24.1 80.4 7.0 1.2 11.3
-----------------------------------------------------------
All workers................................. 126.0 74.5 4.9 3.0 17.7
----------------------------------------------------------------------------------------------------------------
\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.
CAFETERIA PLANS
Legislative History
Under present law, compensation generally is includable in
gross income when received. An exception applies if an employee
may choose between cash and certain employer-provided
nontaxable benefits under a cafeteria plan.
Prior to 1978, ERISA provided that an employer contribution
made before January 1, 1977 to a cafeteria plan in existence on
June 27, 1974, had to be included in an employee's gross income
only to the extent that the employee actually elected taxable
benefits. If a plan did not exist on June 27, 1974, the
employer contribution was to be included in income to the
extent the employee could have elected taxable benefits. The
Revenue Act of 1978 set up permanent rules for plans that offer
an election between taxable and nontaxable benefits.
The Deficit Reduction Act of 1984 (Public Law 98-369)
clarified the types of employer-provided benefits that could be
provided through a cafeteria plan, added a 25-percent
concentration test, and required annual reporting to the IRS by
employers.
The Tax Reform Act of 1986 also modified the rules relating
to cafeteria plans in several respects.
Explanation of Provision
A participant in a cafeteria plan (sec. 125) is not treated
as having received taxable income solely because the
participant had the opportunity to elect to receive cash or
certain nontaxable benefits. In order to meet the requirements
of section 125, the plan must be in writing, must include only
employees (including former employees) as participants, and
must satisfy certain nondiscrimination requirements.
In general, a nontaxable benefit may be provided through a
cafeteria plan if the benefit is excludable from the
participant's gross income by reason of a specific provision of
the Code. These include employer-provided health coverage,
group-term life insurance coverage, and benefits under
dependent care assistance programs. A cafeteria plan may not
provide qualified scholarships or tuition reduction,
educational assistance, miscellaneous employer-provided fringe
benefits, or deferred compensation except through a qualified
cash or deferred arrangement.
If the plan discriminates in favor of highly compensated
individuals regarding eligibility to participate, to make
contributions, or to receive benefits under the plan, then the
exclusion does not apply. 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,
however, the employer might actually find it less costly to
compensate an employee with a dollar's worth of fringe benefit
not subject to FICA and FUTA taxes rather than a dollar of wage
or salary payments that are subject to these taxes.
The employee, however, would prefer to be compensated in
the form that provides the highest aftertax value. An
additional dollar of salary or wage paid to the employee will
be subject to tax. If a fringe benefit is excludable from the
employee's income, the employee pays no tax on receipt of the
benefit. Consequently, the employee receives greater
compensation via the fringe benefit. This differential
treatment of salary or wage payments and excludable fringe
benefits implies that compensation packages designed to
minimize the joint tax liability of employers and employees
could include substantial amounts of excludable fringe
benefits.
Employees may have different preferences about the
allocation of their compensation. For example, an employee with
no dependents may place little value on employer-provided life
insurance. Cafeteria plans permit employees some discretion as
to the provided benefits, and will tend to be preferred to
benefit plans in which all employees of the firm receive the
identical benefit package.
Cafeteria plans are a growing part of compensation plans,
particularly for larger employers. The Bureau of Labor
Statistics estimated that in 1995, 55 percent of employees at
large- and medium-sized firms were eligible for some type of
cafeteria plan. This figure has grown from an estimated 5
percent in 1986 (U.S. Bureau of Labor Statistics, 1993).
Smaller firms generally do not offer cafeteria plans to their
workers. For example, in 1994, only 19 percent of the workers
in small, private establishments (nonfarm establishments with
fewer than 100 employees) were eligible to participate in a
cafeteria plan (U.S. Bureau of Labor Statistics, 1994). The
lower figure for smaller firms reflects in part the less
generous fringe benefit packages provided by smaller firms.
Like any income exclusion, the exclusion from gross income
for cafeteria plan benefits can lead to disparities in the tax
system. Employees with the same total compensation can have
taxable incomes that are substantially different because of the
form in which compensation is received. The exclusion for
cafeteria plan benefits also may be used in some cases to avoid
the 7.5 percent of AGI floor on deductible medical expenses.
The use of cafeteria plans reduces the aftertax cost of health
care to employees using these plans, which could cause these
employees to purchase a larger amount of health care services.
On the other hand, cafeteria plans could encourage employers to
increase the share of premiums, copayments, and deductibles
paid by employees, resulting in increased employee awareness of
the costs of their health plans. This incentive could result in
reduced health care costs.
HEALTH CARE CONTINUATION RULES
Legislative History
The Consolidated Omnibus Budget Reconciliation Act of 1985
added sections 106(b), 162(i)(2), and 162(k) to the Internal
Revenue Code under which certain group health plans are
required to offer health coverage to certain employees and
former employees, as well as to their spouses and dependents.
Parallel requirements were added to title I of ERISA and the
Public Health Services Act. If an employer failed to satisfy
the health care continuation rules, the employer was denied a
deduction for contributions to its group health plans and
highly compensated employees were required to include in
taxable income the employer-provided value of the coverage
received under such plans.
