House Committee on Ways and Means on October 16, 1990 (October 15, 1990). JCX-43-90 Budget Reconciliation-Revenue Provisions Conference Comparison of House Bill and Senate Amendment (October 19, 1990). JCX-44-90 Comparison of Revenue Provisions of H.R. 5835 (Revenue Reconciliation Act of 1990) as Passed by the House and the Senate (October 19, 1990). JCX-45-90 Budget Reconciliation (H.R. 5835)—Revenue Provisions as Reported by the Conferees (October 26, 1990). JCX-46-90 Summary of Distributional Effects, By Income Category-Budget Reconciliation (H.R. 5835)-Revenue Provisions as Reported by the Conferees (October 26, 1990). JCX-47-90 Index to Revenue and Pension Provisions (Titles XI and XII) of the Conference Report for the Omnibus Budget Reconciliation Act of 1990 (H.R. 5835) (November 15, 1990). IRS INFORMATION PAMPHLETS Following are several useful IRS tax publications available free of charge from IRS Form Distribution Centers: Publication 1 Your Rights as a Taxpayer (see Part VII) The ABC's of Income Tax Publication 17 Your Federal Income Tax Publication 225 Farmer's Tax Guide Publication 448 Federal Estate and Gift Taxes Many other general guides and specialized publications are also available free from the IRS. Many of these publications are listed in Publication 17, which also contains information on how to order the publications. PART III. THE FEDERAL TAX SYSTEM Section 1. The Individual Income Tax A. HISTORICAL INTRODUCTION An income tax was first enacted in the Revenue Act of 1862 (Ch. 119, 12 Stat. 432) to finance the Civil War. The tax was repealed a decade later in 1872. The individual income tax made a second, brief appearance as part of a 1894 revenue act enacted during the second administration of President Cleveland. The tax was abolished as a result of the Supreme Court decision in Pollock v. Farmer's Loan and Trust Company, 158 U.S. 601 (1895), that the imposition of the individual income tax was a violation of clause 4 of Article I, section 9 of the United States Constitution, which prohibits "direct" taxation without apportionment among the States. As a result of Pollock, it was clear that in the absence of a constitutional amendment, Congress lacked the power to lay an individual income tax. Nearly 20 years following the Supreme Court's decision in Pollock, the 16th amendment was ratified on February 25, 1913. Under the 16th amendment, Congress has the power to collect taxes "on incomes from whatever source derived," without apportionment among the States. Several months later, Congress enacted the individual income tax as part of the Revenue Act of 1913. In its initial form, the income tax was designed to affect only a relatively small number of households, and by the standards of today, in a modest way. For married couples, the tax did not apply to taxable incomes less than $3,000. The top marginal rate was 7 percent, and applied to taxable income over $500,000 (table 1). Since that time, the individual income tax has grown to be the most significant single source of Federal revenue. In 1989, the individual income tax raised $445.7 billion, or 45 percent of all Federal receipts (table 2). Since 1980, the individual income tax has raised steadily increasing amounts of revenue, but its overall share of total revenue raised has declined slightly over the same period. This is because of the slowly but steadily growing share of payroll taxes in overall Federal receipts (table 3 of this section and tables 1 and 3 of Part IV, "Historical Tables"). B. OVERVIEW Two basic economic principles underlie the structure of the individual income tax: efficiency and equity. These two principles may come into conflict with one another. Some measures designed to increase equity may result in less economic efficiency; similarly, measures which achieve greater economic efficiency may be perceived as inequitable. The principle of efficiency implies that the best tax is one which interferes as little as possible with individuals' choices regarding their economic activity. A completely efficient tax would tax all economic income, from whatever source derived, in exactly the same manner and, consequently, distort economic behavior as little as possible. Of course, the individual income tax system departs in large measure from this model. Even a casual glance at its structure shows that income expended on certain activities, or income earned in certain ways, is taxed at a lower rate than other income. This is because Congress has decided to use the tax system to encourage or discourage certain forms of behavior or because it may view conforming the tax system to the economic model as administratively difficult or unfair. The effect of these decisions is explored in this section. The principles of equity embody commonly held notions of what makes a tax system fair. Under the principle of horizontal equity, individuals in like situations are taxed alike. Under the principle of vertical equity, individuals with more income pay more taxes than individuals with less. Traditionally, the principle of vertical equity has embraced the notion of progressivity, under which individuals with higher income pay a higher percentage of their income in taxes than individuals with less income. Some look to the higher-income person's "greater ability to pay" as justification for progressivity. Progressivity is often supported on the theory that as an individual's income increases, each additional dollar is less important to that individual's overall well being. It is only fair, under this view, to require that higher income individuals pay a higher percentage of income in taxes than low-income individuals for whom a greater percentage of income is required for the necessities of life. This theory is sometimes denoted as the principle of declining marginal utility of income. Critics of the theory, however, question the empirical support of its assumptions. They argue that, taken to its extreme, the theory should lead one to equalize all incomes. According to this view, a tax strictly proportional to income is sufficient to meet the goals of vertical equity. In today's income tax system, the goal of vertical equity is accomplished in three ways. First, as a taxpayer's income grows, it is subject to higher marginal rates. Second, income below certain thresholds is exempt from taxation altogether through the provision of personal exemptions and the standard deduction. Third, the earned income tax credit is available to reduce the tax liability of low-income taxpayers. For very low-income families, the earned income tax credit is refundable, and serves as a reverse, or "negative," income tax and results in