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94th Congress } COMMITTEE PRINT
2d Session
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TAX EXPENDITURES
Compendium of Background Material
on Individual Provisions
COMMITTEE ON THE BUDGET
UNITED STATES SENATE
w
MARCH 17, 1976
C
Printed for the use of the Commit~e on the
U.S. GOVERNMENT PRINTING OFFICE
WASHINGTON 1976
:. ~
A
67-312
D
1~r~a1fb ~fr'~iperintendent of Documents, ITS. Government Printing Office
Washington, D.C., 20402 - Price $2.20
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COMMITTEE ON THE BUDGET
EDMUND S. MUSKIE, Maine, Chairman
WARREN G. MAGNUSON, Washhlgton
FRANK E. MOSS, Utah
WALTER F. MONDALE, Minnesota
ERNEST F. HOLLINGS, South Carolina
ALAN CRANSTON, California
LAWTON CHILES, Florida
JAMES ABOUREZK, South Dakota
JOSEPH R. BIDEN, Ja., Delaware
SAM NUNN, Georgia
DOUGLAS J. BENKET, Jr., Staff Director
JOHN P. McEvo~, Chief Counsel
ROBERT S. BOYD, Minority Staff Director
W. THOMAS FOXWELL, Director of Publications
(ii)
HENRY BELLMON,~ Oklahoma
ROBERT DOLE, Kansas
J. GLENN BEALL, JR., Maryland
JAMES L. BUCKLEY, New York
JAMES A. McCLURE, Idaho
PETE V. DOMENICI, New Mexico
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LETTER OF TRANSMITTAL
To THE MEMBERS OF THE COMMITTEE ON THE BUDGET:
The Congressional Budget and Impoundment Control Act of 1974
requires that the Budget Committees and the Congress examine tax
expenditures as part of overall Federal budgetary policy. This re-
quirement stems from a recognition that numerous provisions of
Federal tax law confer benefits on some individuals and institutions
that are comparable to direct Federal spending, but that these tax
law benefits seldom are reviewed, in comparison with direct spending
programs.
This Committee print has been prepared to gather together basic
background information concerning tax expenditures to assist members
of the Budget Committee and other Members of the Congress in
carrying out their responsibilities with respect to tax expenditures
under the Budget Act. It is a compendium of summaries which
describes the operation and impact of each tax expenditure; indicates
the authorization and rationale for its enactment and perpetuation;
estimates both the revenue loss attributable to each provision and,
where provisions affect individual taxpayers directly, the percentage
distribution by adjusted gross income class of the tax savings conferred
by the provision; and cites selected bibliography for each provision.
The concept of tax expenditures is a relatively new one which is
still in the process of being refined, both with respect to the provisions
classified as tax expenditures and the methods of calculating the rev-
enue losses stemming from such provisions. Nevertheless, failure to
take tax expenditures into account in the budget process now would
be to overlook significant segments of Federal policy. They should be
given particularly thorough scrutiny because, as the compendium
indicates, tax expenditures are generally enacted as permanent legis-
lation and thus are comparable to continuing direct spending entitle-
riment programs, often with increasing annual revenue losses.
This compendium was prepared jointly by Jane Gravelle of the
Congressional Research Service, Ronald Hoffman, Charles Davenport,
John Roth, and Roger Golden of the Congressional Budget Office, and
Ira Tannenbaum, Kenneth Biederman, and Bert Carp of the Budget
Committee staff.
Nothing in this compendium should be interpreted as representing
the views or recommendations of the Budget Committee or any of its
individual members.
Sincerely,
HENRY BELLMON, EDMUND S. MIJSKIE,
Ranking Minority Member. Chairman.
WALTER F. MONDALE,
~Jhairman, Task Force on Tax
Policy, and Tax Expenditures.
(III)
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CONTENTS
Page
Letter of transmittal III
Introduction 1
National defense:
Exclusion of benefits and allowances to Armed Forces 7
Exclusion of military disability pensions 9
International affairs:
Exclusion of gross-up on dividends of less developed country corpora-
tions 11
Exclusion of certain income earned abroad by U.S. citizens 13
Deferral of income of Domestic International Sales Corporations
(DISCs) 15
Special rates for Western Hemisphere Trade Corporations 19
Deferral of income of controlled foreign corporations 21
Agriculture:
Expensing of certain capital outlays 23
Capital gain treatment of certain income 25
Natural Resources, Environment, and Energy:
Expensing of intangible drilling, exploration and development costs - 27
Excess of percentage over cost depletion 31
Capital gain treatment of royalties on coal and iron ore 35
Timber: Capital gains treatment of certain income 37
Pollution control: 5-year amortization 39
Commerce and Transportation:
Corporatesurtaxexemption 41
Deferraloftaxonshippingcompaflies 43
Railroad rolling stock: 5-year amortization 45
Bad debt deductions of financial institutions in excess of actual losses. - 47
Deductibility of nonbusiness State gasoline taxes 49
Depreciation on rental housing in excess of straight line, and deprecia-
tion on buildings (other than rental housing) in excess of straight
line 51
Expensing of research and development costs 55
Investment tax credit 57
Asset depreciation range 61
Dividend exclusion 63
Capital gains: Individual (other than farming and timber) 65
Capital gains treatment: Corporate (other than farming and timber)_ 67
Exclusion of capital gains at death 71
Deferral of capital gains on home sales 73
Deductibility of mortgage interest and property taxes on owner-
occupied property 75
Exemption of credit unions 77
Deductibility of interest on consumer credit 79
Credit for purchasing new home 81
(v)
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VI
Community and Regional Development: Page
Housing rehabilitation: 5-year amortization 83
Education, Training, Employment, and Social Services:
5-year amortization of child care facilities 85
Exclusion of scholarships and fellowships 87
Parental personal exemption for student age 19 or over 89
Deductibility of charitable contributions to educational institutions
other than educational institutions_ - 91
Deductibility of child and dependent care services 95
Credit for employing public assistance recipients under Work In-
centive (WIN) Program 97
Health:
Exclusion of employer contributions to medical insurance premiums
and medical care 99
Deductibility of medical expenses 101
Income Security:
Exclusion of social security benefits (disability insurance benefits,
OASI benefits for the aged, and benefits for dependents and sur-
vivors) 103
Exclusion ofrailroad retirement benefits 105
Exclusion of sick pay 107
Exclusion of unemployment insurance benefits 109
Exclusion of worker's compensation benefits 111
Exclusion of public assistance benefits 113
Net exclusion of pension contributions and earnings:
Employer plans 115
Plans for self-employed and others 117
Exclusion of other employee benefits:
Premiums on group term life insurance 119
Premiums on accident and accidental death insurance 121
Privately financed supplementary unemployment benefits 123
Meals and lodging 125
Exclusion of interest on life insurance savings 127
Exclusion of capital gains on house sales if over 65 129
Deductibility of casualty losses 131
Excess of percentage standard deduction over low income allowance.. 133
Additional exemption for the blind 135
Additional exemption for over 65 137
Retirement income credit 139
Earned Income credit 143
Maximum tax on earned income 145
Veterans' Benefits and Services:
Exclusion of disability compensation, pensions, and GI bill benefits - 147
General Government:
Credits and deductions for political contributions 149
Revenue Sharing and General Purpose Fiscal Assistance:
Exclusion of interest on State and local bond debt 151
Exclusion of income earned in U.S. possessions 155
Deductibility of nonbusiness State and local taxes (other than on
oWner-occupied homes and gasoline) 157
Appendix A:
Forms of tax expenditures 159
Appendix B:
Capital gains 165
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INTRODUCTION
This compendium gathers basic information concerning 74 Federal
income tax provisions currently treated as tax expenditures. The
provisions included in this compendium are the same as those listed
in Estimates of Federal Tax Expenditures, prepared for the Committee
on Ways and Means and the Committee on Finance by the staffs of
the Treasury Department and Joint Committee on Internal Revenue
Taxation (July 8, 1975). With respect to each of these expenditures,
this compendium provides:
An estimate of the Federal revenue loss associated with the
provision for individual and corporate taxpayers, for fiscal years
1975, 1976, and 1977;
The legal authorization for the provision (e.g., Internal Revenue
Code section, Treasury Department regulation, or Treasury
rulmg);
A description of the tax expenditure, including an example of
its operation where this is useful;
A brief analysis of the impact of the provision;
An estimate, where applicable, of the percentage distribution-
by adjusted gross income (AGI) class-of the individual income
tax saving resulting from the provision;
A brief statement of the rationale for the adoption of the tax
expenditure where it is known, including relevant legislative
history; and
References to selected bibliography.
The information presented for each of these tax expenditures is not
intended to be exhaustive or definitive. Rather, it is intended to pro-
vide an introductory understanding of the nature, effect, and back-
ground of each of these provisions. Good starting points for further
research on each item are listed in the selected bibliography following
each provision.
Defining Tax Expenditures
Tax expenditures are revenue losses resulting from Federal tax
provisions that grant special tax relief designed to encourage certain
kinds of behavior by taxpayers or to aid taxpayers in special circum-
stances. These provisions may, in effect, be viewed as the equivalent
of a simultaneous collection of revenue and a direct budget outlay of an
equal amount to the beneficiary taxpayer.
Section 3(a) (3) of the Congressional. Budget and Impoundment
Control Act of 1974 specifically defines tax expenditures as:
those revenue losses attributable to provisions of the Federal tax laws
which allow a special exclusion, exemption, or deduction from gross income or
which provide a special credit, a preferential rate of tax, or a deferral of tax
liability; . . . . .
(1)
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2
In the legislative history of the Congressional Budget Act, provisions
classified as tax expenditures are contrasted with those provisions
which are part of the "normal structure" of the individual and cor-
porate income tax necessary to collect government revenues.
The concept of tax expenditures is relatively new, having been
developed over only the past decade. Tax expenditure budgets which
list the estimated annual revenue losses associated with each tax
expenditure first were required to be published in 1975 as part of the
Administration budget for FY 1976, and will be required to be
published by the Budget Committees for the first time this April.
The tax expenditure concept is still being refined, and therefore the
classification of certain provisions as tax expenditures continues to
be discussed. Nevertheless, there is widespread agreement for the
treatment as tax expenditures of most of the provisions included
in this compendium.'
The listing of a provision as a tax expenditure in no way implies
any judgment about its desirability or effectiveness relative to other
tax or nontax provisions that provide benefits to specific classes of
individuals and corporations. Rather, the listing of tax expenditures,
taken in conjunction with the listing of direct spending programs, is
intended to allow Congress to scrutinize all Federa] programs-both
nontax and tax-when it develops its annual budget. Only if tax ex-
penditures are included will Congressional budget decisions take into
account the full spectrum of Federal programs.
In numerous instances, the goals of these tax expenditures might
also be achieved through the use of direct expenditures or loan
programs. Because any qualified taxpayer may reduce tax liability
through use of a tax expenditure, such provisions are comparable
to entitlement programs under which benefits are paid to all eligible
persons. Since tax expenditures are generally enacted as permanent
legislation, it is important that, as entitlement programs, they be
given thorough periodic consideration to see whether they are
efficiently meeting the national needs and goals that were the reasons
for their initial establishment.
Major Types of Tax Expenditures
Tax expenditures may take any of the following forms: (1) exclu-
sions, exemptions, and deductions, which reduce taxable income;
(2) preferential tax rates, which reduce taxes by applying lower
rates to part or all of a taxpayer's income; (3) credits, which are
subtracted from taxes as ordinarily computed; and (4) deferrals of
tax, which result from delayed recognition of income or from allowing
in the current year deductions that are properly attributable to a
future year.2
The amount of tax relief per dollar of each exclusion, exemption,
and deduction increases with the taxpayer's marginal tax rate. Thus,
the exclusion of interest income from State and local bonds saves $50
in tax for every $100 of interest for the taxpayer in the 50 percent tax
bracket, whereas the savings for the taxpayer in the 25 percent bracket
is only $25. Similarly, the extra exemption for persons over age 65 and
1 For a discussion of gonie of the conceptual problems involved in defining tax expenditures, see Budget
of the United States Government, Fiscal year 1977, "Special Analysis F", 116-122.
2 See Appendix A for further analysis of these types of tax expenditures.
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3
any itemized deduction is worth twice as much in tax saving to a
taxpayer in the 50 percent bracket as to one in the 25 percent
bracket.
A tax credit is subtracted directly from the tax liability that would
otherwise be due; thus the amount of tax reduction is the amount of
the credit-which does not depend on the marginal tax rate.
The numerous tax expenditures that take the form of exclusions,
deductions, and exemptions are relatively more valuable to upper than
to lower or middle income individuals. However, this fact should be
viewed in the context of recent increases in the low-income allowance
and in the standard deduction, which provide more tax saving for
certain low-middle income taxpayers than itemized deductions,
thus reducing the number of them who itemize.
Moreover, even though some tax expenditures may provide most
of their tax relief to those with high taxable incomes, this may be
the consequence of overriding economic considerations. For example,
tax expenditures directed toward capital formation may deliberately
benefit savers who are primarily higher income taxpayers.
Estimating Tax Expenditures
The estimated revenue losses for all the listed tax expenditures
have been provided by the Congressional Budget Office (CBO) based
upon work done by the staffs of the Treasury Department and the
Joint Committee on Internal Revenue Taxation.3 Except for five
expenditures, the estimates are identical to those that appear for
the same provisions in the Administration's FY 1977 tax expenditure
budget.4 Most of these differences stem from CBO assumptions that
certain tax expenditures scheduled to expire during 1976 will be con-
tinued through FY 1977.
In calculating the revenue loss from each tax expenditure, it is
assumed that only the provision in question is deleted and that all
other aspects of the tax system remain the same. In using the tax
expenditure estimates, several points should be noted.
First, in some cases, if two or more items were eliminated, the
combination of changes would probably produce a lesser or greater
revenue effect than the sum of the amounts shown for the individual
items.
Second, the amounts shown for the various tax expenditure items
do not take into account any effects that the removal of one or more
of the items might have on investment and consumption patterns
or on any other aspects of individual taxpayer behavior, general
economic activity, or decisions regarding other Federal budget outlays
or receipts.
Finally, the revenue effect of new tax expenditure items added to
the tax law may not be fully felt for several years. As a result, the
eventual annual cost of some provisions is not fully reflected until
some time after enactment. Similarly, if items now in the law were
eliminated, it is unlikely that the full revenue effects would be im-
mediately realized.
3 The revenue estimates are based on the tax code as of January 1, 1976, with the exception that the tem-
porary provisions applying to the investment credit, surtax exemption, earned income
credit, and the standard deduction are estimated as if they will continue through F'Y 1977.
The Budgct of the United States Government, Fiscal Year 1977, "Special Analysis F" at 125-127.
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4
However, these tax expenditure estimating considerations are similar
to estimating considerations involving entitlement programs. Like
tax expenditure'~, ~nnua1 budget estimates for each transfer and income
security program are computed separately. However, if one program,
such as veterans' pensions, were either terminated or increased, this
would affect the level of payments under other programs, such as
welfare payments Also, like tax expenditure estimates, the elimmation
or curtailment of a spending program, such as military spending or
unemployment benefits, would have substantial effects on consumption
pattOrns and economic activity that would directly affect the levels
of other spending programs. Finally, like tax expenditures, the budge-
tary effect of terminating certain entitlement programs would not
be fully reflected until several years later because the termination
of benefits is usually only for new recipients with persons already
receiving benefits continued under "grandfather" provisions
Adjusted Gross Income Class Distributions
Distributions of the tax benefits by adjusted gross income (AGI)
class are given for almost all tax expenditures providing direct tax
relief to individual taxpayers. These distribution figures show the por-
tion of the total estimated revenue loss attributed to each tax expendi-
ture that goes to all taxpayers with adjusted gross income falling within
the boundaries of the respective income classes. No distribution to
individual income classes is made of the tax expenditure benefits
provided directly to corporations, since to do so would require un-
substantiated assumptions concerning the ultimate beneficiaries
of these corporate tax relief provisions
Taxable individual income tax returns falling within each AGI
class for calendar 1974 were: .
Percent of
Taxable returns taxable returns
AGI class (thousands) in each class
0 to $7 000 19 909 29 7
$7 000~o $15 000 27 380 409
$1~,000 to $50,000 18,862 . 28.2
$50,000 and over 815 1.2
rfhe tax expenditure distributions by AGI class are taken from a
study. done by the Treasury. Department in 1975 at the request of
Senator Walter F. Mondale of Minnesota and are the most recent
estimates of this type.
These distributions indicate in a general way whether specific . tax.
expenditures provide tax benefits largely to lower, middle, or high
income~ taxpayers. However, adjusted gross income includes less~
than a fully comprehensive definition of income. It is total. gross
(non-exempt) income reduced by allowable deductions. Adjusted
gross income will differ substantially from a more inclusive definition
of money income where' individuals have relatively large amounts of
income which, pursuant to one or more tax expenditure provisions,
are exempt from tax Foi example, the exclusion of income earned by
certain U S citizens working or residing abroad (see p 13) permits up
to $25,000 a year of economic income to be excluded from adjusted
gross income. Thus, many of the provision's beneficiaries will appear in
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5
the $0 to $7,000 ACT class, giving the appearance the provision largely
benefits low income persons. However, in fact, many of these persons
actually earned salaries in the area of $20,000 to $30,000.
Order of Presentation
The tax expenditures are presented in an order which parallels as
closely as possible, the budget functional categories used in the Con-
gressional budget, i.e., tax expenditures related to "national defense"
are listed first, and those related to "international affairs" are listed
next.
This order of presentation differs to a limited degree from that
used in the tax expenditure budgets published by the Administration
for 1976 and 1977 and prepared by the staffs of the Joint Committee on
Internal Revenue rfaxation and the Treasury Department for 1976.
These budgets listed certain items under three headings-"business
investment", personal investment", and "other tax expenditures"-
that are not budget functional categories. However, in order that tax
expenditures be presented in a manner which parallels as closely as
possible the presentation of direct expenditures, the items that were
listed under those three headings have been distributed in this com-
pendium to the budget functional categories to which they are most
closely related. This format is consistent with the requirement of
Section 301 (d) (6) of the Budget Act, which requires the tax expendi-
ture budgets published by the Budget Committees as parts of their
April 15 reports to present the estimated levels of tax expenditures
"by maj or functional categories".
Rationale
The material on each tax expenditure contains a brief statement of'
the rationale for the adoption of the tax expenditure where it is known.
These rationales are the principal ones which were publicly given at the
time the provisions were enacted.
Further Comment
In the case of a number of tax expenditures, additional information is
provided under the heading "Further Comment." It is material which
either focuses attention on some of the principal issues related to a pro-
vision or describes recent legislative proposals to amend a provision.
This is material that does not fit within the other elements of the
format of the compendium-either in the "Description," "Impact," or
"Rationale" sections. As the examples which are provided in the
descriptions of only some of the tax expenditures, the "Further
Comment" sections are included only where they were deemed to be
useful. Providing information under the "Further Comment" sections
for only certain tax expenditures in no way implies any judgment about
these provisions.
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EXCLUSION OF BENEFITS AND ALLOWANCES
TO ARMED FORCES
Estimated Revenue Loss
[In millions of dollarsi
Fiscal year Individuals Corporations Total
1977.
650
650
1976
650
650
1975
650
650
Authorization
Sections 112 and 113,1 Regulation § 1.61_2,2 and court decisions.
Description
Military personnel are not taxed on a variety of in-kind benefits
and cash payments given in lieu of such benefits. These tax-free bene-
fits include quarters and meals or-alternatively-cash allowances
for these purposes, certain combat pay, and a number of less signifi-
cant items.
impact
All military personnel receive one or more of these benefits which
are generally greater in the higher pay brackets. The amount of tax
relief increases with the individual's tax bracket and therefore de-
pends on a variety of factors unrelated to the taxpayer's military
pay, such as other income including income from a spouse, and the
amount of itemized deductions. Therefore, the exclusion of these bene-
fits from taxation alters the distribution of net pay to service personnel.
Estimated Distribution of individual income Tax Expenditure by
Adjusted Gross income Class
Percentage
Adjusted gross income class (thousands of dollars): distribution
0 to 7 46. D
7 to 15 36. 2
15to50 16.2
50 and over 0. 8
1 The word "Section" denotes a section of the Internal Revenue Code of 1954 as amended
unless otherwise noted.
2 Reference to "regulations" are to Income Tax Regulations unless otherwise noted.
(7)
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8
Rationale
Although the principle of exemption of Armed Forces benefits
and allowances appeared early in the history of the income tax, it
has evolved through subsequent specific statute, regulations, revenue
ruhngs, and court decisions For some benefits, the rationale was a
specific desire tO reduce tax burdens of military personnel during
wartime (as in the use of combat pay provisions); other preferences
were apparently based on the belief that certain types of benefits
were not strictly compensatory but rather an intrinsic element in the
military structure.
Further Comment
Administrative difficulties and complications could be encountered
in taxing some military benefits and allowances that are tax exempt;
for example, it could be difficult to value meals and lodging when the
option to receive cash is not available. However, eliminating the
exclusions and adjusting pay scales accordingly might simplify
decision-making about military pay levels and make "actual" salary
more apparent to recipients.
Selected Bibliography
Binkin, Martin. The Military Pay Muddle, The Brookings Insti-
tütion, Washington, D.C., April 1975.
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EXCLUSION OF MILITARY DISABILITY
PENSIONS
Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total
1977 90 90
1976
80
80
1975
70
70
Authorizdion
Section 104(a) (4) and Regulation § 1.104-i (e).
Description
Service personnel who have at least a 30-percent disability or who
have at least 20 years of service and any amount of disability may
draw retirement pay based on either percentage of disability or years
of service. If the chosen pension is less than 50 percent of the basic
pay, it will be raised to 50 percent during the first 5 years of retirement.
Pay based on percentage of disability is fully excluded from gross
income under Section 104. If pay is based on years of service, only
the portion that would have been paid on the basis of disability is
excluded from income.
Impact
Because it is exempt from tax, disability pay provides more net
income than taxable benefits at the same level. The tax benefit of
this provision increases as the pensioner's marginal tax rate increases.
Thus, the after-tax pension benefits increase as a percentage of active
duty pay as the individual's tax bracket increases.
Estimated Distribution of Individual Income Tax Expenditure
by Adjusted Gross Income Class
PercentaQe
Adjusted gross income class (thousands of dollars): distribution
0 to 7 46.2
7 to 15 36.9
15 to 50 16.9
SOandover 0
Rationale
The rationale for this exclusion is not clear. It was adopted in 1942
during World War II.
Selected Bibliography
Binkin, Martin. The Military Pay Muddle, The Brookings Institu-
tion, Washington, D.C., April 1975.
(9)
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EXCLUSION OF GROSS-UP ON DIVIDENDS OF
LESS DEVELOPED COUNTRY CORPORATIONS
Estimated Revenue Loss
[In millions of dollars]
Fiscal year
Individuals
Corporations
Total
1977
55
55
1976
55
55
1975
55
55
Authorization
Sections 78 and 902 and Executive Order No. 11071, December 27,
1962.
Description
A domestic corporation that receives dividends from a foreign
corporation in which the domestic corporation owns 10 percent or
more of the voting stock may claim a foreign tax credit against its
U.S. tax liability for the foreign income taxes paid by the subsidiary.
If the foreign corporation is not a less developed country corporation
(LDCC), the dividend must be "grossed-up" (i.e., increased) by the
amount of foreign tax paid with respect to the dividend. The "grossed-
up" amount is included in taxable income, and the U.S. tax rate is
applied to the "grossed-up" taxable income to calculate the U.S. tax.
The foreign tax may then be credited against (i.e., deducted from) the
U.S. tax. However, dividends paid by LDCCs are not "grossed-up,"
but foreign taxes paid with respect to them are available as a foreign
tax credit. To qualify as an LDCC, a corporation must have 80 per-
cent or more of its gross income and assets connected with activities
in less developed countries. Shipping companies with ships or aircraft
registered in less developed countries qualify. Pursuant to Executive
Order No. 11071 of December 27, 1962, all countries qualify as less
developed except 16 Western European nations, Australia, New
Zealand, South Africa, Canada, and Sino-Soviet bloc members.
Example
Assume the foreign tax rate is 24 percent, and an LDCC earns $100,
pays a foreign tax of $24, and distributes the remaining $76 as a
dividend. If "gross-up" is required, the U.S. tax before the credit is
$48 (48 percent-the U.S. corporate tax rate-of $100) and the $24
(11)
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12
foreign tax payment is credited against the $48 resulting in a $24
U.S. liability after the credit. Thus, the total tax rate, including both
the foreign and U.S. tax, is 48 percent which is equal to the U.S. rate.
If "gross-up" is not required, then the U.S. tax is $36.48 (48 percent
of $76) less $18.24 (24 percent of $76), which is the amount of the
foreign tax paid on the dividend and which therefore can be credited.
Thus, the net U.S. tax liability is $18.24, a total tax rate of 42.24 per-
cent ($18.24 plus $24.00 divided by $100). Failure to "gross-up"
therefore saves the parent corporation $5.76 ($24.00-$18.24) of U.S.
taxes.
Impact
Income remitted to parent companies by LDCCs is taxed at a
lower rate than dividends from other subsidiaries. The amount of the
benefit depends on the tax rate of the foreign country relative to the
U.S. tax rate. The benefit is greatest when the foreign tax rate is half
the 48 percent U.S. tax rate. In this case, the total U.S. and foreign
tax is 42.24 percent (see the example above). The benefit declines as
the foreign tax rate rises above or falls below half the U.S. tax rate;
thus the net U.S. tax liability varies with the foreign effective tax
rate. There is no benefit when the foreign tax rate equals or exceeds
the U.S. tax rate and no benefit when. the foreign tax rate is zero.
Rationale
The "gross-up" requirement for developed countries was added in
1962. Prior to that time, "gross-up" was not required, and the method
~of computing the tax was derived from a 1942 Supreme Court decision
(American Chicle (Jo. v. U.S., 316 U.S. 450) which interpreted the
language of the provision allowing a foreign tax credit. While the 1962
revision recognized that this provision should be corrected generally,
the Finance Committee recommended exempting dividends from
LDCCs from this requirement `because it did not wish to' discourage
investment in such countries
Further Comment
This preferential treatment for LJJCC. dividends would be elimi-
nated by H.R. 10612, passed by the Housein December 1975.
Selected Bibliography
Hellawell, Robert, "United States Income Taxation and Less
Developed Countries: A Critical Appraisal," Columbia Law Review,
December 1966, pp. 1393-4277.
U.S. Congress, House, Committee on Ways and Means, General
Tax Reform, Panel Discussions, 93rd Congress, 1st Sess., Part TI-Tax
Treatment of Foreign Income, February 28, 1973, pp. 1671-1881.
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EXCLUSION OF CERTAIN INCOME EARNED
* ABROAD BY U.S. CITIZENS
Estimated Revenue Loss
[In millions of dollars]
F isealyear Individuals Corporations Total
1977 160 160
1976 - - - - 145 - - 145
1975 130 130
Authorization
Sections 911-912.
* Description
While U.S. citizens are generally taxable on their world-wide in-
come, up to $20,000 of foreign earned income (largely salary income)
may be excluded annually from income under section 911 by a citizen
who (1) is a bona fide resident of a foreign country foi an uninterrupted
period that includes a taxable year, or (2) has been piesent in a foreign
country for 510 d'iys (17 months) out of 18 consecutive months The
annual exclusion is i aised to $25,000 for an individual who has been a
bona fide resident of a foreign country for at least 3 consecutive years.
Section 911 does not apply to salaries received from the U.S. Govern-
ment.
Section 912 exempts from tax certain allowances that are received by
Federal civilian employees working abroad. The principal exempt
allowances are for high local hying costs, education, and housing.
impact
Some U.S. citizens living abroad pay no income taxes to the coun-
tries in which they reside. Section 911 allows their income up to the
appropriate ceiling to be tax free in the United States as well.
In cases where U.S. citizens pay foreign income taxes, those taxes,
including the taxes paid on the income excluded from taxation under
this section, can be credited against any U.S. tax liability that would
otherwise exist on other foreign income: earned income above the
$20,000 or $25,000 excludable limits and investment income. This
allows U.S. taxpayers to offset all the foreign tax-including that paid
on the amount of excluded income-against U.S. tax that would
otherwise be due on the income in excess of the excluded amount.
Thus, the combination of the exclusion and the foreign tax credit can
result in levels of income actually exempt from U.S. tax in excess of the
stated limits.
(13)
PAGENO="0020"
14
In addition to the U.S. citizens who directly benefit from this
favorable treatment, overseas employers also benefit to the extent
that salary levels are lower because of the exclusion. To the ex-
tent this occurs, they maintain an advantage relative to domestic
employers. U.S. corporations that bid on overseas construction proj-
ects assert that the salary savings make them more competitive with
foreign bidders, some of the employees of which also enjoy similar
salary savings.
The value of the Section 912 exemption for allowances received by
Federal civilian employees working abroad increases with the re-
cipient's tax bracket. The value therefore depends on a variety of
factors including the level of the recipient's Federal salary, the extent
of his other income, and the amount of his itemized deductions.
Estimated Distribution of Individual Income Tax Expenditure by
Adjusted Gross Income Class
Adjusted gross income class (thousands of dollars):
Oto7 38.9
7to15 17.8
15to50 34.4
50 and over 8. 9
Rationale
A less restrictive form of Section 911 was first enacted in 1926
to encourage foreign trade. After World War II, the exclusion was
justified as part of the Marshall Plan to encourage persons with
technical knowledge to work abroad. Although the provision was
revised on s~rera1 occasions, dollar limitations were first enacted in
1953 at $20,000 and $35,000. The latter figure was reduced to $25,000
in 1964.
The exemption for civilian Federal employee overseas allowances
was enacted in 1943. The principal rationale was to provide additional
compensation for these employees, who were performing vital wartime
services.