The Technical and Miscellaneous Revenue Act of 1988 made
several changes to the health care continuation rules. Sections
106(b), 162(i)(2), and 162(k) were repealed and replaced by
section 4980B. Section 4980B imposes an excise tax on the
employer or other responsible party who fails to satisfy the
rules instead of denying deductions and the exclusion. The
Health Insurance Portability and Accountability Act of 1996
made some changes to the health care continuation rules in
cases of disability.
Explanation of Provision
The health care continuation rules in section 4980B require
that an employer provide qualified beneficiaries with the
opportunity to participate for a specified period in the
employer's health plan after that participation otherwise would
have terminated. If the employee elects such continuation
coverage, the employee may be required to pay for the coverage.
The amount the employee can be required to pay is subject to
certain limits.
The qualifying events that may trigger rights to
continuation coverage are: (1) the death of the employee; (2)
the voluntary or involuntary termination of the employee's
employment (other than by reason of gross misconduct); (3) a
reduction of the employee's hours; (4) the divorce or legal
separation of the employee; (5) the employee becoming entitled
to benefits under Medicare; and (6) a dependent child of the
employee ceasing to be a dependent under the employer's plan.
The maximum period of continuation coverage is 36 months,
except in the case of termination of employment or reduction of
hours for which the maximum period is 18 months. The 18-month
period is extended to 29 months in certain cases involving the
disability of the qualified beneficiary. Certain events, such
as the failure by the qualified beneficiary to pay the required
premium, may trigger an earlier cessation of the continuation
coverage.
A beneficiary has a prescribed period of time during which
to elect continuation coverage after the employee receives
notice from the plan administrator of the right to continuation
coverage.
GROUP HEALTH PLAN REQUIREMENTS
The Health Insurance Portability and Accountability Act of
1996 imposes certain requirements regarding health coverage
portability through limitations on preexisting condition
exclusions, prohibitions on excluding individuals from coverage
based on health status, and guaranteed renewability of health
insurance coverage. An excise tax is imposed with respect to
failures of a group health plan to comply with the
requirements. The tax is usually imposed on the employer
sponsoring the plan. The amount of the tax is generally equal
to $100 per day for each day during which the failure occurs
until the failure is corrected. The maximum tax that can be
imposed is the lesser of 10 percent of the employer's payments
during the taxable year in which the failure occurred under
group health plans or $500,000. The Secretary of the Treasury
may waive all or part of the tax to the extent that payment of
the tax would be excessive relative to the failure involved
(see discussion of health care continuation rules).
TAX BENEFITS FOR ACCELERATED DEATH BENEFITS AND LONG-TERM CARE
INSURANCE
Legislative History
Accelerated death benefits
If a contract meets the definition of a life insurance
contract, gross income does not include insurance proceeds that
are paid pursuant to the contract by reason of the death of the
insured (sec. 101(a)). In addition, the undistributed
investment income (inside buildup) earned on premiums credited
under the contract is not subject to current taxation to the
owner of the contract. The exclusion under section 101 applies
regardless of whether the death benefits are paid as a lump sum
or otherwise.
If a contract fails to be treated as a life insurance
contract under section 7702(a), inside buildup on the contract
is generally subject to tax (sec. 7702(g)).
To qualify as a life insurance contract for Federal income
tax purposes, a contract must be a life insurance contract
under the applicable State or foreign law and must satisfy
either of two alternative tests: (1) a cash value accumulation
test, or (2) a test consisting of a guideline premium
requirement and a cash value corridor requirement (sec.
7702(a)). A contract satisfies the cash value accumulation test
if the cash surrender value of the contract may not at any time
exceed the net single premium that would have to be paid at
such time to fund future benefits under the contract. A
contract satisfies the guideline premium and cash value
corridor tests if the premiums paid under the contract do not
at any time exceed the greater of the guideline single premium
or the sum of the guideline level premiums, and if the death
benefit under the contract is not less than a varying statutory
percentage of the cash surrender value of the contract.
Long-term care insurance
Prior to the Health Insurance Portability and
Accountability Act of 1996, tax law generally did not provide
explicit rules relating to the tax treatment of long-term care
insurance contracts or long-term care services. Thus, the
treatment of long-term care contracts and services was unclear.
Prior and present law provide rules relating to medical
expenses and accident or health insurance.
Amounts received by a taxpayer under accident or health
insurance for personal injuries or sickness generally are
excluded from gross income to the extent that the amounts
received are not attributable to medical expenses that were
allowed as a deduction for a prior taxable year (sec. 104).
Explanation of Provision
Accelerated death benefits
The Health Insurance Portability and Accountability Act of
1996 provides an exclusion from gross income as an amount paid
by reason of the death of an insured for amounts received under
a life insurance contract and for amounts received for the sale
or assignment of a life insurance contract to a qualified
viatical settlement provider, provided that the insured under
the life insurance contract is either terminally ill or
chronically ill.
The exclusion does not apply in the case of an amount paid
to any taxpayer other than the insured, if such taxpayer has an
insurable interest by reason of the insured being a director,
officer, or employee of the taxpayer, or by reason of the
insured being financially interested in any trade or business
carried on by the taxpayer.
