E. Simplification of the EITC through Structural Changes

Summary of Full Report Submitted to the Joint Committee on Taxation

for its Study of the Overall State of the Federal Tax System*

By Annette Nellen, Esq. CPA

San José State University

The earned income tax credit (EITC) is one of the most complex provisions of the tax law, yet its purpose is to provide a benefit to low-income taxpayers, who should not be facing such complexity. While there have been various proposals over the past several years to simplify the EITC, few changes have been made and recent law changes, such as the enactment of the child credit, have made the EITC even more complex for many of the individuals who claim it. In addition to complexity, the EITC is also prone to fraud and additional provisions have been added to combat this.

At credit levels of 7.65%, 34% and 40% depending on the type of individual claiming the EITC, the credit results in a refund of all or some portion of the employee's share of FICA and Medicare taxes. In these situations, the EITC is basically a mechanism to refund a tax that perhaps just as easily could not have been withheld in the first place. Such a result could be achieved by using a system similar to the income tax withholding system that doesn't begin until a certain income level is reached. If further simplifications were made to conform definitions used for the EITC, such as "qualifying child," to other definitions used in computing federal taxable income, such as "dependent," the structural change would be more feasible and further simplification could be achieved. In addition, if some of the EITC benefit were provided via an increase in the dependent child deduction and/or child credit, the amount of EITC benefit to be delivered through an alternative payroll tax withholding structure would be reduced and simplified.

The current EITC benefit levels could be retained (if desired) through the alternative payroll tax withholding structure. In addition, a "leveling" mechanism could be incorporated into the new withholding structure to level the payroll tax withholding for non-EITC-eligible workers throughout the year and to provide a more constant benefit to EITC-eligible workers in each paycheck throughout the year. This would be similar to the current income tax withholding

structure.

Beyond simplification, an additional potential benefit of an alternative structure and simplification of qualifying status requirements would be that it might make it easier to move to a return-free tax system. Structural changes as described above would also serve to provide the EITC benefit to low-income taxpayers in each paycheck without a need for individuals to apply to their employer to receive an advance EITC (assuming they are eligible for the advance EITC).

F. Reforming and Simplifying the Income Taxation of Private Business Enterprises

Summary of Full Report Submitted to the Joint Committee on Taxation for its Study of the Overall State of the Federal Tax System

By George K. Yin and David J. Shakow

University of Virginia Law School and Professor Emeritus, University of Pennsylvania Law School, Respectively

Under current law, many private businesses, no matter what their organizational form or characteristics, have the choice of being taxed under one of three possible income tax regimes. In general, they can be taxed under the set of rules traditionally reserved for corporations (subchapter C), for partnerships (subchapter K), or for certain closely-held corporations (subchapter S).

In this paper, we argue that there is no policy justification for permitting firms to continue to choose among these three sets of rules, and that the existence of the choice unnecessarily complicates the law for both taxpayers and the IRS. In general, we recommend that the choice be narrowed to two -- subchapter K and subchapter S -- with the options being reconfigured somewhat to make them more consistent with one another and more rational. Subchapter S is preserved and liberalized because it offers a simplified method of taxing the income of private businesses. We would reserve this option for those firms that are owned exclusively by individuals and that have straightforward economic arrangements, two characteristics that make such firms less susceptible to tax advantage and abuse, and therefore less in need of complicated anti-abuse protections. In general, all other firms, including any eligible firms not choosing the subchapter S option, would be taxed under subchapter K as modified by selected reforms.

Rarely is there an opportunity to adopt a proposal that provides both meaningful reform and simplification of the tax laws. Too often, those objectives are in conflict with one another. While many details need to be carefully considered, we believe that the recommendations outlined in this paper have the potential for achieving that happy combination.

This paper summarizes the principal recommendations of an American Law Institute Reporters' Study prepared by the authors on this topic. Interested readers should consult the Study for the complete set of proposals and a fuller discussion of the issues. Copies are available from the ALI (800-253-6397).

II. ACADEMIC PAPERS SUBMITTED TO THE JOINT COMMITTEE STAFF

A. Simplification for Low Income Taxpayers: 2001

By

Jonathan Barry Forman*

What can be done to simplify the federal tax system for low-income individuals and for the Internal Revenue Service? That was the focus of my 1996 article: Jonathan Barry Forman,

Simplification for Low Income Taxpayers: Some Options, 57 OHIO STATE LAW JOURNAL 145-201 (1996). Specifically, that article identified some statutory and regulatory changes that would: (1) reduce the number of low-income individuals required to file tax returns; and (2) simplify the return-filing process for those who must file. This paper summarizes and updates that 1996 article.

