ance of itemized deductions is to increase the marginal tax rate of affected taxpayers by almost 1 percentage point.2 Many taxpayers face both the PEP and Pease provisions, thus experiencing even larger increases in their implicit marginal tax rates. For example, a married couple filing jointly, with two dependent children, if affected by both provisions will have a marginal rate of about 34 percent in certain income ranges (31 percent plus 2 percent from the phaseout of exemptions plus almost 1' percent from the cutback of itemized deductions). See table below for a summary of the increases in marginal rates due to these two provisions. For those who itemize deductions and have ad- Add 1 ....... Pease 1 For those who itemize deductions and have ad- Add 1 ........ Pease 1 justed gross income above $108,450. For those who have adjusted gross income Add 0.5 for PEP 2 each 1 Cutback of itemized deductions. personal tion. 2 Phaseout of personal exemptions. Like the rate increase created by the phaseout of personal exemptions, the marginal rate increase caused by the cutback in itemized deductions will not be seen by the taxpayer as an explicit marginal rate increase. Rather, the taxpayer will calculate the actual reduction in his otherwise allowable itemized deductions, and then apply his statutory marginal rate-28 or 31 percent-to re 2 The effect of the provision on marginal rates is calculated as follows. For every dollar of income over $108,450, the taxpayer loses a deduction of $0.03. At a marginal tax rate of 31 percent, the loss of a deduction of three cents means a tax increase of 0.93 cents, i.e., an increase in the marginal rate of 0.93 percent. At a marginal tax rate of 28 percent, the provision results in a marginal rate increase of 0.84 percent. sulting taxable income. Visible or not, both PEP and Pease create a de facto marginal rate increase for affected taxpayers.3 Earned Income Tax Credit The earned income tax credit (EITC) was enacted in 1975. Its purpose is threefold: to provide an income supplement to low-income workers, to provide relief from the Social Security and other payroll taxes, and to provide work incentives. The EITC is a refundable credit, therefore, the credit acts as a direct wage supplement. The EITC functions in part as an income transfer mechanism. For example, if the total credit exceeds the taxpayer's income tax liability, the excess credit is paid to the taxpayer by the Government in cash. Eligibility for the credit is restricted to households with earned income who have children. Eligibility for the EITC is limited to a taxpayer who maintains a household, with at least one qualifying child, and has earned income. The EITC can be paid to an eligible taxpayer either through a tax refund at the end of the year when a tax return is filed, or on an advance basis. Under the advance system, the eligible individual's employer reduces the individual's income tax withholding ratably over the taxable year. Prior law. Prior to the Omnibus Budget Reconciliation Act of 1990, the EITC was available to married individuals filing joint returns who were entitled to a dependency exemption for the child; surviving spouses (who, by definition, maintain a household for a dependent child); and unmarried heads of household who maintained a household for a child. These eligibility criteria resulted in certain low-income working families being ineligible for a credit. A dependency exemption was available to a married couple filing jointly, only if the couple provided more than one-half the child's total support. The head-of-household eligibility criterion of maintaining a household for a child was met only if the taxpayer furnished more than one-half of the child's total support. For purposes of determining whether the taxpayer provided more than one-half the child's support or maintained a household for the child, benefits under Aid to Families with Dependent Children (AFDC) and other Government transfer programs were not considered. Thus, if more than one-half of a household's income was from certain Government transfer programs, the EITC was generally unavailable to that household. In addition, no supplemental young child or health insurance credit was available as part of the EITC. Modifications under OBRA of 1990.-Under OBRA of 1990 the following significant changes were made to the EITC: (1) the size of the EITC was expanded and adjusted for family size; (2) eligibility standards for the credit were simplified; (3) a supplemental credit for infants (children under the age of 1) was added; and (4) a supplemental credit for the health insurance expenses of children was added. 3 Other "bubbles" are also present in the tax system (e.g., the earned income tax credit phaseout, the passive activity loss phaseout rules, Social Security taxation rules, the child and dependent care credit phaseout, and the individual retirement account deduction income limitations). Family Size Adjustment The income thresholds, which are indexed for inflation, remain the same as under prior law. Thus, in 1993, the credit is projected to attain its maximum level at earned income of $7,750; the credit phaseout is projected to commence at income of $12,200, with complete phaseout at $23,054. The credit percentages and phaseout rates are now as follows: For 1993, the maximum credit is $1,434 for taxpayers with one qualifying child and $1,511 for taxpayers with two or more qualifying children. The advance payment of the credit, through reduced withholding, is limited to the amount that the taxpayer could receive with one qualifying child. Simplification of Eligibility Standards These changes expand the class of households who would qualify for the EITC. Very generally, under the modifications a low-income individual