[JPRT 105-3-98]
[From the U.S. Government Publishing Office]



                        [JOINT COMMITTEE PRINT]


 
                       PRESENT LAW AND ANALYSIS
                   RELATING TO INDIVIDUAL EFFECTIVE
                          MARGINAL TAX RATES

                     Scheduled for a Public Hearing

                                 by the

                   HOUSE COMMITTEE ON WAYS AND MEANS

                          ON FEBRUARY 4, 1998

                               __________

                         Prepared by the Staff

                                 of the

                      JOINT COMMITTEE ON TAXATION

 [GRAPHIC] [TIFF OMITTED] TONGRESS.#13


                            FEBRUARY 3, 1998


                                 ______

                    U.S. GOVERNMENT PRINTING OFFICE
 46-072                    WASHINGTON : 1998                          JCS-3-98

------------------------------------------------------------------------------
             For sale by the U.S. Government Printing Office
Superintendent of Documents, Congressional Sales Office, Washington, DC 20402
                          ISBN 0-16-056106-X




                      JOINT COMMITTEE ON TAXATION

                       105th Congress, 2d Session
                                 ------                                
               SENATE                               HOUSE
WILLIAM V. ROTH, Jr., Delaware,      BILL ARCHER, Texas,
  Chairman                             Vice Chairman
JOHN H. CHAFEE, Rhode Island         PHILIP M. CRANE, Illinois
CHARLES GRASSLEY, Iowa               WILLIAM M. THOMAS, California
DANIEL PATRICK MOYNIHAN, New York    CHARLES B. RANGEL, New York
MAX BAUCUS, Montana                  FORTNEY PETE STARK, California

              Mary M. Schmitt, Deputy Chief of Staff (Law)
      Bernard A. Schmitt, Deputy Chief of Staff (Revenue Analysis)



                            C O N T E N T S

                              ----------                              
                                                                   Page
Introduction.....................................................     1

 I. Executive Summary.................................................2

II. Provisions for Which Effective Marginal Tax Rates Differ From 
    Statutory Marginal Tax Rates.....................................10

        A. Overview of Issues Relating to Marginal Tax Rates.....    10

        B. Phaseouts of Exclusion of Social Security Benefits....    20

        C. Limitations on Itemized Deductions (``Pease'' 
            Limitation; Floors on Deductions for Medical and 
            Miscellaneous Expenses and Casualty Losses)..........    25

        D. Personal Exemption Phaseout...........................    32

        E. Phaseout of Earned Income Credit......................    36

        F. Phaseout of Child Tax Credit..........................    46

        G. Partial Phaseout of Dependent Care Tax Credit.........    50

        H. Phaseout of Eligibility for Deductible and Roth IRA 
            Contributions........................................    54

        I. Phaseout of Eligibility to Make Contributions to 
            Education Savings Accounts (``Education IRAs'')......    62

        J. Phaseout of Education Tax Credits (HOPE and Lifetime 
            Learning Tax Credits)................................    66

        K. Phaseout of Deductibility of Interest on Qualified 
            Student Loans........................................    71

        L. Phaseout of Exclusion of Interest from Education 
            Savings Bonds........................................    74

        M. Phaseout of Tax Credit for Elderly and Disabled.......    77

        N. Phaseout of Adoption Tax Credit and Exclusion for 
            Adoption Expenses....................................    79

        O. Phaseout of First-Time Homebuyer Tax Credit for the 
            District of Columbia.................................    84

        P. Phaseout of Allowance of Certain Rental Real Estate 
            Losses Under the Passive Loss Rules..................    86

        Q. Income Phasein of Recapture of Subsidy from Use of 
            Qualified Mortgage Revenue Bonds and Mortgage Credit 
            Certificates.........................................    90

III.Discussion of Issues Generally...................................93

                              INTRODUCTION

    This pamphlet,1 prepared by the staff of the 
Joint Committee on Taxation (``Joint Committee staff''), 
provides a description of present law, legislative history, and 
an analysis relating to various provisions of the Internal 
Revenue Code (the ``Code'') under which the effective marginal 
tax rate may differ from the statutory marginal tax rates 
specified in the Code. The Joint Committee staff prepared this 
pamphlet in response to a request from the Chairman of the 
House Committee on Ways and Means, Bill Archer. Also, the 
effective marginal tax rate issues are a subject of the 
February 4, 1998 public hearing before the Committee on Ways 
and Means on tax rates and other tax reduction issues.
---------------------------------------------------------------------------
    \1\ This pamphlet may be cited as follows: Joint Committee on 
Taxation, Present Law and Analysis Relating to Individual Effective 
Marginal Tax Rates (JCS-3-98), February 3, 1998.
---------------------------------------------------------------------------
    Part I of the pamphlet is an executive summary. Part II 
commences with a description of the statutory marginal tax 
rates under present law and a discussion of the concept of 
``effective marginal tax rate.'' The subsequent sections of 
Part II identify phaseouts, phase-ins, floors and other 
provisions that cause a taxpayer's effective marginal tax rates 
to differ from the statutory marginal tax rates. The order of 
the presentation of the provisions commences with those that 
are of greater significance or are more frequently noted by 
commentators, followed by those provisions of more narrow 
application. Each section describes present law, provides a 
brief legislative history, and describes the effective marginal 
tax rate created by the provision. Data document the number of 
taxpayers affected by the provision. Footnotes accompany each 
section with algebraic derivations of the effective marginal 
tax rate created by the provision. For simplicity of 
mathematical exposition, the footnotes assume a tax system with 
one single statutory marginal tax rate. This assumption does 
not affect the derivation of the effective marginal tax rate. 
The analysis of Part II calculates effective marginal tax rates 
solely by reference to the regular Federal individual income 
tax.
    Part III provides a discussion of the tax policy issues 
raised by provisions that cause the effective marginal tax 
rates to deviate from the statutory marginal tax rates. The 
primary issues are the effects of these provisions on economic 
efficiency, equity, and tax complexity. Part III also discusses 
the calculation of effective marginal tax rates when the 
payroll tax, the alternative minimum tax, and State income 
taxes are considered in addition to the regular Federal 
individual income tax.

                          I. EXECUTIVE SUMMARY

Marginal tax rate defined
    The term ``marginal tax rate'' refers to the additional, or 
incremental, increase in tax liability that a taxpayer incurs 
under the income tax from a $1.00 increase in his or her 
income. The term ``statutory marginal tax rate'' refers to the 
marginal tax rates for individuals as defined in section 1 of 
the Code. The basic rate structure of the Federal individual 
income tax is defined in terms of five marginal tax rates: 15 
percent, 28 percent, 31 percent, 36 percent, and 39.6 percent. 
The statutory marginal tax rates increase as the taxpayer's 
taxable income increases. In general, if an additional $1.00 of 
income to the taxpayer resulted in the taxpayer's taxable 
income increasing by $1.00, then there would be no difference 
between statutory marginal tax rates and effective marginal tax 
rates. Because of the design of certain provisions of the Code, 
an ``effective marginal tax rate'' may not always correspond to 
the statutory marginal tax rate.
Scope of provisions
    The Code includes 22 provisions that can result in a 
taxpayer's effective marginal tax rate deviating from the 
statutory marginal tax rate. In general, these provisions 
represent phaseouts, phase-ins, and floors that limit the 
ability of certain taxpayers to claim certain deductions, 
credits, or other tax benefits. The Joint Committee staff 
estimates that in 1998, 33.2 million taxpayers, or 
approximately one quarter of all taxpayers, will have an 
effective marginal tax rate different from their statutory tax 
rate. These deviations from the statutory marginal tax rate 
largely are the result of the provisions analyzed in this 
pamphlet. Chart 1, below, summarizes the provisions of the Code 
that give rise to deviations between effective marginal tax 
rates and statutory marginal tax rates and summarizes the 
income range over which the deviation will occur. Chart 1 also 
includes a calculation of the effective marginal tax rate that 
results from the provision and presents an estimate of the 
number of taxpayers for whom the effective marginal tax rate 
deviates from the statutory marginal tax rate as a result of 
the provision.
Efficiency
    Economists argue that effective marginal tax rates create 
incentives, or disincentives, for taxpayers to work, save, 
donate to charity, and the like. These incentives may distort 
taxpayer choice. Distorted choice may promote an inefficient 
allocation of society's labor and capital resources. The 
magnitude of the inefficiencies potentially created by 
deviations of effective marginal tax rates from statutory 
marginal tax rates depends upon taxpayer behavioral response to 
tax changes. There is not consensus on the extent to which 
taxpayers alter their labor supply or saving in response to tax 
changes. Additionally, increased effective marginal tax rates 
may encourage taxpayers to seek compensation in the form of 
tax-free fringe benefits rather than taxable compensation. Such 
distortions in consumption represent an efficiency loss to the 
economy. Increased effective marginal tax rates also may alter 
taxpayers' decisions regarding when to recognize income or 
claim expenses. Any such tax-motivated changes in the timing of 
income or expense generally require time and expense by the 
taxpayer. Such time and expense represents an efficiency loss 
to the economy. To put potential efficiency losses from the 
provisions analyzed in this pamphlet in context, one should 
compare them to the efficiency of an alternative tax system 
that did not include such provisions.
Equity
    Higher marginal tax rates also lead to increased aggregate 
tax liabilities. A second question of tax policy is whether 
these increased aggregate tax liabilities are equitably 
distributed across taxpayers. The Federal individual income tax 
is a progressive tax. The existence of phaseouts and other 
provisions that create effective marginal tax rates that differ 
from statutory marginal tax rates do not make the Federal 
individual income tax a regressive or proportional tax. The 
phaseouts and other provisions identified in this pamphlet 
generally operate to increase the overall progressivity of the 
income tax. The majority of the provisions deny tax benefits to 
higher-income taxpayers, while preserving tax benefits to low-
income and middle-income taxpayers. However, because the 
phaseouts and other provisions often relate to specific defined 
economic activities, two different taxpayers may have the same 
income and one can be subject to a phaseout provision while 
another is not. That is, these provisions may create horizontal 
inequities in the Code.
Complexity
    The creation of phaseouts adds complexity to the Code. On 
the other hand, by limiting the number of taxpayers eligible to 
qualify for certain tax benefits, some of the provisions reduce 
computations, possibility of error, and record keeping. These 
provisions also may create a lack of clarity in taxpayers' 
minds regarding what precisely is the tax base and what sort of 
preferences exist in the Code. Complexity and lack of clarity 
may promote taxpayer disillusionment and a sense of unfairness 
regarding the Code, and may reduce compliance.

   Chart 1.--Summary of Provisions Creating Effective Marginal Tax Rates Different From Statutory Marginal Tax  
                                                  Rates (1998)                                                  
----------------------------------------------------------------------------------------------------------------
                                                                                                Estimated number
                                                             Effective       Applicable range     of taxpayers  
             Provision                  Code section     marginal tax rate        of AGI            affected    
                                                                                                   (millions)   
----------------------------------------------------------------------------------------------------------------
Phaseout of exclusion of social      Section 86          1.5 times the      Single: $25,000-          5.0       
 security benefits                                        statutory rate     various \1\                        
                                                          for first tier    Joint: $32,000-                     
                                                                             various \1\                        
                                                         1.85 times the     Single: $34,000-                    
                                                          statutory rate     various \1\                        
                                                          for second tier   Joint: $44,000-                     
                                                                             various \1\                        
``Pease'' limitation on itemized     Section 68          1.03 times the     $124,500-various          4.5       
 deductions                                               statutory rate                                        
7.5-percent floor on medical         Section 213         1.075 times the    Any taxpayer              4.5       
 deduction                                                statutory rate     itemizing                          
                                                                             medical                            
                                                                             deductions                         
2-percent floor on miscellaneous     Section 67          1.02 times the     Any taxpayer              8.8       
 deductions                                               statutory rate     itemizing                          
                                                                             miscellaneous                      
                                                                             deductions                         
10-percent floor on casualty loss    Section 165(h)(2)   1.10 times the     Any taxpayer              0.2       
                                                          statutory rate     itemizing                          
                                                                             deductions for                     
                                                                             casualty loss                      
Phaseout of personal exemption       Section 151         The statutory      Single: $124,500-         1.4       
                                                          rate multiplied    $247,000                           
                                                          by 1.0 plus       H/H: $155,650-                      
                                                          0.0216 for each    $278,150                           
                                                          exemption, e.g.,  Joint: $186,800-                    
                                                           1.0216 times      $309,300                           
                                                          the statutory                                         
                                                          rate for one                                          
                                                          personal                                              
                                                          exemption,                                            
                                                           1.0432 times                                         
                                                          the statutory                                         
                                                          rate for two                                          
                                                          personal                                              
                                                          exemptions                                            
Phase-in of earned income credit     Section 32          No children:       $0-$4,460 \2\             4.4       
                                                          statutory rate                                        
                                                          minus 7.65                                            
                                                          percentage                                            
                                                          points                                                
                                                         One child:         $0-$6,690 \2\                       
                                                          statutory rate                                        
                                                          minus 34                                              
                                                          percentage                                            
                                                          points                                                
                                                         Two children:      $0-$9,390 \2\                       
                                                          statutory rate                                        
                                                          minus 40                                              
                                                          percentage                                            
                                                          points                                                
Phaseout of earned income credit     Section 32          No children;       $5,570-$10,030 \2         11.7      
                                                          statutory rate     \,\3\                              
                                                          plus 7.65                                             
                                                          percentage                                            
                                                          points                                                
                                                         One child;         $12,260-$26,473 \                   
                                                          statutory rate     2\,\3\                             
                                                          plus 15.98                                            
                                                          percentage                                            
                                                          points                                                
                                                         Two children;      $12,260-$30,095 \                   
                                                          statutory rate     2\,\3\                             
                                                          plus 21.06                                            
                                                          percentage                                            
                                                          points                                                
Phaseout of child credits            Section 24          Statutory rate     Single: $75,000--         0.6       
                                                          plus 5             various \3\                        
                                                          percentage        Joint: $110,000                     
                                                          points             \3\                                
Partial phaseout of dependent care   Section 21          Statutory tax      $10,000-$28,001           1.6       
 credit                                                   rate plus 2.4                                         
                                                          percentage                                            
                                                          points                                                
                                                          (generally 17.4                                       
                                                          percent)                                              
Phaseout of eligibility for          Section 219         Between 1.0 and    Single: $30,000-          1.5       
 deductible IRA                                           1.2 times          $40,000                            
                                                          statutory rate    Joint: $50,000-                     
                                                          \4\                $60,000                            
Phaseout of eligibility for Roth     Section 408A        Single: between    Single: $95,000-   Not available    
 IRA                                                      1.0 and 1.133      $110,000                           
                                                          times the         Joint: $150,000-                    
                                                          statutory rate     $160,000                           
                                                          \4\                                                   
                                                         Joint: between                                         
                                                          1.0 and 1.2                                           
                                                          times the                                             
                                                          statutory rate                                        
                                                          \4\                                                   
Phaseout of eligibility for          Section 530         Greater than       Single: $95,000-   Not available    
 education IRA                                            statutory rate     $110,000                           
                                                          by a percentage   Joint: $150,000-                    
                                                          determined by      $160,000                           
                                                          the 5 percent or                                      
                                                          3.3 percent                                           
                                                          phaseout rate                                         
                                                          and the interest                                      
                                                          rate                                                  
Phaseout of HOPE credit              Section 25A         Single: statutory  Single: $40,000-   1.2 (includes    
                                                          rate plus 15       $50,000 \3\        lifetime        
                                                          percentage        Joint: $80,000-     learning credit)
                                                          points for each    $100,000 \3\                       
                                                          $1,500 in                                             
                                                          credits                                               
                                                         Joint: statutory                                       
                                                          rate plus 7.5                                         
                                                          percentage                                            
                                                          points for each                                       
                                                          $1,500 in                                             
                                                          credits                                               
Phaseout of Lifetime learning        Section 25A         Single: statutory  Single: $40,000-   Included in      
 credit                                                   rate plus 15       $50,000 \3\         estimate of    
                                                          percentage        Joint: $80,000-      HOPE credit.   
                                                          points for each    $100,000 \3\                       
                                                          $1,500 in                                             
                                                          credits                                               
                                                         Joint: statutory                                       
                                                          rate plus 7.5                                         
                                                          percentage                                            
                                                          points for each                                       
                                                          $1,500 in                                             
                                                          credits                                               
Phaseout of deductibility of         Section 221         1.167 times        Single: $40,000-          0.3       
 interest on qualified student                            statutory rate     $55,000 \3\                        
 loans                                                    (for maximum      Joint: $60,000-                     
                                                          deduction          $75,000 \3\                        
                                                          available in                                          
                                                          2001)                                                 
Phaseout of exclusion of interest    Section 135         Single: (1 +       Single: $52,250-   Not available    
 from education savings bonds                             exclusion/         $67,250 \3\                        
                                                          $15,000)  statutory       $67,250 \3\                        
                                                          rate              Joint: $78,350-                     
                                                         Joint: (1 +         $108,350 \3\                       
                                                          exclusion/                                            
                                                          $30,000)  statutory                                          
                                                          rate                                                  
Phaseout of credit for elderly and   Section 22          Statutory rate     Single: $7,500-           0.2       
 disabled                                                 plus 7.5           maximum of                         
                                                          percentage         $17,500                            
                                                          points            Joint: $10,000-                     
                                                                             maximum of                         
                                                                             $20,000                            
Phaseout of adoption credit and      Section 23          Credit: credit     $75,000-$115,000   Not available    
 exclusion                                                amount/$40,000     \3\                                
                                                          plus statutory                                        
                                                          rate                                                  
                                                         Exclusion: (1 +                                        
                                                          exclusion amount/                                     
                                                          $40,000)  statutory                                          
                                                          rate                                                  
Phaseout of first-time homebuyer     Section 1400C       Statutory rate     Single: $70,000-   Not available    
 credit for D.C.                                          plus 25            $90,000 \3\                        
                                                          percentage        Joint: $110,000-                    
                                                          points             $130,000 \3\                       
Phaseout of rental real estate       Section 469(i)      1.5 times          $100,000-$150,000  Not available    
 losses under passive loss rules                          statutory rate                                        
                                                          \5\                                                   
Phaseout of rehab tax credit under   Section 469(i)      1.5 times          $200,000-$250,000  Not available    
 passive loss rules                                       statutory rate                                        
Income phase-in of recapture of      Section 143         Statutory rate     Defined relative   Not available    
 subsidy of qualified mortgage                            plus percentage    to area median                     
 bonds                                                    points equal to    income                             
                                                          the taxpayer's                                        
                                                          recapture amount                                      
                                                          divided by 5,000                                      
----------------------------------------------------------------------------------------------------------------
Footnotes to Chart 1:                                                                                           
\1\ Applicable range defined by reference to provisional income and modified AGI is used in lieu of AGI. See    
  text Part II.B.                                                                                               
\2\ Assumes all income is earned income.                                                                        
\3\ Income range measured by reference to modified AGI.                                                         
\4\ Phaseout affects future year tax liability. Present value of effective marginal tax rate depends on length  
  of time the account is maintained and the interest rate.                                                      
\5\ Stated effective rate overstates lifetime effect as provision allows suspended losses in future years.      
                                                                                                                
Source: Joint Committee on Taxation.                                                                            


   II. PROVISIONS FOR WHICH EFFECTIVE MARGINAL TAX RATES DIFFER FROM 
                      STATUTORY MARGINAL TAX RATES

          A. Overview of Issues Relating to Marginal Tax Rates

                              Present Law

Regular income tax
    The present-law Federal income tax system imposes tax on 
the income of individuals, corporations, and trusts and 
estates.2 Under the individual income tax system, a 
United States citizen or resident alien generally is subject to 
the U.S. individual income tax on his or her worldwide taxable 
income.3 Taxable income equals the taxpayer's total 
gross income 4 less certain exclusions, exemptions 
(e.g., personal exemptions for the taxpayer, his or her spouse, 
and any dependents), and deductions. A taxpayer may claim 
either a standard deduction or itemized deductions. A taxpayer 
may reduce his or her income tax liability by any applicable 
tax credits.
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    \2\ Sections 1 and 11 of the Internal Revenue Code of 1986 (``the 
Code'').
    \3\ Foreign tax credits generally are available to offset U.S. 
income tax imposed on foreign source income to the extent of foreign 
income taxes paid on that income.
    \4\ Under the Internal Revenue Code of 1986 (the ``Code''), gross 
income means ``income from whatever source derived'' except for certain 
items specifically exempted or excluded by statute.
---------------------------------------------------------------------------
    Tax liability is determined by applying the tax rate 
schedules (or the tax tables) to the taxpayer's taxable income. 
The rate schedules are divided into several ranges of income, 
known as income brackets, and the marginal tax rate increases 
as a taxpayer's income increases. The income bracket amounts 
are indexed for inflation.5 Separate rate schedules 
apply based on an individual's filing status. The four filing 
status classifications are: (1) married individuals filing a 
joint return and certain surviving spouses; (2) heads of 
households; (3) single individuals; and (4) married individuals 
filing separately. In order to limit multiple uses of a 
graduated rate schedule within a family, unearned income of a 
child under age 14 in excess of approximately $1,400 (for 1998) 
is taxed at the parent's tax rate. The individual income tax 
rate schedules for 1998 are shown in Table 1. Different rates 
may apply to capital gains.
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    \5\ ``Indexed for inflation'' generally refers to the present-law 
mechanism for inflation indexing. This measurement is made by reference 
to changes in the Consumer Price Index (``CPI'') from September of two 
years prior to the current taxable year through August of the year 
prior to the current taxable year.

