by Robert J. Kleine, M.B.A., Vice President & Senior Economist
|This Advisor discusses some proposals for changing the federal individual income tax and their potential effect on taxpayers.|
“The hardest thing in the world to understand is the income tax.” —Albert Einstein
The federal income tax has been the target of criticism for many years, but with the Republicans in control of Congress, calls for reform of the tax have increased. Some of the proposals call for outright repeal of the tax (and the elimination of the Internal Revenue Service) and replacing it with a national sales tax, consumption tax, or value-added tax. Another popular proposal is to establish a flat rate income tax and eliminate most itemized deductions. Any major change in the federal income tax has significant consequences for the economy and taxpayers.
To better understand the federal individual income tax and the potential effect of changes on individual taxpayers, the latest data for Michigan (1993 tax year) is discussed below.
The federal income tax is the largest revenue source for the federal government, generating about 41 percent of total federal revenue (social security taxes account for about 40 percent of federal revenue). The tax is based on ability to pay with rates from 15 percent for taxable income below $38,000 (1994 rate/married filing jointly) to 39.6 percent for incomes above $250,000.
However, because of personal exemptions, credits, and deductions, effective tax rates are much lower. As shown in exhibit 1, the effective tax rate [tax liability as a percentage of adjusted gross income (AGI)] averages only 14 percent. The rate ranges from 4.7 percent for taxpayers with incomes below $15,000 to 29.9 percent for taxpayers with incomes of $200,000 or more. For 96.7 percent of taxpayers, the effective rate is 15.6 percent or lower.1
A major feature of most tax reform plans is a reduction in itemized deductions in exchange for a lower tax rate and higher personal or family exemptions. As shown in exhibit 1, only 32.8 percent of taxpayers itemize deductions; therefore, about two-thirds of Michigan taxpayers would be unaffected by the elimination of deductions. However, most of these taxpayers have adjusted gross incomes of less than $50,000. More than 90 percent of taxpayers with incomes above $50,000 itemize deductions, and these are the taxpayers most likely to vote and with the most political influence. For most of these taxpayers, the largest exemptions are for mortgage interest and state and local taxes (mainly income and property). For example, the average deduction for these two categories for taxpayers with AGI of $50,000 to $75,000 is $10,022 (see exhibit 1). At the marginal tax rate of 28 percent, the elimination of these deductions would increase their tax liability by about $2,800 on average.
One of the provisions in the Republican tax cut bill is a reduction in the capital gains tax rate. In the long run, proponents expect this cut to increase investment and economic growth, but in the short run, the benefits will accrue largely to high-income taxpayers as 63 percent of capital gains accrue to taxpayers with an AGI of $100,000 or more.
The Republican plan to balance the budget by 2002 includes a provision to reduce the earned income tax credit (EITC).2 As shown in exhibit 1, the credit is limited to persons earning less than $30,000. Specifically, a family with two or more children had to have earned income and an AGI of $25,296 or less to qualify for the credit. In 1993, 396,000 Michigan filers received $371 million in refundable tax credits. The credit was liberalized in 1994 when individuals without children became eligible; the maximum credit increased from $1,434 to $2,038 for one qualifying child and from $1,511 to $2,528 for two qualifying children. The IRS also tightened procedures to eliminate fraud. The 1994 data is not available for Michigan, but nationwide the cost of the credit rose from $14.6 billion in 1993 to $19.9 billion in 1994, a 36.3 percent increase. The credit was claimed on 17.7 million returns in 1994, up 24.3 percent from 1993. Based on the national increase, the value of the credit to Michigan claimants was about $500 million in 1994.
Our view is that the EITC is one of the best features of the federal tax code. It provides a reward for work and helps lift many of the working poor above the poverty level. A single individual with a full-time job (40 hours a week) earns about 17 percent more than the poverty threshold ($7,570 in 1994). However, a family of three with one full-time minimum wage earner earns about 25 percent less than the poverty threshold ($11,855 in 1994). Until the economy can provide more high-paying jobs, the EITC should be expanded rather than cut to bring all full-time workers up to the poverty threshold. This is expensive, but it is preferable to an increase in the minimum wage, which most economists agree will reduce employment opportunities. However, we do support tying the minimum wage to inflation to prevent its real value from being eroded.
As Robert Greenstein stated in his June 1995 monograph “The Earned Income Credit: A Target for Budget Cuts?”:
The EITC boosts the incomes of millions of poor and near-poor families that are working and staying off welfare. With the steady erosion over the past 20 years in wages paid for low-paid work and the likely continuation of this trend in the future, the EITC plays a crucial role. It also provides an important underpinning for welfare reforms to move families from welfare to work, and it helps to offset the regressive taxes that low-income workers face.
It is likely that there will be some reforms in the federal income tax before the end of the decade, particularly if a Republican is elected president in 1996. Clearly there is a need for simplification of the tax if Einstein could not understand it, although for most of the two-thirds of taxpayers who do not itemize, the tax form is easy to complete and can even be done over the phone. Surprisingly, however, nearly half of low-income taxpayers use a tax preparer to file their tax return (see exhibit 1).
Our view is that major revisions in the tax will founder on the opposition of middle- and upper-income taxpayers to the loss of such cherished deductions as mortgage interest and state and local taxes. State and local officials, particularly in higher tax states, are strongly opposed to elimination of the deduction for state and local taxes because it provides a subsidy for these taxes. For example, for a taxpayer in the 28 percent tax bracket, a $1 increase in deductible state and local tax costs the taxpayer only $.72, with the federal government picking up the remainder. It would be ironic if this deduction was eliminated at the same time that some federal responsibilities are shifted to state and local governments, making it more difficult for these governments to respond to a likely need for higher taxes.
A flat tax sounds attractive, but there are some serious equity problems. For Michigan taxpayers, a revenue neutral flat rate would be 17.5 percent if all deductions were eliminated. This would only benefit taxpayers with incomes above $100,000, unless generous personal and family exemptions were allowed. The elimination of all deductions and personal exemptions would allow a flat rate of 14 percent, but there is almost no support for eliminating all personal exemptions. A strong case can be made for setting exemptions at a level that eliminates federal taxes for anyone below the poverty threshold, which is the current situation for most families.
Simplification and equity are often in conflict. As much as we value simplification, it is not as important as equity, or perceived equity. Nothing can destroy faith in the tax system and the government more than perceived unfairness. While many taxpayers dislike the federal income tax and view it as unfair, reforms that move the tax even further away from an ability-to-pay basis and reduce taxes for the affluent can only increase cynicism. While some changes to the federal individual income tax are needed, it is more important to overhaul the federal corporate income tax and the social security tax, which are more unfair and damaging to the economy than the individual income tax.
Exhibit 1 (available in Acrobat® format only)