A terminally ill individual is defined as one who has been
certified by a physician as having an illness or physical
condition that reasonably can be expected to result in death
within 24 months of the date of certification.
A chronically ill individual has the same meaning as
provided under the long-term care rules (see below). In the
case of a chronically ill individual, the exclusion with
respect to amounts paid under a life insurance contract and
amounts paid in a sale or assignment to a viatical settlement
provider applies if the payment received is for costs incurred
by the payee (not compensated by insurance or otherwise) for
qualified long-term care services for the insured person for
the period, and two other requirements (similar to requirements
applicable to long-term care insurance contracts) are met.
The first requirement is that under the terms of the
contract giving rise to the payment, the payment is not a
payment or reimbursement of expenses reimbursable under
Medicare (except where Medicare is a secondary payor under the
arrangement, or the arrangement provides for per diem or other
periodic payments without regard to expenses for qualified
long-term care services). No provision of law shall be
construed or applied so as to prohibit the offering of such a
contract giving rise to such a payment on the basis that the
contract coordinates its payments with those provided under
Medicare. The second requirement is that the arrangement
complies with the consumer protection provisions applicable to
long-term care insurance contracts and issuers that are
specified in Treasury regulations.
Long-term care insurance
Exclusion of long-term care insurance proceeds.--The Health
Insurance Portability and Accountability Act of 1996 provides
that a long-term care insurance contract generally is treated
as an accident and health insurance contract. Amounts (other
than policyholder dividends or premium refunds) received under
a long-term care insurance contract generally are excludable as
amounts received for personal injuries and sickness, subject to
a dollar cap on aggregate payments under per diem contracts. A
reporting requirement applies to payors of excludable amounts.
The amount of the dollar cap on aggregate payments under
per diem contracts with respect to any one chronically ill
individual (who is not also terminally ill) is $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 used first by the chronically ill
person, and any remaining amount is to be allocated in
accordance with Treasury regulations. If payments under such
contracts exceed the dollar cap, then the excess is excludable
only to the extent of actual costs (in excess of the dollar
cap) incurred for long-term care services. Amounts in excess of
the dollar cap, with respect to which no actual costs were
incurred for long-term care services, are fully includable in
income without regard to rules relating to return of basis
under section 72. A grandfather rule applies to any per diem-
type contract issued to a policyholder on or before July 31,
1996.
Exclusion for employer-provided long-term care coverage.--A
plan of an employer providing coverage under a long-term care
insurance contract generally is treated as an accident and
health plan. Thus, employer-provided long-term care coverage is
generally excludable from income and wages and deductible by
the employer. Employer-provided coverage under a long-term care
insurance contract is not, however, excludable by an employee
if provided through a cafeteria plan; similarly, expenses for
long-term care services cannot be reimbursed under a flexible
spending arrangement.
Definition of long-term care insurance contract.--A long-
term care insurance contract is defined as any insurance
contract that provides only coverage of qualified long-term
care services and that meets other requirements. The other
requirements are that: (1) the contract is guaranteed
renewable; (2) the contract does not provide for a cash
surrender value or other money that can be paid, assigned,
pledged or borrowed; (3) refunds (other than refunds on the
death of the insured or complete surrender or cancellation of
the contract) and dividends under the contract may be used only
to reduce future premiums or increase future benefits; and (4)
the contract generally does not pay or reimburse expenses
reimbursable under Medicare (except where Medicare is a
secondary payor, or the contract makes per diem or other
periodic payments without regard to expenses).
A contract does not fail to be treated as a long-term care
insurance contract solely because it provides for payments on a
per diem or other periodic basis without regard to expenses
incurred during the period.
Medicare duplication rules.--No provision of law may be
applied to prohibit the offering of a long-term care insurance
contract on the basis that the contract coordinates its
benefits with those provided under Medicare.
Definition of qualified long-term care services.--Qualified
long-term care services means necessary diagnostic, preventive,
therapeutic, curing, treating, mitigating and rehabilitative
services, and maintenance or personal care services that are
required by a chronically ill individual and that are provided
pursuant to a plan of care prescribed by a licensed health care
practitioner.
Chronically ill individual.--A chronically ill individual
is one who has been certified within the previous 12 months by
a licensed health care practitioner as: (1) being unable to
perform (without substantial assistance) at least two
activities of daily living for at least 90 days due to a loss
of functional capacity; (2) having a similar level of
disability as determined by the Secretary of the Treasury in
consultation with the Secretary of Health and Human Services;
or (3) requiring substantial supervision to protect such
individual from threats to health and safety due to severe
cognitive impairment. Activities of daily living are eating,
toileting, transferring, bathing, dressing and continence. For
purposes of determining whether an individual is chronically
ill, the number of activities of daily living that are taken
into account under the long-term care insurance contract may
not be less than five.
Expenses for long-term care services treated as medical
expenses.--Unreimbursed expenses for qualified long-term care
services provided to the taxpayer or the taxpayer's spouse or
dependents are treated as medical expenses for purposes of the
itemized deduction for medical expenses (subject to the
present-law floor of 7.5 percent of 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
Self-employed individuals may currently deduct 40 percent
of their health insurance expenses for themselves and their
spouses and dependents. The deduction also applies to certain
long-term care premiums treated as medical expenses. Under the
Taxpayer Relief Act of 1997, the deduction for health insurance
of self-employed individuals will increase as follows: the
deduction will be 45 percent in 1998 and 1999; 50 percent in
2000 and 2001; 60 percent in 2002; 80 percent in 2003-5; 90
percent in 2006; and 100 percent in 2007 and thereafter.
