sulted in a windfall gain either to the employee or the employer. The second reason was that employers may have substituted TJTCeligible individuals for other potential workers. This could be viewed as merely a shift in employment opportunities from one group to another, with no net increase in jobs created. Such substitution of credit-eligible workers for others may not have been socially undesirable. For example, it might be considered an acceptable trade-off for a targeted group member to displace a secondary earner from a well-to-do family (e.g., a spouse or student working part-time). Empirical research on the employment gains from the TJTC indicated that only a small portion of the TJTC-eligible population found employment because of the program. Studies found that net new job creation was between 5 and 30 percent of the total certifications. This finding is consistent with some additional employment as a result of the TJTC program, but with considerable uncertainty as to the exact magnitude.9 A necessary condition for the credit to be an effective employment incentive is that firms incorporate TJTC eligibility into their hiring decisions. This could be done by determining credit eligibility for each potential employee or by making a concerted effort to hire individuals from segments of the population likely to include members of targeted groups. Studies examining this issue found that some employers made such efforts, while other employers did little to determine eligibility for the TJTC prior to the decision to hire an individual. 10 Firms with larger numbers of employees were more likely to be aware of the program and to participate in hiring TJTC-eligible individuals.11 În these latter cases, the TJTC provided a cash benefit to the firm, without affecting the decision to hire a particular worker. To be fully effective as a longterm employment incentive, employers need to retain eligible employees in their work force after the expiration of the TJTC eligibility period. 12 9 Macro Systems, Inc., Impact Study of the Implementation and Use of the Targeted Jobs Tax Credit: Overview and Summary, U.S. Department of Labor, 1986; John H. Bishop and Mark Montgomery, "Does the Targeted Jobs Tax Credit Create Jobs at Subsidized Firms?", Industrial Relations, vol. 32, no. 3, Fall 1993, pp. 289-306; "Targeted Jobs Tax Credit Program: Employment Inducement or Employer Windfall?", U.S. Department of Labor, Office of Inspector General, Report No. 04-94-021-03-320, August 18, 1994. 10 For example, see U.S. General Accounting Office, Targeted Jobs Tax Credit: Employer Actions to Recruit, Hire, and Retain Eligible Workers Vary (GAO HRD 91–33), February 1991. 11 John H. Bishop and Mark Montgomery, "Evidence on Firm Participation in Employment Subsidy Programs," Industrial Relations, vol. 25, no. 1, Winter 1986, pp. 56-64. 12 The Department of Labor Office of Inspector General's report found some evidence that TJTC participants stayed with their employer for a longer time than did a population of individuals with similar earnings, although the turnover rates for both groups was high. Less than a quarter of the TJTC participants were with the same employer five quarters after being hired. Only about one-sixth of the members of the comparison group were with the same employer after that time. "Targeted Jobs Tax Credit Program: Employment Inducement or Employer Windfall?", U.S. Department of Labor, Office of Inspector General, Report No. 04-94-021-03320, August 18, 1994, p. 30. 2. Exclusion for employer-provided educational assistance (sec. 127 of the Code) Present and Prior Law Under present law, taxpayers generally may not deduct education and training expenses. However, a deduction for education expenses is allowed under section 162 if the education or training (1) maintains or improves a skill required in a trade or business currently engaged in by the taxpayer, or (2) meets the express requirements of the taxpayer's employer or requirements of applicable law or regulations imposed as a condition of continued employment. 13 Education expenses are not deductible if they relate to minimum educational requirements or to education or training that enables a taxpayer to begin working in a new trade or business. In the case of an employee, education expenses (if not reimbursed by the employer) may be claimed as an itemized deduction only if such expenses are job related and only to the extent that the expenses, along with other miscellaneous deductions, exceed two percent of the taxpayer's adjusted gross income. Education expenses that are reimbursed by the employer are excludable from the employee's gross income (and wages for employment tax purposes) as a working condition fringe benefit (sec. 132(d)) if the education qualifies as job related under section 162. Under prior law, an employee's gross income and wages for income and employment tax purposes did not include amounts paid or incurred by the employer for educational assistance provided to the employee (whether or not job related) if such amounts were paid or incurred pursuant to an educational assistance program meeting certain requirements (sec. 127). This exclusion, which expired after December 31, 1994, was limited to $5,250 of educational assistance with respect to an individual during a calendar year. Legislative Background The section 127 exclusion was first established on a temporary basis by the Revenue Act of 1978 (through 1983). It subsequently was extended, again on a temporary basis, by Public Law 98-611 (through 1985), by the Tax Reform Act of 1986 (through 1987), by the Technical and Miscellaneous Revenue Act of 1988 (through 1988), by the Omnibus Budget Reconciliation Act of 1989 (through September 30, 1990), by the Omnibus Budget Reconciliation Act of 1990 (through 1991), by the Tax Extension Act of 1991 (through June 30, 1992), and by the Omnibus Budget Reconciliation Act of 1993 (through December 31, 1994). Public Law 98-611 adopted a $5,000 annual limit on the exclusion; this limit was subsequently raised to $5,250 in the Tax Reform Act of 1986. The Technical and Miscellaneous Revenue Act of 1988 made the exclusion inapplicable to graduate-level courses. The restriction on graduate-level courses was repealed by the Omnibus Budget Reconciliation Act of 1990, effective for taxable years beginning after December 31, 1990. In the 104th Congress, H.R. 127 (introduced on January 4, 1995, by Messrs. Levin, Shaw, Camp, and Rangel) would permanently ex 13 Treas. Reg. sec. 1.162-5. 