SECTION 14. TAX PROVISIONS RELATED TO RETIREMENT, HEALTH, POVERTY, EMPLOYMENT, DISABILITY AND OTHER SOCIAL ISSUES CONTENTS Introduction Tax Provisions Use of Distributional Analysis Tax Provision Estimates Net Exclusion of Pension Contributions and Earnings Legislative History Explanation of Provision Effect of Provision Coverage Trends in Coverage Individual Retirement Plans Legislative History Explanation of Provision Effect of Provision Exclusion of Social Security and Railroad Retirement Benefits Legislative History Explanation of Provision Effect of Provision Exclusion of Employer Contribution for Medical Insurance Premiums and Medical Care Legislative History Explanation of Provision Effect of Provision Medical Savings Accounts Explanation of Provision Cafeteria Plans Legislative History Explanation of Provision Effect of Provision Health Care Continuation Rules Legislative History Explanation of Provision Group Health Plan Requirements Explanation of Provision Tax Benefits for Long-Term Care Insurance and Accelerated Death Benefits Legislative History Explanation of Provision Deduction for Health Insurance Expenses of Self-Employed Individuals Explanation of Provision Exclusion of Medicare Benefits Legislative History Explanation of Provision Deductibility of Medical Expenses Legislative History Explanation of Provision Effect of Provision Earned Income Credit Legislative History Explanation of Provision Interaction with Means-Tested Programs Effect of Provision Exclusion of Public Assistance and SSI Benefits Legislative History Explanation of Provision Dependent Care Tax Credit Legislative History Explanation of Provision Effect of Provision Exclusion for Employer-Provided Dependent Care Legislative History Explanation of Provision Effect of Provision Work Opportunity Tax Credit Explanation of Provision Exclusion of Workers' Compensation and Special Benefits for Disabled Coal Miners Legislative History Explanation of Provision Additional Standard Deduction for the Elderly and Blind Legislative History Explanation of Provision Effect of Provision Tax Credit for the Elderly and Certain Disabled Individuals Legislative History Explanation of Provision Effect of Provision Tax Provisions Related to Housing Owner-Occupied Housing Low-Income Housing Credit The Effect of Tax Provisions on the Income and Taxes of the Elderly and the Poor Hypothetical Tax Calculations for Selected Families Tax Treatment of the Elderly Distribution of Family Income and Taxes Federal Tax Treatment of Families in Poverty Tax Credit and Exclusion for Adoption Expenses INTRODUCTION The preceding sections of this publication discuss direct payments to individuals for retirement, health, public assistance, employment, and disability benefits provided through entitlement programs within the jurisdiction of the Committee on Ways and Means. The Federal Government also provides benefits to individuals through elements of the income tax set forth in the Internal Revenue Code of 1986 (``The Code''). The Code is entirely within the jurisdiction of the Committee on Ways and Means. Tax Provisions Several different types of income tax provisions are available to provide economic incentives. Examples include: exclusions, exemptions, deductions, preferential rates, deferrals and credits. Measuring the amount of benefit afforded by a tax provision is difficult. However, one way to measure the benefit is to review the total estimated amounts excluded, exempted, or otherwise afforded special treatment under various provisions of the income tax. Use of Distributional Analysis Analyzing the effectiveness of tax provisions at achieving their policy goals often involves examining the distribution of benefits from the provisions allocated by the income class of those who take advantage of the provisions. The income concept used to show the distribution of tax expenditures by income class is adjusted gross income plus: (1) tax-exempt interest; (2) employer contributions for health plans and life insurance; (3) employer share of FICA taxes; (4) workers' compensation; (5) nontaxable Social Security benefits; (6) insurance value of Medicare benefits; (7) minimum tax preferences; and (8) excluded income of U.S. citizens living abroad. This definition of income includes items that clearly increase the ability to pay taxes, but that are not included in the definition of adjusted gross income. However, it omits certain items that clearly affect ability to consume goods and services either now or in the future, including accrual of pension benefits, other fringe benefits (such as military benefits, veterans benefits, and parsonage allowances), and means-tested transfer payments (such as AFDC, Supplemental Security Income, food stamps, housing subsidies, and general assistance). The tax return is the unit of analysis. Table 14-1 shows the distribution of all tax returns for 1995 by income class. Unless specifically indicated, all distributional tables exclude returns filed by dependents. All projections of income and deduction items and tax parameters are based on economic assumptions consistent with the December 1995 forecast of the Congressional Budget Office. Tax Provision Estimates Table 14-2 estimates the 25 tax provisions related to retirement, health, poverty, employment, disability, and housing. These provisions are examined in detail in this chapter including their legislative history, an explanation of current law, and a brief assessment of their effects. TABLE 14-1.--DISTRIBUTION OF TAX RETURNS BY INCOME CLASS, 1995 [Money amounts in millions of dollars, returns in thousands] ---------------------------------------------------------------------------------------------------------------- All returns Taxable Itemized Tax Income class (thousands) \1\ \2\ returns returns liability ---------------------------------------------------------------------------------------------------------------- Below $10................................................... 22,750 2,324 157 -$5,442 $10-$20..................................................... 25,752 9,538 899 -1,870 $20-$30..................................................... 20,735 13,669 2,058 18,777 $30-$40..................................................... 16,649 14,202 3,489 35,921 $40-$50..................................................... 12,208 11,674 4,179 42,732 $50-$75..................................................... 17,703 17,566 9,861 99,675 $75-$100.................................................... 7,817 7,790 6,174 78,062 $100-$200................................................... 5,833 5,817 5,233 114,829 $200 and over............................................... 1,568 1,565 1,469 184,398 --------------------------------------------------- Total................................................... 131,015 84,145 33,519 567,081 ---------------------------------------------------------------------------------------------------------------- \1\ The income concept is defined on the preceding page of this chapter. \2\ Includes filing and nonfiling units. Filing units include all taxable and nontaxable returns. Nonfiling units include individuals with income that is exempt from Federal income taxation (e.g., transfer payments, interest from tax-exempt bonds, etc.). Note.--Detail may not add to total due to rounding. Source: Joint Committee on Taxation. NET EXCLUSION OF PENSION CONTRIBUTIONS AND EARNINGS Legislative History Prior to 1921, no special tax treatment applied to employee retirement trusts. Retirement payments to employees and contributions to pension trusts were deductible by the employer as an ordinary and necessary business expense. Employees were taxed on amounts actually received as well as on employer contributions to a trust if there was a reasonable expectation of benefits accruing from the trust. The 1921 Code provided an exemption for a trust forming part of a qualified profit sharing or stock bonus plan. The rules relating to qualified plans were substantially revised by the Employee Retirement Income Security Act of 1974 (ERISA), which added overall limitations on contributions and benefits and other requirements on minimum participation, coverage, vesting, benefit accrual, and funding. Further revisions of these rules have been made in every major tax bill enacted after 1974. Since ERISA, Congress has also acted to broaden the range of qualified plans. In the Revenue Act of 1978, Congress provided special rules for qualified cash or deferred arrangements under section 401(k). Under these arrangements, known popularly as 401(k) plans, employees can elect to receive cash or have their employers contribute a portion of their earnings to a qualified profit sharing, stock bonus, or pre- ERISA money purchase pension plan. TABLE 14-2.--ESTIMATED TAX BASE EXCEPTIONS AND CREDITS UNDER THE PRESENT INCOME TAX FOR VARIOUS ITEMS, \1\ CALENDAR YEARS 1997-2001 [In billions of dollars] ---------------------------------------------------------------------------------------------------------------- Item 1997 1998 1999 2000 2001 1997-2001 ---------------------------------------------------------------------------------------------------------------- I. Tax base exceptions related to: Retirement: Net exclusion of pension contributions and earnings......... $312.4 $324.9 $337.5 $350.8 $342.6 $1,668.2 Keogh plans......................... 18.4 19.6 20.8 22.2 23.6 104.6 Individual retirement plans......... 40.8 42.8 44.9 47.2 49.8 225.5 Exclusion of Social Security and railroad retirement benefits in excess of employee share of payroll tax \2\............................ 255.2 264.8 274.9 285.2 296.0 1,376.1 Health: Exclusions of employer contributions for medical care, health insurance premiums and long-term care insurance premiums \3\............. 304.9 329.3 352.5 378.3 404.5 1,769.5 Exclusion of Medicare benefits: Medicare part A................. 129.1 139.9 151.6 164.2 177.9 762.7 Medicare part B................. 62.5 69.4 77.0 85.5 94.8 389.2 Deductibility of medical expenses \4\................................ 35.5 39.0 42.7 46.8 51.4 215.4 Deductibility of health insurance expenses of the self employed \5\.. 5.0 6.3 6.8 7.5 8.2 33.7 Exclusion of accelerated death benefits........................... 0.7 1.1 1.4 1.7 2.1 7.0 Poverty: Exclusion of public assistance and SSI cash benefits.................. 55.4 55.9 58.8 62.0 58.4 290.5 Employment: Exclusion of employer-provided dependent care \6\................. 4.5 5.2 6.0 6.6 7.2 29.5 Employee stock ownership plans (ESOPs)............................ 10.3 11.1 12.1 13.2 14.1 60.8 Exclusion for benefits provided under cafeteria plans \7\.......... 25.7 29.6 33.3 36.6 40.2 165.5 Elderly and disabled: Exclusion of workers' compensation and special benefits for disabled coal miners: Workers' compensation........... 30.4 31.2 32.0 32.9 33.8 160.3 Special benefits for disabled coal miners.................... 0.4 0.4 0.4 0.4 0.4 2.0 Additional standard deduction for elderly and blind.................. 11.2 12.3 13.0 13.9 14.6 65.0 Housing: Deductibility of mortgage interest.. 159.1 164.0 168.7 174.1 179.7 845.6 Deductibility of property tax on owner-occupied housing............. 64.7 68.0 71.7 75.3 79.5 359.1 Deferral of capital gain on sale of principal residence................ 76.4 77.2 77.9 78.7 79.5 389.7 Exclusion of capital gain on sale of residence of persons 55 and over... 20.9 21.5 22.2 22.8 23.5 111.0 Exclusion of interest on State and local government bonds for owner- occupied housing................... 9.6 9.7 10.0 10.2 10.3 49.8 Depreciation of rental housing in excess of alternative depreciation system............................. 10.1 9.2 8.4 8.4 8.8 44.9 Exclusion of interest on State and local government bonds for rental housing............................ 4.5 4.6 4.8 4.9 4.9 23.8 II. Tax credits related to: Poverty: Earned income credit: Nonrefundable portion........... 3.6 3.9 3.9 4.5 4.9 20.8 Refundable portion.............. 22.4 23.1 24.4 25.4 26.2 121.5 Employment: Dependent care credit............... 2.8 2.9 2.9 3.0 3.0 14.6 Work opportunity tax credit......... 0.1 0.2 0.1 (\8\) (\8\) 0.4 Elderly and disabled: Tax credit for elderly and disabled. (\8\) (\8\) (\8\) (\8\) (\8\) 0.1 Housing: Low-income housing tax credit....... 2.8 3.2 3.5 3.9 4.5 17.9 ---------------------------------------------------------------------------------------------------------------- \1\ Estimates of exclusions and deductions represent changes in the tax base; they do not measure changes in tax liability. Tax effects of provisions are not comparable. \2\ In addition to OASDI benefits for retired workers, these figures also include disability insurance benefits, and benefits for dependents and survivors. \3\ Estimate includes employer-provided health insurance purchased through cafeteria plans and health care spending through flexible spending accounts. \4\ Amounts reported on tax returns in excess of the medical deductions floor (7.5 percent of adjusted gross income). \5\ Amounts deductible from gross income (40 percent of health insurance expenses in 1997 and 45 percent in 1998- 2001). Remaining amounts are deductible on schedule A with other itemized medical expenses. \6\ Estimate includes employer-provided child care purchased through dependent care flexible spending accounts. \7\ Estimate includes amounts of employer-provided health insurance purchased through cafeteria plans and employer-provided child care purchased through flexible spending accounts. These amounts are also included in other line items in this table. \8\ Less than $50 million. Note.--Details may not add to totals due to rounding. Source: Joint Committee on Taxation. An employee stock ownership plan (ESOP) is a special type of qualified plan that is designed to invest primarily in securities of the employer maintaining the plan. Certain qualification rules and tax benefits apply to ESOPs that do not apply to other types of qualified plans. Explanation of Provision In general Under a plan of deferred compensation that meets the qualification standards of the Internal Revenue Code (sec. 401(a)), an employer is allowed a deduction for contributions to a tax-exempt trust to provide employee benefits. Similar rules apply to plans funded with annuity contracts. An employer that makes contributions to a qualified plan in excess of the deduction limits is subject to a 10-percent excise tax on such excess (sec. 4972). The qualification rules limit the amount of benefits that can be provided through a qualified plan and require that benefits be provided on a basis that does not discriminate in favor of highly compensated employees. In addition, qualified plans are required to meet minimum standards relating to participation (the restrictions that may be imposed on participation in the plan), coverage (the number of employees participating in the plan), vesting (the time at which an employee's benefit becomes nonforfeitable), and benefit accrual (the rate at which an employee earns a benefit). Also, minimum funding standards apply to the rate at which employer contributions are required to be made to certain plans to ensure the solvency of pension plans. If a defined benefit pension plan is terminated, any assets remaining after satisfaction of the plan's liabilities may revert to the employer. Such reversions are included in the gross income of the employer and are subject to income tax plus an additional excise tax payable by the employer (sec. 4980). The excise tax is 20 percent if the employer establishes a qualified replacement plan or provides certain benefit increases. Otherwise, the excise tax is 50 percent. Transfers of excess assets can be made from an ongoing defined benefit plan to pay certain retiree health benefits if certain requirements are satisfied (sec. 420). The assets transferred are not includable in the income of the employer or subject to the tax on reversions. Minimum participation rules A qualified plan generally may not require as a condition of participation that an employee complete more than 1 year of service or be older than age 21 (sec. 410(a)). Vesting rules A plan is not a qualified plan unless a participant's employer-provided benefit vests at least as rapidly as under one of two alternative minimum vesting schedules (sec. 411). Benefit accrual rules The protection afforded employees under the minimum vesting rules depends not only on the minimum vesting schedules, but also on the accrued benefits to which these schedules are applied. In the case of a defined contribution plan, the accrued benefit is the participant's account balance. In the case of a defined benefit plan, a participant's accrued benefit is determined under the plan benefit formula, subject to certain restrictions. In general, the accrued benefit is defined in terms of the benefit payable at normal retirement age and does not include certain ancillary nonretirement benefits. Each defined benefit plan is required to satisfy one of three accrued benefit tests. The primary purpose of these tests is to prevent undue backloading of benefit accruals (i.e., by providing low rates of benefit accrual in the employee's early years of service when the employee is most likely to leave and by concentrating the accrual of benefits in the employee's later years of service when he is most likely to remain with the employer until retirement) (sec. 412). Coverage rules A plan is not qualified unless the plan satisfies at least one of the following coverage requirements: (1) the plan benefits at least 70 percent of all nonhighly compensated employees, (2) the plan benefits a percentage of nonhighly compensated employees that is at least 70 percent of the percentage of highly compensated employees benefiting under the plan, or (3) the plan meets an average benefits test (sec. 410(b)). In addition, a plan is not a qualified plan unless it benefits the lesser of (1) 50 employees or (2) 40 percent of the employees of the employer (sec. 401(a)(26)). For years beginning after 1996, pursuant to the Small Business Job Protection Act of 1996, the latter rule is modified to apply only to defined benefit plans. For years beginning after 1996, a defined benefit plan is not a qualified plan unless it benefits at least the lesser of (1) 50 employees, or (2) the greater of (a) 40 percent of the employees of the employer or (b) 2 employees (or if there is only 1 employee, such employee). General nondiscrimination rule In general, a plan is not a qualified plan if the contributions or benefits under the plan discriminate in favor of highly compensated employees (sec. 401(a)(4)). Limitations on contributions and benefits The maximum annual benefit that may be provided by a defined benefit pension plan (payable at the Social Security retirement age) is the lesser of (1) 100 percent of average compensation, or (2) $120,000 for 1996 (sec. 415(b)). The dollar limit is adjusted annually for inflation. The dollar limit is reduced if payments of benefits begin before the Social Security retirement age and increased if benefits begin after the Social Security retirement age. Funding rules Pension plans are required to meet a minimum funding standard for each plan year (sec. 412). In the case of a defined benefit pension plan, an employer must contribute an annual amount sufficient to fund a portion of participants' projected benefits determined in accordance with one of several prescribed funding methods, using reasonable actuarial assumptions. Plans with asset values of less than 100 percent of current liabilities are subject to additional, faster funding rules. Taxation of distributions An employee who participates in a qualified plan is taxed when the employee receives a distribution from the plan to the extent the distribution is not attributable to employee contributions (sec. 402). With certain exceptions, a 10-percent additional income tax is imposed on early distributions from a qualified plan (sec. 72(t)). A 15-percent excise tax is imposed on distributions that exceed a certain amount in any year (sec. 4980A). The Small Business Job Protection Act of 1996 temporarily waives this 15-percent excise tax for distributions in 1997, 1998, and 1999. Failure to satisfy qualification requirements If a plan fails to satisfy the qualification requirements, the trust that holds the plan's assets is not tax exempt. An employer's deduction for plan contributions is only allowed when the employee includes the contributions or benefits in income, and benefits generally are includable in an employee's income when they are no longer subject to a substantial risk of forfeiture. SIMPLE retirement plans The Small Business Job Protection Act of 1996 creates a simplified retirement plan for small business called the savings incentive match plan for employees (``SIMPLE'') (secs. 408(p) and 401(k)(11)). SIMPLE plans may be adopted by employers with 100 or fewer employees and who do not maintain another employer-sponsored retirement plan. A SIMPLE plan can be either an individual retirement arrangement (``IRA'') for each employee or part of a qualified cash or deferred arrangement (``401(k) plan''). If established in IRA form, a SIMPLE plan is not subject to the nondiscrimination rules generally applicable to qualified plans and simplified reporting requirements apply. If adopted as part of a 401(k) plan, the plan does not have to satisfy the special nondiscrimination tests applicable to 401(k) plans and is not subject to the top-heavy rules. The other qualified plan rules continue to apply. SIMPLE plans are subject to special rules regarding eligibility of employees to participate and special contribution limits. Effect of Provision The tax treatment of pension contributions and earnings has encouraged employers to establish qualified retirement plans and to compensate employees in the form of pension contributions to such plans. There are two potential tax advantages of being compensated through pension contributions. One advantage is the ability to earn tax-free returns to savings. When saving is done through a pension plan, the employee earns a higher rate of return than on fully taxed savings. \1\ The second advantage is that an employee's tax rate may be lower during retirement than during the working years. --------------------------------------------------------------------------- \1\ This applies to pension contributions made by employers. Employees may also be able to contribute to qualified plans. Employee contributions may be made with aftertax dollars. If so, the tax advantage given to these contributions is smaller than the tax advantage given to employer contributions, and consists of the deferral of tax on accumulated earnings. --------------------------------------------------------------------------- These tax provisions directly benefit only persons who work for employers with qualified plans and who work for a sufficient period of time before their benefits vest in such plans. The current extent of this coverage and recent trends in coverage are described below. Coverage The term ``covered,'' as used here, means that an employee is accruing benefits in an employer pension or other retirement plan. The best current comprehensive evidence on pension coverage comes from a supplement to the April 1993 Current Population Survey (U.S. Department of Labor, 1994). The data referred to below come from that survey unless otherwise noted. As of April 1993, 63 percent of full-time wage and salary workers employed in the private sector reported that they worked in firms with an employer-sponsored pension plan. Half of the full-time wage and salary workers employed in the private sector were covered by an employer-sponsored pension plan. Most of these workers were covered by basic defined benefit or defined contribution plans (23 percent), and another 10 percent had both a basic plan and a 401(k) type contributory plan (see table 14-3). \2\ For another 17 percent, the 401(k) type plan was their only retirement plan. --------------------------------------------------------------------------- \2\ Some private-sector employees contribute to 403(b) tax- sheltered annuities instead of 401(k) plans. TABLE 14-3.