may claim the EITC with respect to any non-adult child (or adult disabled child) who lives with that individual for more than one-half the year, provided no other taxpayer may also claim the credit for that child. More specifically, an individual (or married couple) is eligible for the EITC with respect to another person if that other person: (1) is a son, daughter (or descendent of either), stepson or stepdaughter, or a foster child or adopted child of the taxpayer. (A foster child is defined as a person for whom the individual cares for as the individual's child; it is not necessary to have a placement through a foster care agency), (2) is under the age of 19 (or a full time student and under the age of 24) at the close of the taxable year; or is permanently and totally disabled, and (3) shares the same place of abode as the person claiming the credit for more than one-half the year (the entire year for foster children). As under prior law, the residence must be in the United States. As under prior law, the two following requirements apply: if the qualifying child is married at the close of the year, the individual may claim the EITC for that child only if the individual may also claim the dependency exemption for the child; married taxpayers may claim the EITC only if they file a joint return. In addition, the following rules apply where the EITC could be claimed twice with respect to the same qualifying child: (1) If more than one individual may claim any part of the EITC with respect to any qualifying child, then only the individual with the highest adjusted gross income may claim the EITC with respect to the child. For example, assume a household is comprised of a grandmother, mother (age 20); and child (age 2). Both the grandmother and mother are eligible to claim the credit with respect to the child. In this case, the individual with the higher adjusted gross income is the only person eligible to claim the credit for the child (assuming all other requirements are met). (2) An individual who is a qualifying child can not claim the EITC with respect to himself or herself. For example, assume the same facts as in the case above, except the mother is age 17 (instead of age 20), and she is a qualifying child of the grandmother. In this case, only the grandmother could claim the EITC, with respect to her own daughter (age 17), and her grandchild (age 2). Under OBRA of 1990, the taxpayer must supply a taxpayer identification number (TIN) for each child for whom the credit is claimed who is at least 1 year old at the end of the year for which the credit is claimed. If the EITC is claimed, a separate schedule must be attached to the tax return, showing the name and age of each qualifying child as well as the TIN for each child over the age of 1. Supplemental Credit for Infants Under OBRA of 1990, a supplemental credit was added for children under 1 year (at the end of the year for which the credit is claimed). The basic limits (including indexing) are the same. For 1993, the supplemental credit will equal 5 percent of the first $7,750 of earned income with a maximum credit of $388. The phaseout for this supplemental credit equals 3.57 percent. An individual may not claim the dependent care credit for expenses related to any child for whom the individual claims the supplemental young child credit. The supplemental credit is not available on an advance basis. Supplemental Credit for Health Insurance OBRA of 1990 also created a supplemental EITC for certain health insurance premium expenses. The credit is available with respect to the health insurance premiums paid for health insurance coverage for the taxpayer's qualifying children. The credit cannot exceed out-of-pocket costs for health insurance. The same income limits for the basic EITC apply for purposes of the supplemental health credit. For 1993, the credit will equal 6 percent of the first $7,750 of earned income with a maximum credit of $465. The credit is phased out at a rate of 4.285 percent. The taxpayer cannot claim an itemized deduction for the health insurance costs used to compute the supplemental health credit. The following table summarizes the changes made by OBRA to the projected size of the EITC: EARNED INCOME TAX CREDIT PERCENTAGE AND MAXIMUM CREDIT AMOUNT, The objective of providing a progressive income tax has long embodied the notion that taxpayers with incomes below certain threshold levels should not be subject to the income tax at all. With this goal in mind, tax policymakers have traditionally viewed these "tax entry points" as one of the measures of the fairness of the income tax system. The standard deduction and personal exemptions are the key structural elements that determine the level of the tax entry points. Because of these two features alone, a moderate-income family of four, comprised of a married couple and two dependent children, in 1993 would pay no taxes on the first $15,600 of income. This is because income equal to the sum of $6,200 (the standard deduction) plus $9,400 (four personal exemptions) would not be taxed. The earned income tax credit significantly raises the tax entry point above the point created by the standard deduction and personal exemptions alone. Table 8 shows tax entry points, with and without the earned income tax credit, for taxpayers of different filing status, for 1993 and 1994. Indexing In the absence of indexing, inflation could have significant consequences on all the structural features of the individual income tax. As prices rose, the real value of the personal exemption, standard deduction bracket boundaries, and credits expressed in nominal dollars would decline. As taxpayers' incomes rose with inflation but the structural features of the income tax did not, taxpayers would |