Further Comment
H.R. 10612 passed by the IThuse of Representatives in December
1975 would phase out Section 911 over a 3-year period. However, it
would provide a new tax deduction for amounts paid as tuition for
children of U.S. citizens working abroad.
Selected Bibliography
U.S. Congress, House, Committee on Ways and Means, General
Tax Reform, Panel Discussion, 93rd Congress, 1st Session, Part II-
Tax TrOatment of Foreign Income, February 28, 1973, pp. 1671-1888.
PAGENO="0021"
DEFERRAL OF INCOME OF DOMESTIC INTER-
NATIONAL SALES CORPORATIONS (DISCs)
Estimated Revenue Loss
~In millions of dollars]
Fiscal year
Individuals
Corporations
Total
1977
1, 420
1, 420
1976
1, 340
1, 340
1975
1, 130
1, 130
Authorization
Sections 991-997.
Description
Corporations qualifying as DISCs (Domestic International Sales
Corporations) must be incorporated in the United States, at least 95
percent of their assets must be related to export functions, and at
least 95 percent of their gross receipts must stem from export sale or
lease transactions.
DISCs typically are wholly owned subs~d~ary corporations through
which parent corporations channel their export sales. DISCs are
not themselves subject to corporate income tax, but their parent
corporations are taxed on th.e DISC income when it is distributed or
attributed to them.
The tax savings from using a DISC result principally from two
interrelated aspects of the tax law: (1) the allocation rules that allow at
least half of the total, combined profit of the parent and DISC from
export sales to be attributed to the DISC, and (2) the potentially
permanent tax deferral that is allowed on half of those profits attributed
to the DISC under the liberal allocation rules. The other half of a
DISC's income is either actually or deemed to be distributed annually
to its parent corporation and thus does not qualify for deferral.
The allocation rules provide that a DISC is deemed to have earned
either: (1) 50 percent of the combined taxable income of the parent
corporation and DISC from export sales or (2) 4 percent of the gross
receipts from the export sales, whichever is greater. The 50 percent
allocation is used much more frequently. The rules for allocating
DISC profits are much more favorable than the otherwise applicable
tax law standard (Section 482) which requires a sale by a manufac-
turer or producer to a wholly owned sales subsidiary to be at an arm's
length price. If the Section 482 rule were applied to DISCs, only a
relatively small, or no, sales commission would be allocated to the
(15)
PAGENO="0022"
16
DISC, while the proportionately larger profits from production would
go to the parent corporation.
The deferral of tax (on 50 percent of the income allocated to the
DISC) continues as long as the undistributed DISC income is invested
in qualified assets; the duration may be indefinite, and in such cases
constitutes the practical equivalent of a permanent tax exemption.
Example
Assume a company incurs total costs of $8,000 in producing goods
selling on the export market for $10,000. The allocation rule attributes
50 percent of the $2,000 total net profit to the DISC and 50 percent
to the parent firm. Taxes are deferred on $500 of the $1,000 allocated to
the DISC and the 48 percent corporate tax rate is applied to the
remaining $1,500 of direct profits and DISC earnings attributed or
paid to the parent firm. The total tax liability is $720. If a DISC had
not been used, the tax liability would have been ~960 ($2,000 X .48
tax rate). The DISC provides a ta~x savings of $240 ($500 of deferrable
DISC income X .48 tax rate) and, therefore, lowers the effective tax
rate to 36 percent on this export sales income.
Impact
This provision reduces the marginal tax rate on DISC-related
export income from 48 percent to 3 perèent (and to 24 percent in the
relatively few cases where the total profit on export sales of the DISC
and its parent is no more than 4 percent of gross export receipts).
Whether U.S. expdrters reduce export prices in response to reduced
effective tax rates. is' unclear. To the extent they do, foreign purchasers,
~s well as domestic exporters, would be subsidized.
According to several studies, the overall impact of DISC in stimu-
lating exports has been small in comparison to its annual revenue
cost. U.S. exports have increased dramatically since the~ DISC
provisions were added, but the increase is said to be due to the devalu-
ations of. the.dollar,~ worldwide inflation, and. a stable U.S. ~share of'
expanding worldwide trade On the other hand, many compames winch
utilize DISOargue'it should be retained because: (1) in their view,
DISC has substantially increased exports which, m turn, have m-
creased U S employment levels, and (2) other countries employ a
variety of export promotion devices
Corporations with profitable export operations benefit from the tax
reduction The Treasury Department study cited below in the bibliog-
raphy reported ,that 72 percemit of `the net income of 1,510 DISCs with
corporate owners foi which asset size data were available accrued to
186 companies with gross assets in excess of $250 million., with 44 per-
cent going to only 28 compames
Rationale .
Originally adopted as part of the Revenue Act of 1971, the stated
purpose of DISC was to stimulate exports and enhance the attractive.-
ness' of domestic manufacturing vis-a-vis manufacturing . through' for-
eign subsidiaries
PAGENO="0023"
17
Further Comment
H.R. 10612, passed by the House in December 1975, would reduce
current DISC benefits by roughly one-third by limiting income
qualifying for deferral to that earned by exports in excess of 75 percent
of a company's exports during a prescribed base period.
Selected Bibliography
U.S. Congress, House, Committee on Ways and Means, General
Tax Reform, Panel Discussions, 93rd Congress, 1st Session, Part II-
Tax Treatment of Foreign Income, February 28, 1973, pp. 1671-1880.
U.S. Congress, Senate, Task Force on Tax Policy and Tax Expendi-
tures, Committee on the Budget, Seminar-DISC: An Evaluation of
the Costs and Benefits, Committee Print, November 1975.
U.S. Department of Treasury, "The Operation and Effect of the
Domestic International Sales Corporation Legislation," 1973 Annual
Report, April 1975, 30 pages.
PAGENO="0024"
PAGENO="0025"
SPECIAL RATES FOR WESTERN HEMISPHERE
TRADE CORPORATIONS
Estimated Revenue Loss
[In millions of dollars]
Fiscal year
Individuals
Corporations
Total
1977
50
50
1976
50
50
1975
50
50
Authorization
Sections 921 and 922.
Description
Western Hemisphere Trade Corporations (WHTCs) are granted a
special deduction which has the effect of reducing the tax rate by
as much as 14 percentage points.' The amount of the special deduction
is the taxable income of the corporation (before the special deduction)
multiplied by a fraction, the numerator of which is 14 percent and the
denominator of which is the overall rate (i.e. the sum of the normal
tax rate and the surtax rate) on the corporation's total taxable income.
A WHTC is a U.S. corporation: (1) all of whose business is done
in the Western Hemisphere; (2) 95 percent or more of whose income
over the last three years was derived from sources outside the U.S.;
and (3) 90 percent or more of whose income over the same three years
was derived from the active conduct of a trade or business.
WHTCs may not defer U.S. taxation of their income (as in the
case of a controlled foreign corporation), but they may take a tax
credit for foreign taxes imposed on that income. The WHTC deduction
may not be taken for a taxable year in which the corporation is a
Domestic International Sales Corporation (DISC) or in which it
owns any stock in a DISC or former DISC.
Example
If taxable income is $100,000 when computed without regard to
the WHTC deduction, the WHTC deduction equals $100,000 X (14
percent/48 percent)=$29,166.67; taxable income is reduced to
1 Under the permanent corporate rate structure, the full 14 percentage point reduction applies to
all WHTCs with income in excess of $35,294. Corporations with less income obtain a deduction which will
reduce their tax rate by less than 14 percentage points. Under the temporary tax reductions in the Tax
Reduction Act of 1975 and the Revenue Adjustment Act of 1975 which expire on Tune 30, 1976, the principle
remains the same, but the cut-ofT figure for the full 14 percent reduction is slightly higher.
(19)
PAGENO="0026"
20
$70,833.34, and tax liability on this amount is $27,500 (assuming a
22% rate on the first $25,000 of taxable income and a 48% rate on
the income in excess of $25,000). Without this special deduction the.
tax would have been $41,500. Thus, the effective tax rate has been
reduced by 14 percentage points.
* Impact
For many companies, tax deferral through foreign incorporation
has been more advantageous than the WHTC provision. But, because
only domestic corporations may take percentage depletion, com-
panies with Western Hemisphere extractive industry operations out-
side the TJ.S. were traditionally organized as WHTCs. Currently,
however, the WHTC provision yields little or no tax saving for such
operations because the application of large foreign tax credits com-
pletely or nearly completely offsets any U.S. tax liability.
The WHTC provision also has been used by sales subsidiaries.
However, the more recent DISC legislation can be more valuable
in many cases, and the absence of growth in use of WHTOs may
reflect replacement of WHTC sales subsidiaries by DISCs.
Rationale
The Revenue Act of 1942 enacted the WHTO provisions to exempt
a few corporations then engaged in operations outside the United
States but within the Western Hemisphere from the high wartime cor-
pOrate surtaxes. The current provisions were continued in 1950 when
the tax structure was changed. The WHTC treatment is now justified
by some persons as necessary to maintain the competitive position
of corporations competing in the Western Hemisphere with foreign
corporations.
Further Comment
H.R. 10612, passed by the House of Representatives in December
1975, would phase out this provision by the end of taxable years
that begin in 1980.
Selected Bibliography
Musgrave, Peggy, "Tax Preferences to Foreign Investment" in
U.S. Congress, Joint Economic Committee, The Economics of Federal
Subsidy Programs, Part 2-International Subsidies, 92nd Congress,
2nd Session, July 15, 1972, p. 195.
Surrey, Stanley S., "Current Issues in the Taxation of Corporate
Foreign Investment", Columbia Law Review, June 1956, pp. 830~-838.
U.S. Congress, House Committee on Ways and Means, General
Tax Reform, Panel Discussion, Part TI-Tax Treatment of Foreign
Income, 93rd Congress, 1st Session, February 28, 1973, pp. 167 1-1888.
U.S. Congress, Joint Committee on Internal Revenue Taxation,
U.S. Taxation of Foreign Source Income of Individiial~ and Corpora-
tions and the Domestic International Sales Corporation Provisions,
September 29, 1975.
PAGENO="0027"
DEFERRAL OF INCOME OF CONTROLLED
FOREIGN CORPORATIONS
Estimated Revenue Loss
[In millions o
f dollars]
Fiscal year
Individuals
Corporations
Total
1977
365
365
1976
525
525
1975
590
590
Authorization
Sections 11(f), 882, and 951-964.
Description
A U.S. corporate parent of a foreign subsidiary is not taxed on the
income of that subsidiary until the income is remitted (or "repatri-
ated") to the parent. The deferral of U.S. tax liability on the sub-
sidiary's income is permanent to the extent that the income is rein-
vested in the subsidiary or other foreign subsidiaries rather than
remitted to the U.S. parent. A tax credit in the amount of foreign
taxes paid on repatriated income, plus any "gross up" required (see
page 11), is allowed at the time of repatriation.
On the other hand, income from foreign branches (as distinguished
from subsidiaries) of U.S. corporations is taxed on a current basis
since the branches are parts of U.S. corporations. Certain so-called
tax haven income also is taxed currently in the U.S. irrespective of
whether earned by a foreign subsidiary or a branch. The Tax Reduc-
tion Act of 1975 strengthened the provisions requiring current taxation
of such income.
Impact
Companies that operate in countries with effective income tax rates
less than the U.S. rate may receive tax benefits from this provision.
A substantial portion of the revenue loss is attributable to deferral
on shipping income, which is estimated to account for over $100
million of the current revenue loss. This occurs because shipping firms
are often based in countries without income taxes, such as Liberia and
Panama. U.S. Department of Commerce data indicate that 423 of the
678 foreign flag ships owned by U.S. corporations and their sub-
sidiaries are registered in Panama or Liberia. Much (485) of this total
shipping fleet is composed of tankers.
(21)
PAGENO="0028"
22
Rationale
Historically, the United States has not taxed foreign source income
of foreign corporations on the premise that only domestic corporations
or income with a U.S. source is subject to U.S. jurisdiction. In effect,
the separate corporate status of foreign subsidiaries of domestic
corporations was respected. In 1962 these principles were abrogated
for certain so-called tax haven income under subpart F of the Code.
Such income is taxed even though earned abroad and even though
not repatriated.
Further Comment
Opponents of deferral allege it encourages investment in foreign
countries and reduces domestic investment, thus reducing U.S. tax
revenues and U.S. exports, and adversely affecting the balance of
payments, the balance of trade, and domestic employment. Pro-
ponents deny such allegations and argue that deferral must be con-
tinued for U.S. corporations to remain competitive with foreign
companies in overseas markets.
Deferral of tax on foreign profits is not neutral compared to invest-
ment in the United States in the sense that if the foreign country
tax rate is less than the U.S. tax rate and the income is not going to
be repatriated, a U.S. corporation has a tax incentive to invest abroad
using a foreign subsidiary instead of investing at home. However,
the deferral rules do neutralize advantages foreign competitors
may have over U.S. corporations operating abroad. Moreover,
there are also offsetting tax rules which favor investment in the U.S.
by domestic companies rather than abroad such as the general limita-
tion of the investment credit and asset depreciation range (ADR)
depreciation to assets used in the United States.
Selected Bibliography
Krause, Lawrence B. and Kenneth W. Dam. Federal Tax Treat-
ment of Foreign Income, The Brookings Institution, Washington, D.C.
1964, 145 pages.
Musgrave, Peggy, "Tax Preferences to Foreign Investment,"
in U.S. Congress, Joint Economic Committee, The Economics of
Federal Subsidy Programs, Part 2-International Subsidiaries, 92nd
Congress, 2nd Session, July 15, 1972, pp. 176-219.
U.S. Congress, House, Committee on Ways and Means, General
Tax Reform, Panel Discussions, 93rd Congress, 1st Session, Part II-
Tax Treatment of Foreign Income, February 28, 1973, pp. 1671-1881.
U.S. Congress, House, Committee on Ways and Means, U.S.
Taxation of Foreign Income-Deferral and the Foreign Tax Credit,
Prepared by the Joint Committee on Internal Revenue Taxation,
Committee Print, September 27, 1975.
U.S. Taxation of American Business Abroad. An Exchange of Views,
A.E.I.-Hoover Policy Studies, American Enterprise Institute,
Washington, D.C., 1975, 101 pages.
PAGENO="0029"
AGRICULTURE: EXPENSING OF CERTAIN
CAPITAL OUTLAYS
Estimated Revenue Loss
[In millions of dollars]
Fiscal year
Individuals
Corporations
Total
1977
360
115
475
1976
355
105
460
1975
475
135
610
Authorization
Sections 162, 175, 180, 182, 278 and Regulations §~ 1.61-4, 1.162-11,
and 1.471-6.
Description
Farmers may use the cash method of tax accounting to deduct costs
attributable to goods held for sale and in inventory at the end of the
tax year. They are also allowed to expense (i.e., deduct when they are
incurred) some costs of developing assets that will produce income in
future years. Both of these rules deviate from generally applicable
tax accounting rules, which do not permit deduction of inventory costs
until the inventory is sold, and which require the cost of income-
producing assets to be deducted over their useful lives. These rules
thus allow farmers to claim deductions before realizing the income
associated with the deductions.
Items that may be deducted before income from them is realized in-
clude cattle feed, expenses of planting crops for the succceding year's
harvest, and development costs such as those incurred in planting
vineyards and fruit orchards. There are special restrictions on the
expensing of farming outlays for citrus and almond groves.
In addition, the statute allows expensing of certain items that
otherwise might be considered capital expenditures rather than
current expenses. These items include expenses for soil and water
conservation (Section 175), land clearing (Section 182), and fertilizer
(Section 180).
impact
The effect of deducting costs before the associated income is realized
is the understatement of income in that year followed by an over-
statement of income when it is realized. The net result is that tax lia-
bility is deferred from the time the deduction is taken to the period
of the asset's remaining useful life. This affords the taxpayer an
interest-free loan in the amount of the deferred tax. When the income
(23)
PAGENO="0030"
24
is finally taxed, it may be taxed at preferential capital gains rates
(seep. 25 below).
The expensing of capital outlays is available to all taxpayers who
have farm investments. Therefore, these rules provide a tax subsidy
for all farming operations, and particularly for those with a long de-
velopment period (such as orchards and vineyards).
Concern has focused on the use of farming as a tax shelter by high
income bracket individuals who seek to offset their nonfarm taxable
income with large, artificial, farming losses. Such investment packages
normally have been characterized by a highly leveraged capital structure.
To a high income taxpayer, this translates into a relatively riskiess
investment, since tax savings generated through the deduction of
losses may return most or all of the initial cash outlay in the first year
of operation.
Estimated Distribution of Individual Income Tax Expenditure by
Adjusted Gross Income
Percentage
Adjusted gross income class (thousands of dollars): ; distribution
Oto7 18.1
7to15
15to50 33.6
5Oandover 12.9
1 The distribution refers tothe individual tax expenditure only. The corporate tax expenditure resulting
from these tax provisions ii not reflected in this distribution table.
Rationale
The special rules with respect to development costs and cash ac-
counting were established in regulations issued very early in the de-
velopment of the tax law. At that time, because accounting methods
were less sophisticated, tax rates were low, and the typical farming
operation was small, the regulations apparently were adopted to
simplify record keeping for the farmer. The statutory rules permitting
deductions for soil and water conservation, land clearing expenses, and
fertilizer costs were added between 1954 and 1962 to encourage con-
servation practices. The special restrictions on the expensing of farm-
ing outlays for citrus and almond growers were enacted in 1969.
The current use of cash basis accounting for farmers is justified
by its proponents as much simpler, and more workable and consistent
than the accrual method.
Selected Bibliography
U.S. Congress, House, Committee on Ways and Means, Panel
Discussion on General Tax Reform, Part 5-Farm Operations, Febru-
ary 8, 1973, pp. 615-96.
U.S. Congress, House, Joint Committee on Internal Revenue
Taxation, Tax Shelters: Farm Operations, Prepared for the Use of the
Committee on Ways and Means, September 6, 1975, 25 pages.
U.S. Congress, House, Committee on Ways and Means, Tax Re-
form Hearings. Tax Reform, Part 2-Farm Operations, July 15, 1975,
pp. 1360-1402.
PAGENO="0031"
AGRICULTURE: CAPITAL GAIN TREATMENT
OF CERTAIN INCOME
Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total
1977
565
40
605
1976
490
30
520
1975
455
30
485
Authorization
Sections 1201-1202, 1221-1223, 1231, 1245, and 1251-1252.
Description
If gains from the sale or exchange of property used in a trade or
business exceed losses from such property in any year, the gain is
treated as long term capital gain. Real estate or depreciable property
used in farming operations and held for more than six months, but not
held for sale, generally qualifies as such property. However, horses and
cattle qualify only if they have been held more than 24 months, and all
other livestock, more than 12 months.
In some cases, all or much of the cost of the farm property used in the
business has previously been deducted under the farm accounting rules
discussed on page 23. Consequently, in 1969, Congress enacted legisla-
tion to tax as ordinary income some gains previously taxed as capital
gain. These gains are principally those from the sale of (a) land held for
less than ten years, but only to the extent of previously deducted soil
and water conservation expense, and (b) farm property, to the extent
that prior farm losses exceeded $25,000 in any year in which the tax-
payer had nonf arm income in excess of $50,000.
Impact
Subject to these rules, taxpayers owning farm assets may obtain long
term capital gain treatment on qualifying assets even though much of
the asset cost has been deducted against ordinary income. While this
favorable tax treatment is limited to property used in the farming
business, many farm assets have a dual potential of being held for sale
or for use in the business. Assets having this ambiguous nature are
(25)
PAGENO="0032"
26
often sold before the ambiguity is resolved, and the gain is treated as
capital gain. Over 90 percent of the tax saving is claimed by non-
corporate farmers. The tax benefit per dollar of capital gain increases
with the taxpayer's marginal tax rate. The interaction between the
deduction of costs and capital gain treatment for the sale of such assets
has resulted in many tax shelter operations in farming.
Estimated Distribution of Individual Income Tax Expenditure by
Adjusted Gross Income Class1
Percentage
Adjusted gross income class (thousands of dollars): distribution
Oto7 18.3
7to15 35.6
15to50 33.7
50 and over 12. 5
1 The distribution refers to the individual tax expenditure only. The corporate tax expenditure resulting
from these tax provisions is not reflected in this distribution table.
Rationale
Preferential treatment for capital gains for individuals was intro-
duced in 1921. However, long term capital gain treatment for property
used in a trade or business was not enacted until 1942. Between 1942
and 1951, there was a dispute whether livestock qualified as such
property, and legislation in 1951 gave livestock that status. The 1942
legislation was enacted to provide tax relief for war-related gains.
Further Comment
Many proposals for changing the present law have been made from
time to time. They include proposals to limit or eliminate the expensing
of capital outlays, to impede tax shelter operations, to lengthen the
holding periods for farm assets, and to change the definition of quali-
fying property.
Selected Bibliography
Carlin, Thomas A. and W. Fred Woods. Tax Loss Farming,
ERS-546, Economic Research Service, U.S. Department of Agri-
culture, April 1974.
U.S. Congress, House, Committee on Ways and Means, General
Tax Reform. Panel Discussions. Part 5-Farm Operations, February
8, 1973, pp. 615-96.
U.S. Congress, House, Joint Committee on Internal Revenue
Taxation, Tax Shelters: Farm Operations. Prepared for the Use of
the Committee on Ways and Means, September 6, 1975, 24 pages.
U.S. Congress, Committee on Ways and Means, Tax Reform.
Hearings. Part 2-Farm Operations, July 15, 1975, pp. 1360-1402.
PAGENO="0033"
EXPENSING OF INTANGIBLE DRILLING,
EXPLORATION AND DEVELOPMENT COSTS
Estimated Revenue Loss
[In millions of dollars]
Fiscal year
Individuals
Corporations
Total
1977
1976
195
155
840
650
1, 035
805
1975
120
500
620
Authorization
Sections 263(c) and 616-617.
Description
rfaxpayers engaged in drilling for oil and gas may deduct in-
tangible drilling costs as incurred while taxpayers engaged in other
mining activities may deduct exploration and development costs
as incurred (i.e., these costs may be "expensed").
Intangible drilling costs are certain expenses incurred in bringing
a well into production, such as labor, materials, supplies and repairs.
Expenses for tangibles such as tanks and pipes are recovered through
depreciation.
Mining exploration costs are those for the purpose of ascertaining
the existence, location, extent or quality of a deposit incurred before
the development stage, such as core drillings and testing of samples.
nnnThese expenses are limited in the case of foreign exploration. For-
eign exploration costs cannot be expensed after the taxpayer has total
foreign and domestic exploration costs of $400,000. Development
expenses include those incurred during the development stage of
the mine such as constructing shafts and tunnels and in some cases
drilling and testing to obtain additional information for planning
operations. There are no limits on the current deductibility of such
costs. Although both intangible drilling costs and mine development
costs may be taken in addition to percentage depletion, mining
exploration costs subsequently reduce percentage depletion deductions.
In the case of mines, there are also "recapture" provisions under
which capital gains from the sale of the property are taken as ordinary
income to the extent of prior deductions for exploration expenses.
(27)
67-312-76----3
PAGENO="0034"
28
Impact
Generally, expenditures which improve assets that yield income
over several years must be capitalized and deducted over the period
in which the assets produce income. The tax advantage of treating
these expenditures as current expenses is the same as any other
allowing premature deductions; the taxpayer is allowed to defer cur-
rent tax liabilities; this treatment amounts to an interest-free loan
(see Appendix A).
These expensing provisions are additional benefits which supple-
ment the special percentage depletion allowances extended to the
mineral industry.1 Although the expensing and depletion provisions
operate somewhat independently, a firm or person may be eligible
for both and receive their combined benefits.
Estimated Distribution of Individual Income Tax Expenditure by
Adjusted Gross Income Class1
Percentage
Adjusted gross income class (thousands of dollars): distribution
0 to 7 2. 5
7 to 15 15. 0
15 to 50 33. 8
50 and over 48. 8
1 The distribution refers to the individual tax expenditure only. The corporate tax expenditure resulting
from these tax provisions is not reflected in this distribution table.
Rationale
The option to expense intangible drilling costs (as well as dry hole
costs) of oil and gas wells developed through regulations issued in
1917 (19 Treas. Dec., Tnt. Rev. 31(1917)). These regulations reflected
the view that such costs were ordinary operating expenses. In 1942,
the Treasury Department recommended that the provisions be re-
moved, but Congress did not consider the suggestion. (Hearings on
Revenue Revision of 1942 before the Committee on Ways and Means,
p. 2996, Vol. 3, 77th Cong., 2nd Sess.) Tn 1945, when a court decision
invalidated the regulations (F.H.E. Oil Uo. v. ~Jommissioner, 147 F.2d
1002, 5th Cir. 1945), Congress adopted a resolution (H. Con. Res. 50,
79th Cong, 1st Sess) approving the treatment and later incorporated
it into law in the 1954 Code The legislative history of this resolution
indicates that it was intended to reduce uncertainty in mineral ex-
ploration and stimulate drilling for military and civilian purposes.
(H. Rep. No. 761, 79th Cong., 1st Sess., pp.; 1-2.) Expensing of
mine development expenditures was enacted in 1951 to reduce am-
biguity in current treatment and encourage mining. The provision
for mine exploration was added in 1966.
Prior to the Tax Reform Act of 1969, a taxpayer could elect either
to deduct without dollar limitation exploration expenditures in the
United States, which subsequently reduced percentage depletion bene-
fits, or to deduct up to $100,000 a year with a total not to exceed
$400,000 of foreign and domestic exploration expenditures without the
application of the recapture rule. The 1969 Act subjected all post-1969
exploration expenditures to recapture.
1 Percentage depletion has been eliminated for larger producers of oil and gas and is being reduced for other
producers; see pages 31-32, below.
PAGENO="0035"
29
Selected Bibliography
Agria, Susan, "Special Tax Treatment of Mineral Industries," in
The Taxation of Income from Capital, The Brookings Institution,
Washington, D.C., 1969, pp. 77-122.
U.S. Congress, Senate, Committee on Interior and Insular Affairs,
An Analysis of the Federal Tax Treatment of Oil and Gas and Some
Policy Alternatives, 1974, 58 pages.
PAGENO="0036"
PAGENO="0037"
EXCESS OF PERCENTAGE OVER COST
DEPLETION
1977
1976
1975
575
500
465
1, 020
1, 080
2, 010
1, 595
1, 580
2, 475
Authorization
Section 613.
Description
Most firms engaged in oil, gas, and other mineral extraction are
permitted to include in their business costs a "depletion" allowance for
the exhaustion of the mineral deposits. Depletion is similar in concept
to depreciation. The depletion allowance is used to recover the cost of a
mineral deposit. There are two methods of calculating depletion:
percentage depletion and cost depletion. Taxpayers who qualify for
percentage depletion must. use it if it is greater than cost depletion.
Under percentage depletion, a taxpayer deducts a fixed percentage
of gross income frommining as a depletion allowance regardless of the
amount invested in the deposit. The deduction for gas and oil (which
was 27.5 percent from 1926-69) is now set at 22 percent. However,.
beginning in 1975 the percentage depletion allowance was repealed
for major oil and gas companies. Other companies (independents)
have been exempted from repeal of 2,000 barrels a day for 1975. The
amount of this exempt portion is being phased down gradually to
1,000 barrels a day. In addition, beginning in 1981, the depletion rate
will be gradually phased down to 15 percent for qualifying producers.
Percentage depletion also applies to other mineral resources at
percentages currently ranging from 22 percent to 5 percent. Sulphur,
uranium, and most other metals mined in the United States qualify
for the 22 percent rate; however, domestic gold, silver, and iron ore
qualify for a 15 percent rate; most minerals mined outside the U.S.
qualify for a 14 percent rate; coal qualifies for a 10 percent rate; and
several forms of clay, gravel, and stone qualify for 5 and 7~ percent
rates.
Percentage depletion may not exceed 50 percent of the net income
from the property. This limitation is known as the "net income
limitation." The total cost which can be recovered by percentage
depletion is not limited to the cost of the property.
(31)
* Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total
PAGENO="0038"
32
Cost depletion resembles depreciation based upon the number of
units produced. The share of the original cost deduction each year is
equal to the portion of the estimated total production (over the life-
time of the well or mine) which is produced in that year. Using cost
depletion, capital recovery cannot exceed the initial cost.
The value of the percentage depletion provision to the taxpayer is
the amount of tax savings on the excess of the percentage depletion
over cost depletion.
Impact
Issues of principal concern are the extent to which percentage
depletion: (1) decreases the price of qualifying oil, gas and other
minerals, and therefore encourages their consumption; (2) bids up
the price of drilling and mining rights; and (3) encourages the develop-
ment of new deposits and increases production.
Most analyses of percentage depletion have focused on the oil and
gas industry, which prior to 1975 accGunted for the bulk of percentage
depletion. Since 1975 legislation repealed the percentage depletion
allowance for most oil and gas production, only one-quarter of
oil and gas production is estimated to be currently eligible for per-
centage depletion. Sales of all other mineral deposits were unaffected
by the 1975 legislation.
Because of the prior focus on oil and gas percentage depletion,
there has been relatively little analysis of the impact of percentage
depletion on other industries. The relative value of the percentage
depletion allowance in reducing the `effective tax rate of mineral
producers is dependent on,a number of factors, including the statutory
percentage depletion rate, the effect of the net income limitation, and
the basic cost structure of the industry. For example, the greater
the mining cost as a percentage of the selling price of the final mineral
product, the greater the value of percentage depletion to the industry.
This effect may account in part for the greater value of percentage
depletion to the copper industry, as reported in SEC data as compared
to the aluminum industry-since the mining of bauxite constitutes a
much smaller portion of the cost of producing aluminum than the
mining of copper does to the cost of finished copper.