         Table 1.--Federal Individual Income Tax Rates for 1998         
------------------------------------------------------------------------
           If taxable income is                Then income tax equals   
------------------------------------------------------------------------
                           Single individuals                           
                                                                        
$0-$25,350................................  15 percent of taxable       
                                             income.                    
$25,351-$61,400...........................  $3,803, plus 28% of the     
                                             amount over $25,350.       
$61,401-$128,100..........................  $13,897, plus 31% of the    
                                             amount over $61,400.       
$128,101-$278,450.........................  $34,574, plus 36% of the    
                                             amount over $128,100.      
Over $278,450.............................  $88,700, plus 39.6% of the  
                                             amount over $278,450.      
                                                                        
                           Heads of households                          
                                                                        
$0-$33,950................................  15 percent of taxable       
                                             income.                    
$33,951-$87,700...........................  $5,093, plus 28% of the     
                                             amount over $33,950.       
$87,701-$142,000..........................  $20,143 plus 31% of the     
                                             amount over $87,700.       
$142,001-$278,450.........................  $36,976, plus 36% of the    
                                             amount over $142,000.      
Over $278,450.............................  $86,098, plus 39.6% of the  
                                             amount over $278,450.      
                                                                        
                Married individuals filing joint returns                
                                                                        
$0-$42,350................................  15 percent of taxable       
                                             income.                    
$42,351-$102,300..........................  $6,353, plus 28% of the     
                                             amount over $42,350.       
$102,301-$155,950.........................  $23,139, plus 31% of the    
                                             amount over $102,300.      
$155,951-$278,450.........................  $39,770, plus 36% of the    
                                             amount over $155,950.      
Over $278,450.............................  $83,870, plus 39.6% of the  
                                             amount over $278,450.      
                                                                        
               Married individuals filing separate returns              
                                                                        
$0-$21,175................................  15 percent of taxable       
                                             income.                    
$21,176-$51,150...........................  $3,176, plus 28% of the     
                                             amount over $21,175.       
$51,151-$77,975...........................  $11,569, plus 31% of the    
                                             amount over $51,150.       
$77,976-$139,225..........................  $19,885, plus 36% of the    
                                             amount over $77,975.       
Over $139,225.............................  $41,935 plus 39.6% of the   
                                             amount over $139,225.      
------------------------------------------------------------------------

Alternative minimum tax

    Present law also imposes a minimum tax on an individual to 
the extent the taxpayer's minimum tax liability exceeds his or 
her regular tax liability. This alternative minimum tax 
(``AMT'') is imposed at rates of (1) 26 percent on the first 
$175,000 of alternative minimumtaxable income in excess of a 
phased-out exemption amount and (2) 28 percent on the amount in excess 
of $175,000. The regular capital gains income tax rates still apply to 
capital gains under the AMT. The exemption amounts are $45,000 in the 
case of married individuals filing a joint return and surviving 
spouses; $33,750 in the case of other unmarried individuals; and 
$22,500 in the case of married individuals filing a separate return or 
an estate or a trust. These exemption amounts are phased out by an 
amount equal to 25 percent of the amount that the individual's 
alternative minimum taxable income exceeds a threshold amount. These 
threshold amounts are $150,000 in the case of married individuals 
filing a joint return and surviving spouses; $112,500 in the case of 
other unmarried individuals; and $75,000 in the case of married 
individuals filing a separate return, estates, and trusts. The 
exemption amounts, the threshold phaseout amounts, and the $175,000 
break-point amount are not indexed for inflation.
    Alternative minimum taxable income (``AMTI'') is the 
taxpayer's taxable income increased by certain preference items 
and adjusted by determining the tax treatment of certain items 
in a manner that negates the deferral of income resulting from 
the regular tax treatment of those items. The major AMT 
preferences and adjustments applicable to individuals are: (1) 
miscellaneous itemized deductions; (2) State, local, and 
foreign real property, personal property and income taxes; (3) 
medical expenses except to the extent in excess of ten percent 
of the taxpayer's adjusted gross income; (4) standard 
deductions and personal exemptions; (5) the special rules 
relating to incentive stock options, and (6) certain business-
related items. 6
---------------------------------------------------------------------------
    \6\ For a more complete discussion of the AMT, see Joint Committee 
on Taxation, Present Law and Issues Relating to the Individual 
Alternative Minimum Tax (``AMT'') (JCX-3-98), February 2, 1998.
---------------------------------------------------------------------------
    The various credits allowed under the regular tax generally 
are not allowed for purposes of the AMT. Thus, the AMT has the 
effect of limiting the amount of credits available to a 
taxpayer.
    If an individual is subject to the AMT in one year, the 
amount of tax that is a result of preferences and adjustments 
that are timing in nature is allowed as a credit in a 
subsequent taxable year to the extent the taxpayer's regular 
tax liability exceeds the taxpayer's tentative minimum tax in 
the subsequent year. Most individual AMT preferences and 
adjustments are not timing in nature.

                          Legislative History

Regular income tax

    The Tariff Act of 1913 which imposed the individual income 
tax had a tax rate structure with rates ranging between 1 
percent and 7 percent. Subsequent legislation modified the rate 
structure numerous times over the next fifty years, the most 
progressive rate structure resulting in a maximum marginal 
statutory rate in excess of 90 percent. Generally, between 1965 
and 1982, the range of the individual income tax rates began at 
a rate of 14 percent and ended with a top tax rate of 70 
percent. The Economic Recovery Tax Act of 1981 (``ERTA'') 
reduced income tax rates in each tax bracket, indexed the tax 
brackets for inflation, and reduced the top tax rate from 70 
percent to 50 percent. After ERTA, the 50-percent tax rate in 
1982 applied to taxable income in excess of : (1) $85,600 for 
married individuals filing a joint return and certain surviving 
spouses; (2) $60,600 for heads of households; (3) $41,500 for 
single individuals; (4) $41,400 for trusts and estates; and (5) 
$42,800 for married individuals filing separately.
    Immediately prior (i.e., 1986) to the Tax Reform Act of 
1986 (``1986 Act''), there were 14 taxable income tax rate 
brackets (15 taxable income tax rate brackets for single 
individuals) in addition to the zero tax rate bracket (``zero 
bracket amount''). The zero bracket amount was provided in lieu 
of the standard deduction. The tax rates in each schedule 
started at 11 percent for amounts in the first taxable income 
tax bracket above the zero bracket amount. The 11-percent rate 
started at: (1) $3,400 for married individuals filing a joint 
return and certain surviving spouses; (2) $2,300 for heads of 
households and single individuals; and (3) $1,700 for married 
individuals filing separately. The 50-percent rate started at: 
(1) $162,400 for married individuals filing a joint return and 
certain surviving spouses; (2) $108,300 for heads of 
households; (3) $81,800 for single individuals; (4) $79,500 for 
trust and estates; and (5) $81,200 for married individuals 
filing separately.
    There were two tax rates for individuals under the 1986 
Act: 15 and 28 percent. The phaseout of the benefit of the 
lower rates and the personal exemption in effect created a 
third marginal rate of 33 percent.7 The Omnibus 
Budget Reconciliation Act of 1990 (``OBRA 1990'') added a 31-
percent rate for taxable years beginning after December 31, 
1990. (See also the discussion of the personal exemption 
phaseout in Part II.D., below.) OBRA 1990 also removed the 
phase out of the benefit of lower rates and the personal 
exemption. The Omnibus Budget Reconciliation Act of 1993 
(``OBRA 1993'') added the 36- and 39.6-percent tax rate 
brackets, generally effective for taxable years beginning after 
December 31, 1992.
---------------------------------------------------------------------------
    \7\ See discussion in Part II.D below.
---------------------------------------------------------------------------

Alternative minimum tax

    The Tax Reform Act of 1969 imposed an ``add on'' minimum 
tax on individuals. The individual alternative minimum tax was 
first introduced in 1978. Prior to the 1986 Act, individuals 
were subject to an alternative minimum tax that resembled the 
AMT of present law. The tax was payable in addition to all 
other tax liabilities to the extent it exceeded the 
individual's regular tax liability. The tax was imposed at a 
flat rate of 20 percent on alternative minimum taxable income 
in excess of an exemption amount. A taxpayer's alternative 
minimum tax liability could be reduced by foreign tax credits 
and refundable credits. An individual's alternative minimum 
taxable income was his or her adjusted gross income, increased 
by certain preferences and reduced by alternative tax itemized 
deductions.
    The 1986 Act broadened the base of the pre-existing 
individual AMT. In addition, the 1986 Act increased the AMT 
rate to 21 percent, phased out the exemption amounts, provided 
the AMT credit, and changed the individual AMT from essentially 
an add-on system of preferences to a separate tax system of 
preferences and adjustments, the latter of which were deferral 
items that could ``turnaround'' (i.e., decrease AMTI) over the 
life of the related property. The individual AMT rate was 
raised from a flat 21 percent to a flat 24 percent by OBRA 
1990. OBRA 1993 instituted the two-tier individual rate system 
(at 26 and 28 percent) of present law and increased the 
individual AMT exemption amounts.

               Background Discussion of Tax Rate Analysis

Marginal tax rates

    This section of the pamphlet primarily analyzes effective 
marginal income tax rates. The term ``marginal tax rate'' 
refers to the additional, or incremental, increase in tax 
liability that a taxpayer incurs under the income tax from a 
$1.00 increase in his or her income. For the purposes of this 
pamphlet, the term ``statutory marginal tax rate'' refers to 
the marginal tax rates for individuals as defined in section 1 
of the Code and as indicated in Table 1 above. Thus, the basic 
rate structure of the Federal individual income tax is defined 
in terms of five marginal tax rates: 15 percent, 28 percent, 31 
percent, 36 percent, and 39.6 percent. These statutory marginal 
tax rates are applied to a taxpayer's taxable income within a 
specified range; for example, the 28-percent marginal tax rate 
applies to taxable income between $42,350 and $102,300 for a 
married couple filing a joint return. In fact, the personal 
exemptions and standard deduction create a sixth marginal tax 
rate--a zero marginal tax rate. A taxpayer with an income less 
than the sum of the allowable standard deduction and personal 
exemptions owes no additional income tax if his or her income 
increases by $1.00. The statutory marginal income tax rates 
increase as the taxpayer's taxable income increases.
    In general, if an additional $1.00 of income to the 
taxpayer resulted in the taxpayer's taxable income increasing 
by $1.00, then there would be no difference between statutory 
marginal tax rates and effective marginal tax rates. Because of 
the design of certain provisions of the Code, an ``effective 
marginal tax rate'' may not always correspond to the statutory 
marginal tax rate. There are numerous situations in which the 
effective marginal tax rate differs from those statutory 
marginal tax rates specified in Table 1. For example, the 
exclusion from income of the interest paid to a bondholder of 
qualified State and local debt implies that for an additional 
$1.00 of interest paid to the taxpayer, the taxpayer's taxable 
income does not increase at all. In this circumstance, the 
taxpayer's effective marginal tax rate on that interest income 
is zero, even though the taxpayer's effective marginal tax rate 
on an additional dollar of other income may equal the statutory 
marginal tax rate. The Code provides statutory marginal tax 
rates for income from the realization of capital gains that are 
different, and generally lower, from those of Table 1. As this 
pamphlet will discuss, there are other provisions of the Code 
where an additional $1.00 of income to the taxpayer results in 
the taxpayer's taxable income increasing by more than $1.00. In 
such a circumstance, the taxpayer's effective marginal tax rate 
will exceed the statutory marginal tax rate. In other 
circumstances, an additional $1.00 of income to thetaxpayer 
results in the taxpayer losing all or part of a credit against tax 
liability he or she could otherwise claim. In this circumstance, the 
taxpayer's effective marginal tax rate will exceed the statutory 
marginal tax rate. This pamphlet identifies and discusses provisions of 
the Code where a phaseout, phase-in, or floor creates a difference 
between the effective marginal tax rate and the statutory marginal tax 
rate.
    As the subsequent description of provisions and their 
legislative history will attest, the number of provisions with 
a phaseout, phase-in, or floor has increased over the past 15 
years. As a result, the Joint Committee staff estimates that a 
substantial number of taxpayers are subject to a provision 
where the taxpayer's effective marginal tax rate differs from 
the statutory marginal tax rate.
    Table 2, below, presents the Joint Committee staff's 
estimate of the distribution of taxpayers by income for all 
taxpayers, for all taxpayers for whom their effective marginal 
tax rate equals their statutory marginal tax rate, and for 
taxpayers for whom their effective marginal tax rate is 
different from their statutory marginal tax rate. Table 2 also 
shows the average effective marginal tax rate of all taxpayers 
in each income category. For purposes of this table, the 
effective marginal tax rate was calculated as follows. The 
Joint Committee staff increased wage income by one dollar for 
those taxpayers who otherwise reported wage or salary income 
and increased other income by one dollar for those taxpayers 
who otherwise reported no wage or salary income.\8\ The Joint 
Committee staff used its individual tax model to calculate the 
change in each taxpayer's total tax liability resulting from 
the one dollar increase in income. This change in tax liability 
is reported as the effective marginal tax rate.
---------------------------------------------------------------------------
    \8\ The calculations of effective marginal rates generally assume 
an additional dollar of income to the taxpayer would be taxed as 
ordinary income. If the additional, or incremental, dollar of income to 
the taxpayer were from capital gains, the provisions discussed below 
still would cause the taxpayer's effective marginal tax rate to deviate 
from the statutory marginal tax rate, but the calculation of effective 
marginal tax rate would have to made relative to the taxpayer's 
statutory marginal tax on income from capital gains.

Table 2.--Distribution by Income of Taxpayers for Whom Effective Marginal Tax Rates Equal Statutory Marginal Tax
            Rates and for Whom Effective Marginal Tax Rates Differ From Statutory Marginal Tax Rates            
                                              [Calendar year 1998]                                              
----------------------------------------------------------------------------------------------------------------
                                        All taxpayers \2\     Taxpayers with effective  Taxpayers with effective
                                   --------------------------  MTR equaling statutory      MTR different from   
                                                                         MTR                  statutory MTR     
                                                   Average   ---------------------------------------------------
        Income category \1\                        marginal                  Average                   Average  
                                      Millions     tax rate                  marginal                  marginal 
                                                  (percent)     Millions     tax rate     Millions     tax rate 
                                                                            (percent)                 (percent) 
----------------------------------------------------------------------------------------------------------------
Less than $10,000.................         19.8         -2.9         15.7          1.0          4.0        -18.0
10,000 to 20,000..................         25.1          6.9         20.1          6.2          5.0         10.1
20,000 to 30,000..................         20.3         14.4         14.6         11.0          5.7         23.3
30,000 to 40,000..................         16.3         16.2         12.9         14.1          3.4         24.5
40,000 to 50,000..................         12.4         18.0         10.4         17.5          2.0         20.5
50,000 to 75,000..................         19.6         19.5         15.4         19.1          4.2         20.9
75,000 to 100,000.................         10.0         27.0          7.3         26.9          2.7         27.4
100,000 to 200,000................          8.5         29.5          4.3         28.2          4.2         30.7
200,000 and over..................          2.2         36.4          0.2         32.9          2.0         36.7
                                   -----------------------------------------------------------------------------
      Total, all taxpayers........        134.1         14.1        100.9         12.8         33.2         18.1
----------------------------------------------------------------------------------------------------------------
\1\ The income concept used to place tax returns into income categories is adjusted gross income plus [1] tax   
  exempt interest [2] employer contributions for health plans and life insurance, [3] employer share of FICA    
  tax, [4] workers' compensation [5] nontaxable social security benefits, [6] insurance value of Medicare       
  benefits, [7] alternative minimum tax preference items, and [8] excluded income of U.S. citizens living       
  abroad. Categories are measured at 1998 levels.                                                               
\2\ Includes filing and nonfiling units. Excludes individuals who are dependents of other taxpayers and         
  taxpayers with income less than zero.                                                                         
                                                                                                                
Detail may not add to total due to rounding.                                                                    
                                                                                                                
Source: Joint Committee on Taxation.                                                                            

    Table 2 reports that in 1998, 33.2 million taxpayers, or 
approximately one quarter of all taxpayers, will have an 
effective marginal tax rate different from their statutory tax 
rate. The difference between the effective marginal tax rate 
and the statutory marginal tax rate generally results from the 
provisions discussed in the subsequent sections of this 
pamphlet.9 Some of the differences are attributable 
to taxpayers subject to the alternative minimum tax, but for 
1998 such taxpayers will number only approximately 
850,000.10 Table 2 shows that for taxpayers with 
incomes greater than $75,000 and for taxpayers with incomes 
between $20,000 and $30,000, more than 25 percent of taxpayers 
face effective marginal tax rates different from their 
statutory marginal tax rate. For no income category do fewer 
than 16 percent of taxpayers face effective marginal tax rates 
different from their statutory marginal tax rate.
---------------------------------------------------------------------------
    \9\ Tables 2, above, and 3, below, may slightly undercount the 
number of taxpayers who are affected by the provisions analyzed in this 
pamphlet because of the manner in which the personal exemption phaseout 
operates. The personal exemption phaseout operates in steps of $2,500. 
Thus, a one dollar increment in income does not necessarily result in 
an effective marginal tax rate that differs from the taxpayer's 
statutory marginal tax rate. (See the discussion in Part II.D., below.)
    \10\ Eliminating taxpayers with positive tax liability under the 
AMT does not materially alter the results of Table 2, above, or Table 
3, below.
---------------------------------------------------------------------------
    Table 3 reports the same projections, but with taxpayers 
distributed by their statutory marginal tax rate as determined 
by their taxable income under the regular tax. Table 3 reports 
that three quarters of all taxpayers in the 31-, 36-, and 39.6-
percent statutory marginal tax brackets are projected to face 
effective marginal tax rates different from their statutory 
marginal tax rate. Of taxpayers in the 28- and 15-percent 
statutory marginal tax rate brackets, the comparable 
percentages are 26 percent and 25 percent, respectively.
    Another feature of Tables 2 and 3 is the negative average 
effective marginal tax rate estimated for some taxpayers. This 
is a consequence of taxpayers eligible for the Earned Income 
Credit (``EIC''). (See Part II.E., below for a detailed 
discussion.)