--EMPLOYER SPONSORSHIP AND EMPLOYEE COVERAGE UNDER PENSION OR RETIREMENT PLAN, PRIVATE WAGE AND SALARY WORKERS [Percent of workers in firms with plans and percent of workers covered by plans] ------------------------------------------------------------------------ Total Full time Part time ------------------------------------------------------------------------ Employer sponsors plan........... 58 63 37 Basic pension only........... 24 24 23 Basic and 401(k) type........ 14 16 4 401(k) type only............. 21 23 10 Employer does not sponsor........ 35 32 49 Does not know.................... 7 5 14 Employee covered under plan...... 43 50 12 Basic pension only........... 20 23 7 Basic and 401(k) type........ 8 10 2 401(k) type only............. 15 17 4 Employee is not covered.......... 50 44 73 Does not know.................... 7 6 14 -------------------------------------- Number of private wage and salary workers (in thousands)................ 88,679 72,752 15,927 ------------------------------------------------------------------------ Source: U.S. Department of Labor, 1994, tables A2, B1, B2. Pension coverage varies substantially among full-time, privately employed workers. Differences depend on the age of the worker, job earnings, the industry of employment, and the size of the firm. Younger workers are much less likely to be covered by a pension than middle aged and older workers. Coverage rates rise steadily from 21 percent for those under age 25 to about 60 percent for those aged 40 or over. This pattern holds for both men and women. However, the jump in coverage for middle aged men is slightly larger than the increase for middle aged women (see table 14-4). TABLE 14-4.--DISTRIBUTION BY AGE AND GENDER, COVERAGE UNDER EMPLOYER- SPONSORED PENSION OR RETIREMENT PLAN, FULL-TIME PRIVATE WAGE AND SALARY WORKERS ------------------------------------------------------------------------ Percent covered Age (in years) -------------------------------------- Total Men Women ------------------------------------------------------------------------ Under 25......................... 21 19 22 25-29............................ 41 41 42 30-34............................ 50 50 51 35-39............................ 54 57 51 40-44............................ 58 61 54 45-49............................ 63 66 59 50-54............................ 61 60 62 55-59............................ 59 60 57 60-64............................ 56 59 52 65 or older...................... 46 54 34 -------------------------------------- Total...................... 50 51 48 ------------------------------------------------------------------------ Source: U.S. Department of Labor, 1994, table B5. Higher paying jobs are more likely to offer pensions. Just 8 percent of full-time private wage and salary workers earning less than $10,000 per year in 1993 were covered compared to 81 percent of those earning $50,000 or more (see table 14-5). Coverage may be higher for higher paying jobs because of the greater value of the pension tax benefits to workers in higher tax brackets and because of the declining replacement rate of Social Security at higher earnings levels. Industries with high pension coverage include manufacturing, mining, financial services, and communications and public utilities. Coverage rates exceed 60 percent for full-time private wage and salary workers in each of these industries (U.S. Department of Labor, 1994, pp. B-8 & B-9). In contrast, coverage rates are under 35 percent in agriculture, retail trade, and construction. Part of the difference among industries appears to be due to differences in firm size. Coverage is much lower for smaller firms. Smaller firms are less likely to offer comprehensive fringe benefit packages as part of total compensation. Only 13 percent of full-time private wage and salary workers in firms with fewer than 10 employees are covered. The rate rises with employer size but does not reach 50 percent (the average across all firm sizes) until firms have 100 or more employees (table 14-6). TABLE 14-5.--DISTRIBUTION BY WORKERS' WAGES, COVERAGE UNDER EMPLOYER- SPONSORED PENSION OR RETIREMENT PLAN, FULL-TIME PRIVATE WAGE AND SALARY WORKERS ------------------------------------------------------------------------ Percent covered Wages -------------------------------------- Total Men Women ------------------------------------------------------------------------ Under $10,000.................... 8 7 9 $10,000-$14,999.................. 27 21 31 $15,000-$19,999.................. 42 35 49 $20,000-$24,999.................. 57 51 65 $25,000-$29,999.................. 62 61 64 $30,000-$34,999.................. 67 66 71 $35,000-$39,999.................. 73 74 72 $40,000-$49,999.................. 78 79 77 $50,000-$74,999.................. 81 81 80 $75,000 or over.................. 81 82 78 -------------------------------------- Total \1\.................. 50 51 48 ------------------------------------------------------------------------ \1\ Total includes workers not responding on wages, not shown separately. Source: U.S. Department of Labor, 1994, table B11. TABLE 14-6.--DISTRIBUTION BY SIZE OF FIRM, COVERAGE UNDER EMPLOYER- SPONSORED PENSION OR RETIREMENT PLAN, FULL-TIME PRIVATE WAGE AND SALARY WORKERS ------------------------------------------------------------------------ Percent covered Firm size (number of workers) -------------------------------------- Total Men Women ------------------------------------------------------------------------ Fewer than 10.................... 13 12 14 10-24............................ 25 23 28 25-49............................ 30 32 27 50-99............................ 42 46 37 100-249.......................... 53 57 49 250-499.......................... 62 66 57 500-999.......................... 62 66 58 1,000 or more.................... 73 76 70 -------------------------------------- Total \1\.................... 50 51 48 ------------------------------------------------------------------------ \1\ Total includes workers not responding or for whom firm size is unknown, not shown separately. Source: U.S. Department of Labor, 1994, table B9. Significant differences in coverage also are apparent between full-time private wage and salary workers and other wage and salary workers. Coverage is much lower among part-time workers and much higher among public employees. Among part- time, private wage and salary workers, 12 percent are covered. Seventy-seven percent of public sector wage and salary workers are covered including 85 percent of those who are full-time workers (see table 14-7). TABLE 14-7.--COVERAGE OF WAGE AND SALARY WORKERS UNDER EMPLOYER- SPONSORED PENSION OR RETIREMENT PLAN, BY SECTOR AND WORK STATUS ------------------------------------------------------------------------ Percent covered Sector -------------------------------------- Total Full time Part time ------------------------------------------------------------------------ All wage and salary workers...... 49 56 15 Men.......................... 51 56 9 Women........................ 46 56 17 Private sector................... 43 50 12 Men.......................... 46 51 8 Women........................ 39 48 15 Public sector.................... 77 85 30 Men.......................... 80 86 22 Women........................ 74 84 33 ------------------------------------------------------------------------ Source: U.S. Department of Labor, 1994, table B1. Trends in Coverage At the outset of World War II, private employer pensions were offered by about 12,000 firms. Pensions spread rapidly during and after the war, encouraged by high marginal tax rates and wartime wage controls that exempted pension benefits. By 1972, when the first comprehensive survey was undertaken, 48 percent of full-time private employees were covered. Subsequent surveys found that coverage reached 50 percent in 1979, but by 1983 had fallen back to 48 percent. The decline continued in the 1980s, reaching 46 percent in 1988 (Woods, 1989, p. 17). By 1993, coverage had returned to 50 percent. The decline in coverage in the 1980s was concentrated among younger men. The coverage rate among older men has fallen less dramatically, and among women it has risen at some ages and fallen at others. The decline in pension coverage has occurred at the same time that employers have been shifting from defined benefit plans. Defined benefit plans provided basic plan coverage for 87 percent of private wage and salary workers in 1975 (Turner & Beller, 1989, pp. 65 & 357). This proportion dropped to 83 percent by 1980 and to 71 percent by 1985. This shifting composition has largely been the result of rapid growth in primary defined contribution plans. Employee stock ownership plans and 401(k) plans have been among the most rapidly growing defined contribution plans. INDIVIDUAL RETIREMENT PLANS Legislative History ERISA added section 219 of the Internal Revenue Code, providing a tax deduction for certain contributions to individual retirement arrangements (IRAs) and permitting the deferral of tax on amounts held in such arrangements until withdrawal. Active participants in employer plans were not permitted to make deductible IRA contributions. The Economic Recovery Tax Act of 1981 expanded eligibility to individuals who were active participants and increased the amount of the permitted deduction. The Tax Reform Act of 1986 limited the full IRA deduction to individuals with income below certain levels and to individuals who are not active participants in employer plans. Individuals who are not entitled to the full IRA deduction may make nondeductible contributions to an IRA. The Small Business Job Protection Act of 1996 increased contributions that can be made to the IRA of a nonworking spouse. Explanation of Provision An individual who is an active participant in an employer plan may deduct IRA contributions up to the lesser of $2,000 or 100 percent of compensation if the individual's adjusted gross income (AGI) does not exceed $25,000 for an unmarried individual, $40,000 for a married couple filing a joint return, and $0 for a married individual filing separately. A couple is not treated as married if the spouses file separate returns and do not live together at any time during the year. The deduction is phased out over the following AGI ranges: (1) $25,000- $35,000 for unmarried individuals, (2) $40,000-$50,000 for married individuals filing a joint return, and (3) 0-$10,000 for married individuals filing separate returns. An individual is entitled to make nondeductible contributions to the extent deductible contributions are disallowed as a result of the phaseout. For years beginning before 1997, the $2,000 limit on IRA contributions is increased to $2,250 if a contribution is made on behalf of the individual's nonworking spouse. For years beginning after 1996, deductible contributions of up to $2,000 can be made for each spouse (including a nonworking spouse) if the combined compensation of both spouses is at least equal to the contributed amount. An individual who is not an active participant in an employer plan may deduct IRA contributions up to the limits described above without limitation based on income. The investment income of IRA accounts is not taxed until withdrawn. Withdrawn amounts attributable to deductible contributions and all earnings are includable in income. A 10- percent additional income tax is levied unless the withdrawal (1) is made after the IRA owner attains age 59\1/2\ or dies, (2) is made on account of the disability of the IRA owner, (3) is one of a series of substantially equal periodic payments made not less frequently than annually over the life or life expectancy of the IRA owner (or the IRA owner and his or her beneficiary), or (4) is made after 1996 and is used to pay for medical expenses in excess of 7.5 percent of adjusted gross income or for insurance premiums for unemployed individuals. Effect of Provision Use of IRAs expanded significantly when eligibility was expanded in 1982 to all persons with earnings and contracted correspondingly in 1987 when deductibility was restricted for higher income taxpayers who were covered by an employer- provided pension. The number of taxpayers claiming a deductible IRA contribution jumped from 3.4 million in 1981 to 12.0 million in 1982 and to 15.5 million in 1986. In 1987, only 7.3 million taxpayers reported deductible contributions. Since then, the number has continued to fall (see table 14-8). TABLE 14-8.--USE OF DEDUCTIBLE IRAs FROM 1980-94 ------------------------------------------------------------------------ Number of tax returns Total IRA Year deducting IRA deductions contributions (billions) (millions) ------------------------------------------------------------------------ 1980.................................. 2.6 $3.4 1981.................................. 3.4 4.8 1982.................................. 12.0 28.3 1983.................................. 13.6 32.1 1984.................................. 15.2 35.4 1985.................................. 16.2 38.2 1986.................................. 15.5 37.8 1987.................................. 7.3 14.1 1988.................................. 6.4 11.9 1989.................................. 5.8 10.8 1990.................................. 5.2 9.9 1991.................................. 4.7 9.0 1992.................................. 4.5 8.7 1993.................................. 4.4 8.5 1994.................................. 4.3 8.4 ------------------------------------------------------------------------ Source: Internal Revenue Service, Statistics of Income, 1980 to 1994. Upper-income taxpayers facing higher marginal tax rates receive more benefit per dollar of IRA deduction than do low- income taxpayers facing lower marginal tax rates. When IRAs were available to all workers the percentage of taxpayers contributing to an IRA was substantially higher among taxpayers with higher income. For example, in 1985, 13.6 percent of taxpayers with AGI between $10,000 and $30,000 contributed to an IRA compared with 74.1 percent of taxpayers with AGI between $75,000 and $100,000. The decline in IRA use between 1985 and 1990 among those with AGI between $10,000 and $30,000 appears to be larger than the reduction required by the change in law, since the restrictions on deductible contributions apply only to a small fraction of taxpayers with AGI below $30,000. Eligibility percentages and the real value of the IRA contribution limits decline over time because present law does not index the contribution limits or the income eligibility limits for inflation. For example, the real value of a $2,000 contribution has declined more than 30 percent since 1986 because of inflation. Congress established IRAs to allow workers not covered by employer pension plans to have tax-advantaged retirement saving. Nonetheless, since 1981 IRA participation rates have been higher among those covered by an employer-provided pension plan than those without one, and many of those who are not covered by a pension plan do not contribute to an IRA. In 1987, 10 percent of full-time private-sector earners without pension coverage contributed to an IRA, while 15 percent of those with coverage contributed (Woods, 1989, p. 9). EXCLUSION OF SOCIAL SECURITY AND RAILROAD RETIREMENT BENEFITS Legislative History The exclusion from gross income for Social Security benefits was not initially established by statute. Prior to the Social Security amendments of 1983, the exclusion was based on a series of administrative rulings issued by the Internal Revenue Service in 1938 and 1941. \3\ --------------------------------------------------------------------------- \3\ See I.T. 3194, 1938-1 C.B. 114; I.T. 3229, 1938-2 C.B. 136; and I.T. 3447, 1941-1 C.B. 191. --------------------------------------------------------------------------- Under the Social Security amendments of 1983, a portion of the Social Security benefits paid to higher income taxpayers is included in gross income. In 1993, the Omnibus Budget Reconciliation Act increased the amount of benefits subject to tax and increased the rate of tax for some benefit recipients. The exclusion from gross income of benefits paid under the Railroad Retirement System was enacted in the Railroad Retirement Act of 1935. A portion of the benefits payable under the Railroad Retirement System (generally, tier 1 benefits) is equivalent to Social Security benefits. The tax treatment of tier 1 railroad retirement benefits was modified in the Social Security amendments of 1983 to conform to the tax treatment of Social Security benefits. Other railroad retirement benefits are taxable in the same manner as employer-provided retirement benefits. The Consolidated Omnibus Budget Reconciliation Act of 1985 provided that tier 1 benefits are taxable in the same manner as Social Security benefits only to the extent that Social Security benefits otherwise would be payable. Other tier 1 benefits are taxable in the same manner as all other railroad retirement benefits (for further details, see section 4 above). Explanation of Provision For taxpayers whose ``modified adjusted gross income'' exceeds certain limits, a portion of Social Security and tier 1 railroad retirement benefits is included in taxable income. ``Modified adjusted gross income'' is adjusted gross income plus interest on tax-exempt bonds plus 50 percent of Social Security and tier 1 railroad retirement benefits. A two-tier structure applies. The base tier is $25,000 for unmarried individuals and $32,000 for married couples filing joint returns, and zero for married persons filing separate returns who do not live apart at all times during the taxable year. The amount of benefits includable in income is the lesser of (1) 50 percent of the Social Security and tier 1 railroad retirement benefits, or (2) 50 percent of the excess of the taxpayer's combined income over the base amount. The second tier applies to taxpayers with ``modified adjusted gross income'' of at least $34,000 (unmarried taxpayers) or $44,000 (married taxpayers filing joint returns). For these taxpayers, the amount of benefits includable in gross income is the lesser of (1) 85 percent of Social Security benefits, or (2) the sum of 85 percent of the amount by which modified adjusted gross income exceeds the second-tier thresholds, and