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

be bumped into higher tax brackets. They would face higher marginal tax rates, even though their real incomes had not risen. This is known as "bracket creep." Thus, the result of bracket creep is that taxes rise faster than real incomes.

The Economic Recovery Tax Act of 1981 indexed the structural features of the income tax system to inflation, beginning in 1985: the standard deduction, the personal exemption, and rate brackets. The Tax Reform Act of 1986 indexed the earned income tax credit. OBRA of 1990 made no significant change to the indexing of these provisions.

In General

D. CAPITAL GAINS AND LOSSES

Capital gains are subject to special tax treatment in a variety of ways. In addition to special capital gains tax rates discussed later, the most significant feature of capital gains taxation is deferral: no tax is levied on the gain until the asset is "realized," or sold. This departs from the concepts generally used by economists. Economic theory would argue that increases in the value of an asset during a taxable period are income, even if the asset is not sold. Conversely, losses in asset value would reduce income. Under a realization system, gains are not classified as income until the asset is sold by the taxpayer, thus converting the increases in value into cash or some other form of income. Not classifying the gains as income until the asset is sold or disposed of and the gain is "realized" means that the taxpayer gets the advantage of deferred taxation. The advantage of deferral can be seen in the comparison between $100 invested in a capital asset that grows at a rate of 8 percent per year, and $100 in a bond, savings account or other interestbearing asset that yields 8-percent interest per year. After 10 years, total gain on the capital asset equals $116. If the asset is sold, total after-tax gain at a marginal tax rate of 28 percent equals $83. The interest-bearing investment, on the other hand, has not been growing at a rate of 8 percent per year. Rather at marginal tax rate of 28 percent the after-tax rate of growth on this investment has equalled only 5.76 percent (0.72 × 8 percent). After 10 years, the total after-tax yield on the interest-bearing investment equals only $75 compared with the $83 after-tax gain on the capital asset. This example does not take into account differences in cash flow. Since the bondholder generally has the option to receive the income as cash each year, he or she can consume the income or reinvest it without disturbing the underlying asset.

The second significant feature of capital gains taxation is that the gain is not indexed for inflation. This means that tax may be paid on increases in the value of an asset, even if the real value of the asset has not increased. It is possible that the purchasing power represented by the asset's value may not have increased (if the asset's value and general price inflation are the same). However, when sold, the increase in value could generate taxable in

come.

A third significant feature of capital gains taxation is often termed the "bunching" problem. When a capital asset is sold, gain earned over many years is realized all in 1 year. As a result, the

taxpayer's income may be greatly increased in that year by the gain, rather than moderately increased over each of the several years in which the gain was accrued. In a progressive tax system, the bunching of income in 1 year means that the marginal rate applied to that gain is likely to be higher than it would have been had the gain been taxed in pieces, as it accrued annually. Because the Tax Reform Act of 1986 reduced the number or statutory marginal rate to two, the problem of additional income pushing taxpayers into higher marginal rate brackets is considerably less than it had been in previous years.

A fourth feature of capital gains taxation is the treatment of gains at death. Inheritors of capital assets are permitted to increase, or "step up," the basis of the capital asset to the fair market value of the asset at the time of the decedent's death. This treatment means that there is no tax on the capital gain accrued on an inherited asset before the death of the decedent. For example, if an individual buys three shares of stock for $100, and holds the shares until death, when they are worth $150, the basis of the shares for the heirs equals $150. If the shares are sold at a time when their value equals $150, the inheritors' gain is zero. The $50 of gain accrued during the decedent's lifetime goes untaxed.

Capital Gains Rates

Beginning in 1991, the maximum rate on long-term capital gains for individuals is 28 percent. Net capital gains are currently taxed at the individual's ordinary tax rate, subject to a maximum rate of 28 percent. Thus, individuals in the 15 and 28 percent brackets face the same marginal rate for both ordinary income and capital gains. Individuals in the top bracket face a 31-percent marginal rate on their ordinary income but a 28-percent marginal rate on their long-term capital gains income. This is equivalent to about a 10-percent exclusion.