 Table 3.--Distribution of Taxpayers by Statutory Marginal Tax Rates for Whom Effective Marginal Tax Rates Equal
                                  and Differ From Statutory Marginal Tax Rates                                  
                                              [Calendar year 1998]                                              
----------------------------------------------------------------------------------------------------------------
                                        All taxpayers \1\       Effective rate equals    Effective rate does not
                                   --------------------------      statutory rate         equal statutory rate  
                                                             ---------------------------------------------------
    Marginal tax rate (percent)                    Average                   Average                   Average  
                                      Millions     marginal                  marginal                  marginal 
                                                   tax rate     Millions     tax rate     Millions     tax rate 
                                                  (percent)                 (percent)                 (percent) 
----------------------------------------------------------------------------------------------------------------
0.................................         40.5         -2.0         33.4          0.0          7.1        -11.2
15................................         62.2         16.8         46.8         15.0         15.5         22.4
28................................         26.6         28.4         19.7         28.0          6.9         29.4
31................................          3.0         31.7          0.9         31.0          2.0         32.0
36................................          1.1         37.1          0.1         36.0          1.0         37.2
39.6..............................          0.7         40.2          0.1         39.6          0.6         40.3
                                   -----------------------------------------------------------------------------
  Total, all taxpayers............        134.1         14.1        100.9         12.8         33.2         18.1
----------------------------------------------------------------------------------------------------------------
\1\ Includes filing and nonfiling units. Excludes individuals who are dependents of other taxpayers and         
  taxpayers with income less than zero.                                                                         
                                                                                                                
Detail may not add to total due to rounding.                                                                    
                                                                                                                
Source: Joint Committee on Taxation.                                                                            

Average tax rates

    A taxpayer's average tax rate is the percentage represented 
by the total tax for which the taxpayer is liable divided by 
the taxpayer's total income. As a result, a taxpayer in the 28-
percent marginal tax rate bracket does not pay 28 percent of 
his or her total income in Federal taxes. In fact, the taxpayer 
would pay less than 28 percent of his or her income in taxes 
because some of the income is taxed at the lower 15-percent 
marginal tax rate and some is taxed at a zero percent rate 
(because the taxpayer may claim the standard deduction). Some 
writers refer to the average tax rate as the ``effective tax 
rate.'' This terminology naturally leads to confusion with the 
concept of effective marginal tax rate, described above.
    A taxpayer's total tax liability is calculated by the sum 
of all of the taxpayer's marginal tax liabilities. That is, 
total tax liability equals the sum of marginal tax owed on each 
dollar of income, from the first dollar through the last 
dollar. Thus, a mathematical relationship exists between a 
taxpayer's effective marginal tax rate on each dollar of income 
and the taxpayer's average tax rate. Because of the personal 
exemptions and standard deduction, the taxpayer's effective 
marginal tax rate and average tax rate both equal zero at 
incomes up to the sum of the value of the taxpayer's standard 
deduction and personal exemptions. When the taxpayer first 
enters the 15-percent statutory marginal tax rate bracket, the 
taxpayer's effective marginal tax rate begins to deviate from 
the taxpayer's average tax rate.\11\ Whenever the taxpayer's 
effective marginal tax rate is above the taxpayer's average tax 
rate, the taxpayer's average tax rate is rising. Whenever the 
taxpayer's effective marginal tax rate is below the taxpayer's 
average tax rate, the taxpayer's average tax rate is falling. 
Because the statutory marginal tax rates increase with income, 
few taxpayers are likely to have an effective marginal tax rate 
lower than their average tax rate.
---------------------------------------------------------------------------
    \11\ When one accounts for the earned income credit (``EIC'') the 
taxpayer's average tax rate may be negative while the taxpayer's 
effective marginal tax rate is zero or positive. (See the discussion 
relating to the EIC in Part II.E., below.)
---------------------------------------------------------------------------
    Economists emphasize the difference between the effective 
marginal tax rate and the average tax rate because they argue 
effective marginal tax rates create incentives such as the 
incentive to work, to save, or to donate to charity. This 
pamphlet discusses these incentive effects in Part III, below. 
Analysts typically use the average tax rate as a measure of the 
fairness of the tax system and sometimes as a measure of the 
overall burden of taxation. The emphasis of the analysis of 
this pamphlet is on the examination of effective marginal tax 
rates. However, because effective marginal tax rates determine 
a taxpayer's average tax rate, Part III, below, also discusses 
fairness issues as well as incentive effects.

B. Phaseout of the Exclusion of Social Security and Railroad Retirement 
                            Tier 1 Benefits

                              Present law

In general

    Under present law, taxpayers receiving social security and 
railroad retirement tier 1 benefits are not required to include 
any portion of such benefits in gross income if their 
``provisional income'' does not exceed $25,000, in the case of 
unmarried taxpayers, or $32,000, in the case of married 
taxpayers filing joint returns. For purposes of these 
computations, a taxpayer's provisional income is defined as 
adjusted gross income (AGI) plus tax-exempt interest plus 
certain foreign source income plus one-half of the taxpayer's 
social security or railroad retirement tier 1 benefit. A 
second-tier threshold for provisional income is $34,000, in the 
case of unmarried taxpayers, or $44,000, in the case of married 
taxpayers filing joint returns.
    If the taxpayer's provisional income exceeds the lower 
threshold but does not exceed the second-tier threshold, then 
the amount required to be included in income is the lesser of 
(1) 50 percent of the taxpayer's social security or railroad 
retirement tier 1 benefit, or (2) 50 percent of the excess of 
the taxpayer's provisional income over the lower threshold.
    If the amount of provisional income exceeds the second-tier 
threshold, then the amount required to be included in income is 
the lesser of:
          (1) 85 percent of the taxpayer's social security or 
        railroad retirement tier 1 benefit; or
          (2) the sum of--
                  (a) 85 percent of the excess of the 
                taxpayer's provisional income over the second-
                tier threshold, plus,
                  (b) the smaller of (i) the amount of benefits 
                that would have been included if the 50-percent 
                inclusion rule (the rule in the previous 
                paragraph) were applied, or (ii) one-half of 
                the difference between the taxpayer's second-
                tier threshold and lower threshold.

Earnings limit

    Senior citizens age 70 and older, and disabled individuals, 
regardless of age, may be eligible to receive full social 
security benefits regardless of the amount of earnings they 
have from wages or self-employment. Those between the full 
retirement age (currently age 65) and age 70 receive full 
benefits only if their earnings are lower than an earnings 
limit amount determined by law. Those below full retirement age 
have a separate earnings limit. In 1998, the earnings limit for 
those below the full retirement age is $9,120. The earnings 
limit is indexed to the rise of average wages in the economy. 
Those below full retirement age (currently, age 65) lose $1 of 
benefits for every $2 in wages of self-employment income they 
earn over the limit. In 1998, the limit for those age 65 to 69 
is $14,500. This earnings limit will increase to $15,500 in 
1999, $17,000 in 2000, $25,000 in 2001 and $30,000 in 2002. 
Senior citizens between the age of full retirement (currently 
age 65) and 70 who earn more than the earnings limit lose $1 in 
benefits for every $3 in wages or self-employment income they 
earn over the limit.

                          Legislative History

    The exclusion from gross income for social security 
benefits was not initially established by statute. Prior to the 
Social Security Amendments of 1983, the exclusion was based on 
a series of administrative rulings issued by the Internal 
Revenue Service in 1938 and 1941.12
---------------------------------------------------------------------------
    \12\ See I.T. 3194, 1938-1 C.B. 114; I.T. 3229, 1938-2 C.B. 136; 
and I.T. 3447, 1941-1 C.B. 191.
---------------------------------------------------------------------------
    Under the Social Security Amendments of 1983, a portion of 
the social security benefits paid to higher income taxpayers 
was included in gross income. Generally, if a taxpayer had 
provisional income in excess of the threshold amount of $25,000 
($32,000 in the case of married individuals filing a joint 
return), the amount included in a taxpayer's gross income was 
the lesser of (1) 50 percent of the taxpayer's social security 
or railroad retirement tier 1 benefit, or (2) 50 percent of the 
excess of the taxpayer's provisional income over the applicable 
threshold amount. The Omnibus Budget Reconciliation Act of 1993 
increased the amount of benefits subject to tax and increased 
the rate of tax for higher-income individuals to the present-
law levels.
    The exclusion from gross income for certain benefits paid 
under the Railroad Retirement System was enacted in the 
Railroad Retirement Act of 1935. A portion of the benefits 
payable under the Railroad Retirement System (generally, tier 1 
benefits) is equivalent to social security benefits. The tax 
treatment of tier 1 railroad retirement benefits was modified 
in the Social Security Amendments of 1983 to conform to the tax 
treatment of social security benefits. Other railroad 
retirement benefits are taxable in the same manner as employer-
provided retirement benefits. The Consolidated Omnibus Budget 
Reconciliation Act of 1985 provided that tier 1 benefits are 
taxable in the same manner as social security benefits only to 
the extent that social security benefits otherwise would be 
payable. Other tier 1 benefits are taxable in the same manner 
as all other railroad retirement benefits.

                                Analysis

    The inclusion of portions of Social Security benefits in 
taxable income as income rises above certain thresholds 
effectively increases the marginal tax rates of the affected 
taxpayers. For taxpayers affected by the provision, their 
marginal tax rate can be up to 185 percent of the statutory 
rate. For taxpayers whose income falls below the initial 
threshold, there is no inclusion of Social Security benefits in 
taxable income.
    For taxpayers whose modified AGI plus one-half of their 
Social Security benefits exceeds $25,000 ($32,000 if married 
filing jointly), but is less than $34,000 ($44,000 if married 
filing jointly), up to one-half of the Social Security benefits 
are taxable. Specifically, once a taxpayer reaches the 
threshold, each additional dollar of income will cause an 
additional 50 cents of Social Security benefits to be included 
in taxable income. This effectively raises the Federal marginal 
tax rate to 150 percent of the statutory rate, as each dollar 
of income causes taxable income to rise $1.50. Thus, for 
example, if a taxpayer's statutory rate is 15 percent, the 
additional dollar of income will result in taxes of $0.15 on 
the income itself, plus 15 percent of the $0.50 in additional 
Social Security benefits included in taxable income, or $0.075. 
The total Federal income tax thus rises by $0.225, implying a 
22.5-percent effective Federal marginal tax rate, which is 150 
percent of the statutory rate of 15 percent.13
---------------------------------------------------------------------------
    \13\ Such a taxpayer would also pay $0.0765 in additional Social 
Security taxes (ignoring the employer share) on the income if it were 
labor income. Additionally, the taxpayer might face State or local 
income taxes, which, as a result of the inclusion of Social Security 
benefits in income, could also be 150 percent of the statutory rate for 
those States that piggy-back off Federal income tax definitions.
---------------------------------------------------------------------------
    For taxpayers whose modified AGI plus one-half of their 
Social Security benefits exceeds $34,000 ($44,000 if married 
filing jointly), up to 85 percent of the Social Security 
benefits are taxable. When a taxpayer reaches this second 
threshold, each additional dollar of income will cause an 
additional 85 cents of Social Security benefits to be included 
in taxable income. This effectively raises the Federal marginal 
tax rate to 185 percent of the statutory rate, as each dollar 
of additional income causes taxable income to rise $1.85. If a 
taxpayer's statutory rate is 15 percent, the additional dollar 
of income will result in taxes of $0.15 on the income itself, 
plus 15 percent of $0.85 in additional Social Security benefits 
included in taxable income, or $0.1275. The total Federal 
income taxes thus rise by $0.2775 ($0.15 plus $0.1275) implying 
a 27.75-percent effective Federal marginal tax rate, or a rate 
that is 185 percent of the statutory rate.
    Taxpayers who face some inclusion of Social Security 
benefits in taxable income will not necessarily experience a 
direct transition from effective marginal tax rates that are 
150 percent of the statutory rate to effective marginal tax 
rates that are 185 percent of the statutory rate. Rather, for 
some taxpayers there will be some levels of income for which 
such taxpayers would face only the statutory marginal tax rate 
on additional income once they attain 50 percent inclusion of 
benefits in taxable income. That is, for income beyond a 
certain point, there will be no further inclusion of Social 
Security benefits in income until the next threshold is 
reached. Thus, the marginal tax rates will fall back to the 
statutory rate for additional income in this range. Two 
conditions must be met before this is the case. First, a 
taxpayer's income must at least equal $25,000 ($32,000 for 
married filing jointly) plus one-half of Social Security 
benefits in order for fully one-half of Social Security 
benefits to be included in income. To see this, recall that for 
each dollar that a taxpayer's non-Social Security income and 
one-half of Social Security income exceeds $25,000 ($32,000 if 
married filing jointly), an additional 50 cents of Social 
Security income is included in income. Hence, for one-half of 
total Social Security income to be included in income, a 
taxpayer's income plus one-half of Social Security benefits 
must exceed $25,000 ($32,000 if married filing jointly) by the 
full amount of Social Security benefits. The second condition 
that must be met is that the taxpayer's income plus one-half of 
Social Security benefits not exceed $34,000 ($44,000 if married 
filing jointly), at which point the taxpayer would be subject 
to an inclusion of up to 85 percent of their Social Security 
benefits in income.14 Thus, for example, if a 
taxpayer's Social Security benefits are $2,000, then once his 
other income reaches $26,000, his effective marginal tax rate 
will fall from 50 percent above the statutory rate to the 
statutory rate.15 Single taxpayers whose Social 
Security benefits are at least $9,000, and whose income plus 
one-half of Social Security benefits exceeds $34,000, will 
experience an immediate transition from effective marginal tax 
rates that are 150 percent of the statutory rate to ones that 
are 185 percent of the statutory rate (i.e., without first 
dropping back to the statutory rate). For married filing 
jointly, the Social Security benefits must be at least $12,000 
for this to occur, and their income plus one-half of social 
security benefits must exceed $44,000.
---------------------------------------------------------------------------
    \14\ Therefore, the taxpayer's effective marginal tax rate will 
fall from one that is 150 percent of the statutory rate to one that 
equals the statutory rate for the income levels Y that fall in the 
following range: $25,000 + \1/2\B < Y < $34,000-\1/2\B, where B is the 
Social Security benefits. For married filing jointly, the corresponding 
range is $32,000 + \1/2\B < Y < $44,000-\1/2\B.
    \15\ And for this taxpayer, the effective marginal tax rate would 
have exceeded the statutory rate once his income reached $24,000, as 
$24,000 plus one-half of the Social Security benefits equals $25,000, 
the point at which additional income would cause portions of the Social 
Security benefit to become taxable.
---------------------------------------------------------------------------
    Taxpayers whose income plus one-half of Social Security 
benefits exceeds $34,000 ($44,00 if married filing jointly) 
will face marginal tax rates that are 185 percent of the 
statutory rate until that point at which 85 percent of the 
Social Security benefits will have been included in income, at 
which point the effective marginal tax rate falls back to the 
statutory rate. It should be noted these provisions will only 
affect taxpayers in the 15-percent or the 28-percent statutory 
brackets because of the relatively low level of the specified 
phase-in ranges and the limit on the maximum size of the Social 
Security benefits.16 Thus, the maximum increase in 
effective marginal tax rates is 85 percent of 28 percent, or 
23.8 percentage points, which would lead to an effective 
marginal tax rate of 28 percent plus 23.8 percent, or 51.8 
percent.
---------------------------------------------------------------------------
    \16\ Only single taxpayers can face statutory marginal tax rates as 
high as 28 percent and still be subject to the phase-in of Social 
Security benefits. Given the phase-in rules and the maximum amount of 
Social Security benefits that a married couple could receive, the full 
85 percent of Social Security benefits will have been phased in prior 
to that couple having an income sufficient to bring their taxable 
income to the threshold where the 28-percent rate is effective.
---------------------------------------------------------------------------
    As shown in table 4, the Joint Committee staff estimates 
that, in 1998, 5 million taxpayers, or 3.7 percent of all 
taxpayers, are in the phase-in ranges for the Social Security 
benefits, out of a total of 35.2 million taxpayers with Social 
Security benefits.17 Because the phase-in ranges 
occur at relatively modest income levels, most taxpayers in the 
phase-in range will be in the 15 percent marginal tax rate 
bracket.
---------------------------------------------------------------------------
    \17\ An additional 4.0 million taxpayers are subject to the 
inclusion, but have incomes sufficient to have caused them to already 
be subject to the maximum inclusion, and thus any additional income 
will not cause additional Social Security benefits to be taxable.
---------------------------------------------------------------------------

Earnings limit

    In addition to the Federal income tax provisions that cause 
increasing amounts of Social Security benefits to be included 
in taxable income as income rises, the Social Security benefit 
rules cause benefits to decline for wage income above certain 
thresholds. The thresholds and rules vary by one's Social 
Security retirement status, but the rules can cause up to 50 
cents in Social Security benefits to be lost for an additional 
dollar of wage income. This Social Security provision alone, 
without regard to the Federal income tax, represents a marginal 
tax rate of up to 50 percent. The interaction of this provision 
with the Federal income tax provisions described above can push 
effective marginal tax rates for Social Security recipients 
that have some wage income into the vicinity of 100 percent.

    Table 4.--Distribution of Taxpayers by Income Who Receive Social    
 Security Benefits and Who Are in the Phase-In Range--Calendar year 1998
------------------------------------------------------------------------
                                          Taxpayers with   Taxpayers in 
                                              Social          Social    
           Income category \1\               Security     Security phase-
                                              income         in range   
                                            (millions)      (millions)  
------------------------------------------------------------------------
Less than $10,000.......................             3.0             0.0
10,000 to 20,000........................            10.3             0.0
20,000 to 30,000........................             6.3           (\2\)
30,000 to 40,000........................             4.7             0.7
40,000 to 50,000........................             3.6             1.3
50,000 to 75,000........................             4.3             2.7
75,000 to 100,000.......................             1.5             0.3
100,000 to 200,000......................             1.3           (\2\)
200,000 and over........................             0.4             0.0
                                         -------------------------------
      Total, all taxpayers..............            35.2             5.0
------------------------------------------------------------------------
\1\ The income concept used to place tax returns into income categories 
  is adjusted gross income plus [1] tax exempt interest, [2] employer   
  contributions for health plans and life insurance, [3] employer share 
  of FICA tax, [4] workers' compensation, [5] nontaxable social security
  benefits, [6] insurance value of Medicare benefits, [7] alternative   
  minimum tax preference items, and [8] excluded income of U.S. citizens
  living abroad. Categories are measured at 1998 levels.                
\2\ Less than 50,000 taxpayers.                                         
                                                                        
 ADetails may not add to total due to rounding.                         
                                                                        
 ASource: Joint Committee on Taxation.                                  