90-419 - 95 - 2 tend the section 127 exclusion. H.R. 746 (introduced on January 30, 1995, by Mr. Pickett) also would permanently extend the exclusion. Analysis The exclusion for employer-provided educational assistance programs is aimed at increasing the levels of education and training in the workforce. Employer-provided educational assistance benefits may serve as a substitute for cash wages (or other types of fringe benefits) in the overall employment compensation package. Because of their favorable tax treatment, benefits received in this form are less costly than cash wages in terms of the after-tax cost of compensation to the employer-employee pair. The tax treatment serves to subsidize the provision of education and could lead to larger expenditures on education for workers than would otherwise occur. This extra incentive for education may be desirable if some of the benefits of an individual's education accrue to society at large (through the creation of a better-educated populace or workforce). In that case, absent the subsidy, individuals would underinvest in education (relative to the socially desirable level) because they would not take into account those benefits that others receive. To the extent that expenditures on education represent a purely personal consumption benefit, a subsidy would lead to overconsumption of education. Because the provision allows an exclusion from gross income, the value in terms of tax savings is greater for those taxpayers with higher marginal tax rates. Thus, higher-paid individuals, individuals with working spouses, or individuals with other sources of income may be able to receive larger tax benefits than their fellow workers. In general, in the absence of section 127, the value of employerprovided education is excludable from income only if the education relates directly to the taxpayer's current job. If the education would qualify the taxpayer for a new trade or business, however, then the value of the benefit generally would not be excludable from income. Under this rule, higher-income, higher-skilled individuals may be more able to justify education as related to their current job because of the breadth of their current training and responsibilities. For example, an accountant may find more courses of study directly related to his or her current job and not qualifying him or her for a new trade than would a clerk. The exclusion for employer-provided educational assistance is meant to counteract this effect by making the exclusion widely available. Proponents argue that the exclusion is used by the nonhighly compensated employees to improve their competitive position in the work force. In practice, however, the scant evidence available seems to indicate that those individuals receiving employer-provided educational assistance are somewhat more likely to be higher-paid workers. 14 The size of the benefits paid also appear to be positively correlated with the income of the recipient. Such evidence is consistent with the observation that the exclusion is 14 See, for example, Coopers & Lybrand, "Section 127 Employee Educational Assistance: Who Benefits? At What Cost?", June 1989, p. 15, and Steven R. Aleman, "Employer Education Assistance: A Profile of Recipients, Their Educational Pursuits, and Employers," CRS Report, 89-33 EPW, January 10, 1989, p. 9. more valuable to those individuals in higher marginal tax brackets. A reformulation of the incentive as inclusion of the value of benefits into income in conjunction with a tax credit could make the value of the benefit more even across marginal tax brackets. 15 Another rationale for the exclusion is that it makes the tax laws easier to administer because it reduces the need to determine whether or not education is job related. 16 In the absence of the exclusion, distinguishing between job related and other education expenses may impose significant administrative costs on the Internal Revenue Service ("IRS") and taxpayers. It may also result in numerous disputes between the IRS and taxpayers. Proponents of a permanent extension argue that temporary extensions create unnecessary uncertainty and administrative burdens for taxpayers. 15 If the credit were nonrefundable, then to the extent that a taxpayer may reduce his or her tax liability to zero, he or she may not be able to receive the full value of the credit. 16 The need to determine whether or not expenses are job related still arises if employer-provided education expenses exceed the $5,250 annual limit. 3. Orphan drug tax credit (sec. 28 of the Code) Present Law Prior to January 1, 1995, a 50-percent nonrefundable tax credit was allowed for a taxpayer's qualified clinical testing expenses paid or incurred in the testing of certain drugs for rare diseases or conditions, generally referred to as "orphan drugs." Qualified testing expenses are costs incurred to test an orphan drug after the drug has been approved for human testing by the Food and Drug Administration (FDA) but before the drug has been approved for sale by the FDA. A rare disease or condition is defined as one that (1) affects less than 200,000 persons in the United States or (2) affects more than 200,000 persons, but for which there is no reasonable expectation that businesses could recoup the costs of developing a drug for it from U.S. sales of the drug. These rare diseases and conditions include Huntington's disease, myoclonus, ALS (Lou Gehrig's disease), Tourette's syndrome, and Duchenne's dystrophy (a form of muscular dystrophy). The orphan drug tax credit expired after December 31, 1994. Legislative Background This provision originally was enacted in the Orphan Drug Act of 1983, and was scheduled to expire after 1987. The Tax Reform Act of 1986 extended the credit for three years, through December 31, 1990. The Omnibus Budget Reconciliation Act of 1990 further extended the orphan drug tax credit for one year, through December 31, 1991. The Tax Extension Act of 1991 extended the orphan drug tax credit for six months, through June 30, 1992. The Omnibus Budget Reconciliation Act of 1993 extended the orphan drug tax credit for 30 months (i.e., for qualified clinical testing expenses incurred through December 31, 1994). In the 104th Congress, H.R. 1566 (introduced on May 3, 1995 by Mrs. Johnson of Connecticut and Mr. Matsui) would permanently extend the orphan drug tax credit and provide for carryovers and carrybacks of unused credits. Overview Analysis The orphan drug tax credit was created to encourage the development of drugs to treat rare diseases by providing a tax subsidy for drug companies to undertake clinical testing for such drugs. Because the potential U.S. market for such drugs is small, and because testing of these drugs may be quite expensive, the private market might not develop and test some of these drugs without a government subsidy. The revenues of producers may be smaller than the total amount of consumer benefit (because producers cannot discriminate among consumers and charge each consumer as much as he or she would be willing to pay), making it possible that the private market produces fewer orphan drugs than is socially optimal. This potential undersupply is not limited to orphan drugs, or to drugs in general. However, if society values orphan drugs |