the smaller of the amount included under prior law or $4,500 (unmarried taxpayers) or $6,000 (married taxpayers filing jointly). The portion of tier 1 railroad retirement benefits potentially includable in taxable income under the above formula is the amount of benefits the taxpayer would have received if covered under Social Security. Pursuant to section 72(r) of the Internal Revenue Code of 1986, all other benefits payable under the Railroad Retirement System are includable in income when received to the extent they exceed employee contributions. Effect of Provision About 23 percent of all Social Security recipients pay taxes on their benefits. This percentage is likely to increase over time because the thresholds are not adjusted annually for past inflation or other factors. EXCLUSION OF EMPLOYER CONTRIBUTION FOR MEDICAL INSURANCE PREMIUMS AND MEDICAL CARE Legislative History In 1943, the Internal Revenue Service (IRS) ruled that employer contributions to group health insurance policies were not taxable to the employee. Employer contributions to individual health insurance policies, however, were declared to be taxable income in an IRS revenue ruling in 1953. Section 106 of the Internal Revenue Code, enacted in 1954, reversed the 1953 IRS ruling. As a result, employer contributions to all accident or health plans generally are excluded from gross income and therefore are not subject to tax. Under section 105 of the Internal Revenue Code, benefits received under an employer's accident or health plan generally are not included in the employee's income. In the Revenue Act of 1978, Congress added section 105(h) to tax the benefits payable to highly compensated employees under a self-insured medical reimbursement plan if the plan discriminated in favor of highly compensated employees. Explanation of Provision Gross income of an employee generally excludes employer- provided coverage under an accident or health plan. The exclusion applies to coverage provided to former employees, their spouses, or dependents. Amounts excluded include those received by an employee for personal injuries or sickness if the amounts are paid directly or indirectly to reimburse the employee for expenses incurred for medical care. However, this exclusion does not apply in the case of amounts paid to a highly compensated individual under a self-insured medical reimbursement plan if the plan violates the nondiscrimination rules of section 105(h). Present law permits employers to prefund medical benefits for retirees. Postretirement medical benefits may be prefunded by the employer in two basic ways: (1) through a separate account in a tax-qualified pension plan (sec. 401(h)); or (2) through a welfare benefit fund (secs. 419 and 419A). Generally, the amounts contributed are excluded from the income of the plan or participants. Although amounts held in a section 401(h) account are accorded tax-favored treatment similar to assets held in a pension trust, the benefits provided under a section 401(h) account are required to be incidental to the retirement benefits provided by the plan. Amounts contributed to welfare benefit funds are subject to certain deduction limitations (secs. 419 and 419A). Additionally, the fund is subject to income tax relating to any set-aside to provide postretirement medical benefits. Effect of Provision The exclusion for employer-provided health coverage provides an incentive for compensation to be furnished to the employee in the form of health coverage, rather than in cash subject to current taxation. For example, an employer designing a compensation package for an employee would be indifferent between paying the employee one dollar in cash and purchasing one dollar's worth of health insurance for the employee. \4\ Because the employee is likely to pay Federal and state income taxes and payroll taxes on cash compensation and no tax on health insurance contributions made on his behalf, the employee would likely prefer that some compensation be in the form of health insurance. Employees subject to tax at the highest marginal tax rates have the greatest incentive to receive compensation in nontaxable forms. --------------------------------------------------------------------------- \4\ To the extent the employer bears a portion of the payroll tax, the employer may actually prefer to provide compensation through health insurance (which is not subject to payroll tax). --------------------------------------------------------------------------- The tax preference that the exclusion provides is substantial and has resulted in widespread access to health coverage. A majority of the population now receives health insurance as a consequence of their own employment or of a family member's employment. In 1993, for 59 percent of the population employment-based health insurance was the primary source of health coverage, while 6 percent purchased insurance privately, 13 percent received Medicare benefits, and 8 percent received Medicaid benefits. Fifteen percent of the population had no health insurance (Congressional Budget Office, 1994, p. 7). Health coverage through employer-based plans tends to be more prevalent in the manufacturing sector of the economy, among medium and large firms, and for more highly paid workers, especially those over the age of 30 (see table 14-9). TABLE 14-9.--PRIMARY SOURCE OF HEALTH INSURANCE FOR WORKERS UNDER AGE 65, BY DEMOGRAPHIC CATEGORY, 1994 ---------------------------------------------------------------------------------------------------------------- Percentage distribution by source of insurance Number of --------------------------------------------------------- Category workers Own Other Individual Public No (millions) employer employer policy insurance \1\ insurance ---------------------------------------------------------------------------------------------------------------- All workers............................... 123.0 56.9 13.0 8.6 3.6 17.9 Industry: Agriculture........................... 2.9 26.4 10.6 23.0 4.2 35.8 Construction.......................... 7.3 42.9 11.5 10.9 2.8 31.9 Finance............................... 7.7 66.3 13.7 8.4 1.5 10.2 Government............................ 5.6 79.3 7.6 3.5 2.4 7.2 Manufacturing......................... 20.1 73.1 6.7 4.3 1.9 13.9 Mining................................ 0.7 74.4 5.6 4.6 2.8 12.7 Retail trade.......................... 18.2 40.7 16.2 12.2 4.8 26.0 Services: Professional...................... 27.8 62.7 16.7 7.5 2.8 10.4 Other............................. 12.9 40.7 14.8 12.2 4.5 27.8 Transportation........................ 8.5 72.3 7.2 5.0 1.9 13.5 Wholesale trade....................... 4.3 64.5 10.9 7.8 2.2 14.6 Wage rate \2\ Below $5.00........................... 6.3 28.3 16.1 10.7 9.6 35.3 $5.00-$9.99........................... 33.9 55.9 14.4 6.4 2.6 20.7 $10.00-$14.99......................... 21.6 76.4 10.5 4.0 1.2 7.9 $15.00 or more........................ 23.9 83.9 9.2 2.4 0.4 4.2 Family income as percentage of poverty level: Under 100............................. 9.4 14.4 3.0 10.5 22.0 50.1 100-199............................... 19.6 39.8 8.0 9.9 6.4 36.0 200-299............................... 22.2 56.2 13.5 9.4 2.2 18.7 300 and over.......................... 71.7 67.4 15.6 7.7 0.9 8.4 Firm size (number of employees): Fewer than 10......................... 26.3 28.2 20.9 17.2 4.8 28.9 10-24................................. 12.0 44.1 14.9 11.3 4.1 25.6 25-99................................. 16.6 56.3 12.7 7.5 3.9 19.6 100-499............................... 17.7 65.9 10.5 5.5 3.2 14.8 500-999............................... 7.6 68.9 11.4 5.5 2.5 11.7 1,000 or more......................... 42.8 72.6 9.2 4.8 2.9 10.6 Age (years): Under 30.............................. 31.6 45.9 10.5 10.7 6.1 26.8 30-39................................. 37.4 58.7 13.5 7.0 3.1 17.3 40-49................................. 30.8 61.3 15.0 7.8 2.1 13.7 50-64................................. 23.2 63.4 13.2 9.2 2.2 12.0 ---------------------------------------------------------------------------------------------------------------- \1\ Public insurance includes Medicaid, Medicare, and coverage provided by the Department of Veterans Affairs. \2\ ``Wage'' is the hourly wage for hourly employees and earnings per week divided by hours worked for nonhourly employees. The figures exclude individuals for whom an hourly wage could not be determined. Source: Congressional Budget Office estimates based on the March 1994 Current Population Survey. MEDICAL SAVINGS ACCOUNTS Explanation of Provision The Health Insurance Portability and Accountability Act of 1996 included provisions for medical savings accounts (``MSAs''), effective for years beginning after December 31, 1996. Within limits, contributions to an MSA are deductible if made by an eligible individual and are excludable from income and employment taxes if made by the employer (other than contributions made through a cafeteria plan). Earnings on amounts in an MSA are not currently taxable. Distributions from an MSA for medical expenses are not includable in gross income. Distributions from an MSA that are not for medical expenses are includable in gross income and are subject to an additional tax of 15 percent, unless the distribution is made after death, disability, or age 65. Beginning in 1997, MSAs are available to employees covered under an employer-sponsored high deductible health plan of a small employer and to self-employed individuals covered under a high deductible health plan (regardless of the size of the entity for which the self-employed individual performs services). A small employer is generally defined as an employer with 50 or fewer employees. In order to be eligible for an MSA contribution, an otherwise eligible individual must be covered under a high deductible health plan and no other health plan. A high deductible health plan is a plan with an annual deductible of at least $1,500 and no more than $2,250 in the case of individual coverage (and at least $3,000 and no more than $4,500 in the case of family coverage). The dollar limits are indexed for inflation. High deductible plans must also meet certain limits on out-of-pocket expenses. The number of taxpayers benefiting annually from an MSA contribution is limited to a threshold level (generally, 750,000 taxpayers). If it is determined in a year that the threshold level has been exceeded (called a ``cutoff'' year) then, in general, for succeeding years during the 4-year pilot period 1997-2000, only those individuals who (1) made an MSA contribution or had an employer MSA contribution for the year or a preceding year (i.e., are active MSA participants) or (2) are employed by a participating employer, would be eligible for an MSA contribution. In determining whether the threshold for any year has been exceeded, MSAs of previously uninsured individuals are not taken into account. After December 31, 2000, no new contributions may be made to MSAs except by or on behalf of an individual who previously had MSA contributions and employees who are employed by a participating employer. Self-employed individuals who made contributions to an MSA during the period 1997-2000 also may continue to make contributions after 2000. CAFETERIA PLANS Legislative History Under present law, compensation generally is includable in gross income when received. An exception applies if an employee may choose between cash and certain employer-provided nontaxable benefits under a cafeteria plan. Prior to 1978, ERISA 1974 provided that an employer contribution made before January 1, 1977, to a cafeteria plan in existence on June 27, 1974, was required to be included in an employee's gross income only to the extent that the employee actually elected taxable benefits. If a plan did not exist on June 27, 1974, the employer contribution was to be included in income to the extent the employee could have elected taxable benefits. The Revenue Act of 1978 set up permanent rules for plans that offer an election between taxable and nontaxable benefits. The Deficit Reduction Act of 1984 (Public Law 98-369) clarified the types of employer-provided benefits that could be provided through a cafeteria plan, added a 25-percent concentration test, and required annual reporting to the IRS by employers. The Tax Reform Act of 1986 also modified the rules relating to cafeteria plans in several respects. Explanation of Provision A participant in a cafeteria plan (sec. 125) is not treated as having received taxable income solely because the participant had the opportunity to elect to receive cash or certain nontaxable benefits. In order to meet the requirements of section 125, the plan must be in writing, must include only employees (including former employees) as participants, and must satisfy certain nondiscrimination requirements. In general, a nontaxable benefit may be provided through a cafeteria plan if the benefit is excludable from the participant's gross income by reason of a specific provision of the Code. These include employer-provided health coverage, group-term life insurance coverage, and benefits under dependent care assistance programs. A cafeteria plan may not provide qualified scholarships or tuition reduction, educational assistance, miscellaneous employer-provided fringe benefits, or deferred compensation except through a qualified cash or deferred arrangement. If the plan discriminates in favor of highly compensated individuals regarding eligibility to participate, to make contributions, or to receive benefits under the plan, then the exclusion does not apply. For purposes of these nondiscrimination requirements, a highly compensated individual is an officer, a shareholder owning more than 5 percent of the employing firm, a highly compensated individual determined under the facts and circumstances of the case, or a spouse or dependent of the above individuals. Effect of Provision The optimal compensation of employees (in a tax planning sense) would require that employers and employees arrive at the compensation package that provides the largest aftertax benefit to the employee at minimum aftertax cost to the employer (see Scholes & Wolfson, 1992, chapter 10). Both the potential taxation of compensation provided to employees and the deductibility of compensation provided by the employer would be considered. If only income taxes were considered, employers would be indifferent between the payment of $1 in salary or wages and the payment of $1 in fringe benefits to an employee, because both types of compensation are fully deductible. When the employer payments for FICA and FUTA taxes are considered, the employer might actually find it less costly to compensate an employee with a dollar's worth of fringe benefit not subject to FICA and FUTA taxes rather than a dollar of wage or salary payments that have these taxes assessed on them. The employee, however, would prefer to be compensated in the form that provides the highest aftertax value. An additional dollar of salary or wage paid to the employee will be subject to tax. If a fringe benefit is excludable from the employee's income, the employee pays no tax on receipt of the benefit. Consequently, the employee receives greater compensation via the fringe benefit. This differential treatment of salary or wage payments and excludable fringe benefits implies that compensation packages designed to minimize the joint tax liability of employers and employees could include substantial amounts of excludable fringe benefits. Employees may have different preferences about the allocation of their compensation. For example, an employee with no dependents may place little value on employer-provided life insurance. Cafeteria plans permit employees some discretion as to the provided benefits, and will tend to be preferred to benefit plans in which all employees of the firm receive the identical benefit package. Cafeteria plans are a growing part of compensation plans, particularly for larger employers. The Bureau of Labor Statistics estimated that in 1991, 36 percent of employees at large and medium sized firms were eligible for flexible benefits and/or reimbursement accounts. This figure has grown from an estimated 5 percent in 1986 (see U.S. Bureau of Labor Statistics, forthcoming). Smaller firms generally do not offer cafeteria plans to their workers. For example, in 1992, only 14 percent of the workers in small, private establishments (nonfarm establishments with fewer than 100 employees) were eligible to participate in a cafeteria plan. The lower figure for smaller firms reflects in part the less generous fringe benefit packages provided by smaller firms. Like any income exclusion, the exclusion from gross income for cafeteria plan benefits can lead to disparities in the tax system. Employees with the same total compensation can have taxable incomes that are substantially different because of the form in which compensation is received. The exclusion for cafeteria plan benefits also may be used in some cases to avoid the 7.5 percent of AGI floor on deductible medical expenses. The use of cafeteria plans reduces the aftertax cost of health care to employees using these plans, which could cause these employees to purchase a larger amount of health care services. On the other hand, cafeteria plans could encourage employers to increase the share of premiums, copayments, and deductibles paid by employees, resulting in increased employee awareness of the costs of their health plans. This incentive could result in reduced health care costs. HEALTH CARE CONTINUATION RULES Legislative History The Consolidated Omnibus Budget Reconciliation Act of 1985 added sections 106(b), 162(i)(2), and 162(k) to the Internal Revenue Code under which certain group health plans are required to offer health coverage to certain employees and former employees, as well as to their spouses and dependents. Parallel requirements were added to title I of ERISA and the Public Health Services Act. If an employer failed to satisfy the health care continuation rules, the employer was denied a deduction for contributions to its group health plans and highly compensated employees were required to include in taxable income the employer-provided value of the coverage received under such plans. The Technical and Miscellaneous Revenue Act of 1988 made several changes to the health care continuation rules. Sections 106(b), 162(i)(2), and 162(k) were repealed and replaced by section 4980B. Section 4980B imposes an excise tax on the employer or other responsible party who fails to satisfy the rules instead of denying deductions and the exclusion. The Health Insurance Portability and Accountability Act of 1996 made some changes to the health care continuation rules in cases of disability. Explanation of Provision The health care continuation rules in section 4980B require that an employer provide qualified beneficiaries with the opportunity to participate for a specified period in the employer's health plan after that participation otherwise would have terminated. The qualifying events that may trigger rights to continuation coverage are: (1) the death of the employee; (2) the voluntary or involuntary termination of the employee's employment (other than by reason of gross misconduct); (3) a reduction of the employee's hours; (4) the divorce or legal separation of the employee; (5) the employee becoming entitled to benefits under Medicare; and (6) a dependent child of the employee ceasing to be a dependent under the employer's plan. The maximum period of continuation coverage is 36 months, except in the case of termination of employment or reduction of hours for which the maximum period is 18 months. The 18-month period is extended to 29 months in certain cases involving the disability of the qualified beneficiary. Certain events, such as the failure by the qualified beneficiary to pay the required premium, may trigger an earlier cessation of the continuation coverage. A beneficiary has a prescribed period of time during which to elect continuation coverage after the employee receives notice from the plan administrator of the right to continuation coverage. GROUP HEALTH PLAN REQUIREMENTS Explanation of Provision The Health Insurance Portability and Accountability Act of 1996 imposes certain requirements regarding health coverage portability through limitations on preexisting condition exclusions, prohibitions on excluding individuals from coverage based on health status, and guaranteed renewability of health insurance coverage. An excise tax is imposed with respect to failures of a group health plan to comply with the requirements. The tax is generally imposed on the employer sponsoring the plan. The amount of the tax is generally equal to $100 per day for each day during which the failure occurs until the failure is corrected. The maximum tax that can be imposed is generally the lesser of (1) 10 percent of the employer's payments during the taxable year in which the failure occurred under group health plans, or (2) $500,000. The Secretary of the Treasury may waive all or part of the tax to the extent that payment of the tax would be excessive relative to the failure involved (see discussion of health care continuation rules). TAX BENEFITS FOR ACCELERATED