      C. Limitations on Itemized Deductions (``Pease'' Limitation;

           Floors on Deductions for Medical and Miscellaneous

                     Expenses and Casualty Losses)

                              Present Law

Itemized deductions

    Individuals who do not elect the standard deduction may 
claim itemized deductions (subject to certain limitations) for 
certain nonbusiness expenses incurred during the taxable year. 
Among these deductible expenses are unreimbursed medical 
expenses, casualty and theft losses, charitable contributions, 
qualified residence interest, State and local income and 
property taxes, certain moving expenses, unreimbursed employee 
business expenses, and certain other miscellaneous expenses.
    Qualified residence interest may be deducted on total debt 
of up to $1 million. In addition, interest on up to $100,000 of 
other debt secured by a residence (``home equity loans'') may 
be deducted.

Separate floors

    Certain itemized deductions are allowed only to the extent 
that the amount of the expense incurred during the taxable year 
exceeds a specified percentage of the taxpayer's adjusted gross 
income (AGI). Unreimbursed medical expenses for care of the 
taxpayer and the taxpayer's spouse and dependents are 
deductible only to the extent that the total of such expenses 
exceeds 7.5 percent of the taxpayer's AGI. Nonbusiness casualty 
or theft losses are deductible only to the extent that the 
amount of the loss arising from each casualty or theft exceeds 
$100 and only to the extent that total casualty and theft 
losses exceed 10 percent of the taxpayer's AGI. Unreimbursed 
employee business expenses and certain other miscellaneous 
itemized deductions are deductible only to the extent that the 
total of such expenses and deductions exceeds 2 percent of the 
taxpayer's AGI.

General limitation on itemized deductions (``Pease'' limitation)

    Under present-law, the total amount of otherwise allowable 
itemized deductions (other than medical expenses, investment 
interest, and casualty, theft, or wagering losses) is reduced 
by 3 percent of the amount of the taxpayer's AGI in excess of 
$124,500 in 1998 (indexed for inflation).\18\ Under this 
provision, otherwise allowable itemized deductions may not be 
reduced by more than 80 percent.\19\ In computing the reduction 
under section 68 of total itemized deductions, all present-law 
limitations applicable to such deductions (such as the separate 
floors) are first applied and, then, the otherwise allowable 
total amount of itemized deductions is reduced in accordance 
with this provision.
---------------------------------------------------------------------------
    \18\ Code section 68. This general limitation on itemized 
deductions is commonly referred to as the ``Pease'' limitation after 
the Congressman who originally proposed the provision.
    Under section 68, the threshold of $124,500 is the same for all 
taxpayers, except that the threshold is $62,250 for married taxpayers 
filing separately.
    \19\ Thus, for example, if a taxpayer's AGI for 1998 is $224,500 
(i.e., the taxpayer has $100,000 of excess AGI above the $124,500 
threshold), then total otherwise allowable itemized deductions are 
reduced under section 68 by $3,000 (i.e., 3 percent of the $100,000 
excess AGI). However, if total otherwise allowable itemized deductions 
are, for example, $20,000, then, regardless of how much AGI the 
taxpayer has for the taxable year, itemized deductions can be reduced 
under section 68 by no more than $16,000 (i.e., 80 percent of $20,000). 
For some taxpayers, if the value of the standard deduction is greater 
than 20 percent of the value of the taxpayer's itemized deductions, the 
value of the standard deduction might create a floor beyond which 
itemized deductions cannot be reduced as the taxpayer always has the 
option of electing the standard deduction.
---------------------------------------------------------------------------

                          Legislative History

    The limitation on total itemized deductions was enacted on 
a temporary basis as part of the Omnibus Budget Reconciliation 
Act of 1990, effective for taxable years beginning after 
December 31, 1990, but prior to January 1, 1996. However, the 
Omnibus Budget Reconciliation Act of 1993 permanently extended 
this limitation on total itemized deductions.
    With respect to medical expenses, prior to the Tax Equity 
and Fiscal Responsibility Act of 1982 (``1982 Act''), a 
deduction of up to $150 was allowed for one-half of health 
insurance premiums. A second deduction was allowed for all 
other unreimbursed medical expenses (including health insurance 
premiums not allowed in the first category) to the extent that 
these expenses exceeded 3 percent of the taxpayer's AGI. Drug 
and medicine expenditures (including non-prescription drugs) 
could be included in the second category only to the extent 
that the total of these expenditures exceeded 1 percent of the 
taxpayer's AGI. The 1982 Act increased the floor under the 
itemized medical expense deduction from 3 percent to 5 percent, 
eliminated the separate deduction for $150 of health insurance 
premiums and the separate 1-percent floor for drugs, and 
disallowed the deduction for non-prescription drugs. The Tax 
Reform Act of 1986 (``1986 Act'') increased the floor under the 
itemized medical expense deduction from 5 to 7.5 percent of the 
taxpayer's AGI.
    With respect to casualty and theft losses, prior to the 
1982 Act, a deduction was allowed to the extent that the amount 
of loss arising from each casualty or theft exceeded $100, but 
there was no floor under the deduction of such losses based on 
the taxpayer's AGI. The present-law 10-percent AGI floor for 
casualty and theft losses was enacted as part of the 1982 Act.
    With respect to unreimbursed employee business expenses and 
certain other miscellaneous itemized deductions, the 2-percent 
floor under such expenses and deductions was enacted as part of 
the 1986 Act.

                                Analysis

General limitation on itemized deductions (``Pease limitation'')

    The general limitation on itemized deductions increases the 
effective marginal tax rate for affected taxpayers. This 
limitation reduces (subject to the 80-percent limitation) the 
amount of certain itemized deductions that may be claimed by an 
amount equal to 3 percent of each dollar of income in excess of 
the threshold. Thus if a taxpayer who is above the threshold 
earns an additional $1.00 of income, the taxpayer's taxable 
income increases by $1.03 because the taxpayer's income goes up 
by $1.00 and the itemized deductions must be reduced by 3 
cents. The statutory tax rates apply to taxable income. Thus, 
if the taxpayer is in the 36-percent tax bracket, the increase 
in tax liability resulting from the $1.00 increase in income 
will be $0.37 (the $1.03 in additional taxable income 
multiplied by 0.36). Generally, the effective marginal tax rate 
for taxpayers subject to the limitation on itemized deductions 
is 3 percent higher than the statutory tax rate. That is, the 
taxpayer's effective marginal tax rate equals 103 percent of 
the statutory marginal tax rate. Once the taxpayer's itemized 
deductions are reduced by 80 percent, the taxpayer's effective 
marginal tax rate again equals his or her statutory marginal 
tax rate.
    Some argue that the limitation on itemized deductions 
diminishes a taxpayer's incentive to make charitable 
contributions. While there may be a psychological effect, there 
generally is little or no difference in the tax-motivated 
economic incentive to give to charity for a taxpayer subject to 
the limitation compared to a taxpayer not subject to the 
limitation. This is because while the limitation operates 
effectively to increase the marginal tax rate on the income of 
affected taxpayers, the value of the tax benefit of 
deductibility of the charitable deduction is determined by the 
statutory tax rate. For taxpayers beyond the threshold, a 
specified dollar amount of itemized deductions are denied. The 
specified dollar amount is determined by the taxpayer's income, 
not by the amount of itemized deductions the taxpayer claims. 
Hence, the value of an additional dollar contributed to charity 
increases by exactly one dollar times the total amount of 
itemized deductions that the taxpayer may claim. Because the 
statutory rates apply to taxable income (income after claiming 
permitted itemized deductions), the value of the additional 
contribution to charity is determined by the statutory tax 
rate. Economists would say that the ``tax price'' of giving is 
not altered by the limitation.20
---------------------------------------------------------------------------
    \20\ This can be seen mathematically as follows. Let Y be the 
taxpayer's income and X be the threshold above which the limitation on 
itemized deductions applies. Let D be itemized deductions and t the 
taxpayer's marginal tax rate. Then the taxpayer's total tax liability, 
T, is:

    T = [Y-(D-(.03)(Y-X))]t

        or

    T = Y[1+(.03)]t-Dt-(.03)tX.

    What this implies is that as the taxpayer's income, Y, increases by 
$1.00, his or her tax liability increases by (1.03)t, as noted in the 
text. However, if the taxpayer increases his or her itemized 
deductions, D, by $1.00, his or her reduction in tax liability is t 
dollars. Or, as stated in the text, the statutory tax rate determines 
the value of the deduction. This algebra assumes the taxpayer is not 
subject to the 80-percent limitation.
---------------------------------------------------------------------------
    The Joint Committee staff estimates that in 1998, 4.5 
million taxpayers will be subject to general limitations on 
itemized deductions. This represents 12.4 percent of the 36.4 
million taxpayers who itemize deductions, and 3.4 percent of 
all taxpayers. Because the limitation begins for taxpayers with 
AGI greater than $124,500, only rarely might taxpayers in the 
15-percent statutory marginal tax rate bracket be subject to 
the Pease provision. Some taxpayers in the 28-percent statutory 
marginal tax rate bracket, and taxpayers in 31-, 36-, and 39.6-
percent statutory marginal tax rate brackets would be subject 
to the provision. For those affected taxpayers, their effective 
marginal tax rates would be 28.84 percent, 31.93 percent, 37.08 
percent, and 40.788 percent.

Limitation on deduction for medical expenses

    The 7.5-percent of AGI floor applicable to those taxpayers 
claiming medical expense deductions creates an effective 
marginal tax rate higher than the statutory marginal tax rate 
for those taxpayers with large medical expenses. As the 
taxpayer's income increases by $1.00, the floor above which 
medical expenses may be claimed increases by 7.5 cents. That 
is, a $1.00 increase in AGI reduces medical expense deductions 
by 7.5 cents. A reduction of 7.5 cents in medical expenses 
claimed increases the taxpayer's taxable income by 7.5 cents. 
Thus, a $1.00 increase in AGI increases taxable income by 
$1.075. The taxpayer's tax liability increases by 1.075 times 
his or her statutory marginal tax rate. That is, the taxpayer's 
effective marginal tax rate equals 107.5 percent of the 
statutory marginal tax rate.21 Thus, for example, a 
taxpayer in the 15-percent statutory marginal tax rate bracket 
who also has substantial out-of-pocket medical expenses would 
have an effective marginal tax rate of 16.125 percent. As is 
the case with the general limitation on itemized deductions, 
the value of the deduction for additional out of pocket medical 
expenses is determined by the statutory tax rate.
---------------------------------------------------------------------------
    \21\ Mathematically, let Y be the taxpayer's income, M medical 
expenses, and t the taxpayer's marginal tax rate. Then the taxpayer's 
total tax liability, T, is:

    T = [Y-(M-(.075)Y)]t

        or

    T = Y[1+(.075)]t-Mt.

    What this implies is that as the taxpayer's income, Y, increases by 
$1.00, his or her tax liability increases by (1.075)t, as noted in the 
text.
---------------------------------------------------------------------------
    The Joint Committee staff estimates that in 1998, 4.5 
million taxpayers will claim medical expense deductions above 
the 7.5 percent floor and thereby will have effective marginal 
tax rates equal to 107.5 percent of their statutory marginal 
tax rate. See Table 5, below. The affected taxpayers represent 
12.4 percent of taxpayers who itemize deductions and 3.4 
percent of all taxpayers. Because there is no income threshold, 
taxpayers in all of the statutory marginal tax rate brackets 
could be affected, producing effective marginal tax rates of 
16.125 percent, 30.1 percent, 33.325 percent, 38.7 percent, and 
42.57 percent. However, taxpayers who itemize deductions are 
more prevalent in the higher statutory marginal tax rate 
brackets than in the lower statutory marginal tax rate 
brackets.

Limitation on miscellaneous itemized deductions

    The 2-percent of AGI floor applicable to those taxpayers 
claiming certain itemized deductions creates an effective 
marginal tax rate higher than the statutory marginal tax rate 
for those taxpayers with relatively large miscellaneous 
expenses. As the taxpayer's income increases by $1.00, the 
floor above which miscellaneous expenses may be claimed 
increases by 2 cents. That is, a $1.00 increase in AGI reduces 
miscellaneous itemized deductions by 2 cents. A reduction of 2 
cents in miscellaneous itemized deductions claimed increases 
the taxpayer's taxable income by 2 cents. Thus, a $1.00 
increase in AGI increases taxable income by $1.02. The 
taxpayer's tax liability increases by 1.02 times his or her 
statutory marginal tax rate. That is, the taxpayer's effective 
marginal tax rate equals 102 percent of the statutory marginal 
tax rate.22 Thus, for example, a taxpayer in the 36-
percent statutory marginal tax rate bracket who also has 
substantial out-of-pocket miscellaneous itemized deductions 
would have an effective marginal tax rate of 36.72 percent. As 
is the case with the general limitation on itemized deductions, 
the value of the deduction for additional miscellaneous 
itemized deductions is determined by the statutory tax rate.
---------------------------------------------------------------------------
    \22\ Mathematically, let Y be the taxpayer's income, M 
miscellaneous itemized deductions, and t the taxpayer's marginal tax 
rate. Then the taxpayer's total tax liability, T, is:

    T = [Y-(M-(.02)Y)]t

        or

    T = Y[1+(.02)]t-Mt.

    What this implies is that as the taxpayer's income, Y, increases by 
$1.00, his or her tax liability increases by (1.02)t, as noted in the 
text.
---------------------------------------------------------------------------
    The Joint Committee staff estimates that in 1998, 8.8 
million taxpayers will claim miscellaneous itemized deductions 
above the 2 percent of AGI floor and thereby will have 
effective marginal tax rates equal to 102 percent of their 
statutory marginal tax rates. See Table 5, below. The affected 
taxpayers represent 24.2 percent of all taxpayers who itemize 
deductions and 6.6 percent of all taxpayers. Because there is 
no income threshold, taxpayers in all of the statutory marginal 
tax rate brackets could be affected, producing effective 
marginal tax rates of 15.3 percent, 28.56 percent, 31.62 
percent, 37.72 percent, and 40.392 percent. However, taxpayers 
who itemize deductions are more prevalent in the higher 
statutory marginal tax rate brackets than in the lower 
statutory marginal tax rate brackets.

Limitation on unreimbursed casualty loss deduction

    The 10-percent of AGI floor applicable to those taxpayers 
claiming unreimbursed casualty losses deductions creates an 
effective marginal tax rate higher than the statutory marginal 
tax rate for those taxpayers with relatively large unreimbursed 
casualty losses. As the taxpayer's income increases by $1.00, 
the floor above which unreimbursed casualty loss deductions may 
be claimed increases by 10 cents. That is, a $1.00 increase in 
AGI reduces allowable casualty loss deductions by 10 cents. A 
reduction of 10 cents in miscellaneous itemized deductions 
claimed increases the taxpayer's taxable income by 10 cents. 
Thus, a $1.00 increase in AGI increases taxable income by 
$1.10. The taxpayer's tax liability increases by 1.10 times his 
or her statutory marginal tax rate. That is, the taxpayer's 
effective marginal tax rate equals 110 percent of the statutory 
marginal tax rate.23 Thus, for example, a taxpayer 
in the 28-percent statutory marginal tax rate bracket who also 
has substantial out-of-pocket miscellaneous itemized deductions 
would have an effective marginal tax rate of 30.8 percent. 
Because there is no income threshold, taxpayers in all of the 
statutory marginal tax rate brackets could be affected, 
producing effective marginal tax rates of 16.5 percent, 30.8 
percent, 34.1 percent, 39.6 percent, and 43.56 percent. 
However, taxpayers who itemize deductions are more prevalent in 
the higher statutory marginal tax rate brackets than in the 
lower statutory marginal tax rate brackets. Relatively few 
taxpayers claim unreimbursed casualty loss deductions. The 
Joint Committee staff estimates that in 1998, approximately 
200,000 taxpayers will claim unreimbursed casualty loss 
deductions. As is the case with the general limitation on 
itemized deductions, the value of the deduction for additional 
unreimbursed casualty losses is determined by the statutory tax 
rate.
---------------------------------------------------------------------------
    \23\ Mathematically, let Y be the taxpayer's income, C unreimbursed 
casualty loss deductions, and t the taxpayer's marginal tax rate. Then 
the taxpayer's total tax liability, T, is:

    T = [Y-(C-(.10)Y)]t

        or

    T = Y[1+(.10)]t-Ct.

    What this implies is that as the taxpayer's income, Y, increases by 
$1.00, his or her tax liability increases by (1.10)t, as noted in the 
text.

     Table 5.--Distribution of Taxpayers by Income of Those Who Itemize and Those Who Are Subject to Various    
                             Limitations on Itemized Deductions--Calendar Year 1998                             
----------------------------------------------------------------------------------------------------------------
                                                                Taxpayers   Taxpayers   Taxpayers               
                                                                claiming   subject to   claiming     Taxpayers  
                                                                itemized      Pease      medical      claiming  
                      Income category 1                        deductions  limitation  deductions  miscellaneous
                                                                                                     deductions 
                                                               (millions)  (millions)  (millions)    (millions) 
----------------------------------------------------------------------------------------------------------------
Less than $10,000............................................         0.1         0.0         0.0           (2) 
10,000 to 20,000.............................................         0.8         0.0         0.1           0.1 
20,000 to 30,000.............................................         2.0         0.0         0.5           0.4 
30,000 to 40,000.............................................         3.3         0.0         0.8           0.9 
40,000 to 50,000.............................................         3.9         0.0         0.7           1.0 
50,000 to 75,000.............................................         9.7         (2)         1.4           2.6 
75,000 to 100,000............................................         7.3         0.1         0.6           1.7 
100,000 to 200,000...........................................         7.3         2.5         0.3           1.6 
200,000 and over.............................................         2.0         1.9         (2)           0.4 
                                                              --------------------------------------------------
      Total, all taxpayers...................................        36.4         4.5         4.5           8.8 
----------------------------------------------------------------------------------------------------------------
1 The income concept used to place tax returns into income categories is adjusted gross income plus [1] tax     
  exempt interest, [2] employer contributions for health plans and life insurance, [3] employer share of FICA   
  tax, [4] workers' compensation, [5] nontaxable social security benefits, [6] insurance value of Medicare      
  benefits, [7] alternative minimum tax preference items, and [8] excluded income of U.S. citizens living       
  abroad. Categories are measured at 1998 levels.                                                               
2 Less than 50,000 taxpayers.                                                                                   
                                                                                                                
Detail may not add to total due to rounding.                                                                    
                                                                                                                
Source: Joint Committee on Taxation.                                                                            

                     D. Personal Exemption Phaseout

                              Present Law

    In order to determine taxable income, an individual reduces 
AGI by any personal exemptions, deductions, and either the 
applicable standard deduction or itemized deductions. Personal 
exemptions generally are allowed for the taxpayer, his or her 
spouse, and any dependents (sec. 151). For 1998, the amount 
deductible for each personal exemption is $2,700. This amount 
is indexed annually for inflation. The deduction for personal 
exemptions is phased out ratably (personal exemption phaseout, 
or ``PEP'') for taxpayers with AGI over certain thresholds. 
These thresholds of PEP are indexed annually for inflation. 
Specifically, the total amount of exemptions that may be 
claimed by a taxpayer is reduced by 2 percent for each $2,500 
(or portion thereof) by which the taxpayer's AGI exceeds the 
applicable threshold. (The phaseout rate is 2 percent for each 
$1,250 for married taxpayers filing separate returns.) Thus, 
the personal exemptions claimed are phased out over a $122,500 
range (which is not indexed for inflation), beginning at the 
applicable threshold. Under PEP, the applicable thresholds for 
1998 are $124,500 for single individuals, $186,800 for married 
individuals filing a joint return, $155,650 for heads of 
households, and $92,400 for married individuals filing separate 
returns. For 1998, the point at which a taxpayer's personal 
exemptions are completely phased out is $247,000 for single 
individuals, $309,300 for married individuals filing a joint 
return, $278,150 for heads of households, and $214,900 for 
married individuals filing separate returns.