EXCLUSION OF MEDICARE BENEFITS
Legislative History
The exclusion from income of Medicare benefits has never
been expressly established by statute. A 1970 IRS ruling, Rev.
Rul. 70-341, 1970-2 C.B. 31, provided that the benefits under
part A of Medicare are not includable in gross income because
they are disbursements made to further the social welfare
objectives of the Federal Government. The Internal Revenue
Service relied on a similar ruling, Rev. Rul. 70-217, 1970-1
C.B. 13, with respect to the excludability of Social Security
disability insurance benefits in reaching this conclusion. (For
background on the exclusion of Social Security benefits, see
above section on pension contributions.) Rev. Rul. 70-341 also
held that benefits under part B of Medicare are excludable as
amounts received through accident and health insurance (though
the subsidized portion of part B also may be excluded under the
same theory applicable to the exclusion of part A benefits).
Explanation of Provision
Benefits under part A and part B of Medicare are excludable
from the gross income of the recipient. In general, part A pays
for certain inpatient hospital care, skilled nursing facility
care, home health care, and hospice care for eligible
individuals (generally the elderly and the disabled). Part B
covers certain services of a physician and other medical
services for elderly or disabled individuals who elect to pay
the required premium.
DEDUCTIBILITY OF MEDICAL EXPENSES
Legislative History
An itemized deduction for unreimbursed medical expenses
above a specified floor has been allowed since 1942. From 1954
through 1982, the floor under the medical expense deduction was
3 percent of the taxpayer's adjusted gross income (AGI); a
separate floor of 1 percent of AGI applied to expenditures for
medicine and drugs.
In the Tax Equity and Fiscal Responsibility Act of 1982
(TEFRA), the floor was increased to 5 percent of AGI (effective
for 1983 and thereafter) and was applied to the total of all
eligible medical expenses, including prescription drugs and
insulin. TEFRA made nonprescription drugs ineligible for the
deduction and eliminated the separate floor for drug costs.
The Tax Reform Act of 1986 increased the floor under the
medical expense deduction to 7.5 percent of AGI, beginning in
1987.
Explanation of Provision
Individuals who itemize deductions may deduct amounts they
pay during the taxable year, if not reimbursed by insurance or
otherwise, for medical care of the taxpayer and of the
taxpayer's spouse and dependents, to the extent that the total
of such expenses exceeds 7.5 percent of AGI (sec. 213).
Medical care expenses eligible include: (1) health
insurance (including aftertax employee contributions to
employer health plans); (2) diagnosis, treatment, or prevention
of disease, or for the purpose of affecting any structure or
function of the body; (3) transportation primarily for and
essential to medical care; (4) lodging away from home primarily
for and essential to medical care, up to $50 per night; and (5)
prescription drugs and insulin.
Expenses paid for the general improvement of health, such
as fees for exercise programs, are not eligible for the
deduction unless prescribed by a physician to treat a specific
illness. A deduction is not allowed for cosmetic surgery or
similar procedures that do not meaningfully promote the proper
function of the body or treat disease. However, such expenses
are deductible if the cosmetic procedure is necessary to
correct a deformity arising from a congenital abnormality, an
injury resulting from an accident, or disfiguring disease.
Medical expenses are not subject to the general limitation
on itemized deductions applicable to taxpayers with adjusted
gross incomes above a certain limit ($121,200 for 1997 and
adjusted annually for inflation).
Effect of Provision
The Tax Code allows taxpayers to claim an itemized
deduction if unreimbursed medical expenses absorb a substantial
portion of income and thus adversely affect the taxpayer's
ability to pay taxes. In order to limit the deduction to
extraordinary expenses, medical expenses are deductible only to
the extent that they exceed 7.5 percent of the taxpayer's AGI.
Table 13-10 shows the effect on medical expense deductions
of the increases in the floor on medical deductions. In the
absence of those increases, one would have expected the number
of taxpayers claiming the deduction to have increased because
of inflation of medical costs. However, increasing the floor
should reduce the number of taxpayers claiming the deduction
because many taxpayers with relatively modest expenses no
longer qualify. The average deduction in excess of the 7.5
percent of AGI floor has increased substantially, from $769 in
1980 to $5,039 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.
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.