In the past, the net income limitation kept the effective percentage
depletion rate for coal at around 6 percent although the statutory
rate is 10 percent. Because the rising price of imported oil has in-
creased the average price of all oil, coal has been substituted for oil,
resulting in dramatic increases in the price of coal. The price in-
creases will make the net income limitation inapplicable to much
coal production, so the effective depletion rate is likely to rise to nearly
the statutory rate.
Estimated Distribution of Individual Income Tax Expenditure by
Adjusted Gross Income Class
Adjusted gross income class (thousands of dollars):
Oto7 3.3
7 to 15 9.8
15 to 50 31. 8
50 and over 5& 1
1 The distribution refers to the individual tax expenditure only. The corporate tax expenditure resulting
from these tax provisions is not reflected in this distribution table.
PAGENO="0039"
33
Rationale
Deductions in excess of depletion based on cost were first allowed
in 1918 in the form of "discovery value depletion" which allowed
depletion on the market value of the deposit after discovery rather
than on its cost. The purpose was to stimulate exploration during
wartime and to relieve the tax burdens on small scale prospectors.
Treasury believed that taxpayers often established high discovery
values and thus claimed excessive depletion. In 1926, to avoid the
administrative problems raised by the need to establish market value,
Congress substituted percentage depletion for oil and gas properties.
Beginning in 1932 percentage depletion was extended to most other
minerals.
In 1950, President Truman recommended the reduction of percent-
age depletion to a maximum of 15 percent, but Congress failed to take
action on this recommendation. Only minor changes were made until
1969 when the depletion allowance for oil and gas was reduced from
27.5 percent to 22 percent, and "excess" depletion was made subject
to the minimum tax beginning in 1970.
Selected Bibliography
Agria, Susan, "Special Tax Treatment of Mineral Industries," in
The Taxation of Income from Gapital, The Brookings Institution,
Washington, D.C., 1969, pp. 77-122.
U.S. Congress, Senate Committee on Interior and Insular Affairs,
An Analysis of the Federal Tax Treatment of Oil and Gas and Some
Policy Alternatives, 1974, 58 pages.
PAGENO="0040"
PAGENO="0041"
CAPITAL GAIN TREATMENT OF ROYALTIES
ON COAL AND IRON ORE
Estimated Revenue Loss
[In millions of dollars]
Fiscal year
Individuals
Corporations
Total
1977
50
20
70
1976
45
15
60
1975
40
10
50
Authorization
Section 631(c).
Description
Lessors of coal and iron ore deposits (which have been held more
than 6 months prior to disposition or lease) in which they retain an
economic interest may treat royalties as capital gains rather than as
ordinary income. Percentage depletion is not available in such cases.
This provision Cannot be used by taxpayers obtaining iron ore
royalties from related individuals or corporations. No similar limita-
tion applies to coal royalties.
impact
The extent to which this provision results in tax saving depends on
how the benefits compare with those from percentage depletion. In
past years, percentage depletion on coal often has been large enough
relative to profits to subject many firms to the "net income limitation"
which limits percentage depletion to 50 percent of net income. This
apparently has not been the case for iron ore where the percentage
depletion deduction is less likely to be subject to the net income
limitation.
For corporations, a percentage depletion deduction equal to 50
percent of net income reduces the effective tax rate to 24 percent (one-
half of 48 percent) whereas the capital gains treatment results in a
30 percent tax rate. However, if the mine has a high basis for calcu-
lating cost depletion (which can be claimed ratably as an offset to
capital gains), the election of this provision may result in a lower
tax. Similarly, if the percentage depletion deduction is less than the
net income limitation, capital gains treatment may be preferred.
For individuals, the tax reduction from the capital gains deduction
is equivalent to that for percentage depletion when the net income
limitation is applicable-taxable income is reduced by 50 percent. If
the net income limitation for percentage depletion does not apply, or
(35)
PAGENO="0042"
36
if the individual elects the alternative capital gain rate, capital gains
treatment will be more favorable.
Note that in view of recently rising coal prices, the percentage
depletion allowance will be less likely to reach the net income limita-
tion and thus less likely to reduce tax rates by one-half. The value of
newly purchased coal deposits also will be likely to rise-thus in-
creasing the value of cost depletion. As a consequence, capital gains
treatment which reduces tax rates by one-half for individuals may
become relatively more valuable than percentage depletion for a
larger number of individuals.'
Rationale
Capital gains treatment for coal royalties was adopted in the Reve
nue Act of 1951. The legislative history suggests it was adopted to
(1) extend the same treatment to coal lessors as that allowed to timbe
lessors (see p. 37), (2) provide benefits to long-term lessors with low
royalty rates who were unlikely to benefit significantly from the
percentage depletion deduction, and (3) to encourage the leasing and
production of coal.
Capital gains treatment of iron ore royalties was added in the
Revenue Act of 1964 to make the treatment of iron ore generally
consistent with eoal, and to encourage leasing and production of
iron ore deposits in response to foreign competition.
Selected Bibliography
Agria, Susan. "Special Tax Treatment of Mineral Industries",
in The Taxation of Income from Capital, Arnold C. Harberger and
Martin J. Bailey, eds. Washington, D.C., The Brookings Institution,
1969, pp. 77-122.
U.S. Congress. House Committee on Ways and Means. General
Tax Reform. Public Hearings. Testimony of E. V. Leisenring, National
Coal Association, Part 5, March 19-20, 1973, pp. 2223-30.
1 No estimated distribution of the individual tax expenditure by adjusted gross income class is provided
because in 1975 when the distributions were prepared by the Treasury Department, there was so rela-
tively little known usage of this provision by individuals that no distribution was prepared.
PAGENO="0043"
TIMBER: CAPITAL GAINS TREATMENT OF
CERTAIN INCOME
Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total
1977
65
165
230
1976
60
155
215
1975
60
145
205
Authorization
Sections 631 (a) and (b), 1221 and 1231.
Description
If a taxpayer has held standing timber or the right to cut it for more
than 6 months by the first day of the taxable year, the taxpayer may
elect to treat the cutting of this timber as the sale of a long-term
capital asset at a price equal to its fair market value on the first day
of the taxable year. Therefore, if an election is made, gain realized up
to the first of the year on the cut timber is capital gain. Changes in the
value of the timber after the first of the year as it is processed or manu-
factured will result in ordinary income or loss, and not capital gain or
loss. Capital gain treatment also can apply to the sale of a stand of
timber and the sale of timber as it is cut by the buyer. Timber includes
ornamental evergreens which are 6 years of age when severed from the
roots.
Some of a timber owner's costs which maintain or even arguably
improve his trees, such as disease control and thinning costs, can be
expensed currently (see Appendix A), even though their effects may
continue beyond the year in which they are made, and though they
are related to income which only will be recognized many years in the
future. Therefore, timber ownership offers opportunities for some tax-
payers to deduct current expenses associated with such ownership
against ordinary income from other sources.
Impact
The capital gains treatment of the cutting and sale of timber
constitutes a departure from the general rule that sale of a taxpayer's
inventory yields ordinary income. However, when timber is inventory,
it is usually held substantially longer than other types of inventory.
Both individual and corporate taxpayers are eligible for this treat-
ment. The graduated structure of the individual income tax rates
(37)
PAGENO="0044"
38
makes the provision more beneficial to individuals with high incomes
because the value of the deduction for capital gains increases with the
marginal income tax rate.
Two industries-paper and allied products and lumber and wood
products-claim disproprotionately large amounts of corporate capital
gains. According to 1972 Preliminary Statistics of Income for Corpora-
tions, 24 percent of taxable income of paper and allied products in-
dustries and 42 percent of taxable income of lumber and wood prod-
ucts were long-term capital gains. This proportion may be contrasted
with a proportion of 4.4 percent for all other corporations. These two
industries reported 16.9 percent of all corporate capital gains while
accounting for only 2.7 percent of taxable income. Treasury Depart-
ment studies published in 1969 indicate that in these industries there
were five corporations which account for about one-half of the capital
gains claimed, 16 firms account for about two-thirds, and 80 percent
of the gains are accounted for by approximately 60 corporations.
Estimated Distribution of Individual Income Tax Expenditure by
Adjusted Gross Income Class1
Adjusted gross income class (thousands of dollars):
Oto7 7.3
7to15 12.7
15to50 23.6
5Oandover 56.4
I The distribution refers to the individual tax expenditure only. The corporate tax expenditure resulting
from these tax provisions is not reflected in this distribution table.
S Rationale
The sale of a timber stand that had not been held in the course of
business was long considered the sale of a capital asset. The Revenue
Act of 1943 extended this capital gain treatment to all persons who
cut and sell their timber and to those who lease timber stands for
cutting. One reason for adopting this provision was to equalize treat-
ment between the taxpayer who sold timber as a stand outright, and
the taxpayer who cut timber for use in his business. It was also sug-
gested that this treatment would encourage conservation of timber
through selective cutting and that taxing the capital gain at ordinary
rates was an unfair practice because of the comparatively long de-
velopment time of timber.
Selected Bibliography
Briggs, Charles W. and Condrell, William K., Tax Treatment of
Timber, 5th ed., Forest Industries Committee on Timber Valuation
and Taxation, Washington, D.C. 1969.
Sunley, Emil M., Jr., The Federal Tax Subsidy of the Timber
Industry, U.S. Congress, Joint Economic Committee, The Economics
of Federal Subsidy Programs, Part 3-Tax Subsidies, July 15, 1972,
pp.317-42.
U.S. Congress Joint Publication of the Committee on Ways and
Means and the Committee on Finance. Tax Reform Studies and
Proposals. U.S. Treasury Department. Part 3, February 3, 1969,
pp. 434-38.
PAGENO="0045"
POLLUTION CONTROL: 5-YEAR AMORTIZATION
Estimated Revenue Loss
[In milli*ns of doU~srsJ
Fiscal year
Individuals
Corporations
Total
1977
15
15
1976
20
20
1975
30
30
Authorization S
Section 169.
Description
In lieu of depreciation, pollution control facilities that have been
certified by both State and Federal agencies may be amortized over
a 5-year period using the straight line method (i.e., 20 percent of the
cost may be deducted each year). This rapid amortization is currently
available only with respect to treatment facilities placed in service
before 1976. Certification requires that the new facility be: (1) in-
stalled in connection with a polluting facility; (2) designed specifically
for pollution abatement and not for any other purposes; (3) in com-
pliance with both the Federal Water Pollution Control Act and the
Clean Air Act; and (4) a new structure. The provision applies only
to tangible abatement facilities installed in connection with polluting
facilities in operation before 1969.
Taxpayers may not claim an investment tax credit for property
amortized under this provision.
impact
The amortization provision has been used much less than it would
otherwise have been because the investment tax credit cannot be
used with amortized property. With the recent temporary increase
of the investment tax credit to 10 percent (for 1975 and 1976) and the
shortening of depreciation lives in 1971, the combined benefit of the
credit and accelerated depreciation is usually greater than the bene-
fit of rapid amortization. However, to the extent it is used, 5-year
amortization for assets with longer useful lives benefits the taxpayer
by effectively deferring current tax liability (see Appendix A).
Rather than functioning as an incentive, the 5-year amortization
of pollution control facilities subsidizes corporations that must
comply with Federal or State law regarding pollution. State pollution
(39)
PAGENO="0046"
40
regulations vary, and there are regional cost, differences for a given
facility; both may account for geographical differences in the usage
of the subsidy.
Rationale
Section 169 was introduced for a 5-year period to ease the financial
burden of complying with environmental regulations when the Tax
Reform Act of 1969 repealed the investment tax credit. When the
investment tax credit was reinstated in 1971, rapid amortization
was retained as an option.
Further Comment
Congress, in 1974, extended the availability of the amortization
election for an additional year until December 31, 1975. Although
the extension recently has expired, it still will have a revenue impact
for all years in which property is amortized under its provisions. The
provision may be reinstated retroactively.
Selected Bibliography
Moore, Michael L. and G. Fred Streuling, "Pollution Control
Devices: Rapid Amortization Versus the Investment Tax Credit,"
Taxes, January 1974, pp. 25-30.
McDaniel, Paul R. and Alan S. Kaplinsky, "The Use of the Federal
Income Tax to Combat Air and Water Pollution," Bostoi~ College
Industrial and Commercial Law Review, February 1971, pp. 351-86.
PAGENO="0047"
CORPORATE SURTAX EXEMPTION
Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total
1977 6, 185 6, 185
1976 5, 015 5, 015
1975 ~, 345 3, ~
Authorization
Section 11.
Description
The permanent corporate income tax consists of a normal tax rate
of 22 percent and a surtax of 26 percent for a total tax rate of 48 per-
cent. rfhe first $25,000 of profits are exempted from the surtax.
Temporary provisions in the Tax Reduction Act of 1975 and the
Revenue Adjustment Act of 1975 reduce the normal tax rate to 20
percent on the first $25,000 of profits and 22 percent on the next
$25,000 of profits, thus raising the exemption from the surtax to $50,000.
These changes are presently in effect only through June 30, 1976.
Impact
The surtax exemption is available to all corporations. It tends to
neutralize the tax differential between a business operating as a sole
proprietorship or a partnership and a corporation by lowering the
corporate tax rate on the first $25,000 ($50,000 in 1975 and part of
1976) to rates comparable to the individual rates. The exemption
encourages the use of the corporate structure and allows some small
corporate businesses that might otherwise operate as sole proprietorships
or partnerships to provide fringe benefits. It also encourages the
splitting of operations between sole proprietorships, partnerships and
corporations. Most businesses are not incorporated; only about 5
percent of all businesses are affected by this provision, and not all
of those receive the full tax benefit because their taxable income is
less than $25,000 ($50,000 in 1975 and part of 1976).
Rationale
Since almost the earliest days of the corporate income tax, some
level of profits has been exempted from the full corporate tax rate.
The split between a normal tax and a surtax was not, however, fully
accomplished until the Revenue Act of 1941. The surtax exemption
(41)
PAGENO="0048"
42
in its present form was adopted as part of the 1950 Revenue Act.
The purpose was to provide relief for small businesses. However, many
large businesses fragmented their operations into numerous corpora-
tions to obtain numerous exemptions from the surtax. Some remedial
steps were taken in 1963; in 1969, legislation was enacted limiting
groups of corporations controlled by the same interest to a single surtax
exemption.
Selected Bibliography
Gapital Formation. Prepared for the use of the Committee on Ways
and Means by the Staff of the Joint Committee on Internal Revenue
Taxation, October 2, 1975.
Pechman, Joseph. Federal Tax Policy. Rev. ed. Washington, D.C.:
The Brookings Institution, 1971, pp. 131-33.
PAGENO="0049"
DEFERRAL OF TAX ON SHIPPING COMPANIES
Estimated Revenue Loss
[In millions of dollarsj
Fiscal year
Individuals
Corporations
Total
1977
130
130
1976
105
105
1975
70
70
Authorization
46 U.S.C. Section 1177 (~ 607 of the Merchant Marine Act of 1936
at~amendecl).
Description
United States operators of vessels operating in foreign, Great Lakes,
or noncontiguous domestic trade or in the U.S. fisheries may establish
a capital construction fund (CCF) in which they may deposit income
earned by the vessels. Such deposits are deductible from taxable
income, and income tax on earnings of deposits in the CCF is deferred.
When such tax-deferred deposits and their earnings are withdrawn
from a CCF, no tax is paid if the withdrawal is used for qualifying pur-
poses, such as to construct or acquire a new vessel or to pay off the
indebtedness on a qualifying vessel. The tax basis of the vessel (usually
its cost to the taxpayer) on which the operator's depreciation is com-
puted is reduced by the amount of such withdrawal. Thus, over the life
of the vessel, tax depreciation will be reduced and taxable income will
be increased by the amount of such withdrawal, thereby reversing the
effect of the deposit. However, since gain on the sale of the vessel and
income from the operation of the replacement vessel may also be de-
posited into the CCF, the tax deferral may be extended indefinitely.
Only withdrawals for purposes other than for construction, acquisi-
tion, or payment on indebtedness of a qualifying vessel are taxed at
the time of withdrawal, subject to an interest charge for the period dur-
ing which tax was deferred.
Impact
Since 1970, over $550 million has been deposited into CCFs by 96
carriers, and almost $250 million has been withdrawn.
Rationale
The provision is designed to stimulate American shipbuilding and to
recapture sonie of the foreign yard construction now being done for
U.S. companies.
(43)
~7-312-76-------4
PAGENO="0050"
44
Further Comment
An important unresolved issue is whether the investment tax
credit should be extended to vessels constructed with funds withdrawn
from CCFs. Currently, it does not. However, a provision of the
Maritime Appropriation Authorization Act of 1975, as adopted by
the Senate but dropped in Conference, would have allowed the credit
on such vessels.
Selected Bibliography
Jantscher, Gerald H. Bread Upon the Waters.-Federal Aid to the
Maritime Industries, The Brookings Institution-Washington, D.C.,
1975, 164 pages.
PAGENO="0051"
RAILROAD ROLLING STOCK: 5-YEAR
AMORTIZATION
Estimated Revenue Loss
[In millions of dollars]
Fiscal year
Individuals
Corporations
Total
1977
10
10
1976
30
30
1975
55
55
Authorization
Section 184.
Description
Instead of being depreciated on an accelerated basis over its normal
useful life, qualified railroad rolling stock placed in service after 1968
and before 1976 may be amortized over a 5-year period using the
straight line method. The use of five-year amortization for assets
whose useful lives are longer benefits the taxpayer by effectively
deferring current tax liability (see Appendix A). The investment tax
credit is not available for property subject to this rapid amortization.
Impact
Since this tax incentive was adopted to increase the supply of rail-
road rolling stock, there has been a decline in both total dollar amount
of railroad rolling stock purchases and use of the 5-year amortization
provision. The decreasing use can be explained largely by the rein-
statement of the investment tax credit in 1971, which is generally
more advantageous than rapid amortization.
There are 67 Class I railroads in the United States. Since 1972, 27
of them have used the amortization provision.
Only railroad companies with taxable income benefit directly from
the rapid amortization provision. Railroad companies without taxable
income, in effect, sell their right to this rapid amortization to financial
companies who initially acquire the roiling stock and then lease it to
the railroads. As a result, some of the tax benefits from this provision
accrue to lessors that are not railroad companies.
Rationale
Section 184 was adopted as part of the Tax Reform Act of 1969 when
the investment tax credit was repealed. The purpose was to encourage
the modernization of railroad equipment, increase railroad efficiency,
(45)
PAGENO="0052"
46
reduce freight car shortages during seasonal peaks, and aid the
financing of new equipment acquisitions. Although it expired Decem-.
ber 31, 1975, a retroactive reinstatement may occur in 1976.
Selected ffi~~iograpliy
Benevenutto II, Frank A., "Lease Rolling Stock and Enjoy Con-
siderable Benefits", Taxes, September 1973, pp. 530-36.
PAGENO="0053"
BAD DEBT DEDUCTIONS OF FINANCIAL
INSTITUTIONS IN EXCESS OF ACTUAL LOSSES
Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total
1977
570
570
1976
815
815
1975
880
880
Authorization
Sections 585, 593, and 596; Revenue Rulings 65-92 (C.B. 1965-i,
112), 68-630 (C.B. 1968-2, 84).
Description
In general, businesses are permitted to deduct as a current operating
expense a reasonable allowance for bad debts. The allowance usually
is based on the experience of prior years. However, the special formulae
used by financial institutions to compute bad debt reserves permits
deductions in excess of actual experience.
Prior to 1969, commercial banks were permitted a bad debt deduc-
tion of 2.4 percent of outstanding loans. The 1969 Tax Reform Aèt
reduced this figure to 1.8 percent foryears through 1975, 1.2 percent
from 1976-81, and .6 percent from 1982 through 1987. After 1987,
commercial banks will be limited in their loss reserve deductions to
actual recent loss experience.
As an alternative to. this treatment available for commercial banks,
mutual savings banks and savings and loan associations have an
option, under certain circumstances, to deduct a specified percentage
of their taxable income. Under the provisions of the Tax Reform Act
of 1969, this percentage-of-net-income allowance is being reduced
from 60 to 40 percent by 1979. (The allowance for 1976 is 43 percent
of taxable income.) rfherea,fter, the percentage allowance will remain
at 40 percent. The total bad debt reserve of thrift institutions may
may not exceed 6 percent of qualifying real property loans, or
the percentage-of-net-income bed debt deduction will be disallowed.
In addition, the annual bad debt deduction under this latter method
will be reduced if the thrift institution's investments do not comprise
specified proportions of certain "qualified" assets, which for "thrifts"
are essentially residential mortgages.
(47)
PAGENO="0054"
48
Impact
Bad debt reserve deductions in excess of actual experience lower the
effective tax rates of financial institutions, particularly thrift in-
stitutions, below the normal corporate tax rate of 48 percent. Apart
from any other means of reducing tax liability, the 60 percent bad
debt allowance resulted in a maximum effective tax rate for a thrift
institution prior to the 1969 Tax Reform Act of 19.2 percent.' With
full phase-in of the bad debt provisions of the 1969 Tax Act, the maxi-
mum effective tax rate of a thrift institution qualifying for the full
bad debt allowance will be 28.8 percent.2 Therefore, to the extent the
bad debt deduction induced thrift institutions to hold qualified
assets, such as residential mortgages, before 1969, the provisions of
the 1969 Tax Act have reduced the incentive effect of this tax
expenditure.
Rationale
The tax treatment of commercial banks evolved separately from
that of thrift institutions. The allowance for special bad debt reserves
of commercial banks was first provided by IRS ruling in 1947, when
there was fear of a postwar economic downturn. It was intended to
reflect the banking industry's experience during the depression
period.
The special treatment of bad debt reserves for thrift institutions
was added by statute in 1951. Prior to that time, savings and loan
associations and mutual savings banks were exempt from taxation,
in most instances because they were viewed as mutual organizations
rather than corporations. Upon removal of this tax exempt status,
special, and very favorable, treatment of bad debt reserves was
provided for sayings and loan institutions and~mutuaI savings banks,
which in effect left them virtually tax-exempt for a number of years
thereafter. Some of the same factors which led to their tax exemption
probably account for the special allowance for bad debts, especially
in that these institutions are thought to ifil an important role in
providing home mortgage funds.
Selected Bibliography
U.S. Congress. Joint Publications of the Committee on Ways and
Means and the Committee on Finance, Tax Reform Stndies and Pro-
posals, U.S. Treasury Department, Part 3; Chapter IX-D, Tax
Treatment of Financial Institutions, pp. 458-75.
U.S. Treasury Department, Report on the Financial Institutions
Act of 1973, A Section-by-Section Analysis, Department of the
Treasury News, October 11, 1973.
1 .48-.6(.48)=.192.
2 .48-.4(.48)=.288 (without taking the minimum tax into account).
PAGENO="0055"
DEDUCTIBILITY OF NONBUSINESS STATE
GASOLINE TAXES
Estimated Revenue Loss
[In millions of dollars]
Fiscal year
Individuals
Corporations
Total
1977
600
600
1976
575
575
1975
820
820
Authorization
Section 164 (a) (5).
Description
State and local sales taxes on gasoline, diesel fuel, and other major
fuels are deductible even if the taxes are not trade or business expenses
or expenses for the production of income. Federal fuel taxes are not
so treated.
Impact
This deduction benefits oniy taxpayers who own motor vehicles
and itemize deductions rather than take the standard deduction.
These tend to be middle and higher income taxpayers. Gasoline
prices are reduced for taxpayers who claim the deduction, and the
amount of this tax benefit per dollar of deduction increases with the
tax bracket of the taxpayer.
State and local gasoline taxes are "user taxes" in the sense that the
revenues they generate are generally earmarked for road maintenance
and other State and local services provided highway users. The de-
duction allowed for these taxes is contrary to the general nondeduct-
ible treatment of user taxes. Therefore, one effect of this deduction
is to shift some of the burden of these user taxes to all Federal tax-
payers, regardless of the extent to which they use these local road
facilities.
Estimated Distribution of individual income Tax Expenditure by
Adjusted Gross income Class
Percentage
Adjusted gross income class (thousands of dollars): distribution
Oto7 3.2
7 to 15 32. 3
15 to 50 60. 3
5Oandover 4.2
(49)
PAGENO="0056"
50
Rationale
Before 1964, a deduction for both business and nonbusiness State
and local taxes was allowed in computing taxable income. The Rev-
enue Act of 1964 eliminated the deduction for many taxes. The bill
first passed by the Ways and Means Committee also eliminated the
deduction for gasoline taxes, but the Senate Finance Committee
restored it. It was retained by the Conference. The stated rationale
for retention of the deduction was to prevent large shifts in the tax
burden of individuals, to assist the States with fiscal coordination
in a Federal system, and to allow the States free choice in their selec-
tion of a tax structure.
Selected Bibliography
Goode, Richard. The Individual Income Tax, Rev. ~ed. The Brook-
ings Institution, Washington, D.C., 1976, pp. 168-71.
Davie, Bruce F. and Bruce F. Duncombe, "The Income Distri-
bution Aspects of Energy Policies", Studies in Energy Tax Policy,
Cambridge, Massachusetts, Ballinger Publishing Company, 1975,
pp. 343-72.
Simplification of the Tax Return and Other Miscellaneous Sim-
plification Items, Prepared for the use of the Committee on Ways and
Means by the Joint Committee on Internal Revenue Taxation,
October 2, 1975
PAGENO="0057"
DEPRECIATION ON RENTAL HOUSING IN EX-
CESS OF STRAIGHT LINE, AND DEPRECIATION
ON BUILDINGS (Other Than Rental Housing) IN
EXCESS OF STRAIGHT LINE
Estimated Revenue Loss
[In millions of dollars]
Depreciation on
rental housing
Dc
preciation on
buildings
Fiscal year
mdi- Cor-
vid- pora- Total
uals tions
mdi-
vid-
uals
Cor-
pora- Total
tions
1977
1976
1975
455 125 580
430 120 550
405 115 520
215
215
220
280 495
275 490
220 440
Authorization
Section 167(b) and (j).
Description
Businesses are allowed to recover the costvof their durable assets
that wear out or become obsolete by deducting from gross income an
allocable portion of the cost of the assets. Normally these depreciation
deductions are spread over the useful life of the asset, and the total
amount equals the asset's cost less salvage value. Taxpayers are
generally offered the choice of using the straight line method (in which
an equal amount of depreciation is deducted each year of the asset's
life) or accelerated methods of depreciation (in which greater amounts
are deducted in the early years). A taxpayer can switch from the de-
clining balance or the sum of the years-digits methods of accelerated
depreciation to straight line depreciation when it becomes advantage-
ous to do so as the asset grows older.
The use of accelerated depreciation on structures is limited as
follows:
RESIDENTIAL RENTAL UNITS
(1) New construction may be depreciated under any method
allowed by the Internal Revenue Code.
(2) Used buildings having at least a 20-year life when acquired
may be depreciated under the declining balance method using a
rate not in excess of 125 percent of the straight line rate.
OTHER STRUCTURES
(1) New construction may be depreciated by any accelerated
method which does not yield depreciation greater than the
declining~balance method using a rate not exceeding 150 percent of
the straight line rate.
(51)
PAGENO="0058"
52
(2) Used buildings may be depreciated on the straight line
method or any other reasonable method that is neither a declining
balance or sum of the years digits method.
Example
Assume a used residential structure with a basis of $10,000, an
expected remaining life of 25 years, and no salvage value. If the
straight line method were used, the deduction would be $400 each
year. Under accelerated depreciation, the first-year depreciation allow-
ance can be computed as follows:
Depreciation allowance= 125%X 1/25X$10,000=$500
In the second year, the depreciation allowance is computed in the
same way except the original basis of $10,000 is now reduced by
the amount previously depreciated. Hence, the new basis equals
$9,500. The second year computation is:
Depreciation allowance= 125%X 1/25X $9,500=$475
Thus, in each succeeding year, there is a decrease in the amount of
depreciation claimed for tax purposes, and therefore an increase in
tax liability compared to what it would be otherwise.
Impact
Because accelerated depreciation allows for larger deductions in
the early years of the asset's life and smaller depreciation deductions
in the later years, accelerated depreciation results in a deferral of
tax liability. It is a tax expenditure to the extent it is faster than
economic (i.e. actual) depreciation. It is widely believed to be con-
sistent with actual experience to allow accelerated depreciation for
some machinery and equipment which, in many cases, decline in value
more rapidly in their early years than later years. However, similar
treatment for buildings is generally believed inconsistent with their
rates of economic decline in value which are generally much slower
than those of machinery and equipment.
The direct benefits of accelerated depreciation for structures
accrue to owners of business buildings and rental housing. The benefit
is estimated as the tax saving resulting from the depreciation deduc-
tions in excess of straight line depreciation. About 77 percent of the
tax saving from rental housing and 44 percent of the tax saving from
nonresidential buildings accrue to individual owners. The remaiiiing
portion of each class of benefit goes to corporate owners.
Efforts to repeal accelerated depreciation for real estate have been
opposed on the ground that without this treatment, real estate invest-
ments would be so unattractive relative to other forms of investment
that drastic cut backs in building programs would result. On the
other hand, it is argued that the tax benefits increase the production
of new buildings only to the extent that demand for new buildings
responds to small price changes, and that this response is relatively
small. The impact of accelerated depreciation on rental housmg is
generally estimated to be greater than for nonresidential buildmgs
since the demand for housing is more price elastic.
PAGENO="0059"
53
Estimated Distribution of Individual Income Tax Expenditure by
Adjusted Gross Income Class1
DEPRECIATION ON RENTAL HOUSING
Percentage
Adjusted gross income class (thousands of dollars): distribution
Oto7 4.8
7 to 15 16. 8
15 to 50 44. 3
50 and over 34. 1
DEPRECIATION ON BUILDINGS
Percentage
Adjusted gross income class (thousands of dollars): distribution
Oto7 5.0
7 to 15 17. 3
15to50 44.1
50 and over 33. 6
I The distribution refers to the individual tax expenditures only. The corporate tax expenditures result~
ing from these tax provisions is not reflected in this distribution table.
