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two income brackets: one taxable at 15 percent, one taxable at 28 percent. OBRA of 1990 created a third marginal rate bracket, taxable at 31 percent, for years beginning in 1991 or thereafter. Table 6 shows marginal tax rates for 1993 and 1994.
The top marginal rate has varied widely since the inception of the individual income tax. When first enacted in 1913, the top marginal rate was 7 percent, applicable to taxable incomes in excess of $500,000. Since then, the top marginal rate has climbed as high as 92 percent (1952-1953). Between 1982 and 1986, the top marginal rate was 50 percent. The Tax Reform Act of 1986 brought down the statutory top marginal rate to 28 percent, beginning in 1988. OBRA of 1990 imposed a new top marginal rate of 31 percent, beginning in 1991.
Certain provisions of the income tax result in higher implicit marginal rates than the statutory rates. These provisions generally have been targeted to high-income taxpayers, and generally have denied them the benefits of other provisions that reduce taxable income. Because increases in income above certain thresholds also require an "extra" add-back to taxable income as deductions or lower rates are denied, these income increases are subject to a higherthan-statutory marginal rate.
For example, the Tax Reform Act of 1986 phased out two tax benefits for high-income taxpayers: the personal exemption, and the benefit of the 15-percent rate applied to lower income. The effect of these phaseouts was to add 5 additional percentage points to the statutory marginal rate of 28 percent. Thus, taxpayers with incomes in the phaseout range experienced a marginal rate of 33 percent. For income above the phaseout range, the taxpayer's marginal rate dropped back to 28 percent. As a result, taxpayers with income above the phaseout range experienced marginal tax rates lower than those faced by taxpayers in the phaseout range. For that reason, the higher marginal rates in the phaseout range are sometimes referred to as a "rate bubble."
OBRA of 1990 eliminated the phaseouts as they were structured under the Tax Reform Act of 1986. The rate structure established under OBRA of 1990 remains in effect today. The top statutory marginal rate is 31 percent. OBRA of 1990 established two provisions that implicitly increase marginal tax rates above the statutory rates for certain high-income taxpayers: the phaseout of the personal exemptions ("PEP") and the limitation on itemized deductions ("Pease").
Personal exemptions of high-income taxpayers are phased out as described above. (The exemption amount in 1993 is $2,350 for the taxpayer, the taxpayer's spouse, and each dependent). Over the phaseout range, the denial of personal exemptions raises the taxpayer's marginal rate by approximately 0.5 percentage points for each personal exemption. Thus, a family of 4 in the 31-percent bracket would see their tax rate rise to 33 percent, simply by virtue of the PEP provision.
Itemized deductions are reduced by an amount equal to 3 percent of the excess of taxable income over a certain threshold, $108,450 for 1993, as described above. This provision is called the "Pease" provision for shorthand, in reference to one of its sponsors, Representative Don Pease (retired) of Ohio. The effect of the disallow
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
For those who have adjusted gross income Add 0.5...... above $108,450 and below $233,450. Married couples:
$0 to $36,900
$36,900 to $89,150.....
$89,150 and above
For those who itemize deductions and have ad-
For those who have adjusted gross income
1 Cutback of itemized deductions.
2 Phaseout of personal exemptions.
Add 0.5 for
Tax provision controlling tax rate
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
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 EITČ.
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:
63-239 93 3
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.