Between 1920 and 1986, the top marginal rate on long-term capital gains was typically lower than the rate on ordinary income. Table 9 shows that the top marginal rate on capital gains has varied between 20 percent and 49 percent in just the last three decades. The preferential rate has been contingent on the taxpayer's holding the asset for some specified minimum period of time. Under present law, the holding period necessary for the preferential rate is 1 year. Often, the preferential rate is accomplished by allowing the taxpayer to exclude a portion of the gain before applying the regular tax rate. For example, in 1986, taxpayers were permitted to exclude 60 percent of net long-term capital gain, resulting in a top marginal rate of 20 percent (equal to 40 percent times the 50 percent maximum rate on ordinary income).

The Tax Reform Act of 1986 eliminated the preferential rate for long-term capital gains. As a result, the maximum statutory rate was 28 percent. OBRA of 1990 created a top rate of 31 percent for ordinary income, but retained a maximum rate of 28-percent for

long-term capital gains, thus reintroducing a capital gains differential of about 10 percent for those in the 31-percent bracket.4

Capital Losses

The fact that gains and losses on capital assets are taken into account only when realized has an important implication for the tax treatment of capital losses. Realization taxation, if completely unrestricted, would permit taxpayers to sell capital assets with losses, and deduct the losses against ordinary income, while holding onto assets with gains and deferring tax on the gain. Because gains are not taxed at all on assets held at death, the deferral on gain could be infinite, while the immediate deductibility of losses would be unchecked.

Therefore, a number of restrictions on taxpayers' ability to use this approach have been set in law. First, a taxpayer's realized capital losses must be deducted (netted) against capital gains realized in that year. If the taxpayer's capital loss exceeds capital gain, only $3,000 of the excess capital loss may be deducted against ordinary income in that year. The remaining capital loss may be carried over into successive taxable years and deducted either against capital gains realized in those years, or against ordinary income, subject to the $3,000 limitation each year.

Second, "wash sale" rules restrict a taxpayer's ability to sell a capital asset, realize the loss, and then repurchase the asset. Specifically, a taxpayer may not deduct a loss if sale and purchase of similar assets take place within a 60-day period. Third, additional rules restrict more sophisticated maneuvers.

E. THE MINIMUM TAX

The minimum tax requires an alternative tax computation for taxpayers who make excessive use of deductions and exclusions so as to reduce their tax burden below a politically acceptable amount. The minimum tax represents a compromise between the congressional desire to encourage certain economic activities through preferences in the Internal Revenue Code and the belief that individuals with substantial economic income should pay some moderate amount of tax.

The first minimum tax was an "add-on” minimum tax introduced by the Tax Reform Act of 1969. The tax was computed as 10 percent on a list of certain deductions and exclusions ("preference items") to the extent that the sum of these items exceeded the sum of $30,000 plus the regular income tax.

The "add-on" system eventually proved ineffective in requiring that taxpayers with substantial economic incomes pay at least some tax. Examples of taxpayers "zeroing out" of the income tax received considerable public attention. Accordingly, the minimum tax systems for both individuals and corporations were ultimately converted to "alternative minimum tax" systems, intended to provide a more comprehensive measurement of economic income than the old add-on system. For individuals, this change began in the Reve

Capital gains can be subject to higher implicit marginal tax rates, if the taxpayer is affected by the limitation on itemized deductions and the phaseout of personal exemptions (described above).

nue Act of 1978. Additional changes occurred in the Tax Equity and Fiscal Responsibility Act of 1982 and in the Tax Reform Act of 1986. For corporations, the conversion to the alternative minimum tax system was made in the Tax Reform Act of 1986.

Under present law, the alternative minimum tax for individuals is calculated by applying the minimum tax rate to a new tax base, alternative minimum taxable income (AMTI). The AMTI equals adjusted gross income, plus the taxpayer's tax preferences, minus certain itemized deductions, and (for taxpayers in certain income ranges) minus an exemption. Tax liability equals the greater of the regular tax or the alternative minimum tax.

Beginning in 1991, the alternative minimum tax rate for individuals is 24 percent. The 24-percent rate was enacted by OBRA of 1990. From 1987 through 1990, the alternative minimum tax rate for individuals was 21 percent, enacted in the Tax Reform Act of 1986.