Rationale
Prior to 1954, depreciation policy had developed through adminis-
trative practices and rulings. The straight line method was favored
by IRS and generally used. A ruling issued in 1946 authorized the use
of the 150 percent declining balance method. Authorization for it and
other accelerated depreciation methods first appeared in the statute in
1954 when the double declining balance and other methods were
authorized. The discussion at that time focused primarily on whether
the value of machinery and equipment declined faster in their earlier
years. However, when the accelerated methods were adopted, real
property was included as well even though it did not decline more
rapidly in value in its first years. By the 1960s, most commentators
agreed that accelerated depreciation resulted in excessive allowances
for buildings. In 1964, a provision was enacted which "recaptured"
accelerated depreciation as ordinary income in varying amounts
when a building was sold, depending on the length of time the property
was held. However, recapture was not required for straight line de-
preciation upon the transfer of real estate. In 1969, the current limi-
tations were imposed and the "recapture" provision was slightly
strengthened.
Further Comment
Several proposals have been made either to eliminate accelerated
depreciation or to limit its benefits. One of the more generally ad-
vocated changes would limit depreciation to the equity investment in
the property. Another would not allow real estate losses to offset
income from other sources. There are many variations and combina-
tions of these proposals (see for example H.R. 10612, 94th Cong.,
1st Sess.).
PAGENO="0060"
54
Selected Bibliography
Surrey, Stanley S. Pathways to Tax Reform, Cambridge, Massa-
chusetts, Harvard University Press, 1973. Chapter Vu-Three Special
Tax Expenditure Items: Support to State and Local Governments, to
Philanthropy, and to Housing, pp. 2O9-~46.
Taubman, Paul and Robert Rasche. "Subsidies, Tax Law and
Real Estate Investment". U.S. Congress, Joint Economic Committee.
The Economics of Federal Subsidy Programs. Part 3. Tax Subsidies,
July 15, 1972, pp. 343-69.
U.S. Congress, House, Committee on Ways and Means, General
Tax Reform, Panel Discussions, Part 4, "Tax Treatment of Real
Estate", February 8, 1973, pp 507-611
U S Congress, House, Committee on Ways and Means, Tax Reform
Hearings, Part 2, Panel Nos. 1 and 2, "Tax She1ters~ and Minimum
Tax", July 16, 1975, pp. 1403-1607.
PAGENO="0061"
EXPENSING OF RESEARCH AND
DEVELOPMENT COSTS
Estimated Revenue Loss
[In millions of dollars]
FIscal year
Individuals
Corporations
Total
1977
695
695
1976
660
660
1975
635
635
Authorization
Section 174.
Description
Taxpayers may elect to deduct costs for research and development as
incurred (i.e., these costs may be "expensed") even though such costs
may be associated with income that is earned over several years. The
cost then is deducted before the income it earns is realized.
impact
The mismatching of costs and income operates, as accelerated
depreciation does, to defer tax liability and thereby provide the tax-
payer with an interest-free loan.
For example, if Corporation Z expends $1,000 on an R&D program
in a given taxable year, the entire sum is treated as a deduction from
taxable income and represents a cash flow of $480 to the firm ($1,000
X48 percent marginal tax rate=$480). The value of the current
expense treatment, however, is the amount by which the present value
of the immediate deduction exceeds the present value of periodic
deductions taken over the useful life of the expenditure.
The direct beneficiaries of this provision are firms which undertake
research and development. Mainly, these are large manufacturing
corporations. The scanty evidence available suggests that, of the total
amount claimed as research and experimental costs, about 10 percent
is basic research and 90 percent is product development.
Expensing of research and development costs for tax purposes is
consistent with the recent practice of a growing number of companies
that expense these costs for financial accounting purposes. This
treatment was approved by the Financial Accounting Standards
Board in October 1974.
(55)
PAGENO="0062"
56
Rationale
This provision was added to the tax law in 1954. The general nile,
then as now, was that the cost of assets that benefit future years must
be capitalized and amortized over the assets' useful lives. Probably
because there was difficulty in determining the useful life of such
benefits, deduction was generally allowed The treatment in a specific
case was determined by the IRS administrative practice and court
decisions. The purpose of the 1954 statute was to eliminate uncertainty
in this area and to encourage expenditures for research and
development.
Selected Bibliography
U.S. Congress, House, Committee on Ways and Means, Tax
Reviaiort Gompendium, beginniiig Nov. 16, 1959, vol. ~, section G(4)-
"Research and Development ~xpenditures.," pp. 1 105-23.
PAGENO="0063"
INVESTMENT TAX CREDIT
Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total
1977
1976
1975
1, 530
1, 410
950
7, 585
6, 850
4, 860
9, 115
8, 260
5, 810
Authorization
Sections 38 and 46-50.
Description
The investment tax credit (ITC) is available to any taxpayer who
invests in income-producing property which is eligible for the credit.
Eligible investment is largely limited to tangible personal property,
such as machinery and equipment, that is used in the United States.
Most buildings are not eligible.'
The amount of the credit is subtracted from tax liability calculated
without the credit. The credit is currently 10 percent of the qualified
investment but will revert to 7 percent (4 percent for regulated util-
ities) after December 31, 1976. The amount of investment that quali-
fies for the credit is the full purchase price of property with a life of at
least 7 years, two-thirds for property with a useful life of from 5 to 7
years, one-third for property with 3- to 5-year life, and zero for
property with a life of less than 3 years. Only $100,000 of investment
in used property ($50,000 after December 31, 1976) qualifies in any
year. The maximum credit which can be claimed in any one year is
$25,000 plus 50 percent of tax liability over $25,000 (this rule is tem-
porarily liberalized for regulated utilities). Any unused amount of the
credit may be carried back 3 years and carried over 7 years (for pre-
1971 carryovers a 10-year period is allowed). Use of the credit does not
reduce the cost of an asset for purposes of calculating depreciation.
A corporate taxpayer may elect an additional 1 percent credit until
December 31, 1976, if an amount equal to 1 percent of the qualified
investment is contributed to an employee stock ownership plan.
Impact
The credit has two effects. First, it increases the recipient's cash
flow. Second, it reduces the cost of capital and, therefore, can turn an
unprqfitable investment into a profitable one (or a profitable one into
1 With certain exceptions, investments eligible for the credit include depreciable or amortizable property
having a useful life of three years or more and include: (1) tangible personal property; (2) other tangible
property (not including a building or its components) used as an integral part of (a) manufacturing, (b) ex-
traction, (c) production, or (d) furnishing of transportation, communications, electrical energy, gas, water, or
sewage disposal services; (3) elevators and escalators; and (4) research facilities and facilities for the bulk
storage of fungible commodities.
(57)
PAGENO="0064"
58
a more profitable one). Assume that an investor requires a 15 percent
rate of return to undertake an investment project. Amachine which
costs $1,000 and provides an annual return of $135 does not meet the
15 percent target. However, a 10 percent ITC reduces the net cost
of the machine to $900, so the $135 annual return qualifies at the 15
percent standard (15 percent of $900=$135).
While noncorporate businesses and individu&l investors benefit
from the credit, 80 percent of the credit accrues to corporations. Since
the credit is directly related to investment in durable equipment, much
of the direct benefit is concentrated in manufacturing and utilities.
According to 1972 tax data, 64 percent of the ITO is claimed by
corporations with assets of $250 million or more. Two major industry
categories account for 77 percent of the credit : manufacturing (44
percent) and transportation,, communication, electric, gas, and sani-
tary services (33 percent).
For some firms, e.g., public utilities, the credit on an investment may
exceed the company's tax liability. Instead of purchasing the property,
the firm may find it profitable to lease the equipment from a bank
that is able to obtain full benefit from the credit. Securities and Ex-
change Commission data indicate substantial use of the credit by
banks through leasing arrangements. A refundable investment
credit has been recommended by some persons for business firms that
lose unused credits at the end of the carry-forward period.
"Several studies have produced little evidence that suggests the past
changes in the application of the credit have been effective as short-
run business cycle stabilization tools. Other studies have produced
conflicting evidence as to the long-run effectiveness of the credit in
stimulating investment which increases the rate of capital accumula-
tion and economic growth.
Estimated Distribution of individual income Tax Expenditure by
`Adjusted Gross income Class1
Percentage
Adjusted gross income class (thousands of dollars): distribution
Oto7 5.1
7to15 25.0
15 to 50 49. 3
50andover 20.5
I The distribution refers to the individual tax expenditure only. The corporate tax expenditure resulting
from these tax provisions is not reflected in this distribution table.
Rationale
Originally adopted as part of the Revenue Act of 1962, the, purpose
of the credit was to stimulate investment and economic growth. The
credit was also justified as a means of increasing the ability of American
firms to compete abroad and of compensating for the effect of inflation
on capital replacement. The credit was modified in 1964, suspended
in September 1966, restored in March 1967, repealed in April 1969,
reenacted in August 1971, and temporarily liberalized in March
1975 until the end of 1976.
PAGENO="0065"
59
Selected Bibliography
Branrion, Gerard M., "The Effects of Tax Incentives for Business
Investment: A Survey of the Economic Evidence," U.S. Congress.,
Joint Economic Committee, The Economics of Federal Subsidy Pro-
grams, Part 3, Tax Subsidies, 92d Congress, 2d Session, July 15,
1972, PP. 245-68.
Tax Incentives and Capital Spending, Gary Fromm, ed., the Brook-
ings institution, Washington, D.C., 1971, 301 pages.
U.S. Senate, Task Force on Tax Policy and Tax Expenditures
and T ask Force on Capita] Needs and Monetary Policy, Committee
on the Budget, Seminar-Encouraging Gapital Formation Through
The Tax Gode, Committee Print, September 18-19, 1975.
U.S. Congress, House, Committee on Ways and Means, General
Tax Reform, Panel Discussions, 93d Congress, 1st Session, Part 3,
Tax Treatment of Capital Recovery, February 7, 1973, pp. 345-504.
U.S. Library of Congress, "An Analysis of rilax Provisions Affecting
Business Investment: Depreciation and the Investment Tax Credit"
by Jane Gravelle, Congressiona] Research Service, Multilith 74-151E,
August 14, 1975.
PAGENO="0066"
PAGENO="0067"
ASSET DEPRECIATION RANGE
Estimated Revenue Loss
[In millions of dollars]
Fiscal year
Individuals
Corporations
Total
1977
1976
1975
175
155
140
1, 630
1, 435
1,270
1, 805
1, 590
1,410
Authorization
Section 167(m); Regulation 1.167(a)-li; Rev. Proc. 72-10.
Description
The Internal Revenue Service has established useful lives for classes
of depreciable assets. The asset depreciation range (ADR) system
permits taxpayers to choose any useful life within a range of 20 percent
more or less than the class life specified for a particular asset. If ADR.
is chosen, the taxpayer is not required to justify retirement and re~~
placement policies nor to show that they are consistent with the actual
useful lives of their assets.
Example
Assume that a taxpayer has a $1,500 asset for which the class life
established by the Internal Revenue Service is 10 years. Using double
declining balance depreciation, without ADR, the deduction in the
first year would be 200 percentX .1OX$1,500=$300. After deduction
of this depreciation charge, the adjusted basis of the asset is $1,200
($J,500-$300). In the second year, the deduction would be 200 per-
centX .1OX$1,200 $240.
Under the asset depreciation range, a useful life of between 8 and
12 years may be selected. If the taxpayer chose 8 years, the first year
deduction would be 200 percentX~X$l,500=$375. In the second
year, the deduction would be 200 percentX3~X$l,125==$28l.25.
Therefore, the use of ADR would result in additional deductions of $75
the first year ($375-300) and $41.25 the second year ($281.25-
240.00).
Impact
The ADR system, as accelerated depreciation (see Appendix A),
reduces taxes early in the life of depreciable assets and thus increases.
(01)
PAGENO="0068"
62
cash flow during that time. The subsidy value of ADR is the tax saving
from the allowance of a tax depreciation life shorter than the guideline
life of the asset. Capital intensive businesses such as manufacturing
firms and utilities are necessarily the most likely to take advantage of
ADR.
Securities and Exchange Commission data indicate significant use
of ADR by railroads, utilities, airline companies, and truck and
equipment companies. Treasury Department data indicate that the
use of ADR is more probable the larger the company, and the percent
of investment covered by ADIR increases with the asset size of the
company. Sixty percent of all business fixed investment is covered by
ADIR, but about SO peicent of the business fixed investment of the
360 largest corpbrations is covered.
Estimated Distribution of Individual Income Tax Expenditure by
Adjusted Gross Income Class1
Percentage
Adjusted gross income class (thousands of dollars): distribution
0 to 7 4.8
7 to 15 18. 1
15 to 50 43.8
50 and over 33. 3
1 The distribulion refers to the individual lax expenditure only. The corporate tax expenditure resulting
from these lax provisions is not reliected in this distribution table.
Rationale
rFlle ADIR system was established in 1971 principally to stimulate
investment and economic growth by deferring taxes through the ac-
celeration of depreciation deductions. In addition, it was a~serthd the
system would simp1if~r the administration of the existing depreciation
rules.
Selected Bibliography .
Brannon, Gerard M. "The Effects of Tax Incentives for Business
Investment: A Survey of the Economic Evidence." In U.S. Congress.
~Joint Economic Comriuittee, The Economics of .Federat Subsidy Pro-
grams, Part 3, T ax Subsidies, 92d Congress, 2d Session, July 15, 1972,
pp. 245-68.
U.S. Congress. House Committee on Ways and Means, General
Tax Reform. Panel Discussions. 93rd Congress, I st Session. Part 3-
Tax Treatment of Capital R~covery~ February 7, 1973, pp. 345-504.
U.S. Library of Congress. "An Analysis of Trax ProvisionsAffecting
Business Investm eiit: Depieciatiou and the Investment Tax Credit"
by Jane Giavelie. Congressional Research Service, Multilith 74-
15iI~. August 14, 1975, 50 pages.
PAGENO="0069"
DIVIDEND EXCLUSION
Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total
1977
350
350
1976
335
335
1975
315
315
Authorization
Section 116.
Description
An individual may exclude up to $100 ($200 for a joint return) of:
dividends received from domestic corporations.
impact
Although this provision benefits all t'txpayers who receive dividend
income and have tax liability, only a small percentage of total divi-
dends is affected by the provision because of the dollar limitation.
The tax saving per dollar of exclusion increases with the taxpayer's
marginal tax bracket. in. the aggregate, the benefits tend to accrue
to middle- and high-income taxpayers because they are more likely
to own stock.
Estimated Distribution of individual income Tax Expenditure by
Adjusted Gross income Class
Percentage
Adjusted gross income class (thousands of dollars) : distribution
0 to 7 6.9
7 to 15 21. 3
15 to 50 56. 3
50 and over 15. 6
Rationale
in 1954 a dividend exclusion of $50 and a credit of 4 p9rcent of
dividends above that amount were adopted. The stated purpose was
to provide partial relief from the "double taxation" of dividends (the
corporate income tax and t.he individual income tax on dividends)
which, it was argued, hampered the ability of companies to raise
capital. Tue exclusion was stated to be designed to afford greater relief
for the low-income investor.
(63)
L
PAGENO="0070"
64
In 1964, although the Administration recommended repeal of both
the credit and exclusion, the credit was repealed and the exclusion
was doubled. The reasons offered were (1) that the provisions had not
achieved their objectives, (2) the change would remove the discrimina-
tion in favor of high income taxpayers, (3) the change would en-
courage broader ownership of stock, and (4) the change would raise
revenues that could be used to reduce the individual taxes in general.
Further Comment
As indicated above the issue that gave rise to the initial enactment
of the exclusion and credit is the "double taxation" of dividends or,
more generally, the burden of taxes on capital and on corporate equity
capital in particular. While the exclusion survives, it does relatively
little to resolve this problem because of the low dollar ceiling. Many
proposals for partial and full integration of the corporate and in-
dividual income taxes have been made; some are cited in the selected
bibliography.
Selected Bibliography
Goode, Richard. The Individual Income Tax, Rev. ed., the Brook-
ings Institution, Washington, D.C., 1976, pp. 138-9.
The Taxation of Income from Corporate Shareholding, Symposium
sponsored by the National Tax Association-Tax Institute of America
and Fund for Public Policy Research, National Tax Journal, Septem-
ber 1975.
Richard and Peggy Musgrave, Public Finance in Theory and
Practice, New York: McGraw-Hill Book Co., 1973, pp. 267-297.
PAGENO="0071"
CAPITAL GAINS: INDIVIDUAL (Other Than
Farming and Timber)
Estimated Revenue Loss
[In millions of dollars~
Fiscal year
Individuals
Corporations
Total
1977
6,225
6, 225
1976
5,455
5,455
1975
5,090
5,090
Authorization
Sections 1201-1253.
Description
Gains on the sale of capital assets held for more than six months
are subject to preferentially lower tax rates (see Appendix B). Also,
gain on the sale of property used in a trade or business is treated as
long term capital gain if all gains for the year on such property exceed
all losses for the year on such property. Qualifying property used in a
trade or business generally is depreciable property or real estate which
is held more than six months, but not inventory.
Only one-half of long-term, capital gains are included in income;
or alternatively, on the first $50,000 of capital gain, the taxpayer
may elect to pay a tax of 25 percent.
impact
Tue deduction from gross income of half of capital gains results in
tax rates half the normal rates. The alternative (25 percent) tax
benefits only those individuals whose marginal tax rate is above 50
percent. The tax treatment of capital gains increases the after-tax
earnings on assets and thereby may encourage people to invest in
assets which may appreciate in value. Furthermore, the tax preference
may reduce the inhibiting effects of taxation on the sale of assets.
The benefits of this provision are concentrated among high income
individuals, with approximately two-thirds of the benefit received by
those with adjusted gross incomes of $50,000 or more. The tax saving,
per dollar of capital gain, increases with the tax bracket of the tax-
payer.
Estimated Distribution of individual income Tax Expenditure by
Adjusted Gross income Class
Adjusted gross income class (thousands of dollars): distributin
0 to 7 3. 1
7 to 15 7.5
15 to 50 23. 1
50 and over 66. 3
(65)
PAGENO="0072"
66
Rationale
Although the original 1913 law taxed capital gains at ordinary
rates, the 1921 law provided for an alternative flat rate tax of 12.5
percent. The intent of this treatment was to minimize the influence
of the high progressive rates on market transactions. The Committee
Report noted that these gains are earned over a period of years but
are nevertheless taxed as a lump sum. Over the years many revisions
in this treatment have been made including the temporary adoption
of a sliding scale treatment (where lower rates applied the longer
the asset was held). The current approach was adopted in 1942 and
has remained in that form with minor revisions.
Further Comment
Many reasons have been advanced for preferential treatment of
capital gains income with the major ones being: (1) capital gains are
accrued over a long period of time and should not be subject to tax
under progressive rates as a lump sum, (2) capital gains reflect infla-
tion to a substantial extent and are thus not real income, and (3)
because an asset owner has discretion as to when to realize gains, the
existence of ordinary tax acts as a barrier to transactions in the
capital market and leads to "lock-in" effects (asset iwners refrain
from selling because of the tax) with attendant distorting effects on
savings, investment, and economic efficiency.
On the other hand, arguments have been advanced against the
preferential treatment of capital gains (1) even if capital gains were
taxed as ordinary income, the advantage remains of the deferral of
tax on unrealized gains, (2) inflation affects' returns on assets in
general, not just capital gains transactions, and assists asset purchases
made with borrowed funds, (3) the "lock-in" problem might be dealt
with in other ways, such as taxing gains transferred at death (thus
removing the opportunity to avoid capital gains taxes entirely), and
(4) the "bunching" problem can be met by a special averagmg
provision
Selected Bibliography
Bailey, Martin J., "Capital Gains and Income Taxation," in The
Taxation of Income froim Capital, The Brookings Institution, Washing-
ton, D.C., pp. 11-49.
David, Martin. Alternative Approaches to Capital Gains Taxation,
The Brookings Institution, Washington, D.C., 1968.
Martin, David and Roger Miller, "The Lifetime Distribution of
Realized Capital Gains," U S Congress, Joint Economic Committee,
The Economics of Federal Subsidy Programs, Ptlrt 3-Tax Subsidies,
July 15; 1972, pp. 269-85.
U.S. Congress, House Committee on Ways and Means, Panel
Discussions Gene~ al Tax Reform, Part 2-Capital Gains and Losses,
Februaiy 6, 1973, pp 245-341
PAGENO="0073"
CAPITAL GAINS TREATMENT: CORPORATE
(Other Than Farming and Timber)
Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total
1977
900
900
1976
760
760
1975
695
695
Authorization
Sections 1201, 1231, 1245, 1250, and miscellaneous others.
Description
Two main type' of long-term capital gains are rcahzed by cor-
~01 `~tions-the sale of a capital asset held for more than 6 months
and, if gains for the year exceed losses for the year, the sale of property
used in a trade or business for more than 6 months. (See Appendix B.)
Most corporate capital gain is of the latter kind.
Long term capital gains realized by corporations generally require
a dual tax computation. rfhey are first included in income, and a tax
on the total income, including the capital gain, is computed using the
regular rates. In the "alternative" computation, a tax on all income
other than long-term capital gain is computed at regular rates. The
long term capital gain is taxed at a 30 percent rate, and the two result-
ing taxes are added together to yield the "alternative" tax. The lower
of the tax computed the regular way or the "alternative" tax is the
tax liability. Thus, a corporation niust include the full amount of net
long-term capital gains in taxable income but may apply the special
30 percent alternative capital gain tax rate on the gain.
Regular tax rates for corporations are 22 percent on the first $25,000
and 48 percent on any taxable income over $25,000. (rilemporary pro-
visions allow a 20-percent rate on the first $25,000, 22 percent on the
next $25,000, and 48 percent on amounts over $50,000. These Iro-
visions will expire on June 30, 1976 unless renewed.)
Corporations are allowed to offset capital losses only against capital
gains. Any remaining capital losses may be carried back .for 3 years
and forward for 5 years. Gain on most depreciable tangible personal
property used in a trade or business will be treated as ordinary income
to the extent it arises from depreciation that has been allowed after
1961, i.e., the depreciation is recaptured; but only a small part of
depreciation on real estate is "recaptured."
(67)
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68
Example
To illustrate, assume a corporation has, for the taxable year 1975,
taxable income of $250,000, which includes net long-term capital
gains of $60,000.
Tax Computed in Regular Manner:
Taxable income $250, 000
Tax:
(20 percentX$25,000) 5, 000
(22 percentX$25,000) 5, 500
(48 percentX$200,000) 96, 000
Total 106, 500
Alternative tax:
Partial tax on $190,000 ($250,000-60,000):
(20 percentX$25,000) 5,000
(22 percentX$25,000) 5, 500
(48 percentX$140,000) 67, 200
30 percent of $60,000 18, 000
Alternative tax 95, 700
The alternative tax is $10,800 less than the regular tax, and in this
example, the tax expenditure is the tax savings attributable to the
alternative tax computation.
Impact
Corporations with taxable income over the surtax exemption that
realize income frpm the sale of long-term capital assets are the direct
beneficiaries of this provision. Corporations that make use of the al-
ternative tax reduce their tax liability and consequently increase their
cash flow.
According to 1972 tax ieturn data, capital gains taxed at alternative
rates averaged 5 percent of taxable income for all corporations. For the
following industries (excluding farming and timber) the percentage
was higher than the average: metal mining; primary metals industries;
banks; holding and investment companies; and real estate. Finance,
insurance, and real estate combined claimed 30 percent of all corporate
capital gains taxed at alternative rates.
Rationale
The Revenue Act of 1942 introduced the alternative tax for cor-
porations at a 25-percent rate, the alternative tax rate for mdividuals
This tax relief was premised on the belief that many wartime sales
were involuntary conversions which could not be replaced during
wartime and that resulting gains should not be taxed at the greatly
escalated wartime rates. The Tax Reform Act of 1969 increased the
alternative rate to 30 percent. The adoption of this revision was based
on several considerations, including the adoption of the limitation of
the alternative capital gains tax for individuals to the first $50,000
of capital gains and the absence of the "bunching" problem (i.e.,
income earned over several years is recognized in a single year) that
arises mostly in the individual tax because of graduated rates.
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Further Comment
The effect of the difference in tax rates on ordinary income versus
capital gains is not the same for corporations as for individuals for a
number of reasons. Much of the capital gain results from sales in the
normal course of business for a corporation. Further, the ability to
exempt gains from tax by death transfers is not available. Finally,
there is little "bunching" problem since the corporate rate is generally
not a graduated rate.
Selected Bibliography
David, Martin. Alternative Approaches to Capita~ Gains Taxation,
The Brookings Institution, Washington, D.C., 1968, 280 pages.
U.S. Congress, House Committee on Ways and Means, "Tax
Treatment of Capital Gains," Tax Revision Compendium. Prepared
for the House Committee on Ways and Means by Dan Throop Smith,
1959, Washington, D.C.: Government Printing Office, pp. 1233-1241;
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I
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EXCLUSION OF CAPITAL GAINS AT DEATH
Estimated Revenue Loss
[in millions of dollars]
Fiscal year
Individuals
Corporations
Total
1977
1976
7,280
6,720
7,280
6,720
1975
6, 450
6, 450
Authorization
Sections 1001, 1002, 1014, 1221, and 1222.
Description
A capital gains tax generally is imposed on the increased value of a
capital asset when the asset is sold, transferred, or exchanged. This
tax, however, is not imposed on the appreciated value of such property
if it is transferred as a result of the death of the owner; and any sale
by the transferee is taxable only to the extent of appreciation subse-
quent to the transferor's death (or six months after death if the.
alternative valuation for e~t'ite tax i~ elected) I hus, appreciation
during th.e decedent's life is not subject to th.e income tax.
However, the assets are subject to the Federal estate tax based~
upon their value at the time o death.
Impact
The exclusion of capital gains at death is most advantageous to
individuals who nee(i not dispose of their assets to achieve financial
liquidity. Generally speaking, these tend to be wealthier investors.
The deferral of tax on the appreciation involved combined with the
exemption for the appreciation before death is a significant benefit
for these investors arid their heirs.
Failure to tax capital gains at death encourages "lock-in" of assets
which in turn means less turnover of funds available for investment.
Certain revisions in the portfolio of an investor might result in more
profitable before-tax rates of return, but might not be undertaken if
the resulting capital gain tax would reduce the ultimate size of the
estate. The investor may, therefore, choose to retaiii his assets until
his death, at which time portfolio revisions can be made by executors.
without incurring a capital gains tax liability. rraxpayers are said to be
"locked into" such investments.
(71)
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Estimated Distribution of Individual Income Tax Expenditure by
Adjusted Gross Income Class
Percentage
Adjusted gross income class (thousands of dollars): distribution
0 to 7 6.3
7to15 15.1
15to50 369
~0 and over 41.7
Rationale
The rationale for this exclusion is not indicated in the legislative
history of any of the several interrelated applicable provisions. How-
ever, one current justification given for the exclusion is that death is
considered as an inappropriate event to result in the recognition
of income.
Further Comment
Taxation of capital gains at death could cause liquidity problems
for some taxpayers such as owners of small farms and businesses.
Most proposals for taxing capital gains at death would combine
substantial averaging provisions, deferred tax payment schedules,
and a substantial deductible floor in determining the amount of the
gain to be taxed. Another ~approach would require that the decedent's
tax basis be carried over to the heirs who would be taxed on apprecia-
tion if they sell the property. This solution continues the deferral and
lock-in effect discussed above.
Selected Bibliography
Break, George 1?. and Pechman, Joseph A. Federal Tax Reform:
The Impossible Dream, The Brookings Institution, Washington, D.C.
1975, pp. 47-8.
Pechman, Joseph A. Federal Tax Policy, Rev. ed., the Brookings
Institution, Washington, D.C., 1971, p. 97.
U.S. Congress, House, Committee on Ways and Means, General
Tax Reform, Panel Discussions, Part 10-Estate and Gift Tax Re-
vision, February 27, 1973, pp. 1487-1668.
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DEFERRAL OF CAPITAL GAINS ON HOME SALES
Estimated Revenue Loss
[In millions of dollars]
Fiscal year
Individuals
Corporations
Total
1977
890
890
1976
845
845
1975
805
805
Authorization
Section 1034.
Description
Gain from selling a residence is not taxed if the taxpayer purchases.
another residence with a cost at least equal to the sale price of the old
residence within 18 months before or after the sale of the old residence.
This treatment also applies if the seller constructs a new home of equal
or greater value if construction begins within 18 months of the sale
and if the taxpayer occupies the new residence within 2 years of the
sale.
If the new residence costs less than the sale price of the old, the
difference in price is subject to tax.
The tax basis of the new residence is reduced by the amount of the
untaxed gain on the sale of the old residence. Therefore, the. gain on
the sale of the first home will be recognized, if at all, at the time of the
sale of the second home. However, the tax may again be deferred on
the gain from the sale of both homes if another home is purchased by
a taxpayer meeting the requirements of section 1034. The interaction
of section 1034 and section 121 which benefits those over 65 (see p. 129)
will result in ultimate exemption from tax of part or all of the pre-
viously unrecognized gain if the taxpayer sells his second or subsequent
home with a carryover basis after he is 65.
Impact
As with any tax deferral, the taxpayer receives the equivalent of an
interest-free loan. This provision benefits primarily middle and upper
income taxpayers (about four-fifths of the benefit accrues to those in
the $7,000-$50,000 adjusted gross income (AGI) class). This subsidy
facilitates the ownership of increasingly expensive homes, much of
the increase in which in many cases is attributable to inflation.