DEATH BENEFITS AND LONG-TERM CARE INSURANCE Legislative History Accelerated death benefits If a contract meets the definition of a life insurance contract, gross income does not include insurance proceeds that are paid pursuant to the contract by reason of the death of the insured (sec. 101(a)). In addition, the undistributed investment income (``inside buildup'') earned on premiums credited under the contract is not subject to current taxation to the owner of the contract. The exclusion under section 101 applies regardless of whether the death benefits are paid as a lump sum or otherwise. If a contract fails to be treated as a life insurance contract under section 7702(a), inside buildup on the contract is generally subject to tax (sec. 7702(g)). To qualify as a life insurance contract for Federal income tax purposes, a contract must be a life insurance contract under the applicable State or foreign law and must satisfy either of two alternative tests: (1) a cash value accumulation test or (2) a test consisting of a guideline premium requirement and a cash value corridor requirement (sec. 7702(a)). A contract satisfies the cash value accumulation test if the cash surrender value of the contract may not at any time exceed the net single premium that would have to be paid at such time to fund future benefits under the contract. A contract satisfies the guideline premium and cash value corridor tests if the premiums paid under the contract do not at any time exceed the greater of the guideline single premium or the sum of the guideline level premiums, and if the death benefit under the contract is not less than a varying statutory percentage of the cash surrender value of the contract. Long-term care insurance Prior to the Health Insurance Portability and Accountability Act of 1996, the tax law generally did not provide explicit rules relating to the tax treatment of long- term care insurance contracts or long-term care services. Thus, the treatment of long-term care contracts and services was unclear. Prior and present law provide rules relating to medical expenses and accident or health insurance. Amounts received by a taxpayer under accident or health insurance for personal injuries or sickness generally are excluded from gross income to the extent that the amounts received are not attributable to medical expenses that were allowed as a deduction for a prior taxable year (sec. 104). Explanation of Provision Accelerated death benefits The Health Insurance Portability and Accountability Act of 1996 provides an exclusion from gross income as an amount paid by reason of the death of an insured for (1) amounts received under a life insurance contract and (2) amounts received for the sale or assignment of a life insurance contract to a qualified viatical settlement provider, provided that the insured under the life insurance contract is either terminally ill or chronically ill. The exclusion provided by the act does not apply in the case of an amount paid to any taxpayer other than the insured, if such taxpayer has an insurable interest by reason of the insured being a director, officer or employee of the taxpayer, or by reason of the insured being financially interested in any trade or business carried on by the taxpayer. A terminally ill individual is defined as one who has been certified by a physician as having an illness or physical condition that reasonably can be expected to result in death within 24 months of the date of certification. A chronically ill individual is one who has been certified within the previous 12 months by a licensed health care practitioner as (1) being unable to perform (without substantial assistance) at least two activities of daily living for at least 90 days due to a loss of functional capacity, (2) having a similar level of disability as determined by the Secretary of the Treasury in consultation with the Secretary of Health and Human Services, or (3) requiring substantial supervision to protect such individual from threats to health and safety due to severe cognitive impairment. Activities of daily living are eating, toileting, transferring, bathing, dressing and continence. In the case of a chronically ill individual, the exclusion with respect to amounts paid under a life insurance contract and amounts paid in a sale or assignment to a viatical settlement provider applies if the payment received is for costs incurred by the payee (not compensated by insurance or otherwise) for qualified long-term care services for the insured person for the period, and two other requirements (similar to requirements applicable to long- term care insurance contracts) are met. The first requirement is that under the terms of the contract giving rise to the payment, the payment is not a payment or reimbursement of expenses reimbursable under Medicare (except where Medicare is a secondary payor under the arrangement, or the arrangement provides for per diem or other periodic payments without regard to expenses for qualified long-term care services). No provision of law shall be construed or applied so as to prohibit the offering of such a contract giving rise to such a payment on the basis that the contract coordinates its payments with those provided under Medicare. The second requirement is that the arrangement complies with those consumer protection provisions applicable to long-term care insurance contracts and issuers that are specified in Treasury regulations. Long-term care insurance Exclusion of long-term care insurance proceeds.--The Health Insurance Portability and Accountability Act of 1996 provides that a long-term care insurance contract generally is treated as an accident and health insurance contract. Amounts (other than policyholder dividends or premium refunds) received under a long-term care insurance contract generally are excludable as amounts received for personal injuries and sickness, subject to a dollar cap on aggregate payments under per diem contracts. A reporting requirement applies to payors of excludable amounts. The amount of the dollar cap on aggregate payments under per diem contracts with respect to any one chronically ill individual (who is not also terminally ill) is $175 per day ($63,875 annually) as indexed, reduced by the amount of reimbursements and payments received by anyone for the cost of qualified long-term care services for the chronically ill individual. If more than one payee receives payments with respect to any one chronically ill individual, then everyone receiving periodic payments with respect to the same insured is treated as one person for purposes of the dollar cap. The amount of the dollar cap is utilized first by the chronically ill person, and any remaining amount is to be allocated in accordance with Treasury regulations. If payments under such contracts exceed the dollar cap, then the excess is excludable only to the extent of actual costs (in excess of the dollar cap) incurred for long-term care services. Amounts in excess of the dollar cap, with respect to which no actual costs were incurred for long-term care services, are fully includable in income without regard to rules relating to return of basis under section 72. A grandfather rule applies to any per diem type contract issued to a policyholder on or before July 31, 1996. Exclusion for employer-provided long-term care coverage.--A plan of an employer providing coverage under a long-term care insurance contract generally is treated as an accident and health plan. Thus, employer-provided long-term care coverage is generally excludable from income and wages and deductible by the employer. Employer-provided coverage under a long-term care insurance contract is not, however, excludable by an employee if provided through a cafeteria plan; similarly, expenses for long-term care services cannot be reimbursed under a flexible spending arrangement. Definition of long-term care insurance contract.--A long- term care insurance contract is defined as any insurance contract that provides only coverage of qualified long-term care services and that meets other requirements. The other requirements are that (1) the contract is guaranteed renewable, (2) the contract does not provide for a cash surrender value or other money that can be paid, assigned, pledged or borrowed, (3) refunds (other than refunds on the death of the insured or complete surrender or cancellation of the contract) and dividends under the contract may be used only to reduce future premiums or increase future benefits, and (4) the contract generally does not pay or reimburse expenses reimbursable under Medicare (except where Medicare is a secondary payor, or the contract makes per diem or other periodic payments without regard to expenses). A contract does not fail to be treated as a long-term care insurance contract solely because it provides for payments on a per diem or other periodic basis without regard to expenses incurred during the period. Medicare duplication rules.--No provision of law shall be construed or applied so as to prohibit the offering of a long- term care insurance contract on the basis that the contract coordinates its benefits with those provided under Medicare. Definition of qualified long-term care services.--Qualified long-term care services means necessary diagnostic, preventive, therapeutic, curing, treating, mitigating and rehabilitative services, and maintenance or personal care services that are required by a chronically ill individual and that are provided pursuant to a plan of care prescribed by a licensed health care practitioner. Chronically ill individual.--A chronically ill individual is one who has been certified within the previous 12 months by a licensed health care practitioner as (1) being unable to perform (without substantial assistance) at least two activities of daily living for at least 90 days due to a loss of functional capacity, (2) having a similar level of disability as determined by the Secretary of the Treasury in consultation with the Secretary of Health and Human Services, or (3) requiring substantial supervision to protect such individual from threats to health and safety due to severe cognitive impairment. Activities of daily living are eating, toileting, transferring, bathing, dressing and continence. For purposes of determining whether an individual is chronically ill, the number of activities of daily living that are taken into account under the long-term care insurance contract may not be less than five. Expenses for long-term care services treated as medical expenses.--Unreimbursed expenses for qualified long-term care services provided to the taxpayer or the taxpayer's spouse or dependents are treated as medical expenses for purposes of the itemized deduction for medical expenses (subject to the present-law floor of 7.5 percent of adjusted gross income). For this purpose, amounts received under a long-term care insurance contract (regardless of whether the contract reimburses expenses or pays benefits on a per diem or other periodic basis) are treated as reimbursement for expenses actually incurred for medical care. For purposes of the deduction for medical expenses, qualified long-term care services do not include services provided to an individual by a relative or spouse (directly, or through a partnership, corporation, or other entity), unless the relative is a licensed professional with respect to such services, or by a related corporation (within the meaning of Code section 267(b) or 707(b)). Long-term care insurance premiums treated as medical expenses.--Long-term care insurance premiums that do not exceed specified dollar limits are treated as medical expenses for purposes of the itemized deduction for medical expenses. Consumer protection provisions.--Certain consumer protection provisions apply with respect to the terms of a long-term care insurance contract, for purposes of determining whether the contract is a qualified long-term care insurance contract. In addition, certain consumer protection provisions apply to issuers of long-term care insurance contracts. DEDUCTION FOR HEALTH INSURANCE EXPENSES OF SELF-EMPLOYED INDIVIDUALS Explanation of Provision Self-employed individuals may currently deduct 30 percent of their health insurance expenses for themselves and their spouses and dependents. Under the Health Insurance Portability and Accountability Act of 1996, the deduction for health insurance of self-employed individuals has been increased as follows: the deduction is 40 percent in 1997, 45 percent in 1998 through 2002; 50 percent in 2003; 60 percent in 2004; 70 percent in 2005; and 80 percent in 2006 and thereafter. Because, under that act, certain long-term care premiums are treated as medical expenses, the self-employed health deduction applies to such premiums after 1996. EXCLUSION OF MEDICARE BENEFITS Legislative History The exclusion from income of Medicare benefits has never been expressly established by statute. A 1970 IRS ruling, Rev. Rul. 70-341, 1970-2 C.B. 31, provided that the benefits under part A of Medicare are not includable in gross income because they are disbursements made to further the social welfare objectives of the Federal Government. The Internal Revenue Service relied on a similar ruling, Rev. Rul. 70-217, 1970-1 C.B. 13, with respect to the excludability of Social Security disability insurance benefits in reaching this conclusion. (For background on the exclusion of Social Security benefits, see above.) Rev. Rul. 70-341 also held that benefits under part B of Medicare are excludable as amounts received through accident and health insurance (though the subsidized portion of part B also may be excluded under the same theory applicable to the exclusion of part A benefits). Explanation of Provision Benefits under part A and part B of Medicare are excludable from the gross income of the recipient. In general, part A pays for certain inpatient hospital care, skilled nursing facility care, home health care, and hospice care for eligible individuals (generally the elderly and the disabled). Part B covers certain services of a physician and other medical services for elderly or disabled individuals who elect to pay the required premium. DEDUCTIBILITY OF MEDICAL EXPENSES Legislative History An itemized deduction for unreimbursed medical expenses above a specified floor has been allowed since 1942. From 1954 through 1982, the floor under the medical expense deduction was 3 percent of the taxpayer's adjusted gross income (``AGI''); a separate floor of 1 percent of AGI applied to expenditures for medicine and drugs. In the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), the floor was increased to 5 percent of AGI (effective for 1983 and thereafter) and was applied to the total of all eligible medical expenses, including prescription drugs and insulin. TEFRA made nonprescription drugs ineligible for the deduction and eliminated the separate floor for drug costs. The Tax Reform Act of 1986 increased the floor under the medical expense deduction to 7.5 percent of AGI, beginning in 1987. Explanation of Provision Individuals who itemize deductions may deduct amounts they pay during the taxable year, if not reimbursed by insurance or otherwise, for medical care of the taxpayer and of the taxpayer's spouse and dependents, to the extent that the total of such expenses exceeds 7.5 percent of AGI (sec. 213). Medical care expenses eligible include: (1) health insurance (including aftertax employee contributions to employer health plans); (2) diagnosis, treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body; (3) transportation primarily for and essential to medical care; (4) lodging away from home primarily for and essential to medical care, up to $50 per night; and (5) prescription drugs and insulin. Expenses paid for the general improvement of health, such as fees for exercise programs, are not eligible for the deduction unless prescribed by a physician to treat a specific illness. A deduction is not allowed for cosmetic surgery or similar procedures that do not meaningfully promote the proper function of the body or treat disease. However, such expenses are deductible if the cosmetic procedure is necessary to correct a deformity arising from a congenital abnormality, an injury resulting from an accident, or disfiguring disease. Medical expenses are not subject to the general limitation on itemized deductions applicable to taxpayers with adjusted gross incomes above a certain limit ($117,950 for 1996 and adjusted annually for inflation). Effect of Provision The Code allows taxpayers to claim an itemized deduction if unreimbursed medical expenses absorb a substantial portion of income and thus adversely affect the taxpayer's ability to pay taxes. In order to limit the deduction to extraordinary medical expenses, medical expenses are deductible only to the extent that they exceed 7.5 percent of the taxpayer's AGI. Table 14-10 shows the effect on medical expense deductions of the increases in the floor on medical deductions. In the absence of those increases, one would have expected the number of taxpayers claiming the deduction to have increased because of inflation of medical costs. However, increasing the floor should reduce the number of taxpayers claiming the deduction because many taxpayers with relatively modest expenses no longer qualify while taxpayers with large expenses continue to qualify. The average deduction in excess of the 7.5 percent of AGI floor has increased substantially, from $769 in 1980 to $5,200 in 1995. Both increases in the floor (to 5 percent in 1983 and to 7.5 percent in 1987) substantially reduced the number of taxpayers claiming deductions. TABLE 14-10.--TAX RETURNS CLAIMING DEDUCTIBLE MEDICAL AND DENTAL EXPENSES, 1980-95 ---------------------------------------------------------------------------------------------------------------- Returns claiming medical and dental Total expenses in excess of the AGI floor number of -------------------------------------------- Year of deduction returns Expenses in filed (in Number of excess of the AGI Average millions) returns (in floor (in amount over millions) billions) the floor ---------------------------------------------------------------------------------------------------------------- 1980.................................................. 93.9 19.5 $15.0 $769 1981.................................................. 95.4 21.4 17.9 836 1982.................................................. 95.3 22.0 21.7 986 1983.................................................. 96.3 9.7 18.1 1,859 1984.................................................. 99.4 10.7 21.5 2,009 1985.................................................. 101.7 10.8 22.9 2,127 1986.................................................. 103.0 10.5 25.1 2,382 1987.................................................. 107.0 5.4 17.2 3,202 1988.................................................. 110.1 4.8 18.0 3,741 1989.................................................. 112.1 5.1 20.9 4,080 1990.................................................. 113.7 5.1 21.5 4,215 1991.................................................. 114.7 5.3 23.7 4,444 1992.................................................. 113.6 5.5 25.7 4,674 1993.................................................. 114.6 5.5 26.5 4,829 1994 \1\.............................................. 116.1 5.2 25.8 4,980 1995 \2\.............................................. 117.4 5.4 27.9 5,200 ---------------------------------------------------------------------------------------------------------------- \1\ Preliminary. \2\ Estimate. Source: Internal Revenue Service. Taxpayers in higher tax rate brackets receive more of a benefit from each dollar of deductible medical expense than do taxpayers in lower tax rate brackets. However, because the floor automatically rises with a taxpayer's income, higher income taxpayers are able to deduct a smaller amount (if any) of medical expenses above their floor than are low-income taxpayers incurring the same aggregate amount of medical expenses. In 1995, it is estimated that 5,368,000 taxpayers claimed itemized medical expenses in excess of the medical deductions floor (7.5 percent of adjusted gross income). Of that number, 78 percent had incomes of less than $50,000 (see table 14-11). However, taxpayers with incomes over $50,000 are estimated to have received far more than half of the total tax savings attributable to medical expense deductions. TABLE 14-11.--DISTRIBUTION OF ITEMIZED DEDUCTIONS FOR MEDICAL EXPENSES, 1995 ------------------------------------------------------------------------ Returns Amount Income class (thousands) \1\ Average (thousands) (billions) \2\ ------------------------------------------------------------------------ 0-$10......................... $7,700 515 $4.0 $10-$20....................... 6,400 963 6.2 $20-$30....................... 4,200 1,063 4.5 $30-$40....................... 3,900 912 3.5 $40-$50....................... 3,700 736 8.8 $50-$75....................... 4,900 843 4.2 $75-$100...................... 6,600 211 1.4 $100-$200..................... 9,500 112 1.1 $200 and over................. 28,900 14 0.4 ----------------------------------------- Total................... 