TABLE 13-10.--TAX RETURNS CLAIMING DEDUCTIBLE MEDICAL AND DENTAL EXPENSES, 1980-95
----------------------------------------------------------------------------------------------------------------
Returns claiming medical and dental
expenses in excess of the AGI floor
Total --------------------------------------
number of Expenses in
Year returns Number of excess of Average
filed (in returns the AGI amount over
millions) (in floor (in the floor
millions) billions)
----------------------------------------------------------------------------------------------------------------
1980........................................................ 93.9 19.5 $15.0 $769
1981........................................................ 95.4 21.4 17.9 836
1982........................................................ 95.3 22.0 21.7 986
1983........................................................ 96.3 9.7 18.1 1,859
1984........................................................ 99.4 10.7 21.5 2,009
1985........................................................ 101.7 10.8 22.9 2,127
1986........................................................ 103.0 10.5 25.1 2,382
1987........................................................ 107.0 5.4 17.2 3,202
1988........................................................ 110.1 4.8 18.0 3,741
1989........................................................ 112.1 5.1 20.9 4,079
1990........................................................ 113.7 5.1 21.5 4,215
1991........................................................ 114.7 5.3 23.7 4,444
1992........................................................ 113.6 5.5 25.7 4,675
1993........................................................ 114.6 5.5 26.5 4,829
1994........................................................ 115.9 5.2 26.4 5,044
1995........................................................ 118.2 5.4 27.0 5,039
----------------------------------------------------------------------------------------------------------------
Source: Internal Revenue Service.
In 1995, approximately 5,351,000 taxpayers claimed itemized
medical expenses in excess of the medical deductions floor (7.5
percent of adjusted gross income). Of that number, 79 percent
had incomes of less than $50,000 (see table 13-11). However,
taxpayers with incomes over $50,000 received far more than half
of the total tax savings attributable to medical expense
deductions.
TABLE 13-11.--DISTRIBUTION OF ITEMIZED DEDUCTIONS FOR MEDICAL EXPENSES,
1995
------------------------------------------------------------------------
Average Returns Total amount
Income class (thousands) \1\ deduction (thousands) (billions) \2\
------------------------------------------------------------------------
0-$10......................... $5,819 471 $2.7
$10-$20....................... 5,736 1,140 6.5
$20-$30....................... 3,799 1,035 3.9
$30-$40....................... 4,015 888 3.6
$40-$50....................... 4,086 679 2.8
$50-$75....................... 4,992 790 3.9
$75-$100...................... 7,146 220 1.6
$100-$200..................... 12,038 114 1.4
$200 and over................. 38,442 13 0.5
-----------------------------------------
Total.................... 5,039 5,351 27.0
------------------------------------------------------------------------
\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: Internal Revenue Service.
EARNED INCOME CREDIT
Legislative History
The earned income credit (EIC Code sec. 32), enacted in
1975, generally equals a specified percentage of wages up to a
maximum dollar amount. The maximum amount applies over a
certain income range and then diminishes to zero over a
specified phaseout range. The income ranges and percentages
have been revised several times since original enactment,
expanding the credit (see table 13-12).
In 1987, the credit was indexed for inflation. In 1990 and
again in 1993, Congress enacted substantial expansions of the
credit. Auxiliary credits were added for very young children
and for health insurance premiums paid on behalf of a
qualifying child in 1990. These were repealed in 1993. Also in
1993, eligibility for the credit was expanded to include
childless workers. The Personal Responsibility and Work
Opportunity Reconciliation Act of 1996 incorporated new rules
relating to taxpayer identification numbers and the modified
AGI phaseout of the credit in addition to amending the credit's
unearned income test (described below). The Taxpayer Relief Act
of 1997 also included provisions to improve compliance. The
provisions: (1) deny the EIC for 10 years to taxpayers who
fraudulently claimed the EIC, 2 years for EIC claims which are
a result of reckless or intentional disregard of rules or
regulations); (2) require EIC recertification for a taxpayer
who is denied the EIC; (3) imposes due diligence requirements
on paid preparers of returns involving the EIC; (4) requires
information sharing between the Treasury Department and State
and local governments regarding child support orders; and (5)
allows expanded use of Social Security Administration records
to enforce the tax laws, including the EIC. The Balanced Budget
Act of 1997 also increased the IRS authorization to improve
enforcement of the EIC.
TABLE 13-12.--EARNED INCOME CREDIT PARAMETERS, 1975-97
[Dollar amounts unadjusted for inflation]
----------------------------------------------------------------------------------------------------------------
Mininum Phaseout range
Credit income Phaseout -------------------
Calendar year rate for Maximum rate
(percent) maximum credit (percent) Beginning Ending
credit income income
----------------------------------------------------------------------------------------------------------------
1975-78............................................. 10.00 $4,000 $400 10.00 $4,000 $8,000
1979-84............................................. 10.00 5,000 500 12.50 6,000 10,000
1985-86............................................. 14.00 5,000 550 12.22 6,500 11,000
1987................................................ 14.00 6,080 851 10.00 6,920 15,432
1988................................................ 14.00 6,240 874 10.00 9,840 18,576
1989................................................ 14.00 6,500 910 10.00 10,240 19,340
1990................................................ 14.00 6,810 953 10.00 10,730 20,264
1991:
One child......................................... 16.70 7,140 1,192 11.93 11,250 21,250
Two children...................................... 17.30 7,140 1,235 12.36 11,250 21,250
1992:
One child......................................... 17.60 7,520 1,324 12.57 11,840 22,370
Two children...................................... 18.40 7,520 1,384 13.14 11,840 22,370
1993:
One child......................................... 18.50 7,750 1,434 13.21 12,200 23,050
Two children...................................... 19.50 7,750 1,511 13.93 12,200 23,050
1994:
No children....................................... 7.65 4,000 306 7.65 5,000 9,000
One child......................................... 26.30 7,750 2,038 15.98 11,000 23,755
Two children...................................... 30.00 8,425 2,528 17.68 11,000 25,296
1995:
No children....................................... 7.65 4,100 314 7.65 5,130 9,230
One child......................................... 34.00 6,160 2,094 15.98 11,290 24,396
Two children...................................... 36.00 8,640 3,110 20.22 11,290 26,673
1996:
No children....................................... 7.65 4,220 323 7.65 5,280 9,500
One child......................................... 34.00 6,330 2,152 15.98 11,610 25,078
Two children...................................... 40.00 8,890 3,556 21.06 11,610 28,495
1997:
No children....................................... 7.65 4,340 332 7.65 5,430 9,770
One child......................................... 34.00 6,500 2,210 15.98 11,930 25,750
Two children...................................... 40.00 9,140 3,656 21.06 11,930 29,290
----------------------------------------------------------------------------------------------------------------
Source: Joint Committee on Taxation.