(73)
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Estimated Distribution of individual income Tax Expenditure by
Adjusted Gross income Class
Percentage
Adjusted gross income class (thousands of dollars): distriô~ti~
0 to 7 6. 7
7to 15 - 23. 9
15 to 50 - - - 56 9
50 and over 12. 5
Rationale
The provision was adopted in 1951 to relieve financial hardship
when a personal residence is sold, particularly when the sale is neces-
sitated by such circumstances as an increase in family size or change
in the place of employment. The Senate Committee Report note4
that sales in these circumstances are particularly numerous in periods
of rapid change such as mobilization or reconversion (presumably
referring to wartime conditions).
Further Comment
Many have questioned the taxation of any gain from the sale of a
personal residence, particularly since the tax law does not allow the
deduction of personal capital losses and because the purchase of a per-
sonal residence is less of a profit motivated investment than many
other types of investment. On the other hand, tax deferral of gain
from home sales does favor investment in homes as compared to
other types of investment and, along with other features of the tax
law, contributes to the general favorable treatment afforded home-
owners in the tax law.
Selected Bibliography
U.S. Congress, House, Committee on Ways and Means, Panel
Discussions General Tax Reform, Part 2-Capital Gains and Losses
(note, pai ticularly, testimony of Kenneth B Sanden, p 254)
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DEDUCTIBILITY OF MORTGAGE INTEREST AND
PROPERTY TAXES ON OWNER~OCCUPIED
PROPERTY
Estimated Revenue Loss
[in millions of dollars]
individuals
Fiscal year -
Property Mortgage
taxes interest
Corpora- Total
tions
1977 3,825 4,710 8, 535
1976 3,690 4,545 8,235
1975~~ 4,510 5,405 9,915
Authorization
Sections 163 and 164.
Description
A taxpayer may take an itemized deduction for mortgage interest
and property tax paid on his owner-occupied home.
Impact
The deduction of nonbusiness mortgage interest and property
taxes allows homeowners to reduce their housing costs; tenants
have no such opportunity because they cannot deduct rental pay-
ments.1 High income individuals receive greater proportional
benefits than low income persons, not only because of higher marginal
tax rates, but also because higher income taxpayers are more likely
to own one or more homes (and higher income people are likely to
Own higher priced homes with larger mortgages and higher property
taxes) and to itemize deductions.
These provisions encourage home ownership by reducing its cost in
comparison to renting. Some observers believe that these deductions,
together with other favorable income tax provisions accorded to
homeowners, have been an important factor in the rapid rise of home-
ownership since World War II. Other observers suggest that the hous-
ing market has adjusted for these deductions and that home price
increases have compensated for the tax benefit.
in contrast to the rental income paid to a landlord by a tenant, the rental value of an
owner-occupied home is not imputed-i.e. not included-in the income of the owner. Such
income thus is tax exempt, but the mortgage interest and property tax expense of earning
it is allowed as a deduction from other taxable income. These deductions favor investment
in owner occupied homes over investments in residential rental property or other assets
such as securities.
67-312-76------6
(7*5)
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76
To the extent that the deductibility of State and local property
taxes allows these taxes to be higher than they would otherwise be,
the provision has an effect similar to a revenue sharing program.
Estimated Distribution of Individual income Tax
Adjusted Gross income Class
Expenditure by
Adjusted gross income class
Percentage distribution
Property Mortgage
taxes interest
Oto $7,000
$7,000 to $15,000
$15,000 to $50,000
$50,000 and over
2.2 1.3
19.8 23.6
62.7 65.9
15.3 9.1
Rationale
Generally, the deductibility of interest and of State and local taxes
has been a characteristic of the Federal income tax structure since the
Civil War income tax. An explicit rationale was never advanced, but
close examination of the legislative histories suggests that these pay-
ments were viewed as reductions of income. No distinction was made
between business and nonbusiness expenses. There is no evidence that
deductibility of these items was originally intended to encourage home
ownership or to subsidize the housing industry, which is the present
justification offered for this treatment.
The Code was revised in 1964 to specify the types of nonbusiness
taxes which could be deducted. The treatment for property taxes was
retained because removing the deduction would have precipitated a
large shift in overall tax burdens.
Selected Bibliography
Goode, Richard. The individual income Tax, Rev. Ed., The Brook-
ings Institution, Washington, D.C., 1976, pp. 117-25.
Aaron, Henry. Who Pays the Property Tax, The Brookings Institu-
tion, Washington, D.C., 1975.
"Federal Housing Subsidies," U.S. Congress, Joint Economic Com-
mittee, The Economics of Federal Subsidy Programs, Part 5-Housmg
Subsidies, OctOber 9, 1972, pp.. 571-96.
Laidler, David, "Income Tax Incentives for Owner-Occupied
Homes," Taxation of Income From Capital. Bailey and Harberger,
eds. Washington, D.C., The Brookings Institution, 1969, pp. 50-76,
PAGENO="0083"
EXEMPTION OF CREDIT UNIONS
Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total
1977 135 135
1976 125 125
1975 115 115
Authorizcdion
Section 501 (c) (14).
Description
Credit unions without capital stock, and organized and operated
for mutual purposes and without profit, are not subject to Federal
income tax.
Impact
Because their income is exempt from the income tax, credit unions
are treated more favorably than are competing financial institutions
whose income is taxed. On the other hand, credit unions are subject
to certain special constraints not required of their competitors, such
as limits on the interest rate charged on loans, on the duration of loans,
and on the types of investments that are allowed. In addition, credit
unions may lend only to niembers; however, only a small deposit may
be required for membership that qualifies the member for a loan
greatly in excess of the deposit.
Rationale
Credit unions have never been subject to the Federal income tax.
Initially, they were included in the provision that exempted domestic
building and loan associations-whose business was at one time
confined to lending to members-and nonprofit cooperative banks
operated for mutual purposes. The exemption for mutual banks and
savings and loan institutions was removed in 1951, but credit unions
retained their exemption. No specific reason was given for continuing
the exemption of credit unions.
Selected Bibliography
Geib, Bernard A., Tax Exempt Business Enterprise, The Conference
Board, New York, 1971.
U.S. Congress, House, Committee on Ways and Means, "Some
Considerations on the Taxation of Credit Unions" Prepared by John
T. Crotean for the House Committee on Ways and Means, Tax
Revision Compendium, Vol. 3, 1959, pp. 1833-66.
(77)
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DEDUCTIBILITY OF INTEREST ON CONSUMER
CREDIT
Estimated Revenue Loss
[in millions of dollars]
Fiscal year Individuals Corporations Total
1977
1976
1975
1, 075
1,040
1, 185
1, 075
1,040
1, 185
Authorization
S~ctiori 163.
Description
A taxpayer may take an itemized deduction for interest paid or
accrued on nonbusiness indebtedness (for example, personal and auto
loans and cre(lit account purchases).
impact
This provision reduces net interest charges and thereby reduces the
price of consumer purchases financed by debt~ If the purchase is an
asset that earns income, that is then subject to tax (e.g., borrowing
to purchase mutual fund shares), the interest charge is an expense of
earning income and it would cusomarily be deductible as an invest-
ment expense. For other items the interest deduction acts as a subsidy
and thus encourages their purchase, financed by borrowing. Because
higher income taxpayers are more likely to itemize deductions, they
are more likely to benefit from this provision than are taxpayers in
lower brackets.
Under 1954 legislation, the deduction for carrying charges on most
consumer credit (unless explicitly denominated "interest") was
limited to about 6 percent on the declining balance of consumer debt.
In more recent years, bank charge cards have proliferated, and the
Internal Revenue Service has ruled that charges on those cards
generally can be fully deducted as interest. On the other hand, pur-
chases under deferred payment contracts usually remain subject to
the limitation already mentioned. Thus, the theoretical treatment of
bank charge cards differs substantially from deferred payment sales
where carrying charges are often not called "interest." Whether this
distinction is observed in practice is unknown.
(79)
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80
Estimated Distribution of individual income Tax Expenditure by
Adjusted Gross Income Class
Percentage
Adjusted gross income class (thousands of dollars): di3trthtLtiofl
0 to 7 1.4
7 to. 15 23.7
15 to 50 66. 0
50andover 9.0
Rationale
While the 1862 income tax statute did not contain a special provision
for the deduction of interest, it was allowed~ When the income tax
was reinstituted in 1913, a special provision allowing the deduction of
interest was included, apparently because of concern that interest
might not be treated as a business expense and deducted under the
general business expense provision. At that time, no distinction was
drawn between business a-nd nonbusiness interest-expense, presumably
because the latter constituted a very small proportion of total interest
expense. However, today the nonbusiness interest cost is perceived as
a consumption item and hence different froth business interest.
Selected Bthliography
Kahn, C. Harry. Personal Deductions in the Federal Income Tax,
Princeton, Princeton University Press, 1060, pp. 109-24.
PAGENO="0087"
CREDIT FOR PURCHASING NEW HOME
Estimated Revenue Loss
[in millions of dollars]
Fiscal year Individuals Corporations Total
1977 100 100
1976 625 625
1975
Authorization.
Section 44.
Description
A credit against tax liability is allowed for 5 percent of the purchase
price of a "new principal residen e" purchased after March 12, 1975,
and before January 1, 1976. The maximum amount of the credit is
$2,000 or tax liability for 1975, whichever is less. Only houses on which
construction began before March 26, 1975, are eligible. Single family
houses, condominium and cooperative units, and mobile homes all
qualify. The purchase price may be no higher than it was on Feb-
ruary 28, 1975.
Example
A taxpayer who purchases a new home in July 1975 costing $40,000
or more may claim a credit of $2,000 against his incom.e tax for 1975.
If his tax for 1975 is $3,000, the $2,000 credit can be subtracted directly
from the tax and the tax due will be only $1,000. If the purchase
price 1 of the house is less than $40,000, the credit will be 5 percent of
the purchase price. The amount of the credit may not exceed tax
liability. Thus, if a taxpayer earns a credit of $2,000 but owes a tax
of only $1,500, the credit will be $1,500.
Impact
The distribution of the tax savings by income class will not be known
until 1975 tax returns are filed and analyzed. While some portion of
the benefit from the credit will be received by home sellers who did not
reduce their asking price as much as they would have otherwise, home
buyers-particularly those with taxable income above $20,000-will
also benefit. Some families who qualify will not receive the full amount
of the credit because their tax liability will be less than the credit.
For example, for a family of four, tax liability begins only when income
reaches nearly $6,000, and tax liability does not amount to $2,000 until
income is about $17,500.
1 In calculating the amount of the credit, the purchase price must be reduced by the
amount of gain on the sale of a previous residence unless tax is paid on the gain.
(81)
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The impact of the credit on housing and on the economy is difficult
to measure because it cannot be isolated from the other factors at
work in the housing industry at the same time. Some initial evidence in-
dicates the credit had little or no favorable impact on the inventory of
unsold new houses, new home sales, housing starts, or construction
industry employment.' On the other hand, evidence cited by the home
building industry indicates the credit did have an impact on home
sales.
Rationale
The home purchase tax credit~ was eiacted as part of the Tax
Reduction Act of 1975. Its purpose was described as primarily to
reduce the existing inventory of unsold new homes.
Selected Bibliography
U.S. Congress, Senate, Senate Report No. 94-36, March 17, 1975,
p. 12.
U.S. Congressional Budget Office, "An Analysis of the Impact of
the $2,000 Home Purchase~ Tax Credit" (processed November 20,
1975).
1 Federal Home Loan Bank Board Newsletter, Oct. 14, 197.5; Secretary of Housing and
Urban Development Carla Hills, testimony before the Senate Committee on Banking, Hous-
ing and Urban Affairs, Nov. 5, 1975.
PAGENO="0089"
HOUSING REHABILITATION: 5YEAR
AMORTIZATION
Estimated Revenue Loss
[Inmillions of dollars]
Fiscal year
Individuals
Corporations
Total
1977.
40
25
65
1976
55
35
90
1975
65
40
105
Authorization
Section 167(k).
Description
In lieu of depreciation, certain expenditures incurred to rehabilh ate
low or moderate income rental housing may be amortized over five
years using the straight line method and no salvage value. This rapid
amortization is permitted only with respect to expenditures incurred
after July 24, 1969, and before 1976, or, if made under a pre-1975
binding contract, before 1978. Moreover, the write-off is available only
where during a period of two consecutive years, expenditures exceed
$3,000 per unit, and applies only to expenditures not in excess of
$15,000 per rental unit. The use of 5-year amortization for assets
whose useful lives are longer benefits the taxpayer by effectively
deferring current tax liability (see Appendix A).
Example
Assume a taxpayer spends $10,000 on structural rehabilitation of a
low or moderate income rental housing with a useful life of 20 years.
Without the amortization provision (using the double declining
balance method of computing depreciation), his deduction in the
first year would be:
200 percentX~0X$l0,000=$1,000
In the `second year his depreciation would be:
200 percentX~0X $9,000=$900
The deductions for depreciation would continue in smaller amounts
over the remaining life of the asset.
With five-year amortization, one-fifth of the amount ($2,000) is
deducted each year for 5 years. Afterwards no additional deduction
for amortization or depreciation may be taken.
(83)
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impact
The tax benefit accrues to investors in projects to rehabilitate low
and moderate income housing; about 60 percent of the tax relief goes
to individual taxpayers. Even though the properties in question may
not be currently earning income, the rapid amortization may be de-
ducted against other income from housing investments and may pro-
vide a tax shelter for totally unrelated income. Low income renters
benefit only to the extent that rehabilitated units rent for less than
new units of comparable quality, or to the extent that more units are
rehabilitated than would be otherwise. The very small amount of
evidence available does not indicate a fiow through of tax benefits to
the renters.
Estimated Distribution of individual income Tax Expenditure by
Adjusted Gross income Class1
Percentage
Adjusted gross income class (thousands of dollars): dvstrilneti&a
0 to 7 ~ 0
7 to 15 ~ 0
15 to 50 16. 0
50 and over 76. 0
`The distribution refers to the Individual tax expenditure only. The corporate tax expend-
iture resulting from this tax provision is not reflected in this distribution table.
Rationale
This provision was adopted as part of the Tax Reform Act of 1969
as a temporary* provision to stimulate rehabilitation of low and
moderate income housing. It was subsquently extended for 1 year by
P.L. 93-625 (January 3, 1975). Although it expired December 31,
1975, a retroactive reinstatement may be passed in 1976.
Selected Bibliography
Heinberg, John D. and Emil M. Sunley, Jr., "Tax Incentives for
Rehabilitating Rental Housing," in Housing 1971-1972. AMS Press
(1974). Reprinted as Urban Institute Reprint, URI-10122.
McDaniel, Paul R. "Tax Shelters and Tax Policy." National Tax
Journal, Vol. XXVI, No. 3, September 1973, PP. 353-88.
Surrey, Stanley S. Pathways to Tax Reform. Cambridge, Massa-
chusetts, Harvard University Press, 1973. Chapter VII-Three
Special Tax Expenditure Items: Support to State and Local Gov-
ernments, to Philanthropy, and to Housing, pp. 209-46.
U.S. Congress. House Committee on Ways and Means. General
Tax Reform, Panel Discussions. 93rd Congress, 1st Session. Part
4-Tax Treatment of Real Estate, February 8, 1973 and Part 6-
Minimum Tax and Tax Shelter Devices, February 20, 1973, pp.
507-611 and 697-912.
U.S. Congress, House Committee on Ways and Means, Tax Reform.
Hearings, Part 2. Panels Nos. I and 2-Tax Shelters and Minimum
Tax, July 16, 1975, pp. 1403-1607.
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FIVE YEAR AMORTIZATION OF CHILD CARE
FACILITIES
Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total
1977
5
5
1976
5
5
1975
5
5
Authorization
Section 188.
Description
In lieu of depreciation, an employer may amortize, on a straight line
basis over 60 months, capital expenditures to acquire, construct, re-
construct, or rehabilitate property that qualifies as an employee
child care facility. The types of facilities which qualify are described
generally by regulation as those where children of employees receive
personal care, protection, and supervision in the absence of their
parents. Section 188 applies only to expenditures made after Decem-
bem 31, 1971, and prior to January 1, 1977. The investment credit
cannot be claimed for property subject to this amortization.
Impact
As with any rapid amortization provision, the taxpayer is allowed
to defer some current tax liability (see Appendix A). The effect of this
provision in increasing the number of child care facilities is unclear.
Rationale
This tax benefit, adopted in 1971, is intended to encourage em-
ployers to provide more child care facilities for children of single
parents and working mothers.
Selected Bibliography
U.S. Congress. Joint Committee on Internal Revenue Taxation.
General Explanation of the Revenue Act of 1971, II. R. 10947, 92d
Congress, P.L. 92-178, December 15, 1972, Washington, D.C., U.S.
Government Printing Office, 1972, pp. 62-4.
U.S. Department of Labor, Women's Bureau, Day Care Services:
Industry's Involvement, Bulletin 296, Washington, D.C., U.S. Govern-
ment Printing Office, 1971, p. 33.
Maymi, Carmen R. "Working Mothers-Their Child Care Needs."
Address delivered at meeting of the Chicago Community Coordinated
Child Care Committee. Chicago, Illinois, November 2, 1974.
(85)
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EXCLUSION OF SCHOLARSHIPS AND
FELLOWSHIPS
Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total
1977
220
220
1976
210
210
1975
200
200
Authorization
Section 117.
Description
Generally, individuals may exclude from taxable income amounts
received as scholarships or fellowships. The exclusion includes amounts
received to cover such incidental expenses as travel, research, clerical
assistance, or equipment, but does not apply to any amount received
as payment for teaching, research, or similar services. The amount
that degree candidates may exclude is unlimited. Scholarships and
fellowships for nondegree candidates may be excluded only if the
grantors meet certain requirements; further, the amount that they
may exclude is limited.
impact
The value of the tax benefit received by each recipient of a tax
exempt scholarship or fellowship grant is small in many cases because
grants are of modest amounts and the recipients have little or no tax
liability.
However, the amount of the tax benefit increases with the in-
dividual's tax bracket, and therefore, increases with the existence of
other income such as a spouse's earnings. Furthermore, university
professors often convert sabbatical pay into tax free fellowships.
Estimated Distribution of individual income Tax Expenditure by
Adjusted Gross income Class
Adjusted gross income class (thousands of dollars):
0 to 7 ~ 7
7 to 15 36.9
15 to 50 15. 4
50 and over 0
(87)
PAGENO="0094"
88
Rationale
Prior to the Internal Revenue Code of 1954, scholarships were in-
cluded in income unless the taxpayer could show that the grant was a
gift. This treatment was considered to lack uniformity. The ostensible
purpose of the exclusion was to make treatment of taxpayers con-
sistent and uniform. The only amendment to this section, made in
1961 (P.L. 87-256), expanded the category of qualifying grantors of
nondegree candidates' scholarships and fellowship grants.
Selected Bibliography
U.S. Congress, House Committee on Ways and Means. Internal
Revenue Code of 1954, Report to Accompany H.R. 8300, A Bill to Revise
the Internal Revenue Laws of the United States, Washington, D.C.,
U.S. Government Printing Office, 1954, pp. 16-17, A37-A38 (83rd
Congress, 2nd Session, House Report No. 1337).
U.S. Congress, Senate Committee on Finance. Internal Revenue
Code of 1954, Report to Accompany H.R. 8300, A Bill to Revise the
Internal Revenue Laws of the United States, Washington, D.C., U.S.
Government Printing Office, 1954, pp. 17-18, 188-90 (83rd Congress,
2nd Session, Sei~ate Report No. 1622).
PAGENO="0095"
PARENTAL PERSONAL EXEMPTION FOR
STUDENT AGE 19 OR OVER
Estimated Revenue Loss
[In millions ofdollars]
Fiscal year Individuals Corporations Total
1977
715
715
1976
690
690
1975
670
670
Authorization
Section 151(e).
Description
A taxpayer is allowed to deduct $750 as an exemption for each
dependent. A person with gross income in excess of $750 may not be
claimed as a dependent unless that person is the child of the taxpayer
and is either (a) less than 19 years of age or (b) a full-time student.
Unless support is provided by several taxpayers, a person is a depend-
ent only if the taxpayer claiming him as a dependent provided more
than one-half of the person's support.
Impact
This provision benefits families with tax liability and with children
who are students and have earnings. The value of each $750 personal
exemption deduction is $525 for families with the highest marginal
tax rate of 70 percent and $150 for families taxed at the median
marginal rate of 20 percent. No relief is available to the parents of
students who provide more than one-half of their own support.
Therefore, parents are aided by this dependency exemption if their
student-children do not rely on their earnings or other income to
provide a majority of their support.
Estimated Distribution of Individual Income Tax Expenditure by
Adjusted Gross Income Class
Percentage
Adjusted gross income class (thousands of dollars): distribution
Oto7 7.0
7to15 47.6
15to50 31.0
50 and over 14.4
(`89)
PAGENO="0096"
90
Rationale
A personal exemption for dependents was first provided by the
Revenue Act of 1918, apparently to provide some tax relief for parents
supporting young children or students. The definition of a dependent
was revised over the years and a gross income test was added in 1944.
The 1954 revision of the Internal Revenue Code eliminated the
gross income test for dependent children under the age of 19 and
dependent children of any age who were students. Except for increases
in the amount of the exemption to $750, this provision has been
unchLtnged since 1954.
Selecteçl Bibliography
U.S. Congress, House, Committee on Ways and Means. Internal
Revenue Code of 1954, Report to Accompany H.R. 8300, A Bill to
Revise the Internal Re'venue Laws of the United States, Washington,
D.C., U.S. Government Printing Office, 1954, pp. 18-9, A40-A41,
Tax Revision Compendium. Papers on Broadening the Tax Base,
November 16, 1959, vol. 1, Washington, D.C, U.S. Government
Printing Office, pp. 533-4.
Groves, Harold M. Federal Tax Treatment of the Family, The Brook-
ings Institution, Washington, D.C., pp. 39-43.
Seltzer, Lawrence H. The Personal Exemption in the Income Tax,
National Bureau of Economic Research, New York, 1968, pp. 113-20.
PAGENO="0097"
DEDUCTIBILITY OF CHARITABLE
CONTRIBUTIONS
(1) EDUCATIONAL INSTITUTIONS
(2) OTHER THAN EDUCATIONAL INSTITUTIONS
Estimated Revenue Loss
[In millions of dollars]
Individuals - Corporations
Fi~c~l year Educa- Other Educa- Other Total
tional tional
1977 500 3,955 280 525 5,260
1976 450 3,820 215 395 4,880
1975 440 4,385 205 385 5,415
Authorization
Sections 170 and 642(c).
Description
Subject to certain limitations, charitable contributions may be
deducted by individuals, corporations, and estates and trusts.
The contributions must be made to specific types of organizations
including charitable, religious, educational and scientific organiza-
tions, and Federal, State, and local governments.
Individuals may itemize and deduct qualified contributions amount-
ing up to 50 percent of their adjusted gross income (AGI); however,
the deduction for gifts of appreciated property is limited to 30 percent
of AGI. In the case of a corporation, the limit is 5 percent of taxable
income (with some adjustments).
impact
The deduction for charitable contributions reduces tax liability
and thus makes the net cost of contributing less than the amount of
the gift. In effect, the Federal Government provides the donee with
a matching grant which, per dollar of contribution, increases in
value with the donor's tax bracket. Thus, a taxpayer in the 70 percent
bracket who itemizes deductions can contribute $100 to a charitable
organization at a net cost of $30 while one in the 20 percent bracket
can contribute the same amount at a net cost of $80. An individual
who takes the standard deduction or a non-taxpayer receives no
benefit from the provision.
(91)
67-312----76---7
PAGENO="0098"
92
Types of contributions may vary substantially among income
classes. Contributions to religious organizations are far more con-
centrated at the lower end of the income scale than contributions to
hospitals, the arts, and educational institutions, with contributions
to other types of organizations falling between these levels. However,
the volume of donations to religious organizations is greater than to
all other organizations as a group.
Organizations that receive the contributions (and their clients)
benefit from this provision to the extent it increases charitable giving.
Empirical studies have not reached a consensus as to how much the
deduction encourages charitable contributions and how the deduction
affects the composition of contributions. Tentative conclusions are
that the deduction increases charitable giving by more than the
forgone Treasury revenue, and that it favors educational contribu-
tions relatively more than would a tax credit or a matching grant
program outside the tax system.
Estimated Distribution of Individual Income Tax Expenditure by
Adjusted Gross Income Class1
Percentage distributions
Adjusted gross income class Educational Other
Oto $7,000 0.3 2.3
$7,060 to $15,000 1.4 16.6
$15,000 to $50,000 23.1 47.1
$50,000 and over 74.6 34.0
1 The distribution refers to the individual tax expenditure only. The corporate tax expend-
iture resulting from these tax provisions is `hot reflected in this distribution table.
Rationale
This deduction was added on the Senate floor in 1917. Senator
Hollis, the sponsor, argued that the war and high wartime tax rates
had an adverse impact on the flow of funds to charitable organizations.
He preferred a tax deduction to a direct Govemment.subsidy. The
deduction was extended to estates and trusts in 1918 and to corpora-
tions in 1935.
Selected Bibliography
Bittker, Borris, "Charitable Contributions: Tax Deductions or
Matching Grants?" 28 Tax Law Review 37 (1972).
Feldstein, Martin, "The Income Tax and Charitable Contributions:
Part I-Aggregate and Distributional Effects", National Tax Jo'urnal,
March 1975, pp. 81-11; "The Income Tax and Charitable Contribu-
tions: Part IT-The Impact on Religious, Educational, and Other
Organizations", National Tax Jonrnal, June 1975, pp. 209-226.
McDaniel, Paul R., "Federal Matching Grants for Charitable
Contributions: A Substitute For The Income Tax Deduction", 27
Tax Law Review 377 (1972).
PAGENO="0099"
93
Surrey, Stanley R., Pathways to Tax Reform, Chapter Vu-Three
Special Tax Expenditure Items: Support to State and Local Govern-
ments, to Philanthropy, and to Housing", Cambridge, Massachusetts,
Harvard University Press, 1973, pp. 209-46.
National Tax Association-Tax Institute of America. Tax Impacts
on Philanthropy-a Symposium. Washington, D.C., December 2-3,
1972. Princeton: NTA-TIA and Fund for Public Policy Research,
1972.
Commission on Private Philanthropy and Public Needs, John H.
Filer, Chairman, Giving in America: Toward a Stronger Voluntary
Sector, 1975.
PAGENO="0100"
PAGENO="0101"
DEDUCTIBILITY OF CHILD AND DEPENDENT
CARE SERVICES
Estimated Revenue Loss
[In millions of dollars]
Fiscal year
Individuals
Corporations
Total
1977
420
420
1976
330
330
1975
295
295
Authorization
Section 214.
Description
A taxpayer may deduct certain expenses to care for a dependent
child (under age 15), disabled dependent or spouse, or for household
services when the taxpayer maintains a household for them. Deductible
expenses are those incurred to enable the taxpayer to be gainfully
employed full-time. The services must be rendered in the home,
except for dependent children.
The deduction generally is limited to $400 a month. However, the
monthly deduction limit for services rendered outside the home is $200
for one child, $300 for two children, and $400 for three or more children.
To claim the deduction, a husband and wife both must be employed
full time unless one spouse is disabled.
For 1976 and later years, the deduction is reduced by $1.00 for each
dollar of adjusted gross income (AOl) over $35,000; thus, the maxi-
mum deduction is entirely phased out when AOl equals $44,600.
impact
Only taxpayers who itemize deductions may take advantage of
this provision. Thus, taxpayers with moderate child care expenses
and low levels of income are not likely to receive much tax relief
from this provision, while high income taxpayers receive no relief
from the provision at all because of the phase-out.
Estimated Distribution of Individual Income Tax Expenditure by
Adjusted Gross Income Class
Adjusted gross income class (thousands of dollars):
0 to 7 3. 5
7 to 15 50. 4
15 to 50 46. 1
50 and over 0
(9~5)
PAGENO="0102"
96
Rationale
The deduction for child and dependent care services originated in
1954. The allowance was limited to $600 per year and was phased
out for those with family income between $4,500 and $5,100. The
intent of the provision was to provide for the deduction of expenses
comparable to an employee's business expenses in cases where tax-
payers must incur such expenses.
The provision was made more generous in 1964 and modified in
1971. The Tax Reduction Act. of 1975 substantially increased the
income limits.
Several new justifications were specified in 1971 including encourag-
ing the hiring of domestic workers, encouraging the care of incapac-
itated persons at home rather than in institutions, providing relief to
middle income taxpayers as well as low income taxpayers, and provid-
ing relief for employment-related expenses of household services as
well as for dependent care~ Thus, there was a departure from earlier
intent that oniy "essential" expenditures for such services should be
deductible.
Further Comment
Numerous proposals have been made to treat expenses for household
service and dependent care as business rather than personal expense
and, thus, eliminate the necessity to itemize the deduction in order to
benefit. The substitution of a credit for a deduction was adopted by
the House in H.R. 10612 in December 1975.
Selected Bibliography
Greenwald, Carol S. and Linda G. Martin, Broadening the Child
~Jare Deduction: How Much Will it Gost? Federal Reserve Bank of
Boston, September/October 1974, pp. 22-30.
Keane, John B., "Federal Income Tax Treatment of Child Care
Expenses," Harvard Journal of Legislation, December 1972, pp. 1-40.
Klein, William A., "Tax Deductions for Family Care Expenses,"
Boston College industrial and Commercial Law Review, May 1973, pp.
917-41.
PAGENO="0103"
CREDIT FOR EMPLOYING PUBLIC ASSISTANCE
RECIPIENTS UNDER WORK INCENTIVE (WIN)
PROGRAM
Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total
1977 10 10
10 10
1976
10
10
1975
Authorization
Sections 40, 50A, and soB.
Description
Taxpayers are allowed a credit against their tax liability equal to 20
percent of the wages paid or incurred with respect to Federal welfare
recipients in the aid to dependent children (AFDC) program who
are hired under the Work Incentive Program (WIN).
The WIN credit may not exceed $25,000 plus 50 percent of any tax
liability over $25,000 in any one taxable year. Excess credits may be
applied to past and future tax liability; the credit may be carried back
3 years and forward 7 years.