5,200 5,368 27.9 ------------------------------------------------------------------------ \1\ The income concept is defined in the introduction to this chapter. \2\ Amounts in excess of the floor on itemized medical deductions (7.5 percent of adjusted gross income). Source: Joint Committee on Taxation. EARNED INCOME CREDIT Legislative History The earned income credit (Code sec. 32), enacted in 1975, generally equals a specified percentage of wages up to a maximum dollar amount. The maximum amount applies over a certain income range and then diminishes to zero over a specified phaseout range. The income ranges and percentages have been revised several times since original enactment, expanding the credit (see table 14-12). In 1987, the credit was indexed for inflation. In 1990 and 1993, the expansions of the credit were quite large. In 1990, auxiliary credits were added for very young children and for health insurance premiums paid on behalf of a qualifying child. These were repealed in 1993. Also in 1993, the group eligible for the credit was expanded to include childless workers. The Personal Responsibility and Work Opportunity Reconciliation Act of 1996 incorporated new rules relating to taxpayer identification numbers and the modified AGI phaseout of the credit in addition to amending the credit's unearned income test (described below). Explanation of Provision The EIC is available to low-income working taxpayers. Three separate schedules apply. Taxpayers with one qualifying child may claim a credit in 1996 of 34 percent of their earnings up to $6,330, resulting in a maximum credit of $2,152. The maximum credit is available for those with earnings between $6,330 and $11,610. At $11,610 of earnings the credit begins to phase down at a rate of 15.98 percent of the amount of earnings above that amount. The credit is phased down to 0 at $25,078 of earnings. TABLE 14-12.--EARNED INCOME CREDIT PARAMETERS, 1975-96 [Dollar amounts unadjusted for inflation] ---------------------------------------------------------------------------------------------------------------- Mininum Phaseout range Credit income Phaseout ------------------- Calendar year rate for Maximum rate (percent) maximum credit (percent) Beginning Ending credit income income ---------------------------------------------------------------------------------------------------------------- 1975-78............................................. 10.00 $4,000 $400 10.00 $4,000 $8,000 1979-84............................................. 10.00 5,000 500 12.50 6,000 10,000 1985-86............................................. 14.00 5,000 550 12.22 6,500 11,000 1987................................................ 14.00 6,080 851 10.00 6,920 15,432 1988................................................ 14.00 6,240 874 10.00 9,840 18,576 1989................................................ 14.00 6,500 910 10.00 10,240 19,340 1990................................................ 14.00 6,810 953 10.00 10,730 20,264 1991: One child......................................... 16.70 7,140 1,192 11.93 11,250 21,250 Two children...................................... 17.30 7,140 1,235 12.36 11,250 21,250 1992: One child......................................... 17.60 7,520 1,324 12.57 11,840 22,370 Two children...................................... 18.40 7,520 1,384 13.14 11,840 22,370 1993: One child......................................... 18.50 7,750 1,434 13.21 12,200 23,050 Two children...................................... 19.50 7,750 1,511 13.93 12,200 23,050 1994: No children....................................... 7.65 4,000 306 7.65 5,000 9,000 One child......................................... 26.30 7,750 2,038 15.98 11,000 23,755 Two children...................................... 30.00 8,425 2,528 17.68 11,000 25,296 1995: No children....................................... 7.65 4,100 314 7.65 5,130 9,230 One child......................................... 34.00 6,160 2,094 15.98 11,290 24,396 Two children...................................... 36.00 8,640 3,110 20.22 11,290 26,673 1996: No children....................................... 7.65 4,220 323 7.65 5,280 9,500 One child......................................... 34.00 6,330 2,152 15.98 11,610 25,078 Two children...................................... 40.00 8,890 3,556 21.06 11,610 28,495 ---------------------------------------------------------------------------------------------------------------- Source: Joint Committee on Taxation. Taxpayers with more than one qualifying child may claim a credit in 1996 of 40 percent of earnings up to $8,890, resulting in a maximum credit of $3,556. The maximum credit is available for those with earnings between $8,890 and $11,610. At $11,610 of earnings the credit begins to phase down at a rate of 21.06 percent of earnings above that amount. The credit is phased down to $0 at $28,495 of earnings. Taxpayers with no qualifying children may claim a credit if they are over age 24 and below age 65. The credit is 7.65 percent of earnings up to $4,220, resulting in a maximum credit of $323. The maximum is available for those with incomes between $4,220 and $5,280. At $5,280 of earnings, the credit begins to phase down at rate of 7.65 percent of earnings above that amount, resulting in a $0 credit at $9,500. All income thresholds are indexed for inflation annually. In order to be a qualifying child, an individual must satisfy a relationship test, a residency test, and an age test. The relationship test requires that the individual be a child, stepchild, a descendant of a child, or a foster or adopted child of the taxpayer. The residency test requires that the individual have the same place of abode as the taxpayer for more than half the taxable year. The household must be located in the United States. The age test requires that the individual be under 19 (24 for a full-time student) or be permanently and totally disabled. An individual is not eligible for the earned income credit if the aggregate amount of ``disqualified income'' of the taxpayer for the taxable year exceeds $2,200. This threshold is indexed. Disqualified income is the sum of: 1. Interest (taxable and tax-exempt), 2. Dividends, 3. Net rent and royalty income (if greater than zero), 4. Capital gain net income, and 5. Net passive income (if greater than zero) that is not self- employment income. For taxpayers with earned income (or AGI, if greater) in excess of the beginning of the phaseout range, the maximum earned income credit amount is reduced by the phaseout rate multiplied by the amount of earned income (or AGI, if greater) in excess of the beginning of the phaseout range. For taxpayers with earned income (or AGI, if greater) in excess of the end of the phaseout range, no credit is allowed. The definition of AGI used for phasing out the earned income credit disregards certain losses. The losses disregarded are: 1. Net capital losses (if greater than zero), 2. Net losses from trusts and estates, 3. Net losses from nonbusiness rents and royalties, and 4. Fifty percent of the net losses from businesses, computed separately with respect to sole proprietorships (other than in farming), sole proprietorships in farming, and other businesses. Individuals are not eligible for the credit if they do not include their taxpayer identification number and their qualifying child's number (and, if married, their spouse's taxpayer identification number) on their tax return. Solely for these purposes and for purposes of the present-law identification test for a qualifying child, a taxpayer identification number is defined as a Social Security number issued to an individual by the Social Security Administration other than a number issued under section 205(c)(2)(B)(i)(II) (or that portion of sec. 205(c)(2)(B)(i)(III) relating to it) of the Social Security Act (regarding the issuance of a number to an individual applying for or receiving federally funded benefits). If an individual fails to provide a correct taxpayer identification number, such omission will be treated as a mathematical or clerical error. If an individual who claims the credit with respect to net earnings from self-employment fails to pay the proper amount of self-employment tax on such net earnings, the failure will be treated as a mathematical or clerical error for purposes of the amount of credit allowed. The EIC is the only refundable tax credit; i.e., if the amount of the credit exceeds the taxpayer's Federal income tax liability, the excess is payable to the taxpayer as a direct transfer payment. Under an advance payment system (available since 1979), eligible taxpayers may elect to receive the benefit of the credit in their periodic paychecks, rather than waiting to claim a refund on their return filed by April 15 of the following year. In 1993, Congress required that the IRS begin to notify eligible taxpayers of the advance payment option. Interaction with Means-Tested Programs The treatment of the EIC for purposes of AFDC and food stamp benefit computations has varied since inception of the credit. When enacted in 1975, the credit was not considered income in determining AFDC and food stamp benefits, and the credit could not be received on an advance basis. From January 1979 through September 1981, the credit was treated as earned income when actually received. From October 1981 to September 1984, the amount of the credit was treated as earned income and was imputed to the family even though it may not have been received as an advance payment. Pursuant to the Deficit Reduction Act of 1984, the credit was treated as earned income only when received, either as an advance payment or as a refund after the conclusion of the year. Under the Family Support Act of 1988, States generally were required to disregard any advance payment or refund of the EIC when calculating AFDC eligibility or benefits. However, the credit was counted against the gross income eligibility standard (185 percent of the State need standard) for both applicants and recipients. OBRA 1990 specified that, effective January 1, 1991, the EIC was not to be taken into account as income (for the month in which the payment is received or any following month) or as a resource (for the month in which the payment is received or the following month) for determining the eligibility or amount of benefit for AFDC, Medicaid, SSI, food stamps, or low-income housing programs. Effect of Provision Eighteen million taxpayers are expected to take advantage of the EIC in 1996 (see table 14-13). Their claims are expected to total $25.1 billion, 86 percent of which will be refunded as direct payments to these families. As table 14-13 also shows, approximately 70 percent of the tax relief or direct spending from the EIC accrues to single parents who file as heads of households. Table 14-14 shows the total amount of earned income credit received for each of the calendar years since the inception of the program, the number of recipient families, the amount of the credit received as refunded payments, and the average amount of credit received per family. TABLE 14-13.--DISTRIBUTION OF TAX PROVISIONS: EARNED INCOME CREDIT, 1996 [Number in thousands; amount in millions] ---------------------------------------------------------------------------------------------------------------- Joint returns Head of household and All returns -------------------------- single returns ------------------------- Income class (thousands) \1\ -------------------------- Number Amount Number Amount Number Amount ---------------------------------------------------------------------------------------------------------------- $0-$10............................ 814 $1,063 4,845 $5,137 5,660 $6,201 $10-$20........................... 1,539 3,240 4,751 8,811 6,290 12,051 $20-$30........................... 1,846 2,400 2,651 2,592 4,497 5,589 $30-$40........................... 735 593 588 491 1,323 1,084 $40-$50........................... 87 80 19 15 106 95 $50-$75........................... 22 22 4 12 26 34 $75-$100.......................... (\2\) (\3\) ........... ........... (\2\) (\3\) $100-$200......................... ........... ........... ........... ........... ........... ........... $200 and over..................... ........... ........... ........... ........... ........... ........... ----------------------------------------------------------------------------- Total....................... 5,043 7,400 12,860 17,654 17,902 25,054 ----------------------------------------------------------------------------- Percent distribution by type of return........................... 28.2 29.5 71.8 70.5 100 100 ---------------------------------------------------------------------------------------------------------------- \1\ The income concept is defined in the introduction to this chapter. \2\ Less than 500 returns. \3\ Less than $500,000. Source: Joint Committee on Taxation. TABLE 14-14.--EARNED INCOME CREDIT, 1975-2000 ---------------------------------------------------------------------------------------------------------------- Number of Total Refunded recipient amount of portion of Average Calendar year to which credit applies families credit credit credit per (thousands) (millions) (millions) family ---------------------------------------------------------------------------------------------------------------- 1975........................................................ 6,215 $1,250 $900 $201 1976........................................................ 6,473 1,295 890 200 1977........................................................ 5,627 1,127 880 200 1978........................................................ 5,192 1,048 801 202 1979........................................................ 7,135 2,052 1,395 288 1980........................................................ 6,954 1,986 1,370 286 1981........................................................ 6,717 1,912 1,278 285 1982........................................................ 6,395 1,775 1,222 278 1983........................................................ 7,368 1,795 1,289 224 1984........................................................ 6,376 1,638 1,162 257 1985........................................................ 7,432 2,088 1,499 281 1986........................................................ 7,156 2,009 1,479 281 1987........................................................ 8,738 3,391 2,930 450 1988........................................................ 11,148 5,896 4,257 529 1989........................................................ 11,696 6,595 4,636 564 1990........................................................ 12,612 6,928 5,303 549 1991........................................................ 13,105 10,589 7,849 808 1992........................................................ 14,097 13,028 9,959 926 1993........................................................ 15,117 15,537 12,028 945 1994 \1\.................................................... 17,156 18,666 15,722 1,088 1995 \2\.................................................... 17,376 22,208 19,040 1,278 1996 \2\.................................................... 17,902 25,054 21,566 1,400 1997 \2\.................................................... 18,119 26,016 22,367 1,436 1998 \2\.................................................... 18,287 27,063 23,142 1,480 1999 \2\.................................................... 18,628 28,332 24,421 1,521 2000 \2\.................................................... 19,083 29,858 25,381 1,565 ---------------------------------------------------------------------------------------------------------------- \1\ Preliminary. \2\ Projected. Source: 1975-94: Internal Revenue Service; 1995-2000: Joint Committee on Taxation calculations. EXCLUSION OF PUBLIC ASSISTANCE AND SSI BENEFITS Legislative History While there is no specific statutory authorization, a number of revenue rulings under Code section 61 have held specific types of public assistance payments are excludable from gross income. Revenue rulings generally exclude government transfer payments from income because they are considered to be general welfare payments. Taxing benefits provided in kind, rather than in cash, would require valuation of these benefits, which could create administrative difficulties. Explanation of Provision The Federal Government provides tax-free public assistance benefits to individuals either by cash payments or by provision of certain goods and services at reduced cost or free of charge. Cash payments come mainly from the Aid to Families with Dependent Children (AFDC) and Supplemental Security Income (SSI) Programs. In-kind payments include food stamps, Medicaid, and housing assistance. None of these payments is subject to income tax. DEPENDENT CARE TAX CREDIT Legislative History Under section 21 of the Internal Revenue Code, taxpayers are allowed an income tax credit for certain employment-related expenses for dependent care. The Internal Revenue Code of 1954 provided a deduction to gainfully employed women, widowers, and legally separated or divorced men for certain employment- related dependent care expenses. The deduction was limited to $600 per year and phased out for families with incomes between $4,500 and $5,100. The Revenue Act of 1964 made husbands with incapacitated wives eligible for the dependent care deduction and raised the threshold for the income phaseout from $4,500 to $6,000. The Revenue Act of 1971: (1) made any individual who maintained a household and was gainfully employed eligible for the deduction; (2) modified the definition of a dependent; (3) raised the deduction limit to $4,800 per year; (4) increased from $6,000 to $18,000 the income level at which the deduction began to phase out; (5) allowed the deduction for household services in addition to direct dependent care; and (6) limited the deduction with respect to services outside the taxpayer's household. The Tax Reduction Act of 1975 increased from $18,000 to $35,000 the income level at which the deduction began to be phased out. The Tax Reform Act of 1976 replaced the deduction with a nonrefundable credit. This change broadened eligibility to those who do not itemize deductions and provided relatively greater benefit to low-income taxpayers. In addition, the act eased the rules related to family status and simplified the computation. In the Economic Recovery Tax Act of 1981, Congress provided a higher ceiling on creditable expenses, a larger credit for low-income individuals, and modified rules relating to care provided outside the home. The Family Support Act of 1988 reduced to 13 the age of a child for whom the dependent care credit may be claimed, reduced the amount of eligible expenses by the amount of expenses excludable from that taxpayer's income under the dependent care exclusion, lowered from 5 to 2 the age at which a taxpayer identification number had to be submitted for children for whom the credit was claimed, and disallowed the credit unless the taxpayer reports on her tax return the correct name, address, and taxpayer identification number (generally, an employer identification number or a Social Security number) of the dependent care provider. 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 14-15). In 1996, 6.2 million families are expected to claim an average credit of $445, for a total of $2.8 billion. Changes made in the Family Support Act of 1988 generally reduced the utilization 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. Most of the dependent care credit is claimed by families filing joint returns. Data for 1994 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 46 percent to families with AGI between $20,000 and $50,000; and about 41 percent to families with AGI above $50,000. TABLE 14-15.--DEPENDENT CARE TAX CREDIT, 1976-96 ------------------------------------------------------------------------ Number of returns Aggregate Average claiming amount of credit Calendar 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............................. 6,040 2,532 419 1994............................. 6,002 2,518 420 1995 \1\......................... 6,177 2,746 445 1996 \2\......................... 