transfer payments from the Government to the household. In General C. STRUCTURE OF THE INDIVIDUAL INCOME TAX The individual income tax is levied on "taxable income." Taxable income equals the taxpayer's total income, less certain exclusions, exemptions, and deductions. After applying the appropriate tax rates to his or her taxable income, the taxpayer may reduce tax liability by applying tax credits against the otherwise owed tax li ability. For very low-income households, the earned income tax credit may reduce the household's tax liability below zero and result in refunds to these housholds. To the extent that items may be excluded or deducted from total income because they represent expenditures on congressionally preferred activities, the revenue losses to the Government are generally referred to as "tax expenditures." That is, the revenue loss is treated under this concept as the equivalent of a Government outlay for the preferred activity. (Part V discusses the theory of tax expenditures, dissenting views, and revenue estimates of major tax expenditure items.) The rest of this chapter explores each of these features in turn. Appendix 1 (after table 9), prepared by the Congressional Research Service,1 provides an explanation for a number of commonly used Federal individual income tax terms. The terms covered are explained in the order that they occur in the process of determining one's income tax. Adjusted Gross Income Under the Internal Revenue Code, a taxpayer's gross income is "all income, from whatever source derived." That is, unless specifically exempt or excluded by statute, all sources of income, including compensation for services, investment income (such as interest, dividends and capital gains), alimony, prizes, and awards, are included in the taxpayer's gross income. The most important statutory exceptions to this all-inclusive definition of gross income are exclusions for certain employer-provided fringe benefits, including health care, dependent care assistance and educational assistance and the deferral of tax on accrued pension benefits. The tax expenditure attributable to the deferral of tax on pension contributions and the income on accrued pension benefits totaled $59.8 billion in 1990; the tax expenditure attributable to the exclusion of employer-provided health care, $32 billion. (See table 1 in Part V, "Tax Expenditures" for further data.) In addition, certain items of compensation are excluded from gross income, such as employer-provided meals, lodging, employee discounts, free travel, and so forth. These items are excluded because keeping track of their value to individual employees might impose recordkeeping problems disproportionate to the value of the bene fit. Having computed gross income by totaling all income (except for income excluded by statute), the taxpayer computes adjusted gross income by deducting certain items as permitted by statute. These deductions are colloquially known as "above the line" deductions to distinguish them from itemized deductions (discussed below). The most important deductions allowable from gross income are deductions for trade and business expenses, capital losses, contributions to Individual Retirement Accounts (IRAs), contributions to the pension plans of self-employed individuals, and alimony payments. 1 Source: "Federal Individual Income Tax Terms: An Explanation" by Louis Alan Talley, Congressional Research Service, the Library of Congress, April 20, 1990. Taxable Income Taxable income is computed by deducting from adjusted gross income the sum of two items: personal exemptions and deductions. a. Personal exemptions.-In 1991, each personal exemption is worth a deduction of $2,150. The taxpayer may deduct one personal exemption for the taxpayer, the taxpayer's spouse, and each of the taxpayer's dependents. For example, a married couple filing jointly with four dependent children is entitled to six personal exemptions, worth a total deduction of $8,600. Beginning in 1991, the personal exemption is phased out, or gradually eliminated, for very high-income taxpayers. For 1991, the value of a taxpayer's personal exemptions are reduced by 2 percentage points for every $2,500 or portion thereof by which the taxpayer's adjusted gross income exceeds $150,000 in the case of a married couple filing jointly ($100,000 for an unmarried individual). In 1991, this means that each personal exemption is reduced by $43 (2 percent of $2,150) for every $2,500 of income over the applicable threshold. All personal exemptions are phased-out over a $122,500 range; thus, the greater the number of personal exemptions, the more tax benefit lost as a result of each income increment of $2,500. For example, for a married couple filing jointly with four children, each $2,500 income increment over $150,000 means a reduction in personal exemptions of $258 (6 × $43). For a married couple, exemptions are totally phased out at adjusted gross income of $275,000 ($225,000 for an unmarried individual). The beginning point and end point of the phaseout range are indexed for inflation. The personal exemption is designed to personalize the individual income tax by making adjustments for a larger family's diminished ability to pay taxes. In addition, the personal exemption is an important element in ensuring the progressivity of the income tax system. Even without the phaseout of the exemption, the exemption excludes a higher percentage of income for lower income households than for higher income households. For example, as noted above, a family of six may deduct up to $8,600 through personal exemptions. In the case of a family with income of $25,000, six personal exemptions shelter 34 percent of family income from taxation; with income of $100,000, six personal exemptions shelter only 8.6 percent of family income from taxation. Before enactment of the Tax Reform Act of 1986, personal exemptions were generally available to all taxpayers regardless of income. The Tax Reform Act of 1986 phased out personal exemptions for high-income taxpayers. The method of phasing out personal exemptions was modified by the Omnibus Budget Reconciliation Act of 1990 (OBRA of 1990), effective for years beginning in 1991 (described above). The personal exemption is indexed to inflation. The exemption amount equaled $2,000 in 1989 and $2,050 in 1990. b. Standard deduction.-In addition to allowable personal exemptions, the taxpayer may also deduct an amount equal to the "standard deduction." The standard deduction varies according to filing status. In 1991, the standard deduction is worth $5,700 for a married couple filing jointly; $5,000 for a head of household; and $3,400 |