                          Legislative History

    The Tax Reform Act of 1986 phased out the benefit of the 
15-percent bracket 24 and the personal exemptions 
for an individual, the individual's spouse, and each dependent. 
This phaseout was accomplished by the imposition of an 
additional 5-percent tax for higher-income levels. This 
created, in effect, a 33-percent marginal tax rate. This 33-
percent marginal tax rate terminated and the 28-percent bracket 
resumed after the benefits of the 15-percent bracket and the 
personal exemptions claimed by each taxpayer had been phased 
out.25
---------------------------------------------------------------------------
    \24\ Under the Tax Reform Act of 1986, the individual income tax 
rates were 15 and 28 percent.
    \25\ This provision was commonly referred to as ``the bubble'.
---------------------------------------------------------------------------
    The Omnibus Budget Reconciliation Act of 1990 (``OBRA 
1990'') repealed the additional 5-percent tax and imposed an 
explicit 31-percent marginal tax rate after the 15- and 28-
percent marginal tax rates. Also, OBRA 1990 provided that after 
1990, the deduction for personal exemptions would be phased-out 
as the taxpayer's adjusted gross income exceeded a threshold 
amount. The threshold amount was $150,000 for joint returns, 
$125,000 for head of household, $100,000 for single taxpayers, 
and $75,000 for a married person filing a separate return. The 
length of the phaseout range for all tax returns was $122,500. 
The threshold amounts but not the length of the phaseout range 
were to be indexed for inflation beginning in 1992. Under OBRA 
1990, PEP would have sunset for taxable years beginning on or 
after January 1, 1996.
    The Unemployment Compensation Amendments of 1992 delayed 
the sunset of the PEP so that the phaseout would not apply to 
taxpayers for taxable years beginning on or after January 1, 
1997. The Omnibus Budget Reconciliation Act of 1993 (``OBRA 
1993'') repealed the PEP sunset.

                                Analysis

    The personal exemption phaseout increases effective 
marginal tax rates for those affected taxpayers. The personal 
exemption phaseout operates by reducing the amount of each 
personal exemption that the taxpayer may claim by two percent 
for each $2,500 (or portion thereof) by which the taxpayer's 
income exceeds the designated threshold for his or her filing 
status. Thus, for a taxpayer who is subject to the personal 
exemption phaseout, earning an additional $2,500 will reduce 
the amount of each personal exemption he or she may claim by 
two percent, or by $54 in 1998 (0.02 times the $2,700 personal 
exemption). The taxpayer's additional taxable income is thus 
equal to the $2,500 plus the $54 in denied exemption for each 
personal exemption. For a taxpayer in the 36-percent statutory 
marginal tax rate bracket, the effective marginal tax rate on 
the additional $2,500 of income equals the statutory 36 percent 
plus an additional 0.78 percent ($54 times the statutory rate 
of 0.36, divided by the $2,500 in incremental income) for each 
personal exemption. Thus, if this taxpayer claims four personal 
exemptions, his or her effective marginal tax rate is 39.1 
percent (the statutory 36-percent rate plus four times 0.78 
percent). More generally, for 1998 the taxpayer's effective 
marginal tax rate equals the taxpayer's statutory marginal rate 
multiplied by one plus the product of 2.16 percentage points 
(the $54 in denied personal exemption divided by the 
incremental $2,500 in income) multiplied by the number of 
personal exemptions claimed by the taxpayer.26 Thus, 
a taxpayer who claims five personal exemptions would have an 
effective marginal tax rate approximately 110.5 percent of the 
statutory marginal tax rate.
---------------------------------------------------------------------------
    \26\ Mathematically, let Y be income, T tax liability, t the 
taxpayer's statutory marginal tax rate, E the number of personal 
exemptions, and I the income threshold. In the absence of the phaseout, 
the taxpayer's tax liability may be represented as follows.

        (1) T = (Y-(2,700E)) t = Yt-(2,700E) t

        For a taxpayer with income over the threshold amount, I, the 
taxpayer's tax liability is

        T = (Y-((2,700E)  (1-(Y-I)/2,500)  
.02)) t

        This simplifies to

        (2) T = Y  t  (1 + (.0216)E)-54Et-(.0216)It
    Thus the effective marginal tax rate for a taxpayer in the phaseout 
range is one plus 2.16 percentage points multiplied by the number of 
personal exemptions claimed, all multiplied by the taxpayer's statutory 
marginal tax rate.
    This formula simplifies present law by representing the phaseout as 
a linear function. The phaseout is actually a step function. That is, 
the first dollar of income in the phaseout range causes the taxpayer to 
lose two percent of his or her personal exemptions. That is, the first 
dollar causes the taxpayer's taxable income to increase by the $1.00 of 
additional income plus $54 times the number of personal exemptions. The 
second dollar of income in the phaseout range has no further 
incremental effect. Thus the effective marginal tax rate on the second 
dollar through the 2,500th dollar is the taxpayer's statutory marginal 
tax rate and the marginal tax rate on the first dollar generally is 
5,500 percent of the taxpayer's statutory marginal tax rate for a 
taxpayer claiming one personal exemption, and 10,900 percent of the 
taxpayer's statutory marginal tax rate for a taxpayer claiming two 
personal exemptions. In general, the marginal tax rate on the first 
dollar is a percentage of statutory marginal tax rate equal to 100 + 
540 times the number of personal exemptions claimed by the taxpayer. 
This same result occurs at the first dollar of income after each 
multiple of $2,500.
---------------------------------------------------------------------------
    The Joint Committee staff estimates that in 1998, 1.4 
million taxpayers will be subject to PEP. See Table 6. This 
represents 1.0 percent of all taxpayers. Because the phase-out 
is completed by an AGI of $247,000 for single taxpayers and 
$309,300 for joint filers, generally no taxpayers in the 39.6-
percent statutory bracket would be affected. Because the 
phaseout-range begins at an AGI of $124,500 for single 
taxpayers, $155,650 for heads of households, and $186,800 for 
joint filers, generally few taxpayers in the 15- or 28-percent 
statutory marginal tax rate bracket would be expected to be 
subject to the phaseout. For single taxpayers (one personal 
exemption) the provisions would increase the 31-percent and 36-
percent statutory marginal tax rate bracket to effective 
marginal tax rates of 31.67 percent and 36.78 percent. For 
heads of households and joint filers (assuming only two 
personal exemptions) the corresponding effective marginal tax 
rates would be 32.34 percent and 37.56 percent.

      Table 6.--Distribution by Income of Taxpayers Claiming Personal   
    Exemptions and Those Subject to the Personal Exemption Phaseout--   
                           Calendar Year 1998                           
------------------------------------------------------------------------
                                                             Taxpayers  
                                             Taxpayers    subject to the
                                             claiming        personal   
           Income category \1\               personal        exemption  
                                            exemptions       phaseout   
                                            (millions)      (millions)  
------------------------------------------------------------------------
Less than $10,000.......................            19.8             0.0
10,000 to 20,000........................            25.1             0.0
20,000 to 30,000........................            20.3             0.0
30,000 to 40,000........................            16.3             0.0
40,000 to 50,000........................            12.4             0.0
50,000 to 75,000........................            19.6             0.0
75,000 to 100,000.......................            10.0             0.0
100,000 to 200,000......................             8.5             0.3
200,000 and over........................             2.2             1.1
                                         -------------------------------
      Total, all taxpayers..............           134.1             1.4
------------------------------------------------------------------------
\1\ The income concept used to place tax returns into income categories 
  is adjusted gross income plus [1] tax exempt interest, [2] employer   
  contributions for health plans and life insurance, [3] employer share 
  of FICA tax, [4] workers' compensation, [5] nontaxable social security
  benefits, [6] insurance value of Medicare benefits, [7] alternative   
  minimum tax preference items, and [8] excluded income of U.S. citizens
  living abroad. Categories are measured at 1998 levels.                
                                                                        
Detail may not add to total due to rounding.                            
                                                                        
Source: Joint Committee on Taxation.                                    

                E. Phaseout of the Earned Income Credit

                              Present Law

    The earned income credit (``EIC'') is available to low-
income working taxpayers. Three separate schedules apply.
    Taxpayers with one qualifying child may claim a credit in 
1998 of 34 percent of their earnings up to $6,680, resulting in 
a maximum credit of $2,271. The maximum credit is available for 
those with earnings between $6,680 and $12,260. At $12,260 of 
earnings (or modified AGI, if greater) the credit begins to 
phase down at a rate of 15.98 percent of the amount of earnings 
(or modified AGI, if greater) above that amount. The credit is 
phased down to $0 at $26,473 of earnings (or modified AGI, if 
greater).
    Taxpayers with more than one qualifying child may claim a 
credit in 1998 of 40 percent of earnings up to $9,390, 
resulting in a maximum credit of $3,756. The maximum credit is 
available for those with earnings between $9,390 and $12,260. 
At $12,260 of earnings (or modified AGI, if greater) the credit 
begins to phase down at a rate of 21.06 percent of earnings (or 
modified AGI, if greater) above that amount. The credit is 
phased down to $0 at $30,095 of earnings (or modified AGI, if 
greater).
    Taxpayers with no qualifying children may claim a credit if 
they are over age 24 and below age 65. The credit is 7.65 
percent of earnings up to $4,460, resulting in a maximum credit 
of $341. The maximum is available for those with incomes 
between $4,460 and $5,570. At $5,570 of earnings (or modified 
AGI, if greater), the credit begins to phase down at rate of 
7.65 percent of earnings (or modified AGI, if greater) above 
that amount, resulting in a $0 credit at $10,030.
    All income thresholds are indexed for inflation annually.
    In order to be a qualifying child, an individual must 
satisfy a relationship test, a residency test, and an age test. 
The relationship test requires that the individual be a child, 
a stepchild, a descendant of a child, or a foster or adopted 
child of the taxpayer. The residency test requires that the 
individual have the same place of abode as the taxpayer for 
more than half the taxable year. The household must be located 
in the United States. The age test requires that the individual 
be under 19 (24 for a full-time student) or be permanently and 
totally disabled.
    An individual is not eligible for the earned income credit 
if the aggregate amount of ``disqualified income'' of the 
taxpayer for the taxable year exceeds $2,200. This threshold is 
indexed. Disqualified income is the sum of:
          (1) Interest (taxable and tax-exempt);
          (2) Dividends;
          (3) Net rent and royalty income (if greater than 
        zero);
          (4) Capital gain net income; and
          (5) Net passive income (if greater than zero) that is 
        not self-employment income.
    For taxpayers with earned income (or modified AGI, if 
greater) in excess of the beginning of the phaseout range, the 
maximum earned income credit amount is reduced by the phaseout 
rate multiplied by the amount of earned income (or modified 
AGI, if greater) in excess of the beginning of the phaseout 
range. For taxpayers with earned income (or modified AGI, if 
greater) in excess of the end of the phaseout range, no credit 
is allowed.
    The definition of modified AGI used for phasing out the 
earned income credit disregards certain losses. The losses 
disregarded are:
          (1) Net capital losses (if greater than zero);
          (2) Net losses from trusts and estates;
          (3) Net losses from nonbusiness rents and royalties; 
        and
          (4) 75 percent of the net losses from businesses, 
        computed separately with respect to sole 
        proprietorships (other than in farming), sole 
        proprietorships in farming, and other businesses.
    The definition of modified AGI also includes:
          (1) Tax-exempt interest; and
          (2) Non-taxable distributions from pensions, 
        annuities, and individual retirement accounts (but only 
        if not rolled over into similar vehicles during the 
        applicable rollover period).
    Individuals are not eligible for the credit if they do not 
include their taxpayer identification number and their 
qualifying child's number (and, if married, their spouse's 
taxpayer identification number) on their tax return. Solely for 
these purposes and for purposes of the present-law 
identification test for a qualifying child, a taxpayer 
identification number is defined as a Social Security number 
issued to an individual by the Social Security Administration 
other than a number issued under section 205(c)(2)(B)(i)(II) 
(or that portion of sec. 205(c)(2)(B)(i)(III) relating to it) 
of the Social Security Act (regarding the issuance of a number 
to an individual applying for or receiving federally funded 
benefits).
    If an individual fails to provide a correct taxpayer 
identification number, such omission will be treated as a 
mathematical or clerical error. If an individual who claims the 
credit with respect to net earnings from self-employment fails 
to pay the proper amount of self-employment tax on such net 
earnings, the failure will be treated as a mathematical or 
clerical error for purposes of the amount of credit allowed.
    The EIC is a refundable tax credit; i.e., if the amount of 
the credit exceeds the taxpayer's Federal income tax liability, 
the excess is payable to the taxpayer as a direct transfer 
payment.
    Under an advance payment system (available since 1979), 
eligible taxpayers may elect to receive the benefit of the 
credit in their periodic paychecks, rather than waiting to 
claim a refund on their return filed by April 15 of the 
following year. In 1993, Congress required that the IRS begin 
to notify eligible taxpayers of the advance payment option.

                          Legislative History

    The EIC was enacted in 1975 as a means of targeting tax 
relief to working low-income taxpayers with children, providing 
relief from the Social Security payroll tax for these 
taxpayers, and improving incentives to work. As originally 
enacted, the credit equaled 10 percent of the first $4,000 of 
earned income (i.e., a maximum credit of $400). The credit 
began to be phased out for taxpayers with earned income (or 
AGI, if greater) above $4,000, and was entirely phased out for 
taxpayers with income of $8,000.
    The Revenue Act of 1978 increased the maximum credit to 
$500 (10 percent of the first $5,000 of earned income). Also, 
the income level at which the phaseout began was raised to 
$6,000, with a complete phaseout not occurring until an income 
level of $10,000. The Deficit Reduction Act of 1984 increased 
the maximum credit to $550 (11 percent of the first $5,000 of 
earned income) and the credit was phased out beginning at 
$6,500 of income and ending at $11,000.
    The Tax Reform Act of 1986 increased the maximum credit to 
$800 (14 percent of the first $5,714 of earned income), 
beginning in 1987. The maximum credit was reduced by 10 cents 
for each dollar of earned income (or AGI, if greater) in excess 
of $9,000 ($6,500 in 1987). These $5,714 and $9,000 amounts 
(stated above in 1985 dollars) were indexed for inflation.
    The Omnibus Budget Reconciliation Act of 1990 (``OBRA 
1990'') substantially increased the maximum amount of the basic 
credit and added an adjustment to reflect family size. OBRA 
1990 also created two additional credits as part of the EIC: 
the supplemental young child credit and the supplemental health 
insurance credit. Both of these supplemental credits used the 
same base as the basic EIC.
    OBRA 1990 also modified the definition of taxpayers 
eligible for the EIC. Under prior law, taxpayers were required 
to file a joint return or file as a head of household or 
surviving spouse in order to be eligible for the EIC. OBRA 1990 
generally broadened the set of eligible taxpayers and set out 
uniform requirements for qualifying children. The definition of 
``qualifying child'' enacted in OBRA 1990 is described in the 
present-law section.
    The Omnibus Budget Reconciliation Act of 1993 (``OBRA 
1993'') expanded the EIC in several ways. For taxpayers with 
one qualifying child, the EIC was increased to 26.3 percent of 
the first $7,750 of earned income in 1994. For 1995 and 
thereafter, the credit rate was increased to 34 percent. In 
1995, the maximum amount of earned income on which the credit 
could be claimed is $6,160 (this is a $6,000 base in 1994, 
adjusted for inflation). The phaseout rate for 1994 and 
thereafter is 15.98 percent.
    For taxpayers with two or more qualifying children, the EIC 
was increased to 30 percent of the first $8,425 of earned 
income in 1994. The maximum credit for 1994 was $2,527 and was 
reduced by 17.68 percent of earned income (or AGI, if greater) 
in excess of $11,000. The credit rate increases over time and 
equals 36 percent for 1995 and 40 percent for 1996 and 
thereafter. The phaseout rate is 20.22 percent for 1995 and 
21.06 percent for 1996 and thereafter.
    OBRA 1993 also extended the EIC to taxpayers with no 
qualifying children. This credit for taxpayers with no 
qualifying children is available to taxpayers over age 24 and 
below age 65. Finally, OBRA 1993 repealed the supplemental 
young child credit and the supplemental health insurance 
credit.
    The implementing legislation for the General Agreements on 
Tariffs and Trade, enacted in 1994, made a number of 
modifications to the EIC. First, it denied the EIC to inmates 
for any amount received for services provided by the inmate in 
a penal institution. Second, it generally made nonresident 
aliens ineligible to claim the EIC. Third, it deemed that a 
member of the Armed Forces stationed outside the United States 
while serving on extended active duty would satisfy the test 
that the principal place of abode be within the United States. 
Fourth, it required that members of the Armed Forces receive 
annual reports from the Department of Defense of earned income 
(which includes nontaxable earned income such as amounts 
received as basic allowances for housing and subsistence). 
Fifth, it required a TIN for each qualifying child regardless 
of the dependent's age. Prior to the legislation, taxpayers had 
to provide a TIN only for qualifying children who attained the 
age of one before the close of the taxpayer's taxable year.
    Under the Self-Employed Person's Health Care Reduction 
Extension Act of 1995, effective for taxable years beginning 
after December 31, 1995, a taxpayer is not eligible for the EIC 
if the aggregate amount of disqualified income (i.e., taxable 
and tax-exempt interest, dividends, and (if greater than zero) 
net rent and royalty income) of the taxpayer for the taxable 
year exceeds $2,350 (``the disqualified income test'').
    The Personal Responsibility and Work Opportunity 
Reconciliation Act of 1996 included several changes to the EIC. 
First, it modified the disqualified income test by adding 
capital gain net income and net passive income (if greater than 
zero) that is not self-employment income to the definition of 
disqualified income, and by reducing the threshold above which 
an individual is not eligible for the EIC from $2,350 to $2,200 
(indexed for inflation). Second, it modified the definition of 
AGI used for phasing out the earned income credit by 
disregarding certain losses. The losses disregarded are: (1) 
net capital losses (if grater than zero); (2) net loses from 
trusts and estates; (3) net losses from nonbusiness rents and 
royalties; and (4) 50 percent of the net losses from 
businesses, computed separately with respect to sole 
proprietorships (other than in farming), sole proprietorships 
in farming, and other businesses. Third, it applied 
mathematical and clerical error treatment to the failure to 
provide a correct Social Security Number (``SSN'') or to pay 
the proper amount of self-employment tax on net self-employment 
earnings on which an EIC is claimed. Finally, it denied the EIC 
to individuals whose SSNs were issued solely for purposes of 
the individual applying for or receiving Federally funded 
benefits.
    The Taxpayer Relief Act of 1997 also included provisions to 
improve compliance. The provisions: (1) deny the EIC for 10 
years to taxpayers who fraudulently claimed the EIC (2 years 
for EIC claims which are a result of reckless or intentional 
disregard of rules or regulations); (2) require EIC 
recertification for a taxpayer who is denied the EIC; (3) 
imposes due diligence requirements on paid preparers of returns 
involving the EIC, (4) requires information sharing between the 
Treasury Department and State and local governments regarding 
child support orders, and (5) allows expanded use of Social 
Security Administration records to enforce the tax laws 
including the EIC.
    The Balanced Budget Act of 1997 also increased the IRS 
authorization to improve enforcement of the EIC.