6,220 2,766 445 ------------------------------------------------------------------------ \1\ Preliminary. \2\ Projection. Source: Joint Committee on Taxation. EXCLUSION FOR EMPLOYER-PROVIDED DEPENDENT CARE Legislative History The value of certain employer-provided dependent care is excluded from the employee's gross income. The Economic Recovery Tax Act of 1981 added this exclusion (sec. 129) and amended Code sections 3121(a)(18) and 3306(b)(13) to exclude such employer-provided dependent care from wages for purposes of the Federal Insurance Contributions Act (FICA) and the Federal Unemployment Tax Act (FUTA). The Tax Reform Act of 1986 modified the nondiscrimination rules and limited the exclusion to $5,000 a year ($2,500 in the case of a separate return by a married individual). The Family Support Act of 1988 required the amount of employer-provided dependent care excluded from the taxpayer's income to reduce, dollar for dollar, the amount of expenses eligible for the dependent care tax credit. Explanation of Provision Amounts paid or incurred by an employer for dependent care assistance provided to an employee generally are excluded from the employee's gross income if the assistance is furnished under a program meeting certain requirements. These requirements include that the program be described in writing, satisfy certain nondiscrimination rules, and provide for notification to all eligible employees. The type of dependent care eligible for the exclusion is the same as the type eligible for the dependent care credit. The dependent care exclusion is limited to $5,000 per year except that a married taxpayer filing a separate return may exclude only $2,500. Amounts excluded from gross income generally are excludable from wages for employment tax purposes. Dependent care expenses excluded from income are not eligible for the dependent care tax credit. Effect of Provision The exclusion provides an incentive to taxpayers with expenses for dependent care to seek compensation in the form of dependent care assistance rather than in cash subject to taxation. This incentive is of greater value to employees in higher tax brackets. Many employees covered by the exclusion for employer- provided dependent care also are eligible to use the dependent care tax credit. While the limitations on the exclusion and the credit differ, the credit generally is less valuable than the exclusion for taxpayers who are above the 15-percent tax bracket. According to a survey of private firms with 100 or more workers conducted by the U.S. Bureau of Labor Statistics (1993), nearly one-tenth of full-time workers at these firms were eligible for child care benefits provided by the employer in the form of on-site or near-site child care facilities or through direct reimbursement of employee expenses. A more prevalent form of providing dependent care benefits is through reimbursement accounts, which may cover other nontaxable fringe benefits, such as out-of-pocket health care expenses, in addition to dependent care. Slightly over one-third of full- time employees at large and medium-sized firms were eligible for such accounts in 1991. WORK OPPORTUNITY TAX CREDIT Explanation of Provision The work opportunity tax credit is available on an elective basis for employers hiring individuals from one or more of seven targeted groups. The seven targeted groups are: (1) families eligible to receive benefits under the Title IV-A Temporary Assistance for Needy Families Program (the successor to the Aid to Families with Dependent Children Program), (2) qualified ex-felons, (3) vocational rehabilitation referrals, (4) qualified summer youth employees, (5) qualified veterans, (6) youths who reside in an empowerment zone or enterprise community, and (7) families receiving food stamps. The credit generally is equal to 35 percent of qualified wages. Qualified wages consist of wages attributable to service rendered by a member of a targeted group during the 1-year period beginning with the day the individual begins work for the employer. For a vocational rehabilitation referral, however, the period will begin on the day the individual begins work for the employer on or after the beginning of the individual's vocational rehabilitation plan as under prior law. Generally, no more than $6,000 of wages during the first year of employment is permitted to be taken into account with respect to any individual. Thus, the maximum credit per individual is $2,100. With respect to qualified summer youth employees, the maximum credit is 35 percent of up to $3,000 of qualified first-year wages, for a maximum credit of $1,050. In general, an individual is not to be treated as a member of a targeted group unless: (1) on or before the day the individual begins work for the employer, the employer received in writing a certification from the designated local agency that the individual is a member of a specific targeted group, or (2) on or before the day the individual is offered work with the employer, a prescreening notice is completed with respect to that individual by the employer and within 21 days after the individual begins work for the employer, the employer submits such notice, signed by the employer and the individual under penalties of perjury, to the designated local agency as part of a written request for certification. The prescreening notice will contain the information provided to the employer by the individual that forms the basis of the employer's belief that the individual is a member of a targeted group. No credit is allowed for wages paid unless the eligible individual is employed by the employer for at least 180 days (20 days in the case of a qualified summer youth employee) or 400 hours (120 hours in the case of a qualified summer youth employee). The credit is effective for wages paid or incurred to a qualified individual who begins work for an employer after September 30, 1996, and before October 1, 1997. EXCLUSION OF WORKERS' COMPENSATION AND SPECIAL BENEFITS FOR DISABLED COAL MINERS Legislative History Workers' compensation benefits generally are not taxable under section 104(a)(1) of the Internal Revenue Code of 1986. Workers' compensation benefits are treated as Social Security benefits to the extent that they reduce Social Security benefits received (see above). This exclusion from gross income was first codified in the Revenue Act of 1918. The Ways and Means Committee report for that act suggests that such payments were not subject to tax even prior to the 1918 act. Payments made to coal miners or their survivors for death or disability resulting from pneumoconiosis (black lung disease) under the Federal Coal Mine Health and Safety Act of 1969 (as amended) are excluded from gross income. Payments made as a result of claims filed before December 31, 1972, originally were excluded from Federal income tax by the Federal Coal Mine Health and Safety Act of 1969. Later payments are excluded from gross income because they are considered to be in the nature of workers' compensation (Rev. Rul. 72-400, 1972-2 C.B. 75). Explanation of Provision Gross income does not include amounts received as workers' compensation for personal injuries or sickness. This exclusion also applies to benefits paid under a workers' compensation act to a survivor of a deceased employee. Benefits for disabled coal miners (black lung benefits) are not includable in gross income. There are two types of black lung programs. The first involves Federal payments to coal miners and their survivors due to death or disability, payable for claims filed before July 1, 1973 (December 31, 1973, in the case of survivors). This program provided total annual payments of around $725 million to approximately 155,000 beneficiaries in 1994 (Social Security Administration, 1995). The second program requires coal mine operators to ensure payment of black lung benefits for claims filed on or after July 1, 1973 (December 31, 1973, in the case of survivors) in a federally mandated workers' compensation program. Benefits include medical treatment as well as cash payments. These benefits are paid from a trust fund financed by an excise tax on coal production if there is no responsible operator (an operator for whom the miner worked for at least 1 year) or if the responsible operator is in default. This program provided total annual payments of around $610 million to approximately 156,550 claimants in 1986 (U.S. Department of Labor, 1989, tables 3 & 6). ADDITIONAL STANDARD DEDUCTION FOR THE ELDERLY AND BLIND Legislative History From 1954 through 1986, an additional personal exemption was allowed for a taxpayer or a spouse who was 65 years or older at the close of the year. An additional personal exemption also was allowed for a taxpayer or a spouse who was blind. The Tax Reform Act of 1986 repealed the additional personal exemption for the elderly and blind and replaced it with an additional standard deduction amount. These additional standard deduction amounts are adjusted for inflation. Explanation of Provision The additional standard deduction amount for the elderly or the blind is $800 in 1996 for an elderly or a blind individual who is married (whether filing jointly or separately) or is a surviving spouse, and $1,600 for such an individual who is both elderly and blind. The additional amount is $1,000 for a head of household who is elderly or blind ($2,000, if both), and for a single individual (i.e., an unmarried individual other than a surviving spouse or head of household) who is elderly or blind. The definitions of elderly and blind status have not been changed since 1954. An elderly person is an individual who is at least 65 years of age. Blindness is defined in terms of the ability to correct a deficiency in distance vision or the breadth of the area of vision. An individual is blind only if central vision acuity is not better than 20/200 in the better eye with correcting lenses, or if visual acuity is better than 20/200 but is accompanied by a limitation in the fields of vision such that the widest diameter of the visual field subtends an angle no greater than 20 degrees. Effect of Provision The additional standard deduction increases the tax threshold for elderly and blind taxpayers. For example, the additional amount is $1,600 for two elderly individuals filing a joint return, raising the tax threshold in 1996 from $11,800 to $13,400. In 1994, about 10.7 million taxpayers claimed the extra standard deduction. About 88 percent of the 10.7 million beneficiaries had incomes of less than $40,000. TAX CREDIT FOR THE ELDERLY AND CERTAIN DISABLED INDIVIDUALS Legislative History The present tax credit for individuals who are age 65 or over, or who have retired on permanent and total disability, was enacted in the Social Security amendments of 1983 (Code sec. 22). This credit replaced the previous credit for the elderly, which had been enacted in the Tax Reform Act of 1976. Prior to that provision, the tax law provided a retirement income credit, which initially was enacted in the Internal Revenue Code of 1954. Explanation of Provision Individuals who are age 65 or older may claim a nonrefundable income tax credit equal to 15 percent of a base amount. The credit also is available to an individual, regardless of age, who is retired on disability and who was permanently and totally disabled at retirement. For this purpose, an individual is considered permanently and totally disabled if he is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment that can be expected to result in death, or that has lasted or can be expected to last for a continuous period of not less than 12 months. The individual must furnish proof of disability to the IRS. The maximum base amount for the credit is $5,000 for unmarried elderly or disabled individuals and for married couples filing a joint return if only one spouse is eligible; $7,500 for married couples filing a joint return with both spouses eligible; or $3,750 for married couples filing separate returns. For a nonelderly, disabled individual the initial base amount is the lesser of the applicable specified amount or the individual's disability income for the year. Consequently, the maximum credit available is $750 (15 percent of $5,000), $1,125 (15 percent of $7,500), or $562.50 (15 percent of $3,750). The maximum base amount is reduced by the amount of certain nontaxable income of the taxpayer, such as nontaxable pension and annuity income or nontaxable Social Security, railroad retirement, or veterans' nonservice-related disability benefits. In addition, the base amount is reduced by one-half of the taxpayer's AGI in excess of certain limits: $7,500 for a single individual, $10,000 for married taxpayers filing a joint return, or $5,000 for married taxpayers filing separate returns. These computational rules reflect that the credit is designed to provide tax benefits to individuals who receive only taxable retirement or disability income, or who receive a combination of taxable retirement or disability income plus Social Security benefits that generally are comparable to the tax benefits provided to individuals who receive only Social Security benefits (including Social Security disability benefits). Effect of Provision In 1994, $46 million in elderly and disabled credit was claimed. The utilization rate and average credit granted has been relatively stable since the credit was modified by the Social Security amendments of 1983, as shown in table 14-16. TABLE 14-16.--CREDIT FOR THE ELDERLY AND DISABLED, 1976-96 ------------------------------------------------------------------------ Number of families Total who amount of Average Calendar year received credit credit per credit (millions) return (thousands) ------------------------------------------------------------------------ 1976............................. 1,011 $206 $204 1977............................. 569 93 163 1978............................. 689 145 210 1979............................. 607 132 217 1980............................. 562 135 240 1981............................. 474 124 262 1982............................. 483 131 271 1983............................. 423 116 275 1984............................. 475 107 225 1985............................. 460 106 230 1986............................. 430 86 200 1987............................. 354 67 189 1988............................. 357 69 193 1989............................. 320 65 202 1990............................. 342 63 183 1991............................. 285 57 200 1992............................. 240 51 213 1993............................. 223 49 220 1994 \1\......................... 212 46 216 1995 \2\......................... 200 43 217 1996 \2\......................... 193 40 206 ------------------------------------------------------------------------ \1\ Preliminary. \2\ Projection. Source: Joint Committee on Taxation. TAX PROVISIONS RELATED TO HOUSING Owner-Occupied Housing Legislative history Deductibility of mortgage interest.--Prior to the Tax Reform Act of 1986, all interest payments on indebtedness incurred for personal use (e.g., to purchase consumption goods) were deductible in computing taxable income. The 1986 act amended section 163(h) of the Internal Revenue Code to disallow deductions for all personal interest except for interest on indebtedness secured by a first or second home. In the Omnibus Budget Reconciliation Act of 1987, Congress further restricted the deductibility of mortgage interest. Only two classes of interest were distinguished as deductible: interest on acquisition indebtedness and interest on home equity indebtedness. Acquisition indebtedness, defined as indebtedness secured by a residence and used to acquire or improve the residence by which it is secured, was limited to $1,000,000 ($500,000 in the case of a married individual filing a separate return). Home equity indebtedness, defined as any nonacquisition indebtedness secured by a residence (for example, a home equity loan), was limited to the lesser of (1) $100,000 ($50,000 for married taxpayers filing separately) or (2) the excess of the fair market value of the residence over the acquisition indebtedness. Deferral of capital gains from sale of principal residence.--Prior to 1951, capital gains on housing were taxed when realized. This treatment was consistent with the tax treatment of other capital assets. In 1951, Congress added section 112(n) to the Internal Revenue Code of 1939, permitting capital gains from the sale of a principal residence to be deferred (rolled over) as long as a new principal residence was purchased within the 24-month period beginning 12 months before the date of sale of the old residence and ending 12 months after the sale of the old residence. When capital gains are rolled over, the basis of the newly purchased house must be reduced by the amount of deferred gains. This rollover period had been extended twice and now is 24 months before and 24 months after the sale of the old residence. Exclusion of capital gains for certain taxpayers.--In the Revenue Act of 1964, Congress introduced section 121 of the Internal Revenue Code of 1954, which permitted a one-time exclusion of all or part of the gain on the sale of a principal residence by older individuals. This exclusion was limited to homeowners who had lived in the property as a principal residence for 5 out of the last 8 years before the property's sale or exchange. Furthermore, full exclusion was permitted only for houses that sold for $20,000 or less. The parameters of this exclusion have been modified and expanded a number of times. Currently, the one-time exclusion is allowed to taxpayers 55 or older for capital gain of up to $125,000 if they have lived in the property as a principal residence for 3 of the past 5 years. Explanation of provisions Homeowners may deduct a number of expenses related to housing as itemized deductions in computing taxable income. These include payments of interest on qualified residence debt, certain interest on home equity loans, certain payments of points (i.e., up front interest payments) on the purchase of a house, and payments of real property taxes. Interest on acquisition debt of $1,000,000 or less is fully deductible, as is any interest on debt secured by a residence that was incurred on or before October 13, 1987. Interest on home equity indebtedness of $100,000 is fully deductible for regular tax purposes, as long as the total amount of debt (acquisition plus home equity indebtedness) does not exceed the fair market value of the house. Interest on home equity indebtedness exceeding $100,000 (and incurred after October 13, 1987) or exceeding the difference between the fair market value of the home and the acquisition indebtedness is not deductible. Interest paid on home equity loans is generally not deductible in computing the alternative minimum tax. Capital gains from the sale of residences generally are subject to tax when realized, unless one of two conditions is met. First, capital gains are not taxed if a new residence of equal or greater value is purchased or constructed within a period 24 months before to 24 months after the first residence is sold. If the price of the new residence is less than the selling price of the old residence (less any selling expenses) then the difference between the two prices must be recognized as a gain to the extent that gain would be recognized but for the rollover provision. The basis of the new residence must be reduced by the amount of the excluded gain. Second, taxpayers age 55 or older may exclude once in their lifetime up to $125,000 ($62,500 for married taxpayers filing separately) of capital gain on the sale of a principal residence. Effects of provisions Preliminary tax return information for 1994 indicates that 25 million taxpayers claimed the deduction for mortgage interest. Reliable data are not yet available on how many claimed the one-time exclusion. The favorable treatment of owner-occupied housing may affect both the home ownership rate and the share of total investment in housing in the United States. Home ownership tax provisions.--These provisions may benefit neighborhoods because they encourage home ownership and home improvement. The United States has maintained a high rate of home ownership--65 percent of all American households own the homes they live in (U.S. Bureau of the Census, 1995, p. 733, table 1225). Investment in housing.