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
1997 of 34 percent of their earnings up to $6,500, resulting in
a maximum credit of $2,210. The maximum credit is available for
those with earnings between $6,500 and $11,930. At $11,930 of
earnings the credit begins to phase down at a rate of 15.98
percent of earnings above $11,930. The credit is phased down to
0 at $25,750 of earnings.
Taxpayers with more than one qualifying child may claim a
credit in 1997 of 40 percent of earnings up to $9,140,
resulting in a maximum credit of $3,656. The maximum credit is
available for those with earnings between $9,140 and $11,930.
At $11,930 of earnings the credit begins to phase down at a
rate of 21.06 percent of earnings above $11,930. The credit is
phased down to $0 at $29,290 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 $4,340, resulting in a maximum credit
of $332. The maximum is available for those with incomes
between $4,340 and $5,430. At $5,430 of earnings, the credit
begins to phase down at a rate of 7.65 percent of earnings
above that amount, resulting in a $0 credit at $9,770.
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 gains net income, and
5. Net passive income (if greater than zero) that is not self-
employment income.
For taxpayers with earned income (or modified AGI, if
greater) in excess of the beginning of the phaseout range, the
maximum earned income credit amount is reduced by the phaseout
rate multiplied by the amount of earned income (or modified
AGI, if greater) in excess of the beginning of the phaseout
range. For taxpayers with earned income (or modified AGI, if
greater) in excess of the end of the phaseout range, no credit
is allowed.
The definition of modified AGI used for phasing out the
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. Seventy-five percent of the net losses from businesses,
computed separately with respect to sole
proprietorships (other than in farming), sole
proprietorships in farming, and other businesses.
The definition of modified AGI also includes tax-exempt
interest and nontaxable distributions from pensions, annuities,
and individual retirement accounts (but only if not called over
into similar vehicles during the applicable rollover period).
Individuals are ineligible for the credit if they do not
include their taxpayer identification number and their
qualifying child's number (and, if married, their spouse's
taxpayer identification number) on their tax return. Solely for
these purposes and for purposes of the present-law
identification test for a qualifying child, a taxpayer
identification number is defined as a Social Security number
issued to an individual by the Social Security Administration
other than a number issued under section 205(c)(2)(B)(i)(II)
(or that portion of sec. 205(c)(2)(B)(i)(III) relating to it)
of the Social Security Act regarding the issuance of a number
to an individual applying for or receiving federally funded
benefits.
If an individual fails to provide a correct taxpayer
identification number, such omission will be treated as a
mathematical or clerical error by the Internal Revenue Service.
Similarly, if an individual who claims the credit with respect
to net earnings from self-employment fails to pay the proper
amount of self-employment tax on such net earnings, the failure
will be treated as a mathematical or clerical error for
purposes of the amount of credit allowed.
The EIC is relatively unique because it is a refundable
tax credit; i.e., if the amount of the credit exceeds the
taxpayer's Federal income tax liability, the excess is payable
to the taxpayer as a direct transfer payment. In this sense,
the EIC is like other Federal programs that provide poor and
low-income families with public benefits. However, the EIC
differs from other Federal programs in that its benefits
require earnings.
Under an advance payment system, available since 1979,
eligible taxpayers may elect to receive the credit in their
paychecks, rather than waiting to claim a refund on their tax
return filed by April 15 of the following year. In 1993,
Congress required that the IRS begin to notify eligible
taxpayers of the advance payment option.
Interaction with Means-Tested Programs
The treatment of the EIC for purposes of AFDC and food
stamp benefit computations has varied since inception of the
credit. When enacted in 1975, the credit was not considered
income in determining AFDC and food stamp benefits, and the
credit could not be received on an advance basis. From January
1979 through September 1981, the credit was treated as earned
income when actually received.
From October 1981 to September 1984, the amount of the
credit was treated as earned income and was imputed to the
family even though it may not have been received as an advance
payment. Pursuant to the Deficit Reduction Act of 1984, the
credit was treated as earned income only when received, either
as an advance payment or as a refund after the conclusion of
the year.