In 1975 the credit was temporarily expanded to apply to wages paid
AFDC recipients who were not in the WIN program for services
rendered to employees before July 1, 1976.
Impact
The WIN tax credit operates as a wage subsidy by providing tax
relief for employers who hire eligible employees. Participating em-
ployees benefit, as does the general taxpayer to the extent that em-
ployment and earnings are increased by the program and welfare
payments are reduced. But, other things being eoual, individuals not
enrolled in this program may be at a disadvantage when seeking
employment.
Income tax data for 1972 indicate that slightly more than half of
the corporate claims for the credit were by corporations with assets
of $250 million or more; about 60 percent was claimed by the manu-
facturing sector (nearly 25 percent by the auto industry), followed by
about 15 percent in wholesale and retail trade.
(97)
PAGENO="0104"
98
Rationale
WIN was created by Congress in 1967 to encourage private em-
ployers to hire and train welfare recipients. The WIN tax credit was
created by the Revenue Act of 1971 to further encourage employers
to hire welfare recipients and was extended in 1975 temporarily to
AFDC welfare payment recipients, regardless of participation in the
WIN program, again to encourage employment practices that would
reduce welfare payments.
Selected Bibliography
U.S. Congress, The Joint Committee on Internal Revenue Taxation
General Explanation of the Revenue Act of 1971, H.R. 10947, 92d
Congress, Public Law 92-178, December 15, 1972.
PAGENO="0105"
EXCLUSION OF EMPLOYER CONTRIBUTIONS
TO MEDICAL INSURANCE PREMIUMS AND
MEDICAL CARE
Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total
1977
1976
1975
4, 225
3, 665
3, 275
~
4, 225
3, 665
3, 275
Authorization
Section 106.
Description
Employees do not pay tax on their employers' contributions to
accident and health plans which compensate them for sickness and
injury.
Impact
The exclusion for the employer's contribution to employee health
insurance plans benefits all taxpayers who participate in a plan.
Because of the exemption, employers can provide the insurance cov-
erage at less cost than they would have to pay in taxable wages for
employees to purchase an equal amount of insurance. Thus, in effect,
the provision reduces the employee's net after-tax price of obtaining
health insurance and health services. The exclusion is worth more the
higher the taxpayer's marginal tax rate.
Estimated Distribution of Individual Income Tax Expenditure by
Adjusted Gross Income Class
Percentage
Adjusted gross income class (thousands of dollars): distribution
Oto7 7.8
7to15 32.2
15to50 50.4
50 and over 9. 6
Rationale
Prior to the adoption of the Internal Revenue Code of 1954, amounts
paid by employers for group employee insurance were excluded from
gross income of the employee. However, amounts paid for individual
policies were included. Section 106 equalized the tax treatment of
contributions to the various funds by exempting them all.
(99)
PAGENO="0106"
100
While the objective of the original group policy exemption is not
clear, the current treatment is justified as indirect Federal assistance
to help pay for the health insurance of taxpayers.
Selected Bibliography
Feldstein, Martin and Elizabeth Allison, "The Tax Subsidies of
Private Health Insurance Distribution, Revenue Loss and Effect," in
U.S. Congress, Joint Economic Committee, The Economics of Federal
Subsidy Programs, Part 8-Selected Subsidies, July 29, 1974, pp. 977-
94.
Davis, Karen. National Health Insurance: Benefits, Costs, and
Consequences, The Brookings Institution, Washington, D.C., 1975,
182 pages.
Goode, Richard. The Individual Income Tax, Rev. ed., The Brook-
ings Institution, Washington, D.C., 1976, pp. 156-60.
PAGENO="0107"
DEDUCTIBILITY OF MEDICAL EXPENSES
Estimated Revenue Loss
[In millions of dollars]
Fiscal year
individuals
Corporations
Total
1977
2, 095
2, 095
1976
2, 020
2, 020
1975
2,315
2,315
Authorization
Section 213.
Description
Medical expenses paid by an individual may be itemized and
deducted from income to the extent they exceed 3 percent of adjusted
gross income (AGI). In computing medical expenses, amounts paid
for medicine and drugs may be taken into account only to the extent
they exceed 1 percent of AGI. In addition, the 3 percent floor not-
withstanding, an amount-not in excess of $150 per year-equal to
one-half of medical insurance premiums for the year may be deducted.
impact
For taxpayers who itemize their deductions, this provision reduces
the net (after-tax) price of health insurance and health services. The
deduction is worth more the higher the taxpayer's marginal tax rate.
Estimated Distribution of Individual income Tax Expenditure by
Adjusted Gross income Class
Percnlage
Adjusted gross income class (thousands of dollars): distribution
0 to 7 7. 2
7to15 35.1
15 to 50 47. 5
S0andover 10.2
Rationale
Health costs in excess of a given floor were first allowed as a deduc-
tion in 1942 in order to maintain high standards of public health and
to ease the burden of high wartime tax rates. Originally, the deduction
was allowed only to the extent that medical expenses exceeded 5
percent of AGI (considered to be the average family medical expense
level), and was subject to a $2,500 maximum. In 1951, the floor was
removed for taxpayers 65 or over. In 1954, when the Internal Revenue
(101)
PAGENO="0108"
102
Code was substantially revised, the percentage of AGI was reduced
to 3 percent and the 1 percent floor was imposed on drugs and medicines.
The dollar ceiling was increased several times until it was finally
eliminated in 1965. In that year, the aged were made subject to the
floor and deductions for health insurance premiums were allowed
without a floor. Since insurance premiums help to even out health ex-
penditures and make it less likely that such expenses can be deducted,
it was reasoned that half the cost of insurance premiums should be
outside the floor to prevent the tax system from discouraging the
purchase of health insurance.
Further comment.
Tax deductions and exclusions related to health care may affect the
pattern of purchase .of medical services, particularly the purchase of
medical care through insurance. While~ tax. subsidies :for medical care
provide financial relief for some taxpayers who itemize unusually
large medical expenses (the relief being greater the higher the tax
bracket), at the same time., these subsidies may encourage the pur-
chases of itiedical services and thus contribute to the bidding up of
prices for those services. However, alternative programs. tO provide
national health insurance also may result in bidding up the price of
these services.
Selected Bibliography
Feldstern, Martm and Elizabeth Alhson, "The Tax Subsidies of
Pnvate Health Insurance Distnbution, Revenue Loss and Effect," m
U S Congress, Jomt Economic Committee, The Economics of Federal
Subsidy Programs, Part 8-Selected Subsidies, July 29, 1974, pp
97794
Davis) Karen. National Health Insurance: Benefits, Costs, and
Consequences, The Brookings Institution, Washington, D.C., 1975,
182 pages.
Goode, .Richard. The individual income Tax, .Rev. ed. The Brook-
ings InstitutiOn, Washington, D.C., 1976, pp. 156-CO.
Mitchell, B. M. and R. J. Vogel, Health and Taxes: An Assessment
of the Medical Deduction, R-1222-OEO, The Rand Corporation, Santa
Monica, Calif , August, 1973
PAGENO="0109"
EXCLUSION OF SOCIAL SECURITY BENEFITS
DISABILITY INSURANCE BENEFITS, OASI BENEFITS FOR THR
AGED, AND BENEFITS FOR DEPENDENTS AND SuiwIvoRs
Estimated Revenue Loss
[In millions of dollars]
Individuals
Benefits
Disa-
OASI
for
Cor-
Fiscal
year
bility
in-
surance
benefits
benefits
for aged
depend-
ents and
survi-
vors
pora-
tions Total
1977__ - -
1976_ -
1975~~.
370
315
275
3, 525
3, 045
2,740
565
495
450
--
4, 460
3, 855
3,465
Authorization
I.T. 3194, 1938-1 C.B. 114 and I.T. 3229, 1938-2136, as superseded
by Rev. Rul. 69-43, 1969-1 C.B. 310; I.T. 3447, 1941-1 C.B.~191, as
superseded by Rev. Rul. 70-217, 1970-1 C.B. 12.
Description
Social security benefits to persons who are aged, disabled, or the
widow or widower of a spouse who participated in the system, are
not included in gross income and thus are tax exempt.
Impact
The elderly benefit most from this treatment, since most social
security payments are made to the elderly. The tax saving per dollar of
exclusion increases with the marginal rate of the taxpayer. Therefore,
the exemption is worth much less to a recipient whose income comes
solely from social security benefits, than to recipients with substantial
amounts of taxable income~ Note that the supplemental security
income program (SSI) provides direct income support to only low-
income aged, blind, and disabled persons.
(103)
PAGENO="0110"
104
- Estimated Distribution of Individual Income Tax Expenditure by
Adjusted Gross Income Class
Adjusted gross income class
Percen
tage distribution
Disability
insurance
benefits
OASI
benefits
for aged
Benefits for
dependents
and survivors
Oto $7,000
$7,000 to $15,000
$15,000 to $50,000
$50,000 and over
51.9
31.9
14.0
2.1
51.8
31.6
14.0
2.6
52.4
31.7
13.4
2.4
Rationale
The exemption for social security payments has never been estab-
lished by statute; it derives frOm administrative ruling I.T. 3447,
issued in 1941. A Supreme COurt decision in 1937 and a 1938 IRS
ruling regarding lump sum payments were influential in resolving the
issue. In 1937, the Supreme Court characterized social security as
"general welfare" (Helver'ing vs. Davis, 301 U.S. 619, 640). Two 1939
rulings made lump sum distributions nontaxable (I.T. 3194 and I.T.
3229); internal memoranda suggested that the payments were con-
sidered in the nature of a gift. The reasons underlying the 1941 IRS
ruling on monthly payments appear to include: (1) the benefits are
gratuities and thus not subject to income tax because gifts are not
taxable; (2) Congress indicated its intent that -the benefits not be
taxable since it did not specifically make them taxable; and (3) the
benefits are in the nature of public; assistance for the general welfare
and Congress did not intend to take money from one pocket and put
it into another.
Further Comment
There have been proposals to include these payments in taxable
income to the extent payments exceed employee contributions, and
to adjust allowances, such as the personal exemption and standard
deduction (including the low income allowance) to afford tax relief to
persons below a determined income level. However, the distribution of
net (after-tax) benefits would generally differ from the distribution
of nontaxable benefits. Therefore, if benefits were to be made taxable,
the benefit structure might require adjustment. There also could be
substantial administrative difficulties in taxing the portion of the
benefits which exceeded employee contributions.
Selected Bibliography
Goode Richard. The Individual Income Tax, Rev. ed. The Brook-
ings Institution, Washington, D.C., 1976, pp. 103-07.
Groves, Harold. Federal Tax Treatment of the Family, Chapter III-
Tax Treatment of the Aged and Blind, The Brookings Institution,
Washington, D.C., 1964, pp. 47-55.
PAGENO="0111"
EXCLUSION OF RAILROAD RETIREMENT
BENEFITS
Estimated Revenue Loss
[In millions of dollars]
Fiscal year
Individuals
Corporations
Total
1977
200
200
1976
185
185
1975
170
170
Authorization
45 U.S.C. 228, Railroad Retirement Act of 1935, as amended:
Description
Benefits paid under the Railroad Retirement Act are tax exempt~
Impact
This exclusion benefits retired members of the Railroad Retirement
System. Payments generally are larger than those under social security.
Estimated Distribution of Individual Income Tax Expenditure by
Adjusted Gross Income Class
Percentage
Adjusted gross income class (thousands of dollars): distribution
0 to 51.9
7 to 15 31.9
15 to 50 13. 8
50 and over 2. 5
Rationale
While this exclusion has a statutory foundation, the reasons sup-
porting it have not been stated. Presumably they are similar to those
stated for social security. (See p. 104, above.)
Further Comment
The questions relating to tax treatment of railroad retirement
benefits are similar to those arising in connection with social security
benefits. (See p. 104, above.)
(105)
PAGENO="0112"
106
Selected Bibliography
Goode, Richard. The Individual Income Tax, Rev., ed. The Brook-
ings Institution, Washington, D.C., 1976 pp. 103-07.
Groves, Harold. Federal Tax Treatment of the Family, Chapter III-
Tax Treatment of the Aged and Blind, The Brookings Institution,
Washington, D.C.; 1964, pp. 47-55.
PAGENO="0113"
EXCLUSION OF SICK PAY
Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total
1977
350
350
1976
330
330
1975
315
315
Authorization
Section 105(d).
Description
To a limited extent, benefits received by employees (but not self-
employed individuals) under accident and health plans financed wholly
or partially by employers may be excluded from gross income. The
exclusion applies only to amounts paid as wages or as a wage sub-
stitute during an employee's absence from work due to injury or sick-
ness. If sick pay exceeds 75 percent of the employee's regular wages,
amounts attributable to the first 30 days of absence are included in
income. An employee whose sick pay is 75 percent or less of his regular
weekly rate of pay may exclude up to $75 a week, starting from the
first day he is absent if he is hospitalized for at least 1 day, or other-
wise after 7 days. In all cases, amounts for the period after the first 30
days can be excluded only up to $100 per week.
Impact
The sick pay exclusion is designed to reduce the tax burden of
individuals during extended illness. It also allows some taxpayers
to exempt a portion of their disability pensions until they reach normal
retirement age, whereupon the payments are taxed as pensions.
Estimated Distribution of Individual Income Tax Expenditure by
Adjusted Gross Income Class
Adjusted gross income class (thousands of dollars):
Oto7 16.9
7to15 35.3
15to50 45.9
50 and over 2. 0
(107)
67-3~12-76----8
PAGENO="0114"
108
Rationale
The sick pay exclusion was first enacted in 1954. Prior to that time,
employers' payments to employees under accident and health in-
surance plans had been excluded from income. According to the
Ways and Means Committee report, the rationale was to equalize
the treatment of employer-financed sick pay plans with the treatment
of payments financed under plans contracted with insurance com-
panies. The limitations and extended waiting periods were adopted
in 1964.
Further Comment
H.R. 10612, passed by the House in 1975, would limit the sick pay
exclusion to those who are retired on disability and are permanently
and totally disabled.
Selected Bibliography
Goode, Richard. The Individua~ Income Tax, Rev. ed. The Brook-
ings Institution, Washington, D.C., 1976, pp. 107-09.
Wentz, Roy, "An Appraisal of Individual Income Tax Exclusions,"
in U.S. Congress, House, Committee on Ways and Means, Tax
Revision Compendium, 1959, pp. 329-40.
PAGENO="0115"
EXCLUSION OF UNEMPLOYMENT INSURANCE
BENEFITS
Estimated Revenue Loss
[In millions of dollars]
Fiscal year
Individuals
Corporations
Total
1977
1976
1975
2, 855
3, 305
2,300
2,855
3, 305
2,300
Authorization
jr~~ 3230, 1938-2, C.B. 136; Rev. Rul. 70-280, 1970-1 C.B. 13.
Description
Taxpayers may exclude unemployment compensation benefits
from gross income; thus these benefits are not taxed.
Impact
The tax benefit from this provision depends upon the amount of
unemployment compensation received, and the tax savings per dollar
of tax exempt income increases with the taxpayer's marginal income
tax bracket. Therefore, the exemption is of little value to a recipient
with no other sources of income but of increasing value to taxpayers
with either a spouse who earns a substantial salary, substantial
investment income, or high salaries they earned themselves during
the part of the year they were employed.
Moreover, lower income taxpayers are often ineligible for unemploy-
ment compensation programs because they have worked in occupa-
tions not covered by unemployment insurance or for too short a period
to qualify for the payments. The tax savings per recipient in 1970
were estimated to be nearly twice as high in families with incomes
above $25,000 as in families with incomes under $5,000.
A recent study cited below noted that in 1970 unemployment
benefits averaged about two-thirds of net earnings (i.e., earnings
minus social security and other Federal, State, and local taxes).
Benefits that are high relative to net earnings because they are
tax exempt offer a better cushion against financial hardship during
unemployment, but at the same time they may discourage the seeking
of new employment. Taxation of the benefits might reduce this
disincentive effect upon some of the recipients with substantial
amounts of taxable income.
(109)
PAGENO="0116"
110
Estimated Distribution of individual income Tax Expenditure by
Adjusted Gross income Class
Percew~age
Adjusted gross income class (thousands of dollars): di.~tribution
0 to 7 21. 9
7to15 39.0
15 to 50 33.3
50 and over 5. 7
Rationale
There is no statutory basis for this provision. The decision to exempt
unemployment compensation benefits from income taxation was
made administratively by the Treasury Department in a 1938 ruling.
Selected Bibliography
Feldstein, Martin, "Unemployment Compensation: Adverse In-
centives and Distributional Anomalies," National Tax Journal, Vol.
27 (June 1974), pp. 23 1-44.
PAGENO="0117"
EXCLUSION OF WORKER'S COMPENSATION
BENEFITS
Estimated Revenue Loss
[In millions of dollars]
Fiscal year
Individuals
Corporations
Total
1977
640
640
1976
555
555
1975
505
505
Authorization
Section 104(a) (1).
Description
Worker's compensation benefits are not taxable.
Impact
Similar to the sick pay exclusion, the provision reduces tax burdens
during periods of illness. It also exempts benefits for permanent
injuries. The benefit amounts are specified by State law (in contrast
to the sick pay exclusion, where payments are subject to the em-
ployer's discretion).
Estimated Distribution of Individual Income Tax Expenditure by
Adjusted Gross Income Class
Percentaqe
Adjusted gross income class (thousands of dollars): distribution
Oto7 22.1
7to15 38.5
15 to 50 33. 7
50 and over 5~ 8
Rationale
A rationale for this provision is not offered in the committee reports
accompanying its enactment in 191$.
Further Comment
The level of worker's compensation is specified by law and is related
to salary level. Minimum and maximum benefit levels apply and
payments are based on degree of disability and may be related to
family size, but not to the amount of other family income. If the
benefits were made taxable, their level and structure might require
adjustment.
(111)
PAGENO="0118"
112
Selected Bibliography
Goode, Richard. The Individual Income Tax, Rev. ed. The Brook.
ings Institution, Washington, D.C., 1976, PP. 107-09.
Wentz, Roy, "An Appraisal of Individual Income Tax Exclusions,"
U.S. Congress, House, Committee on Ways and Means, Tax Revision
Compendium, 1959, pp. 329-40.
PAGENO="0119"
EXCLUSION OF PUBLIC ASSISTANCE BENEFITS
Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total
1977
130
130
1976
115
115
1975
105
105
Authorization
No general statutory authorization. A number of revenue rulings
under section 61 have declared specific types of public assistance
payments excludable.
Description
Individuals may exclude public assistance payments from income;
thus the payments are tax exempt.
impact
Because of the level of public assistance payments and other income
of recipients, most individuals who receive these payments would have
no income tax liability even if the payments were taxable. Those
who do benefit from the exclusion tend to be those who receive
high public assistance payments or who receive public assistance
during part of the year and are employed the remainder. There is no
conclusive evidence that the tax treatment affects the recipients'
incentive to work.
Estimated Distribution of individual Income Tax Expenditure by
Adjusted Gross income Class
Percentage
Adjusted gross income class (thousands of dollars): distribution
0 to 7 93. 3
7 to 15 6.7
15 to 50 0
S0andover 0
(113)
PAGENO="0120"
114
Rationale
Revenue rulings generally exclude government transfer payments
from income because they are considered to be general welfare pay-.
ments. While no specific rationale has been advanced for this ex-
clusion, the reasoning may be similar to that for social security
payments-that they are in the nature of gifts, and that Congress did
not intend to tax with one what it pays out with the other.
Further Comment
Perhaps the major question involved in the tax treatment of public
assistance payments is whether they should be excluded from taxable
income or whether exemptions in the tax law designed to remove
low-income individuals from the tax rolls are sufficient. Thus, if the
present level of exemptions reflects a general agreement on an income
level below which taxes are not to be paid, a case might be made for
including public assistance payments in income, just as are other
receipts.
Selected Bibliography
Goode, Richard, The Individual Income Tax, Rev ed, The Brook-
iñgs Institution, Washington, D.C., 1976, pp. 100-03.
PAGENO="0121"
NET EXCLUSION OF PENSION CONTRIBUTIONS
AND EARNINGS
EMPLOYER PLANS
Estimated Revenue Loss
[In millions of dollars]
Fiscal year
Individuals
Corporations
Total
1977
6,475
6,475
1976
5, 745
5,745
1975
5,225
5,225
Authorization
Sections 401-407,410-415.
Description
Employer contributions to qualified pension and profit-sharing plans
on behalf of an employee are excluded from the employee's income, but
generally constitute currently deductible business expenses for the
employer. Investment income of such plans (including that attribut-
able to employer contributions) is exempt. The employee is taxed only
on amounts which he receives (with appropriate adj ustrnent where he
has contributed). For this treatment to apply, the plan must be "quali-
fied", i.e., must satisfy a number of statutory requirements including
nondiscrimination, participation, and vesting.
Impact
The tax expenditure is composed of two elements: (1) the average
employee's marginal tax rate will be lower during his retirement years
than during his working life because of lower income and special tax
provisions for the aged; and (2) current aggregate pension contribu-
tions and investment income which are not taxed exceed aggregate
amounts paid out as taxable benefits.
Once an employee's rights to a pension become nonforfeitable, he
enj oys a tax deferral which is the equivalent of an interest free loan.
There are conflicting views concerning whether employers also enjoy
tax deferral. Their deductions may be viewed as accelerated from the
time the employee's rights become nonforfeitable to the time at which
the contributions are made. Under this view, the employer's liability
is to pay pensions when due, and making the contribution amounts to
a shifting of the form of the employer's assets. On the other hand,
it is argued that the employer's deduction is not accelerated because
(115)
PAGENO="0122"
116
the contribution discharges a current expense, the pension cost for
the current period.
The employees who benefit from this provision are primarily middle
and upper income taxpayers whose employment has been sufficiently
continuous for them to qualify for benefits in a company or union-
administered plan.
Estimated Distribution of individual Income Tax Expenditure by
Adjusted Gross income Class
Percentage
Adjusted gross income class (thousands of dollars): distribution
0 to 7 1 7
7 to 15 22. ~
15 to 50 57. 0
S0andover 16.8
Rationale
This provision was adopted initially in 1921. It was apparently
designed to encourage receptivity to employer established retirement
programs.
Selected Bibliography
U.S. Congress, House Committee on Ways and Means, Panel
Discussions. General Tax Reform, Part 7-Profit Sharing and Deferred
Compensation, February 22, 1973.
"New Developments in Tax Administration and Pension Plans",
Symposium, National Tax Journal, September 1974.
PAGENO="0123"
NET EXCLUSION OF PENSION CONTRIBUTIONS
AND EARNINGS
PLANS FOR SELF-EMPLOYED AND OTHERS
Estimated Revenue Loss
[In millions o
1 dollars]
Fiscal year
Individuals
Corporations
Total
1977
965
965
1976
770
770
1975
390
390
Authorization
Sections 401-405, 408-415.
Description
Self-employed individuals may exclude from gross income 15
percent of their earned income or $7,500 a year, whichever is less,
for contributions to a qualified tax exempt retirement plan.
Any employee not covered by a government pension plan ~r a
qualified retirement plan may set up a tax exempt individual retire-
ment account (IRA) with tax deductible contributions up to the
lesser of $1,500 per year or 15% of compensation.
Payments received from either type of retirement plan are included
in income for tax purposes.
Impact
These provisions, like those for employer plans, allow deferral of
tax liability both on the deductible contributions themselves and the
earnings of the fund. This is equivalent to an interest-free loan. In
addition, when the individual receives the payments from the fund,
he is likely to be in a lower tax bracket than during his earning years
due to the probability of reduced income and the existence of other
tax provisions which reduce the tax liability of the elderly and retired.
The tax benefits of self-employed plans are enjoyed more by higher
income individuals than are those of employer plans because pro-
fessional and other higher income self-employed individuals are more
likely to be able to set aside the maximum contribution amounts. The
extent to which the provision encourages more saving, rather than
changing the form in which the wealth is held, is uncertain.
(117)
PAGENO="0124"
118
Estimated Distribution of individual income Tax Expenditure by
Adjusted Gross income Class
Adjusted gross income class (thousands of dollars):
Oto7
7to15
15 to 50 51. 3
50 and over 44. 8
Rationale
The exclusion for self-employed individuals is intended to provide
treatment similar to that afforded employees securing benefits under,
employers' qualified plans. This legislation was enacted in 1962. It
was considerably liberalized in 1974 when the provision for individual
retirement accounts (IRAs) was enacted.
Further Comment
Several questions continue to be raised apart from the basic issue
of a tax exclusion for saved income: Should the dollar limitation on
self-employed plans differ from that of the individual retirement
accounts? Should there be dollar limitations on such plans when there
are none on employer plans? Should those who are covered by em-
ployer plans be allowed to deduct the difference between their em-
ployer's contribution and the maximum limitations provided in the
law?
Selected Bibliography
U.S. Congress, House, Committee on Ways and Means, Panel
Discussions. General Tax Reform, Part .7-Pensions, Profit-sharing,
and Deferred Compensation, February 22, 1973, pp. 913-1168.
Schmitt, Ray, "Limitations on Private Pension Benefits and Con-
tributions-Problems in Establishing Equitability." Library of Con-
gress. Congressional Research Service, Multilith 75-162ED, July .11,
1975, 62 pages.
U.S. Congress, House, Subcommittee on Oversight of the Com-
mittee on Ways and Means, Survey Report on individual Retirement
Accounts, Prepared by the Education and Public Welfare Division,
Congressional Research Service, Library of Congress, November 17~
1975, 24 pages.
PAGENO="0125"
EXCLUSION OF OTHER EMPLOYEE BENEFITS
PREMmM8 o~ GROUP, TERM LIFE INSURANcE
Estimated Revenue Loss
[Tn millions of dollarsi
Fiscal year Individuals Corporations Total
1977 -- 895 895
1976 805 805
1975 740 740
Authorization
Section 79, L.O. 1014, 2 C.B. 8 (1920).
Description
Employer payments of employee group term life insurance premiums
for coverage up to $50,000 are not included in income by the employee.
Since life insurance proceeds are not subject to income tax, the value
of this fringe benefit is never subject to income tax.
Impact
These insurance plans, in effect, provide additional income to
employees. Since neither the value of the insurance coverage nor the
insurance proceeds are taxable, this income can be provided at less
cost to the employer than the gross amount of taxable wages which
would have to be paid to employees to purchase an equal amount of
insurance. Group term life insurance is a significant portion of total
life insurance covering over 90 million policies and accounting for
over 40 percent of all life insurance in force. Individuals who are
self-employed or who work for an employer without a plan do not
have the advantage of a tax subsidy for life insurance protection.
Estimated Distribution of Individual Income Tax Expenditure by
Adjusted Gross Income Class
Percentage
Adjusted gross income class (thousands of dollars): dtstribution
Oto7 7.4
7to15 32.4
15 to 50 50. 7
50 and over ~ 6
(119)
PAGENO="0126"
120
Rationale
This exclusion was originally allowed, without limitation as to
coverage, by administrative legal opinion (L.O, 1014, 2 C.B. 8 (1920)).
The reason for the ruling is unclear, but it may have related to sup-
posed difficulties in valuing the insurance to individual employees
since the value is closely related to age and other mortality factors.
Studies later indicated valuation was not a problem. The limit on the
amount subject to exclusion was enacted in 1964. Reports accompany-
ing that legislation reasoned that the exclusion would encourage the
purchase of group life insurance and assist in keeping the family
unit intact upon death of the breadwinner.
Selected Bibliography
The Life Insurance Fact Boo/c, 1975.
U.S. Congress, House, Committee on Ways and Means, Hearings
on President's 1963 Tax Message, February 6, 7, 8, and 18, 1963,
pp. 108-13.
PAGENO="0127"
EXCLUSION OF OTIIER EMPLOYEE BENEFITS
PREMIuMs ON ACCIDENT AND ACCIDENTAL DEATH INSURANCE
Estimated Revenue Loss
un millions of dollarsi
Fiscal year Individuals Corporations Total
1977
60
60
1976
55
55
1975
50
50
Authorization
Section 106.
Description
Premiums paid by employers for employee accident and accidental
death insurance plans are not included in the gross income of employees
and, therefore, are not subject to tax.
Impact
As with term life insurance, since the value of this insurance cover-
age is not taxable, the employer would have to pay more in wages,
which are taxable, to confer the same benefit on the employee. Em-
ployers thus are encouraged to buy such insurance for employees.
Insurance awards to employees for accidents and accidental death
are generally exempt from income tax.
Estimated Distribution of Individual Income Tax Expenditure by
Adjusted Gross Income Class
Percentage
Adjusted gross income class (thousands of dollars): distribution
Oto7
7 to 15 32. 5
15to50 50.0
50 and over 10. 0
Rationale
This provision was added in 1954. Previously, only payments for
plans contracted with insurance companies could be excluded from
gross income. The committee report indicated this provision equalized
the treatment of employer contributions regardless of the form of the
plan.
(121)
PAGENO="0128"
122
Selected Bibliography
Guttentag, Joseph F., E. Deane Leonard, and William Y. Rode..
wald, "Federal Income Taxation of Fringe Benefits: A Specific Pro-
posal," National Tax Journal, September 1953, pp. 250-72.
U.S. Congress, House, Committee on Ways and Means, "An Ap-
praisal of Individual Income Tax Exclusions" Prepared by Roy
Wentz for the House Committee on Ways and Means, Tax Revision
CYompendium,1959,pp.329-40.
PAGENO="0129"
EXCLUSION OF OTHER EMPLOYEE BENEFITS
PRIVATELY FINANCED SUPPLEMENTARY UNEMPLOYMENT
BENEFITS
Estimated Revenue Loss
[In millions of dollars]
Fiscal year
Individuals
Corporations
Total
1977
5
5
1976
5
5
1975
5
5
Authorization
Section 501(c) (17).