--The tax advantages for owner- occupied housing encourage people to invest in homes instead of taxable business investments. This shift may reduce investment in business assets in the United States. One study suggested that housing capital is 25 percent higher and other capital is 12 percent lower than it would be if tax policy provided equal treatment for all forms of capital (Mills, 1987). Currently, about one-third of net private investment goes into owner- occupied housing, so even a modest shift of investment to other assets could have sizable effects. Low-Income Housing Credit Legislative history The low-income rental housing tax credit was first enacted in the Tax Reform Act of 1986. The Omnibus Budget Reconciliation Act of 1989 substantially modified the credit. The Omnibus Budget Reconciliation Act of 1993 modified the credit again and made it permanent. Explanation of provision A tax credit may be claimed by owners of residential rental property used for low-income rental housing. The credit is claimed annually, generally for a period of 10 years. New construction and rehabilitation expenditures for low-income housing projects are eligible for a maximum 70 percent present value credit, claimed annually for 10 years. The acquisition cost of existing projects that meet the substantial rehabilitation requirements and the cost of newly constructed projects receiving other Federal subsidies are eligible for a maximum 30 percent present value credit, also claimed annually for 10 years. These credit percentages are adjusted monthly based on an Applicable Federal Rate. The credit amount is based on the qualified basis of the housing units serving the low-income tenants. A residential rental project will qualify for the credit only if: (1) 20 percent or more of the aggregate residential rental units in the project are occupied by individuals with 50 percent or less of area median income; or (2) 40 percent or more of the aggregate residential rental units in the project are occupied by individuals with 60 percent or less of area median income. These income figures are adjusted for family size. Maximum rents that may be charged families in units on which a credit is claimed depend on the number of bedrooms in the unit. The rent limitation is 30 percent of the qualifying income of a family deemed to have a size of 1.5 persons per bedroom (e.g., a two-bedroom unit has a rent limitation based on the qualifying income for a family of three). Credit eligibility also depends on the existence of a 30- year extended low-income use agreement for the property. If property on which a low-income housing credit is claimed ceases to qualify as low-income rental housing or is disposed of before the end of a 15-year credit compliance period, a portion of the credit may be recaptured. The 30-year extended use agreement creates a State law right to enforce low-income use for an additional 15 years after the initial 15-year recapture period. In order for a building to be a qualified low-income building, the building owner generally must receive a credit allocation from the appropriate credit authority. An exception is provided for property that is substantially financed with the proceeds of tax-exempt bonds subject to the State's private-activity bond volume limitation. The low-income housing credit is allocated by State or local government authorities subject to an annual limitation for each State based on State population. The annual credit allocation per State is $1.25 per resident. Effect of provision Comprehensive data from tax returns concerning the low- income housing tax credit are unavailable. Table 14-17 presents data from a survey of State credit allocating agencies. These data indicate that annual allocation of available credit authority generally has been 67 percent or greater. Year-to- year variations in credit allocation probably reflect changes in Federal law affecting the credit and changing economic conditions affecting the construction and housing markets. For example, 1990 was the first year following substantial modification to the credit and included a temporary period during which State credit allocating agencies were limited to allocating authority of $0.9375 per capita rather than the $1.25 per capita of present and prior law. TABLE 14-17.--ALLOCATION OF THE LOW-INCOME HOUSING CREDIT, 1987-94 ------------------------------------------------------------------------ Percentage Years Authority Allocated allocated (millions) (millions) (percent) ------------------------------------------------------------------------ 1987............................. $313.1 $62.9 20.1 1988............................. 311.5 209.8 67.4 1989............................. 314.2 307.2 97.8 1990............................. 317.7 213.1 67.0 1991 \1\......................... 497.3 400.6 80.6 1992 \1\......................... 476.8 332.7 70.0 1993 \1\......................... 546.4 424.7 77.7 1994 \1\......................... 523.7 495.5 94.7 ------------------------------------------------------------------------ \1\ Increased authority includes credits unallocated from prior years carried over to the current year. Source: Survey of State allocating agencies conducted by the National Council of State Housing Associations (1995). An allocation percentage of less than 100 percent does not imply that some credits available for allocation to low-income housing projects go unused. Since 1990, States are permitted to carry forward unused credit subsequently made available for allocation by other States. Thus, the amount allocated in any 1 year could be less than the States' authority, but such authority may ultimately be allocated. THE EFFECT OF TAX PROVISIONS ON THE INCOME AND TAXES OF THE ELDERLY AND THE POOR Table 14-18 presents values of the personal exemptions, standard deductions, additional standard deductions for the elderly and the blind, and taxable income brackets for 1990- 2002. The figures for 1998-2002 are based on Congressional Budget Office projections. As might be expected, the value to taxpayers of personal exemptions, standard deductions, and additional standard deductions for the elderly and the blind grows steadily over the 10-year period. TABLE 14-18.--PERSONAL EXEMPTIONS, STANDARD DEDUCTIONS, AND TAXABLE INCOME LEVELS, 1990-2002 ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ Actual Projected ------------------------------------------------------------------------------------------------------------------------------ 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ Personal exemptions.............................................. $2,050 $2,150 $2,300 $2,350 $2,450 $2,500 $2,550 $2,650 $2,750 $2,800 $2,900 $2,950 $3,050 Standard deductions: Joint........................................................ 5,450 5,700 6,000 6,200 6,350 6,550 6,700 6,900 7,100 7,350 7,550 7,750 8,000 Single....................................................... 3,250 3,400 3,600 3,700 3,800 3,900 4,000 4,150 4,250 4,400 4,500 4,650 4,800 Head of household............................................ 4,750 5,000 5,250 5,450 5,600 5,750 5,900 6,050 6,250 6,450 6,650 6,850 7,050 Deductions for elderly/blind: Joint (each individual)...................................... 650 650 700 700 750 750 800 800 850 850 900 900 950 Single/head of household..................................... 800 850 900 900 950 950 1,000 1,000 1,050 1,100 1,100 1,150 1,200 Taxable income levels: Joint returns: 15 percent rate ends at...................................... 32,450 34,000 35,800 36,900 38,000 39,000 40,100 41,200 42,450 43,750 45,050 46,350 47,700 28 percent rate ends at...................................... 78,400 82,150 86,500 89,150 91,850 94,250 96,900 99,600 102,600 105,750 108,850 112,000 115,300 31 percent rate ends at...................................... ....... ....... ....... 140,000 140,000 143,600 147,700 151,750 156,350 161,150 165,850 170,700 175,700 36 percent rate ends at \1\.................................. ....... ....... ....... 250,000 250,000 256,500 263,750 271,050 279,250 287,800 296,200 304,850 313,800 Single returns: 15 percent rate ends at...................................... 19,450 20,350 21,450 22,100 22,750 23,350 24,000 24,650 25,400 26,200 26,950 27,750 28,650 28 percent rate ends at...................................... 47,050 49,300 51,900 53,500 55,100 56,550 58,150 59,750 61,550 63,450 65,300 67,200 69,200 31 percent rate ends at...................................... ....... ....... ....... 115,000 115,000 117,950 121,300 124,650 128,450 132,350 136,250 140,200 144,350 36 percent rate ends at \1\.................................. ....... ....... ....... 250,000 250,000 256,500 263,750 271,050 279,250 287,800 296,200 304,850 313,800 Heads of household: 15 percent rate ends at...................................... 26,050 27,300 28,750 29,600 30,500 31,250 32,150 33,050 34,050 35,100 36,100 37,200 38,250 28 percent rate ends at...................................... 67,200 70,450 74,150 76,400 78,700 80,750 83,050 85,350 87,950 90,600 93,250 96,000 98,800 31 percent rate ends at...................................... ....... ....... ....... 127,500 127,500 130,800 134,500 138,200 142,400 146,750 151,050 155,450 160,050 36 percent rate ends at \1\.................................. ....... ....... ....... 250,000 250,000 256,500 263,750 271,050 279,250 287,800 296,200 304,850 313,800 ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ \1\ The 39.6 percent tax rate begins at $1 above the 36 percent limit. Source: Congressional Budget Office. Hypothetical Tax Calculations for Selected Families Table 14-19 presents examples of tax liabilities for hypothetical taxpayers. The table presents 1996 Federal income and payroll tax burdens. The worker is assumed to bear both the employer and employee shares of FICA tax (7.65 percent for each). Taxpayers claim the earned income credit, if eligible, and they claim the standard deduction, except where noted in the footnotes. Income sources are listed in the table's footnotes for each example. TABLE 14-19.--EXAMPLE OF FEDERAL INCOME AND PAYROLL TAX LIABILITIES OF HYPOTHETICAL TAXPAYERS, 1996 ---------------------------------------------------------------------------------------------------------------- Overall Overall Income FICA tax Total tax effective marginal Income tax liability liability tax rate tax rate liability \1\ \1\ ---------------------------------------------------------------------------------------------------------------- Joint filer--3 exemptions: \2\ $10,000............................................... -$2,152 $1,530 -$622 -5.8 14.2 $30,000............................................... 2,348 4,590 6,938 21.5 28.1 $50,000 \12\.......................................... 4,853 7,650 12,503 23.2 28.1 $100,000 \13\......................................... 15,045 10,675 25,720 24.4 30.5 H/H--2 exemptions: \2\ $10,000............................................... -2,152 1,530 -622 -5.8 14.2 $30,000............................................... 2,850 4,590 7,440 23.0 28.1 $50,000 \12\.......................................... 5,593 7,650 13,243 24.6 40.2 $100,000 \13\......................................... 16,793 10,675 27,467 26.1 30.5 Elderly couple filing jointly: $10,000 \3\........................................... 0 0 0 0.0 \6\ 0.0 $30,000 \4\........................................... 690 0 690 2.3 \7\ 15.0 $50,000 \5\........................................... 4,590 1,530 6,120 12.1 40.0 Elderly single filer: $10,000 \8\........................................... 0 0 0 0.0 \6\ 0.0 $30,000 \9\........................................... 2,336 0 2,336 7.8 \11\ 22. 5 $50,000 \10\.......................................... 8,451 3,060 11,511 22.3 40.2 ---------------------------------------------------------------------------------------------------------------- \1\ The average tax rate is total tax liability divided by income plus the employer share of FICA. The marginal rate computations also count the employer share of FICA tax as income to the employee (for both payroll and income tax purposes). Unless otherwise noted, all calculations assume the taxpayer takes the standard deduction rather than itemized deductions. \2\ Assumes one child, one earner, and all income is wage income. \3\ All income is Social Security. \4\ $12,000 is Social Security, $12,000 is a taxable pension and $6,000 is taxable interest. \5\ Same as above plus additional $10,000 of taxable interest and $10,000 of wages. \6\ If the marginal dollar of income is assumed to consist of wage income, the marginal tax rate would be 14.2 percent. This represents the FICA tax liability on this income. \7\ If the marginal dollar of income is assumed to consist of wage income, the marginal tax rate would be 28.1 percent, representing both the income tax liability and the FICA tax liability on this income. \8\ $7,500 is Social Security, $2,500 is taxable pension. \9\ $7,500 is Social Security, $7,500 is taxable pension, $15,000 is taxable interest. \10\ Same as above plus $20,000 of wages. \11\ If the marginal dollar of income is assumed to consist of wage income, the marginal tax rate would be 35.1 percent, representing both the income tax liability (22.5 percent marginal rate reflects the inclusion of 50 cents of Social Security benefits as taxable for each additional dollar of AGI) and the FICA tax liability on this income. \12\ Assumes taxpayer claims itemized deductions of $10,000. \13\ Assumes taxpayer claims itemized deductions of $20,000. Source: Joint Committee on Taxation. Tax Treatment of the Elderly Present law contains several provisions that reduce, or in some cases eliminate, the burden of Federal income tax on senior citizens. These provisions are: the exemption from income taxation of some or all of an individual's Social Security benefits; a tax credit for certain taxpayers who do not receive substantial Social Security income; and an additional standard deduction for taxpayers age 65 and older. These are described in detail in preceding portions of this section. As a result of these favorable tax provisions, the tax threshold (the level of income, excluding Social Security, at which tax liability is incurred) for elderly taxpayers is very close to or above the poverty level. For example, in 1996, a single elderly individual with $5,000 in Social Security benefits can have up to $7,200 in other income without incurring tax liability (or total income of $12,200). An elderly married couple filing jointly with $5,000 in excluded Social Security benefits has a tax threshold of $13,500 (or total income of $18,500). By comparison, the poverty levels in 1995 for a single elderly person and an elderly couple were $7,309 and $9,221, respectively (U.S. Bureau of the Census, 1995). Table 14-20 displays similar information for other years and for varying amounts of Social Security benefits. The combination of these tax provisions means that an estimated 51 percent of elderly individuals will have no tax liability for 1997 (see table 14-21). Distribution of Family Income and Taxes Table 14-21 presents estimates of the distribution of families and individuals by the Federal individual income tax rate brackets for calendar year 1997. As shown in the bottom panel, almost 33 million families pay no Federal income taxes. There are almost 55 million families with 134 million individuals who are in the 15 percent bracket. These families on average had income of $37,645 and paid Federal taxes of $2,474 per family. There are approximately 4 million families who face marginal income tax rates of 31 percent or above. Table 14-22 is a more complicated version of table 14-21. It illustrates for various types of wage earners the additional (marginal) Federal tax these wage earners will pay if they earn one more dollar of wages. For purposes of this table, marginal tax rates include both Federal income and payroll taxes. The majority of single wage earners have income below $30,000 per year and face marginal tax rates of 20.0 to 24.9 percent. In addition, the phaseout of certain deductions or exclusions under the Code (e.g., the personal exemption phaseout) and the overall limitation on itemized deductions also have the effect of imposing additional dollars of tax liability on a taxpayer as the taxpayer's income increases. Hence, effective marginal tax rates can exceed the sum of the statutory individual income tax rate and payroll tax rate. TABLE 14-20.--INCOME TAX THRESHOLDS FOR ELDERLY INDIVIDUALS, 1990-2002 ------------------------------------------------------------------------ Amount of Social Security income Year and filing status ------------------------------------------- Zero $2,500 $5,000 $7,500 ------------------------------------------------------------------------ 1990: Single.................... $9,900 $8,233 $6,100 $6,100 Joint..................... 15,567 13,900 12,233 10,850 1991: Single.................... 10,100 8,433 6,400 6,400 Joint..................... 15,867 14,200 12,533 11,300 1992: Single.................... 10,367 8,700 6,800 6,800 Joint..................... 16,333 14,667 13,000 12,000 1993: Single.................... 10,467 8,800 6,950 6,950 Joint..................... 16,533 14,867 13,200 12,300 1994: Single.................... 10,633 8,967 7,200 7,200 Joint..................... 16,833 15,167 13,500 12,750 1995: Single.................... 10,733 9,067 7,350 7,350 Joint..................... 17,033 15,367 13,700 13,050 1996: Single.................... 10,867 9,200 7,550 7,550 Joint..................... 17,267 15,600 13,933 13,400 1997: Single.................... 11,033 9,367 7,800 7,800 Joint..................... 17,533 15,867 14,200 13,800 1998: Single.................... 11,167 9,500 8,000 8,000 Joint..................... 17,800 16,133 14,467 14,200 1999: Single.................... 11,367 9,700 8,300 8,300 Joint..................... 18,100 16,433 14,767 14,650 2000: Single.................... 11,500 9,833 8,500 8,500 Joint..................... 18,433 16,767 15,100 15,150 2001: Single.................... 11,667 10,000 8,750 8,750 Joint..................... 18,633 16,967 15,300 15,450 2002: Single.................... 11,867 10,200 9,050 9,050 Joint..................... 19,000 17,333 15,667 16,000 ------------------------------------------------------------------------ Source: Congressional Budget Office. TABLE 14-21.--DISTRIBUTION OF FAMILIES AND PERSONS BY MARGINAL FEDERAL INCOME TAX RATE, PROJECTED 1997 ---------------------------------------------------------------------------------------------------------------- Families (in Persons (in Families thousands) thousands) ---------------------- -------------------------------------- Average Family type and marginal tax rate (percent) Average Federal Number Percent Number Percent pretax income income tax ---------------------------------------------------------------------------------------------------------------- With children: 0.................................................. 11,074 28.0 41,842 27.3 $11,490 -$1,160 15................................................. 19,989 50.5 77,572 50.6 45,121 2,575 28................................................. 7,284 18.4 28,717 18.7 97,323 11,150 31................................................. 659 1.7 2,675 1.7 178,664 28,548 36................................................. 356 0.9 1,485 1.0 256,913 48,135 39.6............................................... 261 0.7 1,060 0.7 826,733 224,727 ------------------------------------------------------------ Total............................................ 39,623 100.0 153,351 100.0 54,594 5,413 ============================================================ With aged head: 0.................................................. 11,808 51.0 17,157 46.2 18,148 554 15................................................. 8,142 35.2 14,195 38.2 39,076 2,229 28................................................. 2,544 11.0 4,592 12.4 81,567 10,234 31................................................. 441 1.9 745 2.0 154,918 23,422 36................................................. 131 0.6 258 0.7 301,055 57,435 39.6............................................... 85 0.4 189 0.5 1,029,289 215,822 ------------------------------------------------------------ Total............................................ 23,151 100.0 37,136 100.0 40,412 3,758 ============================================================ Other families: 0.................................................. 9,817 18.9 12,561 15.4 6,746 -109 15................................................. 26,751 51.4 42,474 52.1 31,623 2,473 28................................................. 13,308 25.6 22,594 27.7 72,028 9,093 31................................................. 1,427 2.7 2,376 2.9 137,272 22,672 36................................................. 516 1.0 1,022 1.3 239,619 44,647 39.6............................................... 265 0.5 512 0.6 886,337 220,964 ------------------------------------------------------------ Total............................................ 52,083 100.0 81,540 100.0 46,567 5,762 ============================================================ All families: 0.................................................. 32,699 28.5 71,560 26.3 12,470 -226 15................................................. 54,882 47.8 134,241 49.4 37,645 2,474 28................................................. 23,135 20.1 55,903 20.6 81,040 9,866 31................................................. 2,527 2.2 5,796 2.1 151,149 24,336 36................................................. 1,002 0.9 2,765 1.0 253,771 47,553 39.6............................................... 612 0.5 1,761 0.7 880,839 221,853 ------------------------------------------------------------ Total............................................ 114,857 100.0 272,027 100.0 48,095 5,238 ---------------------------------------------------------------------------------------------------------------- Source: Congressional Budget Office tax simulation model. TABLE 14-22.--DISTRIBUTION OF EARNERS BY INCOME AND MARGINAL TAX RATES ON WAGES, PROJECTED 1997 [In thousands of earners; tax rates in percent] -------------------------------------------------------------------------------------------------------------------------------------------------------- Income in thousands of 1997 dollars Marginal tax rate ------------------------------------------------------------------------------------------ All <10 10-20 20-30 30-40 40-50 50-75 75-100 100-200 200+ incomes -------------------------------------------------------------------------------------------------------------------------------------------------------- (9) All earners ages 21-64 without Social Security earnings --------------------------------------------------------------------------------------------------- Less than 0......................................... 3,209 471 39 14 2 0 0 0 0 3,736 0-4.9............................................... 1,586 126 30 7 2 0 0 7 0 1,757 6.0-9.9............................................. 5,127 1,564 156 16 0 0 0 0 0 6,863 10-14.9............................................. 