Under the Family Support Act of 1988, States generally were
required to disregard any advance payment or refund of the EIC
when calculating AFDC eligibility or benefits. However, the
credit was counted against the gross income eligibility
standard (185 percent of the State need standard) for both
applicants and recipients.
OBRA 1990 specified that, effective January 1, 1991, the
EIC was not to be taken into account as income (for the month
in which the payment is received or any following month) or as
a resource (for the month in which the payment is received or
the following month) for determining the eligibility or amount
of benefit for AFDC, Medicaid, SSI, food stamps, or low-income
housing programs.
Effect of Provision
More than 18.5 million taxpayers are expected to take
advantage of the EIC in 1997 (see table 13-13). Their claims
are expected to total $26.8 billion, 81 percent of which will
be refunded as direct payments to these families. As table 13-
13 also shows, approximately 69 percent of the tax relief or
direct spending from the EIC accrues to taxpayers who file as
singles or heads of households.
Table 13-14 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.
EXCLUSION OF PUBLIC ASSISTANCE AND SSI BENEFITS
Legislative History
While there is no specific statutory authorization, a
number of revenue rulings under Code section 61 have held that
specific types of public assistance payments are excludable
from gross income. Revenue rulings generally exclude government
transfer payments from income because they are considered to be
general welfare payments. In addition, taxing benefits provided
in kind, rather than in cash, would require valuation of these
benefits, which could create administrative difficulties.
Explanation of Provision
The Federal Government provides tax-free public assistance
benefits to individuals either by cash payments or by provision
of certain goods and services at reduced cost or free of
charge. Cash payments come mainly from the Aid to Families with
Dependent Children (AFDC) and Supplemental Security Income
(SSI) Programs. Inkind payments include food stamps, Medicaid,
and housing assistance. None of these payments is subject to
income tax.
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.
TABLE 13-13.--DISTRIBUTION OF TAX PROVISIONS: EARNED INCOME CREDIT, 1997
----------------------------------------------------------------------------------------------------------------
Joint returns Head of household and All returns
-------------------------- single returns -------------------------
Income class --------------------------
Number Amount Number Amount Number Amount
----------------------------------------------------------------------------------------------------------------
$0-$10,000........................ 681 $924 4,495 $4,816 5,175 $5,740
$10,000-$20,000................... 1,615 3,592 4,824 9,270 6,439 12,862
$20,000-$30,000................... 2,038 2,873 3,067 3,900 5,106 6,773
$30,000-$40,000................... 920 711 730 602 1,650 1,313
$40,000-$50,000................... 112 93 18 18 130 111
$50,000-$75,000................... 29 35 5 12 33 47
$75,000 and over.................. 0 0 0 0 0 0
-----------------------------------------------------------------------------
Total....................... 5,394 8,229 13,139 18,618 18,534 26,847
-----------------------------------------------------------------------------
Percent distribution by type of
return........................... 29.1 30.7 70.9 69.3 100.0 100.0
----------------------------------------------------------------------------------------------------------------
Note.--Number of returns in thousands; amount of credit in millions.
Source: Joint Committee on Taxation.
TABLE 13-14.--EARNED INCOME CREDIT: NUMBER OF RECIPIENTS AND AMOUNT OF CREDIT, 1975-2000
----------------------------------------------------------------------------------------------------------------
Number of Total Refunded
recipient amount of portions of Average
Year families credit credit credit per
(thousands) (millions) (millions) family
----------------------------------------------------------------------------------------------------------------
1975........................................................ 6,215 $1,250 $900 $201
1976........................................................ 6,473 1,295 890 200
1977........................................................ 5,627 1,127 880 200
1978........................................................ 5,192 1,048 801 202
1979........................................................ 7,135 2,052 1,395 288
1980........................................................ 6,954 1,986 1,370 286
1981........................................................ 6,717 1,912 1,278 285
1982........................................................ 6,395 1,775 1,222 278
1983........................................................ 7,368 1,795 1,289 224
1984........................................................ 6,376 1,638 1,162 257
1985........................................................ 7,432 2,088 1,499 281
1986........................................................ 7,156 2,009 1,479 281
1987........................................................ 8,738 3,391 2,930 450
1988........................................................ 11,148 5,896 4,257 529
1989........................................................ 11,696 6,595 4,636 564
1990........................................................ 12,542 7,542 5,266 601
1991........................................................ 13,665 11,105 8,183 813
1992........................................................ 14,097 13,028 9,959 924
1993........................................................ 15,117 15,537 12,028 1,028
1994 \1\.................................................... 19,017 21,105 16,598 1,110
1995 \2\.................................................... 19,335 25,956 20,829 1,342
1996 \2\.................................................... 18,525 25,935 20,826 1,400
1997 \2\.................................................... 18,652 26,919 21,684 1,443
1998 \2\.................................................... 18,788 27,677 22,452 1,473
1999 \2\.................................................... 18,954 28,728 23,416 1,516
2000 \2\.................................................... 19,212 29,921 24,380 1,557
----------------------------------------------------------------------------------------------------------------
\1\ Preliminary.
\2\ Projected.
Source: For 1975-94, Internal Revenue Service; for 1995-2000, Joint Committee on Taxation.