Description
Employer payments into a qualified supplementary unemployment
insurance benefit trust are not taxable income to the em~~~~)lOyees when
paid into the trust, nor are the earnings of the trust fund taxable as
they accrue. The payments into the fund are deductible as business
expenses by the employer. Benefits paid out are taxable to employees
only upon receipt.
Impact
The employer contributions and earnings thereon provide a fringe
benefit for the employees. In effect, these contributions buy unem-
ployment insurance coverage for each employees. As in the case of
insurance premiums paid by employers to cover their employees,
the employer would have to pay more in wages which would be taxable,
to confer the same value of benefits on the employees as he does by
making payments into these qualified benefit trusts.
Such plans are particularly attractive in industries affected by
cyclical unemployment. Data collected in the mid-sixties indicated
that these plans were concentrated primarily in the auto, steel, gar~
ment, and rubber industries.
Estimated Distribution of Individual Income Tax Expenditure by
Adjusted Gross Income Class
Percentage
Adjusted gross income class (thousands of dollars): di8tributiols
Oto7 20.0
7to15 60.0
15to50 20.0
50 and over 0
(123)
67-312-76-9
PAGENO="0130"
124
Rationale
The specific exemption relating to such plans (501(c) (17)) was
enacted in 1960. However, such plans could also qualify for exemption
under 501 (c) (9), predecessors. of whWi have been, in the .t~x law
since it~ iimeption. The 50 1(c)(17) exemption was made to allow the
qualification of plans that did not otherwise qualify under section
501 (c)(9~, primarily because of limitations on investment: income.
Selected Bibliography
U.S. Department of Labor, Major Gollective Bargaining Agree-
ments-Supplemental Unemployment Benefit Plans and Wage-Employ-
ment Guarantees, Bulletin No. 1425-3, June 1965, 108 pages.
PAGENO="0131"
EXCLUSION OF OTHER EMPLOYEE BENEFITS
MEALS AND LODGING
Estimated Revenue Loss
[In millions of dollars]
Fiscal year
Individuals
Corporations
Total
1977
305
305
1976
285
285
1975
265
265
Authorization
Section 119.
Description
Employees exclude from income the value of meals and lodging
furnished by the employer on his business premises and for his con-
venience; the lodging must be required as a condition of employment.
Impact
Meals and lodging furnished by the employer may, in certain cases,
constitute a very large portion of the employee's compensation (e.g.,
in the case of a live-in housekeeper or an apartment resident manager).
The value to the employee of such in-kind income in some cases may
be difficult to establish. For example, the lodging may simply duplicate
rather than substitute for private quarters. The value of the exclusion
depends on the value of the income in-kind and th.e tax bracket of
the employee. To the extent that money wages are lower as a result
of the~ tax benefit, employment is subsidized in* occupations which
involve this type of income in-kind.
Estimated Distribution of Individual Income Tax Expenditure by
Adjusted Gross income Class
Percentage
Adjusted gross income class (thousands of dollars): distribution
0 to 7 7. 4
7 to 15 32. 0
15 to 50 50.9
50 and over 9. 7
(125)
PAGENO="0132"
126
Rationale
The convenience-of-the-employer rule has been in the tax regula-
tions since 1918, presumab]y in recognition of the problems discussed
above. Treatment of such payments was handled through regulation
and court decisions until 1954. The regulations suggest that immedi-
ately prior to the 1954 Act, meals and lodging that were in the nature
of compensation (i.e., taken into account in computing salary) were
included in income even if they were for the convenience of the
employer. The specific statutory language was adopted to end the
confusion regarding the tax status of such payments by precisely
defining the conditions under which such meals and lodgings were
taxable.
Further Comment
The difficulty in many cases in valuing these benefits is cited as a
major argument against taxing such benefits. On the other hand, this
argument is challenged by others who cite the fact that these payments
are valued under the social security law and under many State welfare
laws.
Selected Bibliography
Kahn, C. Harry. Employee Gompensation Under the Income Tax,
National Bureau of Economic Research, New York, 1968., pp.. 82-7.
Guttentag, Joseph H., E. Deane Leonard, and William Y.
Rodewald, "Federal Income Taxation of Fringe Benefits: A Specific
Proposal ," National Tax Journal, September 1953, pp. 250-72.
PAGENO="0133"
EXCLUSION OF INTEREST ON LIFE
INSURANCE SAVINGS `
Estimated Revenue ss ,
~Tn millions of dollus]
Fiscal year Individuals Coiposations Total
1977 1, 855 1, 855
1976 - 1, 695 . ~ 1, 695
1975. 1, 545 1, 545
Authorization
Section 101(a) and case law interpreting Treas. Reg. 1.451-2.
Desci iption
Most life insurance policies, other th'ui. tuim policu -, accumu'I'tte
interest bearing reserves which benefit the policyholder b~r~ in effect,
reducing his premiums. However, this interest is not included;in the
policyholder's income for tax purposes as it accumulates. Pursuant to
section 101(a), policy proceeds paid becauseof the death of the insured
usually are not included in income. Therefore, when policy proceeds
are not taxed at death, the previously accumulated interest is not
taxed at all. If a policy is surrendered before death, only `the `excess
of the c'tsh surIender value over the premiums paid i~ included in
income, with the result that the cost of the current msur~nce and
initial expense charges can be offset against the interest income
Impact
The effect of this exclusion allows personal insurance to be partly
purchased with tax-free interest income. Although the interest earned
is not currently paid to the policyholder, he may receive the interest
payments if he terminates the policy. In the case of a surrender, the
deferral of tax on this income is equivalent to an interest-free loa.n.
Furthermore, there is usually no taxable income at death or on other
payment of the proceeds, and thus the interest income is usually
exempt from tax.
This provision thus offers preferential treatment for the purchase of
life insurance coverage and for savings held in life insurance policies.
Because middle income taxpayers are the major purchasers of this
insurance, they are the primary beneficiaries of the provision. Higher
income taxpayers who are not seeking insurance protection, can
obtain comparable, it not better, yields `from tax-exempt State and
local obligations.
(127)
PAGENO="0134"
128
Estimated Distribution of Individual Income Tax Expenditure by
Adjusted Gross income Class
Perc~nIagc
Adjusted gross income class (thousands of dollars):
0to7. 11.3
7 to 15 22.5
15 to 50 41.5
50 and over 24. 6
Rationale
The exclusion of death benefits dates back to the 1913 tax law.
While no specific reason was given for exempting such benefits,
insurance proceeds may have been excluded because they are com-
parable to bequests which also were excluded from the tax base.
The nontaxable status of the interest as it accumulates is based
upon the general tax principle of "constructive receipt", i.e., that
income is only taxable to a cash basis taxpayer when it is received by,
or readily available to, him. The interest income is not viewed as
readily available to the policyholder because he must give up the
insurance ~protection bysurrendering the policy in order to obtain the
interest.
Further Comment
Although significant practical, social, and legal questions would be
involved, the interest component could be taxed as earned or could be
taxed when the proceeds are paid. Taxing the interest element when
the proceeds are .paid.wouid still defer tax for the period from when it
is earned until the time the proceeds are paid.
Selected Bibliography
Goode, Richard The Inclwid'ual Income Tax, Rev ed, The Brook-
ings Institution, Washington, D.C., 1976, pp. 125-33.
McLure,, Charles E., "The Income Tax Treatment of Interest
Earned on Savings in Life Insurance," in U.S. Congress, Jomt Eco-
nomic Committee, The Economics of Federal Sit bsidy Programs,
Part 3-Tax Subsidies, July 15, 1972, pp. 370-405.
PAGENO="0135"
EXCLUSION OF CAPITAL GAINS ON HOUSE
SALES IF OVER 65
Estimated Revenue Loss
[In millions of dollars]
Fiscal year individuals Corporations Total
1977
50
50
1976
45
45
1975
40
40
Authorization
Section 121.
Description
An individual who has reached 65 years of age may exclude from
taxable income some or all of the gain realized from selling the house
used as his principal residence for at least 5 of the 8 years before the
sale.
If the residence is sold for $20,000 or less, none of the gain is taxable.
If the residence is sold f or more than $20,000, only a part of the gain-
calculated by multiplying the gain by the ratio of $20,000 to the sales
price-is not taxed.
The provision can be used only once oy a taxpayer.
Example
A residence that cost $30,000 is sold for $40,000. The $10,000 gain is
multiplied by $20,000/$40,000 so $5,000 is excluded from tax. Sim-
ilarly, if the same residence were sold for $60,000, one-third ($20,000f
$60,000) of the $30,000 gain, or $10,000, would be excluded.
Impact
This provision benefits elderly persons who sell their homes and do
not purchase replacement homes. rphe benefits of this provision are
more concentrated among higher income taxpayers than are some other
provisions benefiting the aged (such as social security and the retire-
ment income credit). Other things being equal, there is an incentive
for the homeowner to wait until age 65 before selling the house. Viewed
in conjunction with section 1034 (which permits deferral of tax on
gain realized upon the sale of a residence when a more expensive resi-
dence is purchased within 18 months), section 121 allows a permanent
exemption of some or all of the gain realized on prior home sales
which met the requirements of section 1034.
(129)
PAGENO="0136"
130
Estimated Distribution of individual income Tax Expenditure by
Adjusted Gross income Class
Adjusted gross income class (thousands of dollars):
0 to 7.. - 10. 0
7to15 200
15 to 50 30. 0
50 and over 40. 0
Rationale
This provision was added to the tax law in 1964 to provide relief
for elderly taxpayers who sell their houses to rent apartments or
make other living arrangements. The committee report noted that
section 1034 (see p. 73) often. did not help the elderly who desired to
purchase a smaller house or rent an apartment.
Further Comment
Most of the legislative proposals regarding this provision would
raise the $20,000 ceiling to reflect the impact of inflation, or extend
the exclusion to all taxpayers regardless of age.
Selected f3ibliography
U S, Congre~, louse, Committee on Wa~ and Means, Panel
Discussions. General Tax Reform, Part 2-Capital Gains and Losses
(note, particularly, testimony of Kenneth B. Sanden, p. 254).
PAGENO="0137"
DEDUCTIBILITY OF CASUALTY LOSSES
Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total
1977
330
330
1976
300
300
1975
280
280
Authorization
Section 165(c) (3).
Description
To the extent it exceeds $100, the uninsured portion of losses
attributable to theft, fire, storm shipwreck, or other casualty, may be
deducted from adjusted gross income.
impact
This provision grants some financial assistance to those who suffer
casualties, have tax liability, and itemize deductions. It shifts part of
the loss from the property owner to the general taxpayer and thus
serves as a form of insurance. The same dollar amount of loss has a
proportionately greater effect on a low-income family than on a higher
income family, yet the insurance feature of the deduction is greater
for taxpayers in higher income tax brackets.
Estimated Distribution of individual income Tax Expenditure by
Adjusted Gross income Class
Percent ~qe
Adjusted gross income class (thousands of dollars): distril~ution
0 to 7 2. 7
7 to ~ 28. 2
15 to r~o
50 and over 23. 5
Rationale
The deduction for casualty losses was allowed under the original
1913 income tax law without distinction between business-related
and nonbusiness-related losses. No rationale was offered then. In
1964, the $100 floor on the deduction was enacted, and the. purpose
of relieving hardship was articulated in the legislative history.
(131)
PAGENO="0138"
132
Further Comments
Several proposals to limit the casualty loss deduction have been
made. The most common proposal would permit a deduction for only
as much of the loss as exceeds 3 percent of adjusted gross income.
Proposals of this nature have been made at* various times by the
Treasury Department, members of the Ways and Means Committee,
and others. This approach would continue relief for very large losses (in
relation to income) but would remove the deduction for relatively
smaller losses.
Selected Bibliography
Kahn, C. Harry. Personal Deductions in the Federal Income Tax,
Princeton, Princeton University Press, 1960, pp. 1-6 and 156-61.
Goode, Richard. The Individual income Tax, Rev. ed., the Brook-
ings Institution, Washington, D.C., 1976, pp. 153-55.
PAGENO="0139"
EXCESS OF PERCENTAGE STANDARD
DEDUCTION OVER LOW INCOME ALLOWANCE
Estimated Revenue Loss
[in millions of dollarsj
Fiscal year
Individuals
Corporations
Total
1977
1, 560
1,560
1976
1975
1,465
1, 385
1,465
1, 385
Authorization
Sectiou 141.
Description
Taxpayei~ who do not itemize deductions may claim the standard
deduction, which is caEdulate(l as a percentage of adjusted gross
income (AOl), subject to both a maximum and a minimum dollar
amount. The minimum amount is commonly referred to as the low
income allowance.
Before temporary chauges were made in 1975, the percentage stand-
ard deduction was 15 percent of AOl tip to $2,000 ($1,000 for married
persons filing separately), and the low-income allowance was $1,300
($650 for married persons filing a separate return). rfhese limits will
be reinstated in 1977 if the present temporary limits are not continued.
The Tax Reduction Act of 1975 increased the percentage standard
deduction to' 16 percent of AOl up to $2,300 for single returns, $2,600
for married persons filing joint returns and $1,300 for married persons
filing separate returns. The low-income allowance was increased for
these taxpayers to $1,900, $1,600 and $950 respectively. These amounts
apply to 1975 tax returns.
The Revenue Adjustment Act of 1975 increased the standard
deduction for 1976 only to 16 percent of AOl subject to a maximum
of $2,200 for single persons, $2,400 for married persons filing joint
returns, and $1,200 for married persons who file separately. The pur-
pose of the act is to effect a 6-month tax cut based on annual maxi-
mums of $2,400, $2,800, and $1,400 respectively; if the cut is extended
`for a full year, these latter amounts will be the statutory limits.
Similarly, the low-income allowance for 1976 returns now is $1,500
for single persons, $1,700 for married persons filing jointly, and $850
for married persons filing separately; if the cuts are extended fcr a
full year, the amounts would be $1,700, $2,100, and $1,050 respectively.
(133)
PAGENO="0140"
134
Impact
The minimum standard deduction was first adopted in 1964 and
was expanded and renamed the low income allowance in 1969. The
total of the low-income allowance and the personal exemptions has
roughly äorresponded to the poverty income level. The amount is
viewed as a floor below which income should not be taxed. The
standard deduction is granted in lieu of all so-called itemized deduc-
tions (see Appendix A). To the extent it exceeds the comparable
low income allowance, it is a tax expenditure since it substitutes for
a series of individual itemized deductions that are tax expenditures.
A low-income allowance of $1,700 and $2,100 for single and joint
returns respectively exceeds the percentage standard deduction if
AGI is not greater than $10,625 and $13,125 respectively. The tax
expenditure thus is limited to those with AGI levels above those
amounts.
Until recent years, the standard deduction was chosen by nearly
all persons who did not own their own homes and could not deduct
mortgage interest and property taxes. With the rise in State and local
taxes, a slightly larger group finds itemizing more advantageous than
the standard deduction.
Estimated Distribution of Individual Income Tax Expenditure by
Adjusted Gross Income Class1
Adjusted gross income class (thousands of dollars): distrib~th~
0 to 7 1. 1
7 to 15~. 56. 3
15 to 50 42. 1
50 and over .6
~ The distribution table reflects tax law in 1974.
Rationale
The standard deduction was introduced into the income tax struc-
ture in 1944. At that time the amount allowed was 10 percent of AGI
up to a maximum of $500. The minimum standard deduction was
introduced in 1964 and replaced by the low-income allowance in 1969.
The original objective of the standard deduction was to simplify the
tax structure by eliminating the need to itemize personal deductions.
The low-income allowance was designed to remove poverty level
families from the tax rolls.
Selected Bibliography
Goode, Richard. The individual Income Tax, Rev. ed. the Brook-
ings Institution, Washington, D.C., 1976, pp. 216-21.
Kahn, C. Harry Personal Deductions in the Federal Income Tax~
Princeton, Princeton Unn ersity Press, 1960, pp 162-72
PAGENO="0141"
ADDITIONAL EXEMPTION FOR THE BLIND
Estimated Revenue Loss
[In millions of dollarsi
Fiscal year
Individuals
Corporations
Total
1977
25
25
1976
20
20
1975
20
20
Authorization
Section 151(d).
Description
Blind taxpayers receive a special exemption of $750 in addition to
the normal personal exemption. The extra exemption is not available
for blind dependents.
Impact
The benefits accrue to taxpayers who are blind or have a blind
spouse. Because of their disability, blind persons may incur extra
expenses to live at a given standard, and the extra exemption helps
compensate for this. The amount of tax relief per exemption increases
from $105 to $525 as the marginal tax rate increases from 14 to 70
percent.
Estimated Distribution of Individual Income Tax Expenditure by
Adjusted Gross Income Class
Percentage
Adjusted gross income class (thousands of dollars): distribution
Oto7 26.7
7to15 40.0
15 to 50 26.7
50 and over 6. 7
Rationale
Special tax treatment for the blind first appeared in 1943 when
additional benefits were available through an itemized deduction. The
law was amended in 1948 to offer relief as an exemption so that all
blind taxpayers could claim the allowance.
(135)
PAGENO="0142"
136
Further Comment
Taxpayers with other disabilities such as deafness or paralysis
do not receive comparable benefits, nor do nontaxpayers who are blind.
Either direct spending assistance for the handicapped or a refundable
credit that would be phased down for taxpayers at higher income
levels would be more oriented toward the low-income blind than is
the present provision. Note that the Supplemental Security Income
Program provides direct income support to low-income blind persons,
and that blind persons also may be covered under the disability
provisions of social security.
Selected Bibliography
Goode, Richard. The Individuil Income Tax. Rev. ed. Washington,
D.C., The Brookings Institution, 1976, pp. 222-23.
Selzer, Lawrence H. The Personal Exemption in the income Tax.
New York, National Bureau of Economic Research, 1968, pp. 113-20.
Groves, Harold M. Federal Tax Treatment of the Family. Washing-
ton, D.C., The Brookings Institution, 1963, pp. 54-55.
PAGENO="0143"
ADDITIONAL EXEMPTION FOR OVER 65
Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total
1977
1976
1975
1, 220
1, 155
1, 100
1, 220
1, 155
1, 100
Authorization
Section 151(c).
Description
An additional personal exemption of $750 is allowed for a taxpayer
who is 65 or older.
Impact
The amount of tax relief per exemption increases from $105 to
$525 as the marginal tax rate increases from 14 to 70 percent. This
provision offers no assistance to elderly persons who have no tax
liability.
Estimated Distribution of Individual Income Tax Expenditure by
Adjusted Gross Income Class
Percentage
Adjusted gross income class (thousands of dollars): di~tribution
0 to 7 25. 0
7to15 40.3
15to50 27.6
50 and over 7. 1
Rationale
The additional personal exemption originally was provided in the
Revenue Act of 1948 to provide tax relief for the elderly whose
income sources were reduced by old age.
Further Comment
The present additional exemption should be viewed within the
context of the total transfer payment program currently in force,
parts of which only provide cash payments to needy elderly persons.
See the comment under the exclusion for social security benefits,
page 104.
(137)
PAGENO="0144"
138
Selected Bibliography
Groves, Harold M. Federal Tax Treatment of the Family. Washington,
D.C.: The Brookings Institution, 1963, pp. 52-4.
Seltzer, Lawrence, H. The Personal Exemption in the Income Tax.
New York, National Bureau of Economic Research, 1968, pp. 113-20.
PAGENO="0145"
RETIREMENT INCOME CREDIT
Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total
1977
110
110
1976
120
120
1975
130
130
Authorization
Section 37.
Description
Subject to limitations, individuals are allowed a tax credit equal to
15 percent of their retirement income. For those under 65, retire-
ment income includes only the taxable portion of public retirement
benefits. For those 65 or over, pensions, annuities, certain bond and
other interest, gross rents, and dividends are defined as retirement
income. In order to qualify, an individual must have earned at least
$600 or more in each of any 10 previous years.
Retirement income eligible for the credit is limited to $1,524 for
an individual; however, married taxpayers may take a credit on as
much as $2,286 if either meets the tests for qualification as long as
both are 65 or over. Thus, the maximum credit per person is $229
(15 percent of $1,524).
For those under 62, retirement income must be reduced by all
earned income over $900. For those over 62 but under 72, retirement
income must be reduced by one-half of earnings over $1,200 and under
$1,700 and by all earnings over $1,700. For those over 72, retirement
income is not reduced by earned income. However, for all income
groups, retirement income must also be reduced by tax exempt pen-
sions or annuities, such as social security benefits.
Example
A husband and wife are both 66 and file a joint return. He meets
the 10-year prior earned income test, but she does not. He receives a
taxable pension of $4,000, wages of $1,300 for part-time work, and a
social security pension of $800. She receives a social security pension
(139)
PAGENO="0146"
140
of $400 and wages of $1,800. Under the joint method, the retirement
income is $686, determined as follows:
Maximum amount upon which credit may be based $2, 286
Less:
Husband's social security pension 800
Wife's social security pension 400
One-half of husband's wages over $1,200 but not over $1,700 50
One-half of wife's wages over $1,200 but not over $1,700 250
Wife's wages over $1,700.. 100
TotaL 1,600
Retirement income 686
The retirement income credit under the joint method is $102.90
($686 X 15 percent).
impact
Because the amount of eligible income is reduced by the amount of
social security benefits received, the primary beneficiaries of this
provision are Federal and some State and local government retirees
who do not receive social security benefits. Because the provision is
a credit, its value to the taxpayer is affected only by the level of
benefits and not by the tax bracket of the recipient. Nevertheless,
the benefits from the credit are slightly less concentrated in the lower
range of the income scale than the tax relief from the exclusion of
social security benefits.
Estimated Distribution of individual income Tax Expenditure by
Adjusted Gross income Class
Percentage
Adjusted gross income class (thous.ands of dollars): dzstrthution
Oto7 41.0
7to15 39.0
15 to 50 19. 0
50 and over 1. 0
Rationale
The retirement income credit was enacted in 1954. It was intended
to remove inequities between individuals who received pensions and
other forms of retirement income that were not tax exempt and
recipients of social security, which is tax exempt. At that time many
features of the credit were closely related to the social security benefit
system (for example, the maximum eligible retirement income and the
earnings test). The provision was amended in 1956, 1962, and 1964 to
reflect changes in social security; however, no change has been made
in the maximum amount eligible for the tax credit since 1962, even
though social security benefits have increased substantially since then.
Further Comment
Substantial criticism of the retirement income aredit has developed
because its complexity has deterred many taxpayers from using it
and because it has not kept pace with changes in social security
payments.
PAGENO="0147"
141
Two substantially different proposals have been advanced in
response to these criticisms. One would revise the credit to reflect
changes in levels of benefits and other social security features, thus
reorienting the retirement credit more toward its original purpose.
Another approach, reflecting concern about the complexity of the
provision, would make it available to all taxpayers age 65 or over
without any restrictions on earnings. However, this alternative
would continue to reduce the base for computing the credit by the
amount of any social security or other tax exempt pension income.
H.R. 10612, passed by the House in December 1975, adopted this
latter general approach.
Selected Bibliography
U.S. Congress, House, Committee on Ways and Means, Retire-
mertt Income Credit, Child Care Deduction, Qualified Stock Options, and
Sick Pay Exclusion. Prepared by the staff of the Joint Committee on
Internal Revenue rllaxation, September 22, 1975, pp. 1-4.
PAGENO="0148"
PAGENO="0149"
EARNED INCOME CREDIT
Estimated Revenue Loss
[In millions of dollars]
Fiscal year
Individuals
Corporations
Total
1977
1976
1975
1 1, 390
11, 455
1 1 390
1 1, 455
1 The estimated revenue loss reflects cash refunds of the credit as well as reductions of
tax liability. 0MB includes the refundable amount in direct outlays in the budget, and not
as a tax expenditure. The cash refunds for 1976 are estimated at $~1,165 million, and those
for 1977 are estimated at $1,110 million.
Authorization
Section 43.
Description
This tax credit is available only to low-income workers who have
dependent children and maintain a household. The maximum credit
is 10 percent of the first $4,000 of earned income. The credit is reduced
by 10 percent of the taxpayer's adjusted gross income (AGI) (or
earned income if greater) above $4,000 so that it becomes zero at
AGI of $8,000.
The credit is subtracted from tax liability, if any. As contrasted with
all previously enacted tax credits, credits in excess of tax liability are
paid in cash to the eligible worker.
The Revenue Adjustment Act of 1975 in effect extended this
provision at its previous level to June 30, 1976; otherwise it would have
expired on December 31, 1975. The extension technically specifies a
5-percent credit for income earned in 1976, which would be increased
to 10 percent if the provision is fully extended through December 31,
1976.
Impact
The earned income credit may be viewed as a partial offset to
social security taxes on low-income workers. The combined employer-
employee social security tax rate is 11.7 percent (5.85 percent paid by
each party). Assuming the employee bears the burden of the em-
ployer's portion in the form of lower wages, the 10-percent credit
offsets 85 percent of the tax.
The credit may help to encourage low-income workers to obtain
employment and, thus, reduce the demand for welfare and unemploy-
ment benefits. However, it has been argued that many of those most
in need of relief may fail to file the tax return necessary to claim the
credit.
(143)
PAGENO="0150"
144
Rationale
The earned income credit originated in the Tax Reduction Act of
1975. Providing relief from social security taxes for low-income workers
was one purpose. Other reasons cited by the Ways and Means Com-
mittee include providing relief to low-income people for recent
increases in food and fuel prices. Some opponents believe relief of this
nature would be more efficiently administered as a reduction of social
security tax payments made by low-income wage earners.
Selected Bibliography
U.S. Congress, Senate, Committee on Finance, Tax Red'uctiom Act
of 1975-Report of the Committee on Finance together with Supple-
mental Views on H.R. p2166, 94th Congress, 1st Session, Report No.
94-36, March 17, 1975.
John A. Brittain. "Social Security Taxes: Problems and Prospects
for Reform Revisited." Tax Notes, Washington, D.C. Tax Analysts
and Advocates, February 9, 1976, pp. 18-25.
PAGENO="0151"
MAXIMUM TAX ON EARNED INCOME
Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total
1977
580
580
1976
480
480
1975
400
400
Authorization
Section 1348.
Description
Although marginal tax rates rise to 70 percent, the marginal rate
on earned taxable income is limited to 50 percent. The amount of
income eligible for this maximum tax provision is computed in several
steps as follows:
(1) Earned income that represents compensation for personal
services, is reduced by the amount of expense connected with earning
it. The remainder is earned net income. (2) The ratio of earned net
income to adjusted gross income is then multiplied by total taxable
income. The result is taxable earned income. (3) This amount is then
reduced by certain tax preference income such as capital gains.
(4) The result is the amount eligible for the maximum tax on earned
income.
The tax rate on other income is not affected.
The maximum tax alternative cannot be used by taxpayers who
average income and may not be used by married individuals filing
separate returns.
Impact
This provision reduces the tax rate on high levels of earned income.
However, because of the offset for tax preference income, the tax
benefit is affected not only by the taxpayer's level of earned income
but the extent of his preference income. Each dollar of preference
income removes (i.e., offsets) a dollar of earned taxable income other-
wise eligible for the maximum tax, and taxpayers with very large
amounts of preference income may not benefit much from the provi-
sion. Thus, the offset acts as a tax on preference income.
Virtually all the tax savings resulting from this preferential rate
accrue to taxpayers with $50,000 and over of adjusted gross income.'
1 No estimate of the Income distribution of this provision was done by the Treasury
Department for Senator Mondale.
(145)
PAGENO="0152"
146
Rationale
The maximum tax on earned income was adopted in 1969. Its pur-
pose, as indicated in the Ways and Means Committee report, was to
discourage the use of other tax reducing provisions rather than to
provide tax relief. It was argued that a major motivation for tax
avoidance was to protect earned income from high tax rates. The
Senate Finance Committee, in deleting the amendment, questioned
whether it was appropriate to reduce tax rates on earned income while
still imposing high tax rates on other income, particularly when the
taxpayer could use other devices to avoid high taxes on this other
income and use the 50-percent maximum tax provision as well. The
reduction for preference income, not originally in the House bill, was
added in Conference presumably to respond to these objections.
Selected Bibliography
Sunley, Emil M., Jr., "The Maximum Tax on Earned Income,"
National Tax Journal, December 1974, pp. 543-567.
PAGENO="0153"
VETERANS' BENEFITS AND SERVICES
(1) EXCLUSION OF VETERANS' DISABILITY COMPENSATION
(2) EXCLUSION OF VETERANS' PENsIoNs
(3) EXCLUSION OF GI Bu~L BENEFITS
Estimated Revenue Loss
[In millions
of dollars]
Individuals
Vet-
erans'
Fiscal
year
dis-
ability
corn-
pensa-
tion
Vet-
erans'
pen-
sions
GI
bill
bene-
fits
Oorpora-
tions
Total
1977.~_ 595 30 280 905
1976~_ 590 30 330 950
1975~_ 540 25 255 820
Authorization
38 U.s.c. 3101.
Description
All benefits administered by the Veterans Administration ~re ex-
empt from income' tax. These include Veterans' disability compensa-
tion, veterans' pension payments, and educational payments.
Impact
Veterans' service-connected disability compensation payments are
related not to income levels, but to the average impairment of earnings
capacity in civil occupations resulting from the various injuries.
The pensions paid to qualifying nonservice-disabled and aged vet-
erans are based on "countable" income. Reaching age 65 or older is
considered a de facto disability. The larger a veterans' countable
income is, the smaller his pension will be. countable income excludes
various items, the most significant of which is the earnings of a spouse.
Therefore, veterans with the same pension-based on the same
countable income-can have quite different amounts of total income
when the excluded items are taken into account.
Veterans' educational benefits vary with the number of dependents
and type of training.
Based upon the foregoing criteria, beneficiaries of all three major
veterans' programs to varying degrees may have amounts of taxable
income in addition to their tax exempt veterans' benefits. Thus, the
value of tax exemption of these veterans' benefits increases with the
marginal tax bracket of the recipients.