According to the Census Bureau, some 32.2 million Americans (11.8 percent) live in families with incomes below the poverty line.' The principal federal taxes affecting these lowincome individuals are the individual income tax and the Social Security payroll tax. Once the earned income credit is taken into account, however, relatively few low-income individuals actually have a net federal tax liability. Nevertheless, the current federal tax system requires virtually all low-income individuals to file returns, if only to recover refunds of over-withheld

taxes.

For example, consider the tax treatment of a typical low-income married couple with two children in 2001. If their income consists entirely of wages or salaries, the couple will have no net federal tax liability unless they earn more than $23,562.2 Their $7,600 standard deduction and four $2,900 personal exemptions together will shelter $19,200 from the income tax, and their earned income tax credit and $500 child tax credits will offset the rest of their tax liability. By way of comparison, the poverty level for a family of four in 2001 is just $17,650.4

3

* Professor of Law, University of Oklahoma; B.A. 1973, Northwestern University; M.A. (Psychology) 1975, University of Iowa; J.D. 1978, University of Michigan; M.A. (Economics) 1983, George Washington University.

1

D'Vera Cohn, Poverty Declines to 20-year Low; Central Cities Account for Most of Drop; Incomes Hit Record, WASHINGTON POST, September 27, 2000, at A2.

2 See Appendix Table 1.

3

4

Rev. Proc. 2001-13, 2001-3 I.R.B.1.

U.D. Department of Health & Human Services, Annual Update of the HHS Poverty Guidelines, 66 FEDERAL REGISTER 10,695 (2001).

Indeed, virtually no low-income taxpayers with children will owe federal taxes for the year 2001, and relatively few low-income childless individuals and couples will owe taxes either. Moreover, those low-income taxpayers that do have a net federal tax liability will pay relatively little in federal taxes. For example, of the 53 million taxpayers with adjusted gross incomes of less than $20,000 who filed income tax returns for 1998, only about 8 million actually had any tax due at the time of filing, and the average amount owed by these was just $534.

6

Unfortunately, the current tax system imposes heavy costs and burdens on both lowincome individuals and the IRS. Simplification of the tax system holds the promise for significant economic and equitable gains. It may not be possible to simplify the federal tax system for all individuals. But it should be possible to simplify the federal tax system for lowincome individuals. Here are some possibilities.

1. Let the IRS Prepare Returns for Low-Income Taxpayers

To date, low-income taxpayers have benefited from many of the IRS's efforts to simplify the return-filing process, and the IRS should continue with those efforts. In general, the IRS should continue: (1) working to simplify Internal Revenue forms and publications; (2) developing and expanding its taxpayer assistance programs; and (3) exploring alternative filing methods such as electronic filing.

7

Better still, it might make sense to have the IRS actually prepare income tax returns, at least for low-income taxpayers.' Virtually all welfare programs help individuals apply for benefits, and the earned income credit provides a welfare-like benefit. Why not let the IRS help low-income workers claim their earned income credit refunds?

2. Statutory Changes To Simplify the Income Tax

Another way to simplify the tax system for low-income taxpayers would be to raise the standard deduction amounts or the personal exemption, or to enact an exclusion for some modest amount of miscellaneous income."

8

5

Internal Revenue Service, Selected Historical and Other Data, 19 SOI BULLETIN 159, 165 (Spring 2000); see also Joint Committee on Taxation, Distribution of Certain Federal Tax Liabilities by Income Class for Calendar Year 2000 (JCX-45-00), April 11, 2000.

6

For example, Joel Slemrod has estimated that the total compliance cost of the U.S. income tax system is around $75 billion per year. Joel Slemrod, Which is the Simplest Tax System of Them All?, in ECONOMIC EFFECTS OF FUNDAMENTAL TAX REFORM 355, 367 (Henry J. Aaron & William G. Gale eds. 1996).

7

See Jonathan Barry Forman, Simplification for Low Income Taxpayers: Some Options, 57 OHIO STATE LAW JOURNAL 145, 176-78 (1996).

8 Id. at 181-82, 186-88.