                                Analysis

    The earned income credit, though designed to encourage 
labor supply, also paradoxically increases the effective 
marginal tax rates of taxpayers in the phase-out range of the 
credit. Below the level of earned income where a recipient 
would be eligible for the maximum credit--the phase-in range of 
the credit--the credit rate can be thought of as equivalent to 
a negative marginal tax rate of the same magnitude, because the 
taxpayer is entitled to a cash payment equal to the credit rate 
times earned income. In this phase-in range, each additional 
amount of earned income will cause the recipient to receive an 
increase in the credit. As discussed above, the credit is 
phased in at rates of 7.65 percent, 34 percent, or 40 percent 
of earnings, depending on whether the taxpayer has no 
qualifying children, one qualifying child, or two or more 
qualifying children. For taxpayers in the phase-in ranges, the 
EIC thus represents a negative marginal tax rate of 7.65 
percent, 34 percent, or 40 percent, as each additional dollar 
of earnings will lead to an increase in the credit by the above 
percentages of additional earnings.
    Once the maximum amount of the credit is fully phased in, 
there is a range of additional earnings where the credit will 
remain unchanged before the start of the phase-out range. 
Within this range, the taxpayer's marginal tax rate equals the 
statutory rate, which in all cases will be zero percent, since 
the top of this range is less than the sum of the standard 
deduction and the amount of personal exemptions that could be 
claimed. Once additional earnings cause the taxpayer's modified 
adjusted gross income to hit the phase-out range, the credit 
begins to phase out. Several phase-out ranges exist for the 
EIC, depending on whether the taxpayer has one, two, or no 
qualifying children. The phase-out rates and ranges are 
discussed above. For those in the phase-out ranges, the 
increase in the effective marginal tax rate is exactly 
equivalent to the phase-out rate, as the phaseout of a credit 
is the equivalent of a direct tax increase of the same 
magnitude. Thus, for taxpayers in the phase-out range, the 
increase in the effective marginal tax rates on additional 
increases in modified adjusted gross income are 15.98 percent, 
21.06 percent, or 7.65 percent, depending on whether the 
taxpayer has one, two, or no qualifying children.
    Taxpayers in the phase-out range would also be subject to 
the normal Federal income tax liability on any additional 
income itself. Because the phase-out range occurs at relatively 
low levels of income, the highest statutory marginal tax rate 
such taxpayers will face will be 15 percent. Some taxpayers 
affected by the phaseout might still face a 0 percent statutory 
Federal marginal tax rate if their total income is less than 
their standard deduction plus the value of their personal 
exemptions. Thus the maximum effective marginal tax rate faced 
by taxpayers in the phase-out range will be 15 percent plus the 
applicable phase-out rate of 7.65 percent, 15.98 percent or 
21.06 percent, for effective marginal tax rates of 22.65 
percent, 30.98 percent, or 36.06 percent.
    The phaseout of the credit exists in order to target the 
credit to lower-income workers. Eliminating the phaseout would 
effectively give the credit to all workers, and would have a 
significant budgetary cost. Also, it would be easier to 
decrease Social Security taxes to accomplish the same result. 
Extending the phase-out ranges would lower the increase in 
effective marginal tax rates caused by the phaseout, but would 
correspondingly cause the program to become substantially more 
expensive.
    In addition to the phaseout of the EIC discussed above, one 
can also lose eligibility for any credit if disqualified income 
(defined above) exceeds $2,200. This eligibility criterion 
represents an infinite marginal tax rate for taxpayers who are 
otherwise qualified for the EIC but who earn an additional 
dollar of disqualified income that pushes them into 
ineligibility. For example, a taxpayer with 2 qualifying 
children, $10,000 in wage income, and $2,200 in disqualified 
income is eligible for the maximum EIC of $3,756. If this 
taxpayer should earn an additional dollar of disqualified 
income, and thus have $2,201 in disqualified income, they would 
lose all their EIC benefits.\27\
---------------------------------------------------------------------------
    \27\ Technically, the rate is not infinite--earning an additional 
dollar and losing $3,756 of benefits represents a rate of 376,500 
percent. Only if we measured incremental income in smaller amounts than 
a penny would the rate approach an infinite one, as the full credit 
could be lost for infinitesimally small increments to income.
---------------------------------------------------------------------------
    As shown in table 7, the Joint Committee staff estimates 
that, in 1998, 19.1 million taxpayers will claim EIC benefits. 
Of those, 4.4 million, or 8.7 percent of all taxpayers, will be 
in the phase-in range of the benefits, and 11.7 million, or 3.2 
percent of all taxpayers, will be in the phase-out ranges (the 
remaining 3.0 million will have incomes where an additional 
dollar of income will have no effect on their EIC). Due to the 
low levels of the phase-in ranges, no taxpayers in the phase-in 
ranges would have sufficient income to be in the 15-percent 
marginal tax rate bracket, but rather would be in the 0-percent 
bracket. In the phase-out ranges, taxpayers would be in either 
the 15-percent bracket or the 0-percent bracket. Figures 1-3 
show the effective marginal tax rates (combining the federal 
rates with the EIC phase-in or phaseout) for EIC recipients of 
various qualifying circumstances and income levels.

Table 7.--Distribution by Income of Taxpayers Claiming the Earned Income
           Credit and Those in the Phase-In and Phaseout Range          
                          [Calendar year 1998]                          
------------------------------------------------------------------------
                                                 Taxpayers    Taxpayers 
                                    Taxpayers    in earned    in earned 
                                     claiming      income       income  
       Income category \1\            earned       credit       credit  
                                      income      phase-in     phaseout 
                                      credit       range        range   
                                    (millions)   (millions)   (millions)
------------------------------------------------------------------------
Less than $10,000................          4.8          3.0          1.0
10,000 to 20,000.................          6.7          1.1          3.7
20,000 to 30,000.................          5.3          0.2          4.8
30,000 to 40,000.................          2.1          0.1          2.0
40,000 to 50,000.................          0.2        (\2\)          0.1
50,000 to 75,000.................        (\2\)        (\2\)        (\2\)
75,000 to 100,000................          0.0          0.0          0.0
100,000 to 200,000...............          0.0          0.0          0.0
200,000 and over.................          0.0          0.0          0.0
                                  --------------------------------------
      Total, all taxpayers.......         19.1          4.4         11.7
------------------------------------------------------------------------
\1\ The income concept used to place tax returns into income categories 
  is adjusted gross income plus [1] tax exempt interest, [2] employer   
  contributions for health plans and life insurance, [3] employer share 
  of FICA tax, [4] workers' compensation [5] nontaxable social security 
  benefits, [6] insurance value of Medicare benefits, [7] alternative   
  minimum tax preference items, and [8] excluded income of U.S. citizens
  living abroad. Categories are measured at 1998 levels.                
\2\ Less than 50,000 taxpayers.                                         
                                                                        
Detail may not add to total due to rounding.                            
                                                                        
Source: Joint Committee on Taxation.                                    

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[GRAPHIC] [TIFF OMITTED] TCP03.043

                    F. Phaseout of Child Tax Credit

                              Present Law

In general

    Present law provides a $500 ($400 for taxable year 1998) 
tax credit for each qualifying child under the age of 17. A 
qualifying child is defined as an individual for whom the 
taxpayer can claim a dependency exemption and who is a son or 
daughter of the taxpayer (or a descendent of either), a stepson 
or stepdaughter of the taxpayer or an eligible foster child of 
the taxpayer.

Phase-out range

    For taxpayers with modified AGI in excess of certain 
thresholds, the otherwise allowable child credit is phased out. 
Specifically, the otherwise allowable child credit is reduced 
by $50 for each $1,000 of modified AGI (or fraction thereof) in 
excess of the threshold (``the modified AGI phase-out''). For 
these purposes modified AGI is computed by increasing the 
taxpayer's AGI by the amount otherwise excluded from gross 
income under Code sections 911, 931, or 933 (relating to the 
exclusion of income of U.S. citizens or residents living 
abroad; residents of Guam, American Samoa, and the Northern 
Mariana Islands; and residents of Puerto Rico, respectively). 
For married taxpayers filing joint returns, the threshold is 
$110,000. For taxpayers filing single or head of household 
returns, the threshold is $75,000. For married taxpayers filing 
separate returns, the threshold is $55,000. These thresholds 
are not indexed for inflation. The length of the phase-out 
range is affected by the number of the taxpayer's qualifying 
children. In 1998, the length of the phaseout range is $8,000 
28 of modified AGI for each qualifying child. For 
example, in 1998 the phase-out range for a single person with 
one qualifying child will be between $75,000 and $83,000 of 
modified AGI. The phase-out range for a single person with two 
qualifying children will be between $75,000 and $91,000 of 
modified AGI in 1998.
---------------------------------------------------------------------------
    \28\ $10,000 of modified AGI per qualifying child in 1999 and 
thereafter.
---------------------------------------------------------------------------

Tax liability limitation; refundable credits

    In general, the amount of the child credit, together with 
the other nonrefundable personal credits, is limited to the 
excess of the taxpayer's regular tax over the taxpayer's 
tentative minimum tax (determined without regard to the 
alternative minimum tax foreign tax credit) (sec. 26(a)).
    In the case of an individual with three or more qualifying 
children, the taxpayer also may be allowed a refundable child 
credit (sec. 24(d)).29 The amount of the refundable 
child credit is the amount that the nonrefundable personal 
credits would increase if the tax liability limitation of 
section 26(a) were increased by the excess of the taxpayer's 
social security taxes over the taxpayer's earned income credit 
(if any).30 The amount of the refundable child 
credit is limited to the amount of the child credit allowable 
under section 24, determined without regard to section 26(a). 
Social security taxes means the individual's share of FICA 
taxes and one-half of the SECA tax liability. The amount of the 
refundable child credit is reduced by the amount of the 
alternative minimum tax imposed by section 55 that did not 
result in a reduction of the earned income credit under section 
32(h).
---------------------------------------------------------------------------
    \29\ The provision is described as set forth in the Tax Technical 
Corrections Act of 1997, Title VI (sec. 603(a)) of H.R. 2676, as passed 
by the House on November 5, 1997.
    \30\ For this purpose, the earned income credit is determined 
without regard to the supplemental earned income credit discussed 
below.
---------------------------------------------------------------------------
    The amount of the refundable child credit under section 
24(d) will reduce the amount of the nonrefundable child credit 
(determined without regard to section 26). This will result in 
the proper calculation of personal credit carryovers.

Supplemental child credit

    Part or all of the child credit may be treated as a 
supplemental child credit under the earned income credit (sec. 
32(n)).31 The amount treated as a supplemental child 
credit under section 32(n) reduces the amount of the child 
credit under section 24, but does not change the total amount 
of child credits allowed and has no effect on determining the 
amount of any other credit for any taxable year.
---------------------------------------------------------------------------
    \31\ The provision is described as set forth in the Tax Technical 
Corrections Act of 1997, Title VI (sec. 603(b)) of H.R. 2676, as passed 
by the House on November 5, 1997.
---------------------------------------------------------------------------
    The amount of the supplemental child credit is the amount 
by which the personal credits would be reduced if the section 
26(a) tax liability limitation were reduced by an amount equal 
to the excess of the taxpayer's earned income credit (without 
regard to the supplemental child credit) over the taxpayer's 
social security taxes (as defined above). The amount of the 
supplemental child credit cannot exceed the amount of the 
nonrefundable child credit under section 24, determined without 
regard to the tax liability limitation of section 26. The 
eligibility provisions of section 32 are disregarded in 
determining the amount of supplemental child credit that is 
allowed to the taxpayer.

                          Legislative History

    The child credit was enacted in the Taxpayer Relief Act of 
1997.

                                Analysis

    The phaseout of the child credit is structured in such a 
way that it has a fairly simple effect on effective marginal 
tax rates. Each dollar of credit lost represents an increase in 
the taxpayer's total tax liability. Because the credit itself 
is phased out at a rate of $50 per every $1,000 increase in 
modified adjusted gross income over the specified threshold, 
the phaseout adds 5 percentage points ($50/$1,000) to the 
statutory marginal tax rate for all taxpayers affected by the 
phaseout.32 Thus a taxpayer in the 28 percent 
bracket who is in the phaseout range faces an effective 
marginal tax rate of 33 percent. Because the phaseout range is 
flexible--only the starting threshold is specified--the total 
size of child credits does not affect the rate at which the 
credit is phased out, but only affects the length of the 
phaseout range. Hence the larger the total credit the longer is 
the phaseout range, but the rate of the phaseout remains at $50 
per every $1,000 increase in modified adjusted gross income 
over the specified threshold until the entire credit is phased 
out. The total length of the phaseout range per eligible child 
is $8,000 for 1998 and $10,000 for 1999.
---------------------------------------------------------------------------
    \32\ Mathematically, where Y denotes income, C denotes the size of 
the child credit (assumed to be $400 in this example), I denotes the 
beginning of the phaseout range, and t denotes the statutory marginal 
tax rate, the taxpayer's total tax liability, T, is given by the 
following expression:

        (1) T = Yt-C, where

        C = Max(0, $400-$50  (Y-I)/1000)

    Substituting the expression for C into (1) for taxpayers in the 
phaseout range yields:

        (2) T = Yt-400 + .05 (Y-I)

    Hence, if Y goes up by $1, T rises by t + .05
---------------------------------------------------------------------------
    Technically, the phaseout of the credit works in steps, and 
the first dollar of income over the threshold will cause the 
credit to decline by $50. The next $999 in income would have no 
further effect on the credit, but the next dollar would cause 
the credit to fall by another $50. As income crosses the 
threshhold points, the effective marginal tax rate is 
infinite.33 As income increases between the 
thresholds, the effective marginal tax rate is the statutory 
marginal tax rate. For changes in income that are larger than 
$1,000, the average effective marginal tax rate will be 
approximately 5 percentage points above the statutory rate.
---------------------------------------------------------------------------
    \33\ Technically, the rate is not infinite--earning an additional 
dollar and losing $50 in child credits represents a rate of 5,000 
percent. Only if we measured incremental income in smaller amounts than 
a penny would the rate approach an infinite one, as $50 in credits 
could be lost for infinitesimally small increments to income if it 
caused total income to cross a threshold point.
---------------------------------------------------------------------------
    As shown in table 8, below, the Joint Committee staff 
estimates that, in 1998, only 0.6 million taxpayers, or less 
than one-half of one percent of all taxpayers, are in the 
phase-out ranges for the child credit out of a total of 27.1 
million taxpayers claiming the credit. Because the phase-out 
ranges occur at relatively high income levels, most taxpayers 
in the phase-out ranges will be in the 28 percent marginal tax 
rate bracket or higher.

 Table 8.--Distribution by Income of Taxpayers Claiming Child Tax Credit
                       and Those in Phaseout Range                      
                          [Calendar year 1998]                          
------------------------------------------------------------------------
                                             Taxpayers                  
                                          claiming child   Taxpayers in 
           Income category \1\              tax credit    phaseout Range
                                            (millions)       (millions) 
------------------------------------------------------------------------
Less than $10,000.......................         ( \2\ )             0.0
10,000 to 20,000........................             1.8             0.0
20,000 to 30,000........................             3.8             0.0
30,000 to 40,000........................             4.2             0.0
40,000 to 50,000........................             3.4             0.0
50,000 to 75,000........................             7.3         ( \2\ )
75,000 to 100,000.......................             4.4             0.1
100,000 to 200,000......................             2.1             0.5
200,000 and over........................         ( \2\ )         ( \2\ )
                                         -------------------------------
      Total, all taxpayers..............            27.1             0.6
------------------------------------------------------------------------
\1\ The income concept used to place tax returns into income categories 
  is adjusted gross income plus [1] tax exempt interest, [2] employer   
  contributions for health plans and life insurance, [3] employer share 
  of FICA tax, [4] workers' compensation [5] nontaxable social security 
  benefits, [6] insurance value of Medicare benefits, [7] alternative   
  minimum tax preference items, and [8] excluded income of U.S. citizens
  living abroad. Categories are measured at 1998 levels.                
\2\ Less than 50,000 taxpayers.                                         
                                                                        
Detail may not add to total due to rounding.                            
                                                                        
Source: Joint Committee on Taxation.                                    

          G. Partial Phaseout of the Dependent Care Tax Credit

                              Present Law

    A taxpayer may claim a nonrefundable credit against income 
tax liability for up to 30 percent of a limited amount of 
employment-related dependent care expenses. Eligible 
employment-related expenses are limited to $2,400 if there is 
one qualifying dependent or $4,800 if there are two or more 
qualifying dependents. Generally, a qualifying individual is a 
dependent under the age of 13 or a physically or mentally 
incapacitated dependent or spouse. In addition, no credit is 
allowed for any qualifying individual unless a valid taxpayer 
identification number (TIN) has been provided for that 
individual.
    Employment-related dependent care expenses are expenses for 
the care of a qualifying individual incurred to enable the 
taxpayer to be gainfully employed, other than expenses incurred 
for an overnight camp. For example, amounts paid for the 
services of a housekeeper generally qualify if such services 
are performed at least partly for the benefit of a qualifying 
individual; amounts paid for a chauffeur or gardener do not 
qualify.
    Expenses that may be taken into account in computing the 
credit generally may not exceed an individual's earned income 
or, in the case of married taxpayers, the earned income of the 
spouse with the lesser earnings. Thus, if one spouse is not 
working, no credit generally is allowed. Also, the amount of 
expenses eligible for the dependent care credit is reduced, 
dollar for dollar, by the amount of expenses excludable from 
that taxpayer's income under the dependent care exclusion.
    The 30-percent credit rate is reduced, but not below 20 
percent, by 1 percentage point for each $2,000 (or fraction 
thereof) of adjusted gross income (AGI) above $10,000. Thus, 
the credit is never completely phased-out for higher-income 
individuals. Because married couples are required to file a 
joint return to claim the credit, a married couple's combined 
AGI is used for purposes of this computation.