(147)
PAGENO="0154"
148
Estimated Distribution of individual income Tax Expenditure by
Adjusted Gross income Class
Percen
tage distributions
Veterans'
Adjusted gross income class
disability
pensions
Veterans'
pensions
GI bill
benefits
0 to $7,000
$7,000 to $15,000
$15,000 to $50,000
$50,000 and over
29.7
34.8
32.8
2.7
(1)
(1)
(1)
(1)
75.2
17.6
6.6
.7
1 The percentage distribution for veterans' pensions is not shown because the available data are inadequate to sup-
port the calculation. However, the data which are available indicate the beneficiaries are largely within the 0 to $7,000
AGI class.
Rationale
Since 1917, veterans benefits have been exempt from income tax.
The original rationale for the exemption is not clear.
Further Comment
One general issue concerning these benefit programs which has been
the subject of discussion is whether net (after tax) benefit differentials
should depend on the tax bracket of the recipient. Increases in the
amount of direct payments under the programs are alternatives to the
current exemptions.
`Selected Bibliography
Goode, Richard. The Indivich~al Income Tax. Rev. ed. Washington,
D.C.: The Brookings Institution, 1976, pp. 100-03.
PAGENO="0155"
CREDITS AND DEDUCTIONS FOR POLITICAL
CONTRIBUTIONS
Estimated Revenue Loss
[In millions of dollars]
Fiscal year
Individuals
Corporations
Total
1977
65
65
1976
40
40
1975
40
40
Authorization
Sections 41 and 218.
Description
A~taxpayer is allowed a tax credit equal to one-half of his political
contributions to candidates for Federal, State, or local office and to
national political parties. The credit cannot exceed $25 for a single
individual or $50 for a married couple.
In lieu of the credit, a taxpayer may elect to take an itemized deduc-
tion not to exceed $100 for a single individual or $200 for a married
couple.
Impact
The credit allows a taxpayer to reduce the cost of a limited amount of
political contributions by 50 percent, i.e., for each $2 of contribution-
up to the limit of $50 per taxpayer-the Federal Government returns
a dollar to the taxpayer in effect matching the taxpayer's contribution.
The deduction option is preferable for taxpayers whose income is above
the 50-percent bracket. For example, at the maximum rate of 70 per-
cent, the taxpayer's net cost of the first $100 of contributions is $30;
i.e., the Government matches the $30 contribution with a $70 con-
tribution. Because of the dollar limitations, this provision is obviously
not of great significance to large contributors.
Estimated Distribution of Individual Income Tax Expenditure by
Adjusted Gross Income Class
Percentage
Adjusted gross income class (thousands of dollars): distribution
Oto7 10.0
7to15 30.0
15 to 50 50. 0
50 and over 10. 0
(149)
PAGENO="0156"
150
Rationale
The credit and deduction for political contributions were adopted
with half the current limits as part of the Revenue Act of 1971 and
the maximum amounts were increased in 1974. Their purpose was to
encourage more widespread financing of political campaigns through
small contributions.
Selected Bibliography
U.S. Congress, The Joint Committee on Internai Revenue Taxa-
tion, General Explanation of the Revenue Act of 1971, H.R. 10947,
92d Congress, Public Law 92-178, December 15, 1972.
PAGENO="0157"
EXCLUSION OF INTEREST ON STATE AND
LOCAL BOND DEBT
Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total
1977
1976
1975
1, 390
1,280
1, 130
3, 150
2,890
2, 675
4, 540
4, 170
3, 805
Authorization
Section 103.
Description
Interest on the obligations of State and local governments (in-
cluding, in certain circumstances, "industrial development bonds" 1)
is excluded from gross income.
Impact
Because the interest is exempt from tax, the interest rate on State
and local government obligations is lower than the rate on comparable
taxable bonds. In effect, the Federal Government subsidizes States
and localities by paying part of their interest cost. For example, if
the market rate on tax exempt bonds is 7 percent when the taxable
rate is 10 percent, there is a 3 percentage point subsidy to State and
local governments.
Tax exempt bonds are viewed by some persons as a particularly
attractive form of indirect Federal aid because it operates auto-
matically without Federal regulation.
The tax exempt bond provision is estimated to cost the Treasury
approximately $1 to deliver $.75 in aid to municipal governments
through this means. It is estimated that in fiscal year 1976, $4.8
billion in Federal revenue was foregone to save State and local gov-
ernments about $3.6 billion in interest costs. The estimated difference
of $1.2 billion is tax relief to investors.
Commercial banks and high income individuals are the major
buyers of tax exempt bonds. Of the $207 billion in outstanding munici-
pal debt (more than double the $93 billion in 1964), about 50 percent
is held by commercial banks and 30 percent by individuals. One study
1 Industrial development bonds (IDBs) are obligations issued by State and local govern-
ments, the proceeds of which are used to purchase industrial plants or equipment. These
in turn generally are leased or sold to private firms who in effect pay the interest costs
incurred by the State or local governments in Issuing the IDBs. Interest on IDBs is taxable
except for certain small issues and issues to finance investments in certain exempt facilities
including principally those for air and water pollution control.
(151)
67-~312----76----11
PAGENO="0158"
152
indicated that the tax exemption reduced the tax rate of commercial
banks by an average of 19 percentage points.
Tax exempt institutions, such as pension funds, have little incentive
to invest in tax-free bonds since the return is much lower than that
of other taxable securities. Therefore, the tax exempt nature of State
and local debt, in effect, restricts the potential market for these
securities.
Commercial banks generally do not consider such bonds as priority
items and leave the tax exempt market when money is tight. Tax
exempt financing thus is very sensitive to changes in monetary policy.
This tax expenditure subsidizes interest on debt that generally
finances capital expenditures such as buildings. Thus, such projects
are encouraged in preference to other expenditures that are not fi-
nanced by debt. Exempt industrial development bonds finance corporate
investments such as pollution control facilities.
Estimated Distribution of individual income Tax Expenditure by
Adjusted Gross income Class1
Percentage
Adjusted gross income class (thousands of dollars): di8tributiofl
Oto7 0.0
7to15 .5
15to50 11.3
50 and over 88. 2
1 The distribution refers to the individual tax expenditure only. Phe corporate tax expend-
iture resulting from these tax provisions is not reflected in this distribution table.
Rationale
This exemption has been in the income tax law since 1913 and
apparently was based on the belief that the Federal Goveri4~nent could
not constitutionally tax such interest (e.g., the 1895 Supreme Court
decision in Pollack v. Farmers' Loan cQ~ Trust Company). Today this
view is no longer as widely held, and the continued exemption is
justified principally as a means of assisting State and local govern-
ments with a minimum of Federal interference.
Further Comment
Some projections indicate that tax exempt bonds will become some-
what less important as a means of financing State and local capital
expenditures because debt-financed programs (such as schools and
roads) are growing less rapidly than programs receiving direct Federal
support (such as sewers and water resource projects). Industrial
development bonds for pollution control may become a major vehicle
of tax exempt financing; these bonds would then compete with general
purpose municipal bonds.
Two options are frequently mentioned as alternatives or supple-
ments to the exclusion. The first would give States and localities the
choice of issuing either taxable or tax exempt bonds. A Federal subsidy
then would be provided to those issuing taxable bonds to compensate
them for the higher interest cost that would be incurred. This option
would, among other results, help expand the municipal bond market.
The second option would create a Federally financed development bank
that would raise funds by seffing taxable bonds at market interest
PAGENO="0159"
15~3
rates, and then lend to States and localities at lower interest rates. Un..
der most initial projections, both options would result in substantial
increased long term net outlays by the Federal Government because
the direct subsidy payments are expected to exceed the increased
income taxes paid by the recipients of the taxable securities.
Selected Bibliography
Bedford, Margaret E., "Income Taxation of Commercial Banks,"
Federal Reserve Bank of Kansas City, July-August 1975, pp. 3-11.
Galper, Harvey and John Peterson, "Analysis of Subsidy Plans to
Support State and Local Borrowing," National Tax Journal, Vol. 25
(June 1971).
Huefner, Robert P. Taxable Alternative Municipal Bonds, Federal
Reserve Bank of Boston Research Report No. 53, 1973.
Fortune, Peter, "Tax Exemption of State and Local Interest
Payments: An Economic Analysis of the Issues and an Alternative,"
New England Economic Review, May/June, 1973, pp. 3-31.
Surrey, Stanley S. Pathways to Tax Reform, Harvard University
Press, Cambridge, Massachusetts, 1973, pp. 210-22.
"The Tax Exemption on State and Local Bonds, A Report to the
House Budget Committee," U.S. Congressional Budget Office,
(November 18, 1975).
PAGENO="0160"
PAGENO="0161"
EXCLUSION OF INCOME EARNED IN U.S0
POSSESSIONS
Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total
1977
285
285
1976
240
240
1975
245
245
Authorization
Sections 931-934.
Description
A U.S. corporation engaged in the active conduct of a trade or
business within a U.S. possession is taxable only on its U.S.-source
income if at least 50 percent of its gross income for the last 3 years is
from that trade or business and if at least 80 percent of its gross income
during the same 3-year period had its source in a U.S. possession.
Without these provisions, the corporation would be subject to U.S. tax
on its worldwide income, and would be allowed to credit against this
liability the income taxes it paid to the possessions and foreign
governments.
This exclusion applies to corporations conducting business in the
Commonwealth of Puerto Rico and all possessions of the United
States (mainly Guam, the Canal Zone, and Wake Island) except the
Virgin Islands. The exclusion also applies to business operations of
individuals in some possessions, but not in Guam, and only in Puerto
Rico and the Virgin Islands if the individuals reside there.
Impact
The bulk of income earned in U.S. possessions is derived from Puerto
Rico. Corporations operating in Puerto Rico account for about 99
percent of the estimated revenue loss from these provisions.
Puerto Rico grants substantial tax holidays (i.e. multi-year tax-free
periods) to encourage corporations to engage in manufacturing opera-
tions in the Commonwealth. Most "possessions corporations" are sub-
sidiaries of U.S. corporations with United States (and sometimes
foreign) operations. Often, instead of paying dividends, which would
be taxable to the parent company, a possessions corporation is liqui-
dated-free of U.S. tax-into the corporate parent. Both United
States and Puerto Rican tax is avoided completely if such liquidation
occurs at the end of a Puerto Rican tax holiday.
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Securities and Exchange Commission data indicate that drug cor-
porations, in particular, make substantial use of this provision. For
example, data on five drug firms indicate the income qualifying for
this exclusion ranged from 9 percent to 21 percent of pre-tax profits.
Rationale
This exclusion was established in 1921. Floor debate indicates it
was intended to encourage export trade (especially to South America)
by improving the competitive position of U.S. companies in foreign
markets. It is now justified as necessary to assist the economic growth
of Puerto Rico. The present justification for this provision raises the
same issues as the exclusion for State and local bonds, i.e. how efficient
is the exemption and what is the distribution of benefits?
Further Comment
H.R. 10612 (passed by the House in 1975) would make relatively
minor changes with respect to the annual revenue loss from this
provision.
Selected Bibliography
U.S. Congress, House, Committee on Ways and Means, Energy
Tax and Individual Relief Act of 1974. Report to accompany H.R.
17488, No. 93-1502, November 26, 1974, Pp. 168-73.
U.S. Congress, House, Committee on Ways and Means, General
Tax Reform, Panel Discussions, 93rd Congress, 1st Session, Part II-
Tax Treatment of Foreign Income, February 28, 1973, pp. 1671-88.
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DEDUCTIBILITY OF NONBUSINESS STATE AND
LOCAL TAXES (Other Than on Owner~.Occupied
Homes and Gasoline)
Estimated Revenue Loss
[In millions of dollars]
Fiscal year
Individuals
Corporations
Total
1977
1976
1975
6, 680
6, 505
8, 490
6, 680
6, 505
8, 490
Authorization
Section 164.
Description
An individual can claim certain State and municipal sales, income,~
and personal property tax payments as itemized deductions.
Impact
This deduction for State and local tax payments benefits only tax-
payers who itemize their deductions. They are concentrated in the
middle and higher income brackets, largely among persons who own
homes, because these are the taxpayers who generally itemize.
The Federal tax deduction for State and local sales taxes and mis-
cellaneous taxes accentuates the generally regressive nature of these
taxes, because the amount of tax benefit per dollar of deduction in-
creases with the tax bracket of the taxpayer. State and local income
taxes generally are progressive, but the Federal deduction lessens the
effect of their progressivity.
Estimated Distribution of Individual Income Tax Expenditure by
Adjusted Gross Income Class
Percentage
Adjusted gross income class (thousands of dollars): distribution
Oto7 1.0
7to15 12.9
15 to 50 57. 3
50 and over 28. 8
Rationale
The allowance of a deduction for taxes in general has always been
a part of the income tax structure including the Civil War income
tax. Although the legislative history is not explicit, it suggests that
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taxes were viewed as reducing net income. Some now regard this
treatment as a form of revenue sharing. As with many other deduc-
tions, no distinction was made between business and nonbusiness
taxes. The deduction for the Federal income tax was eliminated in
1917 and, for Federal excise taxes, in 1943. The deduction was elim-
inated for State and local taxes on tobacco and alcoholic beverages
in 1964, along with automobile and drivers' licenses and other State
and local selective excise taxes except gasoline taxes.
Selected Bibliography
Goode, Richard. The Individual Income Tax, Rev. ed., Washington,
D.C., The Brookings Institution, 1976, pp. 168-71.
Kahn, C. Harry, Personal Deductions in the Federal Income Tax,
Princeton, Princeton University Press, 1960, pp. 92-108.
Moscovitch, Edward, "State Graduated Income Taxes-A State
Initiated Form of Federal Revenue Sharing," National Tax Journal,
March 1972, pp. 53-64.
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Appendix A
FORMS OF TAX EXPENDITURES
EXCLUSIONS, EXEMPTIONS, DEDUCTIONS, CREDITS,
PREFERENTIAL RATES, AND DEFERRALS
Tax expenditures may take any of the following forms: (1) special
exclusions, exemptions, and deductions, which reduce taxable income
and, thus, result in a lesser amount of tax; (2) preferential tax rates,
which reduce taxes by applying lower rates to part or all of a taxpayer's
income; (3) special credits, which are subtracted from taxes as ordi-
narily computed; and (4) deferrals of tax, which result from delayed
recognition of income or from allowing in the current year deductions
that are properly attributable to a future year.
Computing Tax Liabilities
A brief explanation of how tax liability is computed will help
illustrate the relationship between the form of a tax expenditure and
the amount of tax relief it provides.
CORPORATE INCOME TAX
Corporations compute taxable income by determining gross income
(net of any exclusions) and subtracting any deductions (essentially
costs of doing business). Although the first $25,000 of corporate taxable
income is taxed at 20 percent and the next $25,000 is taxed at 22
percent,' the corporation income tax is essentially a flat rate tax at
48 percent of taxable income in excess of $50,000. Any credits are
deducted from tax liability calculated in this way. The essentially flat
statutory rate of the corporation income tax means there is very little
difference in marginal tax rates to cause variation in the amount of
tax relief provided by a given tax expenditure to different corporate
taxpayers. However, corporations without current tax liability will
benefit from tax expenditures only if they can carry back or carry
forward a net operating loss or credit.
INDIVIDUAL INCOME TAX
Individual taxpayers compute gross income which is the total of
all income items except exclusions. They then subtract certain de-
ductions (deductions from gross income or "business" deductions) to
arrive at adjusted gross income. The taxpayer then has the option of
"itemizing" personal deductions or taking the standard deduction.
The taxpayer then deducts personal exemptions to arrive at taxable
income. A graduated tax rate structure is applied to this taxable
1 ThIs rate will expire on June 30, 19~76, unless extende~L The rates will then revert to
22 percent on the first $2~,00O and 48 percent on the excess.
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income to yield tax liability, and any credits are subtracted to arrive at
the net after-tax liability.
Exclusions, Deductions, and Exemptions
The amount of tax relief per dollar of each exclusion, exemption, and
deduction increases with the taxpayer's marginal tax rate. Thus, the
exclusion of interest from State and local bonds saves $50 in tax for
every $100 of interest for the taxpayer in the 50-percent bracket,
whereas for the taxpayer in the 25-percent bracket the saving is only
~25. Similarly, the extra exemption for persons over age 65 and any
itemized deduction is worth twice as much in tax saving to a tax-
payer in the 50-percent bracket as to one in the 25-percent bracket.
In general, the following deductions are itemized, i.e., allowed only
if the standard deduction is not taken: medical expenses, specified
State and local taxes, interest on nonbusiness debt such as home
mortgage payments, child care expenses, alimony, certain unreim-
bursed business expenses of employees, charitable contributions,
expenses of investment income, union dues, costs of tax return prep-
aration, uniform costs, and political contributions. Whether or not a
taxpayer minimizes his tax by itemizing deductions depends on
whether the sum of those deductions exceeds the limits on the stand-
ard deduction; higher income individuals are more likely to itemize
because they are more likely to have larger amounts of itemized
deductions which exceed the standard deduction allowance. Home-
owners generally itemize because deductibility of mortgage interest
and property taxes generally leads to larger deductions than the
standard deduction.
Preferential Rates
The amount of tax reduction that results from a preferential tax
rate (such as the 50 percent maximum tax rate on earned income)
depends on the difference between the preferential rate and the tax-
payer's ordinary marginal tax rate. The higher the marginal rate
that would otherwise apply, the greater is the tax relief from the
preferential rate.
Credits
A tax credit (such as the investment credit) is subtracted directly
from the tax liability that would accrue otherwise; thus, the amount
of tax reduction is the amount of the credit and is not contingent upon
the marginal tax rate. A credit can (with one exception) only be used
to reduce tax liabilities to the extent a taxpayer has sufficient tax
liability to absorb the credit. Most tax credits can be carried backward
and/or forward for fixed periods so that a credit which cannot be used
in the year in which it first applies, can be used to offset tax liabilities
in other prescribed years.
The earned income credit is the only tax credit which is now refund-
able. That is, a qualifying individual will obtain in cash the amount
of the refundable credit in excess of his tax liability when he ifies Ins
tax return for the year in which the credit applies.
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Deferrals
Deferral can result either from postponing the time when income is
recognized for tax purposes or from accelerating the deduction of
expenses. In the year in which a taxpayer does either of these, his
taxable income is lower than it otherwise would be, and because of
the current reductiofi in his tax base, his current tax liability is
reduced. The reduction in his tax base may be included in taxable
income at some later date. However, the taxpayer's marginal tax rate
in the later year may differ from the current year rate because either
the tax structure or the applicable tax rate has changed. Further.N
more, in some cases the current reduction in the taxpayer's tax base
may never be included in his taxable income. Thus, deferral works to
reduce current taxes, but there is no assurance that all or even any
of the deferred tax will be repaid. On the other hand, the tax repay-
ment may even exceed the amount deferred.
A deferral of taxes has the effect of an interest-free loan for the tax-
payer. Apart from any difference between the amount of "principal"
repaid and the amount borrowed (i.e., the tax deferred), the value of
the interest-free loan-per dollar of tax deferral-depends on the
interest rate at which the taxpayer would borrow and on the length
of the period of deferral. If the deferred taxes are never paid, the
deferral becomes an exemption. This can occur if, in succeeding years,
additional temporary reductions in taxable income are allowed. Thus,
in effect, the interest-free loan is refinanced; the amount of refinancing
depends on the rate at which the taxpayer's income and deductible
expenses grow and can continue in perpetuity.2
TEMPORARY EXCLUSIONS
The Domestic International Sales Corporation (DISC) provision
is an example of deferral through a temporary exclusion of income,
with recognition of the income for tax purposes occurring subsequently.
In some cases the deferral may continue indefinitely and the effect
is a permanent exclusion of taxable income.
ACCELERATED DEDUCTIONS
More commonly, deferrals occur through the acceleration in the
deduction of expenses. Ordinarily, the cost of acquiring an income-
producin.g asset which undergoes economic decline (such as a machine)
is capitalized and deducted over the asset's useful life. The amount
of deduction taken in each year depends on the useful life and the
rate of depreciation applied. The shorter the useful life and the
higher the rates applied, the more quickly deductions are taken.
To reflect net income, the share of the asset cost used up in any one
year should be deducted as an expense against income produced
by the asset in that year. However, if a larger amount is deducted
The tax expenditures for deferrals are estimates of the difference between tax receipts
under the current law and tax receipts if the provisions for deferral had never been In
effect. Thus, the estimated revenue loss Is greater than what would be obtained in the first
year of transition from one tax law to another. The amounts are long run estimates at the
level of economic activity for the year in question.
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in earlier years, tax liability is lower than it otherwise would be.
Just the reverse is true in later. years when the deduction is lower
and tax liability is higher than it otherwise would be, and thus a tax
deferral occurs.
Rapid write-off methods which are considered tax expenditures
include: (1) expensing 100 percent of capital costs as incurred, (2)
using a shorter life (as in the asset depreciation range), (3) using
a faster rate (as in accelerated depreciation on buildings), and (4)
using various 5-year amortization provisions. The tax saving from
various rapid write-off methods is illustrated using the following
example.
Assume a $10,000 asset with an even rate of economic depreciation
over a 10-year life is held by a taxpayer with a marginal tax rate of 50
percent. The appropriate deduction, in this case "straight line",
would be $1,000 each year and the resulting annual tax reduction
would be $500 (50 percent of $1,000).
Expensing capital acquisitwns
If the asset is expensed, the entire amount ($10,000) is deducted in
the first year, and the tax reduction is $5,000 (50 percent of $10,000).
This tax reduction is $4,500 greater than the $500 amount resulting
from the "straight line" method (where 10 percent is written off in
each year of the 10-year life). In the second and all following years, no
deduction will be taken. Thus, the net effect of expensing the cost of
the asset is a $4,500 loan from the government which is paid back with-
out interest over the next 9 years (as no depreciation is deducted).
Shorter than actual useful lives
The use of any life shorter than the "true" 10-year economic life
(in this example) provides similar but smaller amounts of tax benefit.
If an 8-year life is used instead of a 10-year life, the deduction allowed
in each of the first 8 years is $1,250, and the net tax deferral each year
is $125 ($1,250-1,000 X 50 percent) which is ultimately repaid in the
last 2 years of the asset's actual useful life when no deductions are
taken.
Rapid rate depreciation
There are several rapid rate alternatives to the straight line method.
The use of `a rapid rate simply allows larger deductions in the earlier
years of the asset's useful life (but does not affect the period over
which the asset is written off) For example, the declmmg balance
method applies a larger than straight line rate against the balance
(i.e., the asset cost less the allOwed depreciation) remaining each
year. To illustrate with a $10,000 asset, double declining balance
depreciation in the first year is 2 X 1/lox sio,ooo or $2,000-twice
the straight line depreciation, for a net tax saving of $500 (50 percent
of $1,000) * In the next year the deduction is 2 x 1/10 x $8,000 or
$1,600, fQr a net tax saving of $300. Although depreciation deductions
will continue over the entire life of the asset, they will be larger at the
beginning and smaller at the end of the period
For certain types of machinery and equipment, the pattern of
economic decline may be more closely approximated by a rapid depre-
ciation method than by straight line. Indeed, the use of an accelerated
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depreciation rate for machinery and equipment is not considered a tax
expenditure; however, it is considered so for buildings.3 When, in
the latter periods under an accelerated depreciation plan, the allowed
expense is less than the actual depreciation, the difference "repays"
the loan afforded by the allowance of earlier depreciation in excess
of actual.4
Five-year amortization
There are several provisions in the tax expenditure budget which
allow 5-year amortization. Rapid amortization reduces the taxpayer's
liability by calculating straight line depreciation over an arbitrary
period-5 years-which is shorter than the actual useful life of the
asset. Rapid amortization is a substitute for other depreciation which
would have been allowed. In the $10,000 example, 5-year amortization
would yield deductions of $2,000 in each of 5 years. Double declining
balance depreciation would yield $2,000 the first year, $1,600 the
second year and with declining amounts thereafter. However, the
investment credit cannot be taken if rapid amortization is used;
the taxpayer has the choice of rapid amortization or whatever depre-
ciation is allowed plus the investment tax credit. If a $10,000 asset
is eligible for the investment tax credit, an additional $1,000 of tax
savings would occur in the first year. Thus, the investment tax credit
plus the regular depreciation is likely to be better than 5 year amortiza-
tion for the taxpayer in this case.
For a given asset, rapid amortization provides more tax saving the
longer is the asset's useful life and the higher is the interest rate and
the taxpayer's marginal tax rate. In the case of assets eligible for the
10 percent investment tax credit, it is unlikely the 5-year amortization
provisions will be a better option. Where the investment tax credit
does not apply to capital assets (such as housing rehabilitation
expenditures), the 5-year amortization provision results in more tax
saving than rapid depreciation if the asset's useful life is long enough.
The explanation for this treatment Is that the tax depreciation allowed for machinery
and equipment is thought to be closer to actual depreciation than that allowed on buildings.
See `The Tax Expenditure Budget: A Conceptual Analysis," Annual Report of $ecretary of
the Treasury, F)? 1968, p. 33.
`The taxpayer has the option to switch to straight line depreciation of the undepreciateci
balance and usually may find it beneficial to do so. However, this option does not change
the basic result; it simply increases the amount of interest saving.
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Appendix B
CAPITAL GAINS
In the income tax law, profit from the sale of most investment
assets is referred to as capital gain and receives preferentially lower
tax rates. For individuals this lower rate is about one-half the usual
rate although capital gains may also be subject to the minimum tax
on tax preferences. Corporate long-term capital gains are taxed either
as ordinary income of the corporation or at an alternative rate of 30
percent, whichever produces a lower tax.
Broadly speaking, capital gain or loss is produced by the sale or
exchange 1 of capital assets.2 The sale produces "long-term" gain or
loss if the property has been owned for more than 6 months. If not,
it produces "short-term" gain or loss. While the expression "capital
gains" technically includes both long and short-term gains, it generally
is used to mean only long-term gains. Only long-term gains receive
the preferential treatment.
Stocks and bonds owned by casual investors usually are capital
assets. Inventory owned by a retailer is not a capital asset. Between
these extremes, whether property is a capital asset is less clear, and
in specific cases, the definitional problem may be a very difficult
matter. In general, however, the distinction is that investments are
capital assets but items held for sale in a business are not.
Another kind of property that may produce long-term capital gain
is property used in a business-generally real estate and depreciable
property-if it is not held for the purpose of being sold to customers
and is owned more than 6 months.3 Gain on this kind of property is
treated as long-term capital gain only if all of the gains for the year
exceed all of the losses for the year. If so, the net gain is long-term
capital gain.
The gain on. a particular sale receives preferential treatment only
if it survives a number of complex computations. First, losses on long-
term assets are subtracted from gains on long-term assets. Only the
net figure survives and is referred to as net long-term gain. Short-term
losses which have not been used to eliminate short-term gains are then
offset against this net long-term gain. After this offset, any excess is
defined by the statute as "net section 1201 gain" but is generally
called capital gain and is entitled to preferential treatment.
For individuals, the preference is that one-half of the gain may
be deducted, and only the other one-half is subject to tax. If this
calculation produces a tax on the first $50,000 of gains which exceeds
Capital gain treatment is conferred only If there is a "sale or exchange." Other dis-
positions, e.g., an abandonment, do not result in capital gain or loss but rather in ordinary
gain or loss. This technicality is beyond the scope of this appendix.
2 This gain or loss will be recognized and taken into income unless one of many non-
recognition provisions apply. Non-recognition provisions are beyond the scope of this
appendix.
The holding period is longer for some assets, most notably livestock.
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25 percent of such gains, the lower 25 percent rate is applied to
the first $50,000 of gains. For corporations, the preference results
by limiting the tax to no more than 30 percent of the gain.
The increase in value of capital assets is taxed as a capital gain only
if the asset is sold. As a consequence, the gross gains on unsold assets
accumulate in value without being reduced by any accrued tax.
Without such treatment, accumulation is limited to the after-tax
gain. Moreover, capital gains accrued at death are transferred to heirs,
and the gain is exempted from income tax. Gains accrued on assets
transferred by gift are subject to tax only if the donee sells them before
his death.
Note: The following description is provided for the reader who
wants a more detailed outline of the way capital gains and losses are
treated:
First, the gain or loss must be determined on each transaction in-
volving a capital asset. Then the following procedural rules govern the
tax treatment of capital gains and losses:
(l)~Long-term gains and losses are aggregated.
(2) Short-term gains and losses are aggregated.
(3)~i.(a) If the aggregations in steps 1 and 2 both result in gains,
long-term gain is treated as stated in step 4(a) and
short-term gain is treated as stated in step 4(c).
(b) If the aggregations in steps 1 and 2 both result in losses,
long-term loss is treated as stated in step 4(b), and
short-term loss is treated as stated in step 4(d).
(4)~ If one of the aggregations in steps 1 and 2 produce a loss
and the other a gain, the gain and loss are then aggregated,
and the following rules govern:
(a) If the net is long-term gain, one-half of it is de-
ducted by an individual in calculating gross in-
come. An individual may elect for the first
$50,000 of such gain to be taxed at a 25 percent
alternative rate. Corporate long-term capital gain
is either taxed as other corporate income or at the
alternative rate of 30 percent, whichever yields
the lower tax.
(b) If the net is long-term loss, individuals may deduct
one-half of it from other income but not in excess
of $1,000 per year. Corporations may not deduct
any such loss from other income. There is an un-
limited carryover to future years for individuals
but no carryback. Corporations generally may
carryback for 3 years and carryforward for 5
years, to offset capital gain.
(c) If the net is short-term gain, the entire amount is
subject to tax.
(d) If the net is short-term loss, individuals may deduct
it against ordinary income but not to exceed $1,000
per year, subject to the previously stated rules on
carryovers and carrybacks. Corporations may not
deduct any such loss from other income, subject
to the rules on carryovers and carrybacks.
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