0 0 0 0 0 0 0 0 0 0 15.0-19.9........................................... 739 101 38 19 15 162 6 0 0 1,080 20-24.9............................................. 2,509 10,990 11,763 12,002 10,365 10,851 44 4 4 58,532 25.0-29.9........................................... 0 1,709 403 25 3 826 1,720 1,041 0 5,727 30-34.9............................................. 1,529 54 9 206 258 98 355 1,766 13 4,288 35.0-39.9........................................... 0 1,605 1,887 3,085 2,717 10,113 8,379 4,428 138 32,352 40-44.9............................................. 0 734 3,457 112 14 7 0 203 1,229 5,757 45.0-49.9........................................... 0 0 0 3 1 11 1 79 685 781 --------------------------------------------------------------------------------------------------- Total......................................... 14,698 17,355 17,781 15,489 13,378 22,068 10,505 7,529 2,070 120,873 =================================================================================================== Mean marginal tax rate.............................. 3.9 22.8 28.3 25.4 25.4 28.9 34.5 34.8 43.4 25.2 Mean marginal income tax rate....................... -3.8 15.1 20.7 17.8 17.8 21.5 28.1 29.7 39.8 17.9 Mean marginal Social Security tax rate.............. 7.6 7.6 7.6 7.6 7.6 7.4 6.4 5.1 3.7 7.3 --------------------------------------------------------------------------------------------------- (9) Single earners --------------------------------------------------------------------------------------------------- Less than 0......................................... 2,292 190 7 0 0 0 0 0 0 2,490 0-4.9............................................... 1,508 68 16 6 0 0 0 6 0 1,604 5.0-9.9............................................. 4,361 563 0 0 0 0 0 0 0 4,923 10-14.9............................................. 0 0 0 0 0 0 0 0 0 0 15.0-19.9........................................... 644 13 2 3 1 2 0 0 0 663 20-24.9............................................. 2,504 9,735 8,258 2,691 449 51 0 2 0 23,690 25.0-29.9........................................... 0 391 16 1 0 347 178 9 0 943 30-34.9............................................. 1,529 48 5 0 0 42 338 214 0 2,176 35.0-39.9........................................... 0 1,144 766 3,017 2,675 2,141 174 128 60 10,105 40-44.9............................................. 0 445 853 2 0 0 0 26 113 1,439 45.0-49.9........................................... 0 0 0 0 0 0 0 3 13 16 --------------------------------------------------------------------------------------------------- Total......................................... 12,838 12,596 9,923 5,720 3,125 2,583 690 388 187 48,049 =================================================================================================== Mean marginal tax rate.............................. 6.1 23.5 25.6 29.5 33.8 34.5 33.0 35.2 41.5 21.6 Mean marginal income tax rate....................... -1.6 15.9 18.0 21.9 26.1 27.8 30.0 32.4 39.5 14.1 Mean marginal Social Security tax rate.............. 7.6 7.6 7.6 7.6 7.6 6.7 3.0 2.8 2.1 7.5 --------------------------------------------------------------------------------------------------- (9) Married earners --------------------------------------------------------------------------------------------------- Less than 0......................................... 917 281 32 14 2 0 0 0 0 1,246 0-4.9............................................... 77 59 13 1 2 0 0 0 0 153 5.0-9.9............................................. 766 1,001 156 16 0 0 0 0 0 1,940 10-14.9............................................. 0 0 0 0 0 0 0 0 0 0 15.0-19.9........................................... 96 88 36 16 14 160 6 0 0 416 20-24.9............................................. 5 1,255 3,505 9,311 9,916 10,800 44 2 4 34,842 25.0-29.9........................................... 0 1,318 387 24 3 478 1,542 1,032 0 4,784 30-34.9............................................. 0 6 4 206 258 56 17 1,552 13 2,112 35.0-39.9........................................... 0 461 1,122 68 42 7,972 8,205 4,300 77 22,247 40-44.9............................................. 0 289 2,604 110 14 7 0 178 1,116 4,318 45.0-49.9........................................... 0 0 0 3 1 11 1 76 671 764 --------------------------------------------------------------------------------------------------- Total......................................... 1,861 4,759 7,858 9,769 10,253 19,485 9,815 7,141 1,883 72,824 =================================================================================================== Mean marginal tax rate.............................. -11.3 20.8 31.7 23.1 22.9 28.1 34.6 34.8 43.6 27.5 Mean marginal income tax rate....................... -18.9 13.1 24.0 15.4 15.3 20.7 27.9 29.6 39.8 20.4 Mean marginal Social Security tax rate.............. 7.6 7.6 7.6 7.6 7.6 7.4 6.7 5.2 3.8 7.1 --------------------------------------------------------------------------------------------------- (9) Earners with children --------------------------------------------------------------------------------------------------- Less than 0......................................... 3,021 435 36 13 0 0 0 0 0 3,504 0-4.9............................................... 2 34 22 6 0 0 0 6 0 70 5.0-9.9............................................. 988 978 70 8 0 0 0 0 0 2,044 10-14.9............................................. 0 0 0 0 0 0 0 0 0 0 15.0-19.9........................................... 0 0 2 7 6 144 6 0 0 165 20-24.9............................................. 0 445 1,456 6,444 6,437 7,499 33 2 0 22,317 25.0-29.9........................................... 0 1,682 396 23 2 343 1,047 618 0 4,111 30-34.9............................................. 0 0 0 44 63 21 9 878 0 1,016 35.0-39.9........................................... 0 1,318 1,495 38 80 3,490 4,452 2,218 44 13,135 40-44.9............................................. 0 680 3,323 105 14 7 0 84 610 4,824 45.0-49.9........................................... 0 0 0 0 1 7 0 20 342 371 --------------------------------------------------------------------------------------------------- Total......................................... 4,012 5,573 6,800 6,687 6,603 11,512 5,546 3,827 996 51,555 =================================================================================================== Mean marginal tax rate.............................. -20.9 24.2 36.3 23.0 22.9 26.8 34.4 34.4 43.9 24.8 Mean marginal income tax rate....................... -28.5 16.6 28.7 15.4 15.3 19.4 27.9 29.4 40.2 17.6 Mean marginal Social Security tax rate.............. 7.6 7.6 7.6 7.6 7.6 7.4 6.5 5.0 3.7 7.2 -------------------------------------------------------------------------------------------------------------------------------------------------------- Note.--Marginal tax rates less than zero refers to certain individuals receiving refundable earned income credit (EIC) benefits. Source: Congressional Budget Office tax simulation model. Federal Tax Treatment of Families in Poverty During the 1970s and early 1980s, inflation gradually increased the tax burdens of the poor and lowered the real income level at which a poor family became liable for income taxation. Legislation passed by Congress reversed or slowed this trend, but in the absence of indexing, inflation during this period gradually offset these legislative efforts. One measure of this trend is the degree to which the income at which a poor family begins to pay income taxes (termed the ``tax threshold,'' or the ``tax entry point'') exceeds or falls below the poverty threshold. A second measure is the actual amount of tax liability incurred by a family with income at the poverty line. Table 14-23 shows the income tax threshold, the poverty level, and the tax threshold as a percent of the poverty level for a married couple with two children in selected years. These figures demonstrate that before 1975 a family of four was generally liable for Federal income tax if the family's income was significantly below the poverty line. In 1975, following the enactment of the EIC, a family of four incurred no tax liability until its income exceeded the poverty threshold by 22 percent. Over the next decade this margin eroded; by 1984, a poor family of four incurred income tax liability when its income was 17 percent below the poverty line. By 1993, changes in the tax law resulted in no tax liability for a typical family of four until its income exceeded the poverty threshold by nearly 30 percent. Table 14-24 shows the income tax burden and payroll tax burden of households with incomes at the poverty line for families of different sizes. As a result of the refundable EIC, the table reflects that many individuals receive a substantial credit that more than offsets total income, and in many cases Social Security, taxes paid. TAX CREDIT AND EXCLUSION FOR ADOPTION EXPENSES The Small Business Job Protection Act of 1996 (Public Law 104-188), signed into law on August 20, 1996, includes two tax provisions designed to reduce economic barriers to adoption. First, a tax credit of up to $5,000 (or $6,000 in the case of families adopting special-needs children from the United States) is created to help defray one-time adoption expenses. The credit is phased out for families with incomes above $75,000, and is unavailable to families with incomes above $115,000. Second, employees may receive an income tax exclusion of up to $5,000 per child (or $6,000 in the case of special- needs children) for employer-provided adoption assistance. The effective date for both provisions is January 1, 1997. The credit for foreign special-needs adoptions and the exclusion are not available after December 31, 2001. (Other conditions apply, which will be described in greater detail in future editions of the Green Book. For a description of child protection changes unrelated to taxes, including those removing barriers to interethnic adoption, see appendix L.) TABLE 14-23.--RELATIONSHIP BETWEEN INCOME TAX THRESHOLD AND POVERTY LEVEL FOR A FAMILY OF FOUR, SELECTED YEARS 1959-2002 ------------------------------------------------------------------------ Tax threshold Income tax Poverty as a Year threshold level percent of poverty level ------------------------------------------------------------------------ 1959............................. $2,667 $2,973 89.7 1960............................. 2,667 3,022 88.3 1965............................. 3,000 3,223 93.1 1969............................. 3,000 3,743 80.2 1970............................. 3,600 3,968 90.7 1971............................. 3,750 4,137 90.6 1972............................. 4,300 4,275 100.6 1974............................. 4,300 5,038 85.4 1975............................. 6,692 5,500 121.7 1976............................. 6,892 5,815 118.5 1977............................. 7,520 6,191 121.7 1978............................. 7,533 6,662 113.1 1979............................. 8,626 7,412 116.4 1980............................. 8,626 8,414 102.5 1981............................. 8,634 9,287 93.0 1982............................. 8,727 9,862 88.5 1983............................. 8,783 10,178 86.3 1984 \1\......................... 8,783 10,610 82.8 1986............................. 9,575 11,203 85.5 1987............................. 13,288 11,611 114.4 1988............................. 15,110 12,092 125.0 1989............................. 15,656 12,675 123.5 1990............................. 16,296 13,359 122.0 1991............................. 17,437 13,924 125.2 1992............................. 18,548 14,335 129.4 1993............................. 19,187 14,763 130.0 1994............................. 21,098 14,625 144.3 1995............................. 22,362 15,582 143.5 1996............................. 23,672 16,021 147.8 1997............................. 24,352 16,511 147.5 1998............................. 25,062 17,012 147.3 1999............................. 25,870 17,513 147.7 2000............................. 26,646 18,023 147.8 2001............................. 27,356 18,555 147.4 2002............................. 28,204 19,096 147.7 ------------------------------------------------------------------------ \1\ Effective payroll tax calculated as 6.7 percent for 1984 because in this year employees were allowed a payroll tax credit equal to 0.3 percent of taxable wages. Note.--Poverty levels used are the Bureau of the Census poverty thresholds. These differ from the poverty guidelines used by the Office of Management and Budget to determine eligibility for many government transfer programs. The poverty levels are for all families, not just those with heads under age 65. Tax thresholds represent the income level at which a family of four making full use of the earned income credit owes positive income tax. They are based on the schedule for a married nonelderly couple filing jointly. Source: Congressional Budget Office. TABLE 14-24.--TAX THRESHOLDS, POVERTY LEVELS, AND FEDERAL TAX AMOUNTS FOR DIFFERENT FAMILY SIZES WITH EARNINGS EQUAL TO THE POVERTY LEVEL, 1991-2002 ---------------------------------------------------------------------------------------------------------------- Family size ------------------------------------------------------------- 1 2 3 4 5 6 ---------------------------------------------------------------------------------------------------------------- Poverty level: 1991.......................................... $6,932 $8,865 $10,860 $13,924 $16,456 $18,587 1992.......................................... 7,143 9,137 11,186 14,335 16,592 19,137 1993.......................................... 7,363 9,414 11,522 14,763 17,449 19,718 1994.......................................... 7,547 9,661 11,821 15,141 17,900 20,235 1995.......................................... 7,764 9,932 12,159 15,582 18,035 20,801 1996.......................................... 7,983 10,212 12,502 16,021 18,543 21,388 1997.......................................... 8,227 10,524 12,884 16,511 19,111 22,042 1998.......................................... 8,477 10,843 13,275 17,012 19,690 22,711 1999.......................................... 8,726 11,162 13,666 17,513 20,270 23,379 2000.......................................... 8,981 11,488 14,064 18,023 20,861 24,061 2001.......................................... 9,246 11,827 14,479 18,555 21,476 24,770 2002.......................................... 9,516 12,172 14,901 19,096 22,103 25,493 Income tax threshold: 1991.......................................... 5,550 10,000 16,179 17,437 18,616 19,794 1992.......................................... 5,900 10,600 17,217 18,548 19,774 21,000 1993.......................................... 6,050 10,900 17,841 19,187 20,405 21,624 1994.......................................... 7,179 11,250 18,887 21,098 22,222 23,347 1995.......................................... 7,356 11,550 19,387 22,362 23,426 24,491 1996.......................................... 7,546 11,800 19,884 23,672 24,733 25,793 1997.......................................... 7,796 12,200 20,467 24,352 25,454 26,556 1998.......................................... 8,000 12,500 21,052 25,062 26,185 27,308 1999.......................................... 8,267 12,950 21,740 25,870 27,035 28,199 2000.......................................... 8,501 13,350 22,392 26,646 27,853 29,059 2001.......................................... 8,742 13,650 22,988 27,356 28,583 29,810 2002.......................................... 9,015 14,100 23,691 28,204 29,473 30,742 Income tax at poverty level: 1991.......................................... 207 0 (1,192) (905) (591) (328) 1992.......................................... 187 0 (1,324) (1,053) (711) (422) 1993.......................................... 197 0 (1,434) (1,154) (780) (464) 1994.......................................... 83 0 (1,907) (1,795) (1,308) (895) 1995.......................................... 92 0 (1,956) (2,243) (1,747) (1,187) 1996.......................................... 99 0 (2,010) (2,627) (2,096) (1,497) 1997.......................................... 98 0 (2,054) (2,679) (2,131) (1,514) 1998.......................................... 108 0 (2,121) (2,770) (2,205) (1,569) 1999.......................................... 104 0 (2,189) (2,858) (2,277) (1,623) 2000.......................................... 109 0 (2,252) (2,940) (2,343) (1,669) 2001.......................................... 114 0 (2,318) (3,025) (2,409) (1,716) 2002.......................................... 113 0 (2,386) (3,119) (2,486) (1,772) Payroll tax at poverty level: 1991.......................................... 530 678 831 1,065 1,259 1,422 1992.......................................... 547 699 856 1,098 1,298 1,466 1993.......................................... 563 720 881 1,129 1,335 1,508 1994.......................................... 577 739 904 1,158 1,369 1,548 1995.......................................... 594 760 930 1,192 1,380 1,591 1996.......................................... 611 781 956 1,226 1,419 1,636 1997.......................................... 629 805 986 1,263 1,462 1,686 1998.......................................... 648 830 1,016 1,301 1,506 1,737 1999.......................................... 668 854 1,045 1,340 1,551 1,788 2000.......................................... 687 879 1,076 1,379 1,596 1,841 2001.......................................... 707 905 1,108 1,419 1,643 1,895 2002.......................................... 728 931 1,140 1,461 1,691 1,950 Combined tax at poverty level: 1991.......................................... 738 678 (362) 160 668 1,094 1992.......................................... 734 699 (467) 45 587 1,044 1993.......................................... 760 720 (552) (25) 555 1,044 1994.......................................... 661 739 (1,003) (637) 62 653 1995.......................................... 686 760 (1,025) (1,051) (367) 404 1996.......................................... 710 781 (1,053) (1,401) (677) 139 1997.......................................... 727 805 (1,069) (1,416) (669) 172 1998.......................................... 756 830 (1,105) (1,468) (699) 168 1999.......................................... 772 854 (1,143) (1,518) (727) 166 2000.......................................... 796 879 (1,176) (1,562) (747) 172 2001.......................................... 821 905 (1,210) (1,605) (766) 179 2002.......................................... 841 931 (1,246) (1,658) (795) 179 Combined tax at poverty level as a percent of poverty level: 1991.......................................... 10.6 7.6 -3.3 1.1 4.1 5.9 1992.......................................... 10.3 7.7 -4.2 0.3 3.5 5.5 1993.......................................... 10.3 7.7 -4.8 -0.2 3.2 5.3 1994.......................................... 8.8 7.7 -8.5 -4.2 0.3 3.2 1995.......................................... 8.8 7.7 -8.4 -6.7 -2.0 1.9 1996.......................................... 8.9 7.7 -8.4 -8.7 -3.7 0.7 1997.......................................... 8.8 7.7 -8.3 -8.6 -3.5 0.8 1998.......................................... 8.9 7.7 -8.3 -8.6 -3.6 0.7 1999.......................................... 8.8 7.7 -8.4 -8.7 -3.6 0.7 2000.......................................... 8.9 7.7 -8.4 -8.7 -3.6 0.7 2001.......................................... 8.9 7.7 -8.4 -8.7 -3.6 0.7 2002.......................................... 8.8 7.7 -8.4 -8.7 -3.6 0.7 ---------------------------------------------------------------------------------------------------------------- Source: Congressional Budget Office. REFERENCES Congressional Budget Office. (1995, December). Economic and budget outlook: Fiscal years 1996-2000 (December 1995 update). Washington, DC: Author. Congressional Budget Office. (1994, March). The tax treatment of employment-based health insurance. Washington, DC: Author. Internal Revenue Service. (various years). Statistics of Income. Washington, DC: Author. Mills, E.S. (1987, March-April). Dividing up the investment pie: Have we overinvested in housing? Philadelphia Business Review, pp. 13-23. Scholes, M., & Wolfson, M. (1992). Taxes and business strategy: A planning approach. New York: Prentice-Hall. Social Security Administration. (1995). Black lung benefits program highlights. Annual Statistical Supplement to the Social Security Bulletin. Washington, DC: Author. Turner, J.A., & Beller, D. (1989). Trends in pensions. Washington, DC: U.S. Department of Labor. U.S. Bureau of the Census. (1995). Statistical abstract of the United States: 1995 (115th Ed.). Washington, DC: U.S. Government Printing Office. U.S. Bureau of Labor Statistics. (1993, May). Employee benefits in medium and large firms, 1991. Washington, DC: Department of Labor. U.S. Bureau of Labor Statistics. (forthcoming). Employee benefits in small private establishments, 1992. Washington, DC: Department of Labor. U.S. Department of Labor. (1989, January). Annual report on administration of black lung benefits during calendar year 1986. Washington, DC: Author. U.S. Department of Labor. (1994). Pension and health benefits of American workers: New findings from the April 1993 current population survey. Washington, DC: Author. Woods, J.R. (1989). Pension coverage among private wage and salary workers: Preliminary findings from the 1988 survey of employee benefits. Social Security Bulletin, 52(10), pp. 2-19.