The Revenue Act of 1971: (1) made any individual who
maintained a household and was gainfully employed eligible for
the deduction; (2) modified the definition of a dependent; (3)
raised the deduction limit to $4,800 per year; (4) increased
from $6,000 to $18,000 the income level at which the deduction
began to phase out; (5) allowed the deduction for household
services in addition to direct dependent care; and (6) limited
the deduction with respect to services outside the taxpayer's
household.
The Tax Reduction Act of 1975 increased from $18,000 to
$35,000 the income level at which the deduction began to be
phased out.
The Tax Reform Act of 1976 replaced the deduction with a
nonrefundable credit. This change broadened eligibility to
those who do not itemize deductions and provided relatively
greater benefit to low-income taxpayers. In addition, the act
eased the rules related to family status and simplified the
computation.
In the Economic Recovery Tax Act of 1981, Congress provided
a higher ceiling on creditable expenses, a larger credit for
low-income individuals, and modified rules relating to care
provided outside the home.
The Family Support Act of 1988 reduced to 13 the age of a
child for whom the dependent care credit may be claimed,
reduced the amount of eligible expenses by the amount of
expenses excludable from that taxpayer's income under the
dependent care exclusion, lowered from 5 to 2 the age at which
a taxpayer identification number had to be submitted for
children for whom the credit was claimed, and disallowed the
credit unless the taxpayer reports on her tax return the
correct name, address, and taxpayer identification number
(generally, an employer identification number or a Social
Security number) of the dependent care provider.
The Small Business Protection Act of 1996 required a TIN
for all children for whom a dependent care credit may be
claimed.
Explanation of Provision
A taxpayer may claim a nonrefundable credit against income
tax liability for up to 30 percent of a limited amount of
employment-related dependent care expenses. Eligible
employment-related expenses are limited to $2,400 if there is
one qualifying dependent or $4,800 if there are two or more
qualifying dependents. Generally, a qualifying individual is a
dependent under the age of 13 or a physically or mentally
incapacitated dependent or spouse.
Employment-related dependent care expenses are expenses for
the care of a qualifying individual incurred to enable the
taxpayer to be gainfully employed, other than expenses incurred
for an overnight camp. For example, amounts paid for the
services of a housekeeper generally qualify if such services
are performed at least partly for the benefit of a qualifying
individual; amounts paid for a chauffeur or gardener do not
qualify.
Expenses that may be taken into account in computing the
credit generally may not exceed an individual's earned income
or, in the case of married taxpayers, the earned income of the
spouse with the lesser earnings. Thus, if one spouse is not
working, no credit generally is allowed. Also, the amount of
expenses eligible for the dependent care credit is reduced,
dollar for dollar, by the amount of expenses excludable from
that taxpayer's income under the dependent care exclusion
(discussed below).
The 30-percent credit rate is reduced, but not below 20
percent, by 1 percentage point for each $2,000 (or fraction
thereof) of adjusted gross income (AGI) above $10,000. Because
married couples are required to file a joint return to claim
the credit, a married couple's combined AGI is used for
purposes of this computation.
Effect of Provision
From 1976 to 1994, the number of families that claimed the
dependent care credit increased from 2.7 to 6.0 million, the
aggregate amount of credits claimed increased from $0.5 to $2.5
billion, and the average amount of credit claimed per family
increased from $206 to $420 (see table 13-15). In 1997, 6.1
million families are expected to claim an average credit of
$448, for a total of $2.7 billion.
TABLE 13-15.--DEPENDENT CARE TAX CREDIT: NUMBER OF FAMILIES AND AMOUNT
OF CREDIT, 1976-98
------------------------------------------------------------------------
Number of
returns Aggregate Average
claiming amount of credit
Year dependent credit claimed per
credit claimed return
(thousands) (millions)
------------------------------------------------------------------------
1976............................. 2,660 $548 $206
1977............................. 2,910 521 179
1978............................. 3,431 654 191
1979............................. 3,833 793 207
1980............................. 4,231 956 226
1981............................. 4,578 1,148 251
1982............................. 5,004 1,501 300
1983............................. 6,367 2,051 322
1984............................. 7,456 2,649 351
1985............................. 8,417 3,127 372
1986............................. 8,950 3,398 380
1987............................. 8,520 3,438 404
1988............................. 9,023 3,813 423
1989............................. 6,028 2,440 405
1990............................. 6,144 2,549 415
1991............................. 5,896 2,521 427
1992............................. 5,980 2,527 433
1993............................. 6,090 2,559 419
1994............................. 6,012 2,526 420
1995............................. 5,964 2,518 445
1996............................. 6,003 2,663 444
1997 \1\......................... 6,063 2,714 448
1998 \2\......................... 6,124 2,770 452
------------------------------------------------------------------------
\1\ Preliminary.
\2\ Projected.
Source: Joint Committee on Taxation.
Changes made in the Family Support Act of 1988 reduced the
use of the credit in 1989. The number of families who claimed
the credit dropped by about one-third and the amount of credit
claimed declined by $1.373 billion.
Data for 1995 from the Internal Revenue Service show that
about 13 percent of the benefit from the credit accrues to
families with AGI of less than $20,000; about 47 percent to
families with AGI between $20,000