                          Legislative History

    The Internal Revenue Code of 1954 provided a deduction to 
gainfully employed women, widowers, and legally separated or 
divorced men for certain employment-related dependent care 
expenses. The deduction was limited to $600 per year and phased 
out for families with incomes between $4,500 and $5,100.
    The Revenue Act of 1964 made husbands with incapacitated 
wives eligible for the dependent care deduction and raised the 
threshold for the income phaseout from $4,500 to $6,000.
    The Revenue Act of 1971: (1) made any individual who 
maintained a household and was gainfully employed eligible for 
the deduction; (2) modified the definition of a dependent; (3) 
raised the deduction limit to $4,800 per year; (4) increased 
from $6,000 to $18,000 the income level at which the deduction 
began to phase out; (5) allowed the deduction for household 
services in addition to direct dependent care; and (6) limited 
the deduction with respect to services outside the taxpayer's 
household.
    The Tax Reduction Act of 1975 increased from $18,000 to 
$35,000 the income level at which the deduction began to be 
phased out.
    The Tax Reform Act of 1976 replaced the deduction with a 
nonrefundable credit. This change broadened eligibility to 
those who do not itemize deductions and provided relatively 
greater benefit to low-income taxpayers. In addition, the Act 
eased the rules related to family status and simplified the 
computation.
    In the Economic Recovery Tax Act of 1981, Congress provided 
a higher ceiling on creditable expenses, a larger credit for 
low-income individuals, and modified rules relating to care 
provided outside the home.
    The Family Support Act of 1988 reduced to 13 the age of a 
child for whom the dependent care credit may be claimed, 
reduced the amount of eligible expenses by the amount of 
expenses excludable from that taxpayer's income under the 
dependent care exclusion, lowered from 5 to 2 the age at which 
a TIN had to be submitted for children for whom the credit was 
claimed, and disallowed the credit unless the taxpayer reports 
on his or her tax return the correct name, address, and 
taxpayer identification number (generally, an employer 
identification number or a Social Security number) of the 
dependent care provider.
    The Small Business Job Protection Act of 1996 extended the 
taxpayer identification number requirement to all children 
regardless of their age.

                                Analysis

    The partial phaseout of the dependent care credit 
effectively increases marginal tax rates for taxpayers in the 
phase-out range. The initial credit rate of 30 percent of 
eligible expenses falls by 1 percentage point for each $2,000 
in income (or fraction thereof) above $10,000, though it cannot 
fall below 20 percent. For a taxpayer with the maximum eligible 
expenses of $4,800, the credit rate of 30 percent yields a 
credit of $1,440. In this case, the credit falls by $48 for 
each $2,000 in income in excess of $10,000. Because the loss of 
a credit is equivalent to a direct increase in taxes owed, the 
taxpayer's tax rises by an additional $48 for each $2,000 in 
income beyond that which is owed as a result of the direct tax 
liability on the income itself. The additional $48 in tax on 
$2,000 in income represents a rate of 2.4 percent ($48 / 
$2,000).34 Given the low income range of the 
phaseout of this credit, the taxpayers in the phase-out range 
will be exclusively in the 15 percent statutory rate bracket 
35, and thus their true effective marginal tax rate 
will be increased by a maximum of 2.4 percentage points to an 
effective rate of 17.4 percent.
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    \34\ Mathematically, where Y denotes income, E denotes the size of 
potential eligible expenses, C the actual credit, and t denotes the 
statutory marginal tax rate, the taxpayer's total tax liability, T, is 
given by the following expression:
        (1) T = Yt-C, where

        C = E  (.3-.1(Y-10,000)/20,000) for taxpayers 
in the phase-out range.

    Substituting the expression for C into (1) for taxpayers in the 
phase-out range yields:

        (2) T = Yt-E (.3-Y/200,000 + .05)

              or
        T = Yt-.35E-Y  E / 200,000

    Hence, if Y goes up by $1, T rises by t + E / 200,000. For the 
maximum E of $4,800, E/$200,000 equals .024.
    \35\ In order to be eligible for the credit (a necessary condition 
to be affected by a phaseout), one must have positive regular tax 
liability since the credit is a non-refundable credit. Thus, despite 
the relatively low income range of the partial phaseout of this credit, 
one could not be in the 0 percent bracket and be affected by the 
partial phaseout.
---------------------------------------------------------------------------
    Because this credit actually phases out in steps instead of 
in a directly linear fashion, one could earn an additional 
amount of income that is much smaller than $2,000 and have this 
cause a loss of an additional $48 (at the maximum) in credits. 
For example, if a taxpayer were earning $21,999 dollars, 
additional earnings of $2 would cause the taxpayer to lose an 
additional amount of credit of up to $48 (1 percent of eligible 
expenses). Technically, this would represent a tax liability 24 
times as great as the additional income (ignoring the 15-
percent Federal tax due on the $2), or a 2,400 percent marginal 
tax rate. Similarly, however, one could be earning $22,001 and 
earn an additional $1,500 and face no further loss of the 
credit. On average, however, the phaseout will add an 
additional 2.4 percentage points to the marginal tax rate of a 
taxpayer with maximum eligible expenses.
    As shown in Table 9, the Joint Committee staff estimates 
that, in 1998, 1.6 million taxpayers, or 1.2 percent of all 
taxpayers, are in the phase-out range for the dependent care 
credit out of a total of 6.1 million taxpayers claiming the 
credit. Because the phase-out range occurs at relatively low 
income levels, all taxpayers in the phase-out range will be in 
the 15-percent marginal tax rate bracket.

  Table 9.--Distribution by Income of Taxpayers Claiming Dependent Care 
             Tax Credit and Those in Partial Phaseout Range             
                          [Calendar year 1998]                          
------------------------------------------------------------------------
                                             Taxpayers                  
                                             claiming      Taxpayers in 
           Income category \1\            dependent care  phaseout range
                                            tax credit       (millions) 
                                            (millions)                  
------------------------------------------------------------------------
Less than $10,000.......................           (\2\)             0.0
10,000 to 20,000........................             0.3             0.3
20,000 to 30,000........................             0.7             0.7
30,000 to 40,000........................             0.9             0.6
40,000 to 50,000........................             0.7           (\2\)
50,000 to 75,000........................             1.5           (\2\)
75,000 to 100,000.......................             1.1             0.0
100,000 to 200,000......................             0.8             0.0
200,000 and over........................             0.1             0.0
                                         -------------------------------
      Total, all taxpayers..............             6.1             1.6
------------------------------------------------------------------------
\1\ The income concept used to place tax returns into income categories 
  is adjusted gross income plus [1] tax exempt interest [2] employer    
  contributions for health plans and life insurance, [3] employer share 
  of FICA tax, [4] workers' compensation [5] nontaxable social security 
  benefits, [6] insurance value of Medicare benefits, [7] alternative   
  minimum tax preference items, and [8] excluded income of U.S. citizens
  living abroad. Categories are measured at 1998 levels.                
\2\ Less than 50,000 taxpayers.                                         
                                                                        
Detail may not add to total due to rounding.                            
                                                                        
Source: Joint Committee on Taxation.                                    

  H. Phaseout of Eligibility for Deductible and Roth IRA Contributions

                              Present Law

Deductible IRAs

    Under present law, an individual may make deductible 
contributions to an individual retirement arrangement (``IRA'') 
up to the lesser of $2,000 or the individual's compensation if 
the individual is not an active participant in an employer-
sponsored retirement plan. In the case of a married couple, 
deductible IRA contributions of up to $2,000 can be made for 
each spouse (including, for example, a home maker who does not 
work outside the home) if the combined compensation of both 
spouses is at least equal to the contributed amount.
    If the individual (or the individual's spouse) is an active 
participant in an employer-sponsored retirement plan, the 
$2,000 deduction limit is phased out for taxpayers with 
adjusted gross income (``AGI'') over certain levels for the 
taxable year.
    The phase-out limits for a single individual who is an 
active participant in an employer-sponsored retirement plan are 
as follows: for 1998, $30,000 to $40,000; for 1999, 2000, 2001 
and 2002, the limits increase by $1,000 each year, so that the 
limits by 2002 are $34,000 to $44,000; for 2003, $40,000 to 
$50,000; for 2004, $45,000 to $55,000; and for 2005 and 
thereafter, $50,000 to $60,000.
    The phase-out limits for a married individual filing a 
joint return who is an active participant in an employer-
sponsored plan are as follows: for 1998, $50,000 to $60,000; 
for 1999, 2000, 2001 and 2002, the limits increase by $1,000 
each year, so that the limits by 2002 are $54,000 to $64,000; 
for 2003, $60,000 to $70,000; for 2004, $65,000 to $75,000; for 
2005, $70,000 to $80,000; for 2006, $75,000 to $85,000; and for 
2007 and thereafter, $80,000 to $90,000.
    In the case of a married taxpayer filing a separate return, 
the deduction is phased out between $0 and $10,000 of 
AGI.36
---------------------------------------------------------------------------
    \36\ A couple is not considered married for purposes of the IRA 
deduction rules if the individuals file separate returns and live apart 
from one another at all times during the taxable year; each spouse is 
treated as a single individual in such a case.
---------------------------------------------------------------------------
    The maximum deductible IRA contribution for an individual 
who is not an active participant, but whose spouse is, is 
phased out for taxpayers with AGI between $150,000 and 
$160,000.
    Amounts held in a deductible or nondeductible IRA are 
includible in income when withdrawn (except to the extent the 
withdrawal is a return of nondeductible contributions). 
Includible amounts withdrawn prior to attainment of age 59\1/2\ 
are subject to an additional 10-percent early withdrawal tax, 
unless the withdrawal is due to death or disability, is made in 
the form of certain periodic payments, is used to pay medical 
expenses in excess of 7.5 percent of AGI, is used to purchase 
health insurance of an unemployed individual, is used for 
education expenses, or is used for first-time homebuyer 
expenses of up to $10,000.

Roth IRAs

    For years beginning in 1998, individuals with AGI below 
certain levels may make nondeductible contributions to a Roth 
IRA. The maximum annual contribution that may be made to a Roth 
IRA is the lesser of $2,000 or the individual's compensation 
for the year. The contribution limit is reduced to the extent 
an individual makes contributions to any other IRA in the same 
taxable year. As under the rules relating to IRAs generally, a 
contribution of up to $2,000 for each spouse may be made to a 
Roth IRA provided the combined compensation of the spouses is 
at least equal to the contributed amount. The maximum annual 
contribution that can be made to a Roth IRA is phased out for 
single individuals with AGI between $95,000 and $110,000 and 
for joint filers with AGI between $150,000 and 
$160,000.37
---------------------------------------------------------------------------
    \37\ It was intended that the phase-out range for married taxpayers 
filing separately be $0 to $10,000. A technical correction is necessary 
so that the statute reflects this intent. See the Tax Technical 
Corrections Act of 1997, Title VI (sec. 605) of H.R. 2676, as passed by 
the House on November 5, 1997.
---------------------------------------------------------------------------
    Taxpayers with modified AGI of $100,000 or less may convert 
an IRA into an Roth IRA. The amount converted is includible in 
income as if a withdrawal had been made, except that if the 
conversion occurs in 1998, the income inclusion is spread over 
4 years.
    Amounts held in a Roth IRA that are withdrawn as a 
qualified distribution are not includible in income, nor 
subject to the additional 10-percent tax on early withdrawals. 
A qualified distribution is a distribution that (1) is made 
after the 5-taxable year period beginning with the first 
taxable year in which the individual made a contributions to a 
Roth IRA, and (2) which is made on attainment of age 59\1/2\, 
on account of death or disability, or is made for first-time 
homebuyer expenses of up to $10,000.
    Distributions from a Roth IRA that are not qualified 
distributions are includible in income to the extent 
attributable to earnings, and subject to the 10-percent early 
withdrawal tax (unless an exception applies). The same 
exceptions to the early withdrawal tax that apply to IRAs apply 
to Roth IRAs.

Nondeductible IRAs

    To the extent an individual cannot or does not make 
deductible contributions to an IRA or contributions to a Roth 
IRA, the individual may make nondeductible contributions to an 
IRA. Distributions from a nondeductible IRA are includible in 
income and subject to the 10-percent early withdrawal tax to 
the extent attributable to earnings.

                          Legislative History

    The individual retirement savings provisions were 
originally enacted in the Employee Retirement Income Security 
Act of 1974 (``ERISA''). Individuals who were active 
participants in an employer-sponsored retirement plan were not 
permitted to make contributions to an IRA. The limit on the 
deduction for IRA contributions was generally the lesser of (1) 
15 percent of the individual's compensation for the year, or 
(2) $1,500.
    The Economic Recovery Tax Act of 1981 (``ERTA'') increased 
the deduction limit for contributions to IRAs and removed the 
restriction on IRA contributions by active participants in 
employer-sponsored retirement plans. Beginning in 1982, the 
deduction for IRA contributions was generally the lesser of (1) 
100 percent of the individual's compensation, or (2) $2,000. An 
individual was entitled to make a deductible contribution to an 
IRA even if the individual was an active participant in an 
employer-sponsored retirement plan.
    The Tax Reform Act of 1986 (``1986 Act'') added the 
restrictions on deductible IRA contributions for an individual 
(or the individual's spouse) who is an active participant in 
employer-sponsored retirement plan. For years 1987 through 
1997, if a single taxpayer or either spouse (in the case of a 
married couple) was an active participant in an employer-
sponsored retirement plan, the maximum IRA deduction was phased 
out between $25,000 and $35,000 of AGI. For married taxpayers, 
the maximum deduction was phased out between $40,000 and 
$50,000 of AGI. In the case of a married taxpayer filing a 
separate return, the deduction was phased out between $0 and 
$10,000 of AGI. In addition, the 1986 Act added the present-law 
rules permitting individuals to make nondeductible 
contributions to an IRA.
    The Small Business Job Protection Act of 1996 (``1996 
Act'') modified the rule relating to the maximum deductible IRA 
contribution by permitting deductible IRA contributions of up 
to $2,000 to be made for each spouse (including a spouse who 
does not work outside the home) if the combined compensation of 
both spouses is at least equal to the contributed amount.
    The Taxpayer Relief Act of 1997 (``1997 Act'') (1) 
increased the AGI phase-out limits for deductible IRAs, (2) 
modified the AGI phase-out limits for an individual who is not 
an active participant in an employer-sponsored retirement plan 
but whose spouse is, (3) provided an exception from the early 
withdrawal tax for withdrawals for first-time home purchase (up 
to $10,000), and (4) created a new nondeductible IRA called the 
Roth IRA.

                                Analysis

In general

    As explained above, the Code phases out taxpayer 
eligibility to make deductiblecontributions to an IRA or to 
make contributions of after-tax dollars to a Roth IRA. The phase-out 
rate for deductible IRAs is 20 percent ($2,000 of deductible 
contributions phased out over a $10,000 income range).\38\ For Roth 
IRAs, the phase-out rate is 20 percent for joint filers and 13.3 
percent for single filers ($2,000 of eligible contributions phased out 
over a $15,000 range).
---------------------------------------------------------------------------
    \38\ In the case of married taxpayers who file jointly, the phase-
out rate becomes 10 percent ($2,000 phased out over the income range of 
$80,000 to $100,000) for 2007 and subsequent years.
---------------------------------------------------------------------------
    Some analysts would interpret these phaseouts as having the 
effect of raising the taxpayer's effective marginal tax rate 
above the statutory marginal tax rate. However, these phaseout 
provisions alter effective marginal tax rates differently than 
most of the other provisions discussed in this pamphlet. While 
the provision phasing out the taxpayer's eligibility for 
deductible IRA contributions has the effect of raising the 
taxpayer's tax liability in the current year, it reduces the 
taxpayer's tax liability in the future. This same effect is 
observed in the phaseout of the exemption for real estate 
losses. See Part II.P., below. The provision phasing out the 
taxpayer's eligibility to contribute to a Roth IRA does not 
create an effective marginal tax rate on current year income 
that is in excess of the statutory marginal tax rate, but 
rather subjects more income to income tax in a subsequent year.

Deductible IRAs

    To understand the effects of these provisions, assume a 
taxpayer plans to set aside $2,000 in the current year and 
plans to use the principal and any earnings to provide for 
living expenses in his retirement.\39\ If the taxpayer were to 
contemplate contributing the $2,000 to a deductible IRA and the 
taxpayer is in the income phaseout range, each dollar of 
additional income reduces the deduction he may claim in the 
current year by 20 cents. This means that for each dollar of 
additional income, the taxpayer's taxable income increases by 
$1.20. In the current year, the taxpayer's effective marginal 
tax rate would be 1.2 times his statutory marginal tax rate, or 
120 percent of his statutory marginal tax rate.\40\
---------------------------------------------------------------------------
    \39\ An IRA or Roth IRA also may be used as a saving vehicle for 
education, the first-time purchase of a home, or certain catastrophic 
medical expenses as noted in the description of present law above. The 
text will refer to retirement saving as a short hand designation of the 
enumerated purposes to which funds from an IRA or Roth IRA can be 
withdrawn penalty free.
    \40\ Mathematically, when Y denotes income, D denotes deductible 
IRA contributions, I denotes the beginning of the phaseout range, and t 
denotes the marginal tax rate, the taxpayer's total tax liability, T is 
given by the following expression:

    (1) T = (Y-D)t = (Yt)-(Dt)

    If Y increases by $1.00, tax liability increases by t, the 
statutory tax rate.
    Assume the taxpayer plans to make a $2,000 contribution to 
retirement saving. For taxpayers in the phaseout range, the amount of 
deductible IRA contributions, D is given by the equation (2).

    (2) D = $2,000-(.2)(Y-I)

    To determine the tax liability of taxpayers in the phaseout range, 
one must substitute equation (2) into equation (1). The result follows:

    (3) T = (Y-[2,000-(.2)Y+(.2)I)t

    (4) T = [Y(1.2)t]-[2,000t]-[(.2)It]

    If Y increases by $1.00, tax liability increases by (1.2)t.
---------------------------------------------------------------------------
    For example, consider a married taxpayer filing a joint 
return who intends to save $2,000 for retirement and whose AGI 
is $52,500, that is, $2,500 into the phase out range. Further 
assume this taxpayer is in the 15-percent statutory marginal 
tax bracket. The taxpayer's income is $2,500 above the $50,000 
threshold. Therefore, the permitted $2,000 deductible 
contribution is proportionately reduced by the fraction 2,500 
divided by 10,000, or by one quarter. He may contribute no more 
than $1,500 to a deductible IRA. A $1,500 deductible IRA 
contribution reduces his current year tax liability by $225 
(0.15 times $1,500). Were he permitted to deduct the full 
$2,000 in retirement saving, his current year tax liability 
would have been reduced by $300. The taxpayer's incremental 
income in the phaseout range, $2,500, increases the taxpayer's 
current year tax liability by $2,500 times 15 percent, or $375, 
plus the increase in tax liability from the loss of full 
deductibility of the saving contribution, $75 (15 percent of 
$500). The total marginal increase in tax liability, $450, is 
18 percent of $2,500. Thus, the taxpayer's effective marginal 
tax rate on current year income is 18 percent, which is 1.2 
times his statutory marginal tax rate of 15 percent.
    However, as noted above, whether contributions to 
retirement saving are deductible in the current year affects 
future tax liability. Assume the $2,000 contributed to 
retirement saving earns interest at a rate of 10 percent per 
annum. After 10 years, the account balance would equal 
$5,187.48. Assume further that at that time the taxpayer is 
older than 59 and a half and remains in the 15-percent 
statutory marginal tax bracket. If the $2,000 had all been 
contributed to a deductible IRA, the entire balance would be 
subject to tax upon withdrawal, for a tax liability of $778.12. 
Because the taxpayer in this example was in the phaseout range 
at the time of contribution, he could only contribute $1,500 to 
a deductible IRA. Assume he contributed the remaining $500 to a 
non-deductible IRA.\41\ The aggregate balance in the two 
accounts 10 years hence would remain at $5,187.48. Upon 
withdrawal, $3,890.61 would be attributable to the taxpayer's 
$1,500 deductible contribution and would be fully taxed at 15 
percent for a tax liability of $583.59. The remaining balance 
in the account, $1,296.87 is attributable to the $500 
nondeductible contribution. Therefore, only $796.87 ($1,296.87 
less the $500 nondeductible contribution) is subject to tax, 
for a tax liability of $119.53. In this example, the total tax 
liability of the taxpayer upon withdrawal of his savings in 
retirement is $703.12, or $75 less than if the entire $2,000 
had been deductible at the time of contribution. Thus, the 
taxpayer's higher tax liability at the time of contribution is 
returned to him as a lower liability at the time of withdrawal. 
However, ten years have intervened between the initial higher 
tax payment of $75 and the subsequent tax saving of $75. The 
taxpayer's true economic increase in effective marginal tax 
rate due to the phaseout is the taxpayer's loss of the time 
value of his funds. In this example, with a discount rate of 10 
percent and a time horizon of 10 years, the present value of 
the net increase in tax due to the phaseout is $46.08.\42\ 
Thus, in this example, the taxpayer's incremental income of 
$2,500 increases the net present value of his lifetime tax 
liability by $46.08, or by 1.8 percentage points. That is, the 
taxpayer's effective marginal tax rate from being subject to 
the phaseout is 16.8 percent rather than the statutory marginal 
tax rate of 15 percent. Because the effective marginal tax rate 
depends upon the length of time retirement savings are held 
prior to withdrawal and the taxpayer's discount rate, it is not 
possible to detail precisely the effective marginal tax 
rate.\43\ However, generally one can conclude that the 
effective marginal tax rate is greater than the statutory 
marginal tax rate and less than 1.2 times the statutory 
marginal tax rate. The higher the discount rate and the longer 
the retirement savings are held before withdrawal, the closer 
the effective rate comes to 1.2 times the statutory marginal 
tax rate.
---------------------------------------------------------------------------
    \41\ Because the nondeductible $500 gives rise to a $75 liability, 
an alternative assumption would be that $425 is contributed to the non-
deductible IRA. The initial premise, however, was that the taxpayer 
intended to commit $2,000 to retirement savings regardless of the type 
of account. Some argue that a non-deductible IRA may not be the wisest 
choice for such a taxpayer. For a recent analysis of strategies for 
saving see, John B. Shoven, ``The Allocation of Assets in Pension and 
Conventional Savings Accounts,'' presented at ``Economists' Views on 
Pension Regulations and Taxation,'' a conference sponsored by Stanford 
University Center for Economic Policy Research and TIAA-CREF, 
Washington, D.C., September 30, 1997.
    \42\ The net present value of the increased tax due to the taxpayer 
being subject to the phaseout is calculated as $75 today less $75 
divided by 1.1 to the tenth power.
    \43\ Mathematically, the right-hand term, (.2)(Y-I), in equation 
(2) of footnote 40 is the amount of retirement funds the taxpayer 
contributes to a nondeductible IRA. This basis amount in the 
nondeductible IRA, multiplied by the taxpayer's statutory marginal tax 
rate, is the reduction in tax liability the taxpayer attains upon 
withdrawal of funds in retirement. Let r be the discount rate and n the 
number of years between contribution and withdrawal. Equation (5), 
below modifies equation (4) of footnote 40 to reflect the reduction in 
future taxes.

    (5) T = Y(1.2)t-((.2)(Y-I)/
(1+r)n)t-2,000t-(1.2)It

    This simplifies to

    (6) T = Y(1.2-((.2/
(1+r)n))t-2,000t-(.2)(1+1/
(1+r)n)It

    If Y increased by $1.00, the present value of tax liability 
increases by (1.2-((.2/(1+r)n))t. This presentation assumes 
the taxpayer's statutory marginal tax rate is the same in retirement as 
when the saving contribution was made. If the taxpayer's marginal rate 
is higher in retirement than when the contribution is made, the 
effective marginal tax rate will be lower than that calculated here. If 
the taxpayer's marginal tax rate is lower in retirement than when the 
contribution is made, the effective marginal tax rate will be higher 
than that calculated here.
---------------------------------------------------------------------------

Roth IRAs

    If one maintains the assumption that the taxpayer plans to 
set aside $2,000 in the current year and plans to use the 
principal and any earnings to provide for living expenses in 
his retirement, then the phaseout of the eligibility to 
contribute to a Roth IRA also may be said to create an increase 
in the effective marginal tax rate on those taxpayers in the 
phaseout range. To see this, assume a married taxpayer who 
files a joint return has an AGI of $152,500, that is, $2,500 
into the phase-out range. Further assume the taxpayer is in the 
31-percent statutory marginal rate bracket. As computed in the 
prior example, of the $2,000 the taxpayer plans to set aside 
for retirement, only $1,500 may be contributed to a Roth IRA 
because of the phaseout. As before, assume the remaining $500 
is contributed to a nondeductible, non-Roth IRA. Assuming a 10-
percent return per annum, the aggregate account balance in 10 
years is $5,187.48, of which $3,890.61 is attributable to the 
Roth IRA and may be withdrawn tax-free. The remaining balance 
in the account, $1,296.87 is attributable to the $500 
nondeductible contribution. Of this amount, $796.87 ($1,296.87 
less the $500 nondeductible contribution) is subject to tax, 
for a tax liability of $247.03. However, this tax liability is 
due ten years in the future. The present value of the future 
tax liability, discounted at 10 percent, is $95.24. Thus, 
because the phaseout of eligibility causes the taxpayer to 
deposit $500 in a nondeductible IRA, the present value of the 
taxpayer's future tax liability increases by $95.24. The 
additional $2,500 of income that pushed the taxpayer into the 
phaseout increases her current year tax liability by $775 
($2,500 times 31 percent) and increases her future tax 
liability by a present value of $95.24, for a total increase of 
$870.24. The effective marginal tax rate in this example is 
34.8 percent. In general, the effective tax rate will be closer 
to 1.2 times the statutory marginal tax rate the larger is the 
discount rate and the longer the retirement savings are held 
before withdrawal.\44\
---------------------------------------------------------------------------
    \44\ Mathematically, as explained in footnote 43, above, the amount 
contributed to the nondeductible IRA is (.2)(Y-I). Amounts contributed 
to a nondeductible IRA create a future tax liability given by 
expression (7), where t is the taxpayer's marginal tax rate at the time 
of withdrawal.

    (7) ((.2)(Y-I)(1-r)n-(.2)(Y-I))t
    Because this tax liability occurs n years in the future, it must be 
discounted by (1+r)n.
    Simplifying and looking only at the part of the expression that 
varies with income, Y, the present value of the future tax liability 
created by an additional dollar of income in the phaseout range is

    (8) Y(((1+r)n-1)(.2)(t))/(1+r)n.
---------------------------------------------------------------------------

Summary

    Both the phaseout of the eligibility for deductible IRAs 
and Roth IRAs increase the effective marginal rate of tax for 
taxpayers subject to the phaseout range. In each case the 
effective marginal tax rate depends, in part, on future rates 
of returns and holding periods, because the phaseout may affect 
not only tax payments at the time the IRA contribution is made, 
but also future tax payments. Moreover, the effective marginal 
tax rate does not differ from the statutory marginal tax rate 
unless the phaseout's limitation on eligible contributions is 
binding on the taxpayer. For example, if in both of the 
examples above the taxpayer had only planned to set aside 
$1,000 in an account for retirement, the incremental $2,500 of 
income putting the taxpayer in the phase-out range would not 
have altered the taxpayer's current or future tax liability 
beyond the effect of the statutory rate on the additional 
$2,500 in income.
    The Joint Committee staff estimates that in 1998, 1.5 
million taxpayers will be subject to the phaseout of 
eligibility to make deductible contributions to an IRA. See 
Table 10. This represents 21 percent of all taxpayers making 
deductible contributions to IRAs and 1.1 percent of all 
taxpayers. Because the phaseout ranges in between AGI of 
$30,000 to $40,000 for a single taxpayers and $50,000 to 
$60,000 for a joint filer, only taxpayers in the 15- and 28-
percent statutory marginal tax rate brackets would be affected. 
As explained above, the maximum effective marginal tax rate is 
120 percent of the statutory rate, so the maximum effective 
marginal tax rates for taxpayers affected by the provision 
would be 18-percent and 33.6-percent.
    Eligibility for a Roth IRA is phased out at higher income 
levels. Generally taxpayers in the 15-percent statutory 
marginal tax rate bracket and those in the 36- and 39.6-percent 
statutory marginal tax rate brackets would be unaffected. For 
those affected taxpayers in the 28- or 31-percent statutory 
marginal tax rate brackets, the maximum effective marginal tax 
rates would be 31.7 percent and 35.1 percent for single 
taxpayers (phase-out rate of 13.3 percent) and 33.6 percent and 
37.2 percent for joint filers (phase-out rate of 20 percent).

 Table 10.--Distribution by Income of Taxpayers Making Contributions to 
      Deductible IRAs and Those in the Contribution Phaseout Range      
                          [Calendar year 1998]                          
------------------------------------------------------------------------
                                             Taxpayers                  
                                              making       Taxpayers in 
                                           contribution         the     
           Income category\1\              to deductible   contribution 
                                               IRAs            range    
                                            (millions)      (millions)  
------------------------------------------------------------------------
Less than $10,000.......................             (2)             0.0
10,000 to 20,000........................             0.3             0.0
20,000 to 30,000........................             0.8           (\2\)
30,000 to 40,000........................             1.1             0.5
40,000 to 50,000........................             1.0             0.2
50,000 to 75,000........................             1.9             0.8
75,000 to 100,000.......................             0.7             (2)
100,000 to 200,000......................             1.1             0.1
200,000 and over........................             0.2             0.0
                                         -------------------------------
      Total, all taxpayers..............             7.2             1.5
------------------------------------------------------------------------
\1\ The income concept used to place tax returns into income categories 
  is adjusted gross income plus [1] tax exempt interest, [2] employer   
  contributions for health plans and life insurance, [3] employer share 
  of FICA tax, [4] workers' compensation [5] nontaxable social security 
  benefits, [6] insurance value of Medicare benefits, [7] alternative   
  minimum tax preference items, and [8] excluded income of U.S. citizens
  living abroad. Categories are measured at 1998 levels.                
\2\ Less than 50,000 taxpayers.                                         
                                                                        
Detail may not add to total due to rounding.                            
                                                                        
Source: Joint Committee on Taxation.                                    

 I. Phaseout of Eligibility to Make Contributions to Education Savings 
                     Accounts (``Education IRAs'')

                              Present Law

    Under present law, an education individual retirement 
arrangement (``education IRA'') may be established for the 
purpose of paying the qualified higher education expenses of a 
named beneficiary. Nondeductible contributions of up to $500 
may be made each year on behalf of the beneficiary for whom the 
education IRA was established. Contributions to an education 
IRA may be made only in cash and may not be made after the 
named beneficiary reaches age 18.
    A penalty excise tax may be imposed to the extent that 
excess contributions above the $500 annual limit are made to 
the education IRA. In addition, a penalty excise may be imposed 
if a contribution is made by any person to an education IRA 
established on behalf of a beneficiary during any taxable year 
in which any contributions are made by anyone to a qualified 
State tuition program (defined in sec. 529) on behalf of the 
same beneficiary.
    The $500 annual contribution limit for education IRAs is 
phased out ratable for contributors with modified AGI between 
$95,000 and $110,000 ($150,000 and $160,000 for joint returns). 
Individuals with modified AGI above the phase-out range are not 
allowed to make contributions to an education IRA established 
on behalf of any other individual.
    Amounts distributed from education IRAs are excludable from 
gross income to the extent that the amounts distributed do not 
exceed qualified higher education expenses (defined in sec. 
529(e)(3), and reduced as provided in sec. 25A(g)(2)) of an 
eligible student incurred during the year the distribution is 
made (provided that a HOPE credit or Lifetime Learning credit 
(defined in sec. 25A) is not claimed with respect to the 
beneficiary for the same taxable year). If a HOPE credit or 
Lifetime Learning credit is claimed with respect to a student 
for a taxable year, then a distribution from an education IRA 
may (at the option of the taxpayer) be made on behalf of that 
student during the taxable year, but an exclusion is not 
available for the earnings portion of such distribution.
    Distributions from an education IRA generally will be 
deemed to consist of distributions of principal (which, under 
all circumstances, are excludable from gross income) and 
earnings (which may be excludable from gross income) by 
applying the ratio that the aggregate amount of contributions 
to the account for the beneficiary bears to the total balance 
of the account. Distributions from an education IRA that exceed 
qualified higher education expenses of the designated 
beneficiary during the year of the distribution are includible 
in the distributee's gross income. An additional 10-percent is 
imposed on any distribution from an education IRA to the extent 
the distribution exceeds qualified higher education expenses of 
the designated beneficiary unless the withdrawal is due to 
death or disability or scholarship received by the 
beneficiary.\45\
---------------------------------------------------------------------------
    \45\ A technical correction is needed to clarify that the 10-
percent additional tax should not be imposed in cases where a 
distribution (although used to pay for qualified higher education 
expenses) is includible in gross income because the taxpayer elects the 
HOPE or Lifetime Learning credit on behalf of the student for the same 
taxable year.
---------------------------------------------------------------------------
    Under present law, tax-free (and penalty-free) transfers or 
rollovers of account balances from one education IRA benefiting 
one beneficiary to another education IRA benefiting another 
beneficiary (as well as redesignations of the named 
beneficiary) are permitted provided that the new beneficiary is 
a member of the family of the old beneficiary.
    The legislative history to the Taxpayer Relief Act of 1997 
provides that any balance remaining in an education IRA will be 
deemed to be distributed within 30 days after the date that the 
named beneficiary reaches age 30 (or, if earlier, within 30 
days of the date that the beneficiary dies).\46\
---------------------------------------------------------------------------
    \46\ A technical correction providing that any balance remaining in 
an education IRA will be deemed distributed within 30 days after the 
date that the designated beneficiary reaches age 30 is included in the 
Tax Technical Corrections Act of 1997, Title VI of H.R. 2676, as passed 
by the House on November 5, 1997.
---------------------------------------------------------------------------

                          Legislative History

    Education IRAs were enacted in the Taxpayer Relief Act of 
1997.

                                Analysis

    As explained above, the Code phases out taxpayer 
eligibility to make contributions of after-tax dollars to an 
``education IRA.'' For education IRAs, the phase out rate is 5 
percent for joint filers ($500 of eligible contributions phased 
out over a $10,000 range) and 3.3 percent for single filers 
($500 of eligible contributions phased out over a $15,000 
range).
    Some analysts would interpret these phaseouts as having the 
effect of raising the taxpayer's effective marginal tax rate 
above the statutory marginal tax rate. However, these phaseout 
provisions alter effective marginal tax rates differently than 
most of the other provisions discussed in this pamphlet. The 
phaseout does not increase a taxpayer's current year tax 
liability. Like the phaseout for eligibility to contribute to a 
Roth IRA, the provision phasing out the taxpayer's eligibility 
to contribute to an education IRA subjects more income to 
income tax in each subsequent year.
    If one assumes that a taxpayer plans to set aside $500 in 
the current year and plans to use the principal and any 
earnings to provide for future qualified education expenses, 
then the phaseout of the eligibility to contribute to an 
education IRA also may be said to create an increase in the 
effective marginal tax rate on those taxpayers in the phaseout 
range. To see this, assume a married taxpayer who files a joint 
return has an income of $152,500, that is, $2,500 into the 
phaseout range. Further assume the taxpayer is in the 31-
percent statutory marginal rate bracket. Because of the 
phaseout, of the $500 the taxpayer plans to set aside for 
future education expenses, only $375 may be contributed to an 
education IRA.\47\ Assume the remaining $125 is contributed to 
another savings vehicle. Assume a 10-percent return per annum 
on both investments and the proceeds of both accounts are used 
for qualified education expenses. The balance of the education 
IRA is permitted to grow tax-free. The balance in the non-
educational IRA account generates taxable interest income 
annually. If the taxpayer remains in the 31-percent statutory 
marginal tax rate bracket, the taxpayer will pay $3.88 in tax 
in the first year on the earnings on the $125 of principle. If 
the net, after-tax, earnings are reinvested in the account, in 
the tenth year the taxpayer will pay $7.06 in tax on the 
earnings on the accumulated balance. That is, because an 
increase in income has moved the taxpayer into the phaseout 
range, the taxpayer loses part of the advantage of tax-free 
accumulation and must pay additional taxes on her designated 
education saving for each year until the account is liquidated 
to pay qualified education expenses. The present value of the 
future tax liabilities in this example, discounted at 10 
percent, is $31.08. That is, because the phaseout of 
eligibility causes the taxpayer to deposit $125 in a fully 
taxable account, the present value of the taxpayer's future tax 
liability increases by $31.08. The additional $2,500 of income 
that pushed the taxpayer into the phaseout increases her 
current year tax liability by $775 ($2,500 times 31 percent) 
and increases her future tax liability by a present value of 
$31.08, for a total increase of $806.08. The effective marginal 
tax rate in this example is 32.2 percent. If the investment 
were held in the taxable account longer than 10 years, the 
present value of the future tax liabilities would be larger and 
likewise the effective marginal tax rate would be larger. If 
the earnings rate is smaller, the present value of the future 
tax liabilities is smaller. In general, the effective marginal 
tax rate is greater than the taxpayer's statutory marginal tax 
rate by an amount determined, in part, by the phase-out rate, 
the prevailing interest rate, and length of time the investment 
is held before withdrawal.\48\
---------------------------------------------------------------------------
    \47\ An income of $152,500 is $2,500 above the phase-out threshold. 
At a 5-percent phase out rate, the $500 contribution to an Education 
IRA is reduced by $125.
    \48\ Mathematically, the amount contributed to the non-qualified 
account is (.05)(Y-I), where Y is the taxpayer's income and I is 
beginning of phaseout threshold. Amounts contributed to a non-qualified 
account create a tax liability, Ti, in each future year, i, 
until the account is liquidated given by equation (1), where t is the 
taxpayer's marginal tax rate.

    (1) Ti = 
((.05)(Y-I)(1+r(1-t))i-1)rt

    Because this tax liability occurs i years in the future, it must be 
discounted by (1+r)i.
    The taxpayer's total tax liability, T, is the tax liability on 
current year income, Yt, plus the discounted sum of the 
Ti over all years, i, from the first year subsequent to 
opening the account until the account is liquidated. This is given by 
equation (2).

    (2) T = Yt+(T1/(1+r)i)

    Substituting equation (1) into equation (2) produces equation (3).

    (3) T = 
Yt+((.05)(Y-I)(1+r(1-t))i-1)r
t/(1+r)i)

    Simplifying and looking only at the part of the expression that 
varies with income, Y, the present value of the future tax liability 
created by an additional dollar of income in the phaseout range is

    (4) 
Yt(1+(.05)r(((1+r(1-t))i-1
)/(1+r)i)).

    While the expression in (4) is not transparent, it does show, as 
the text explained by example, that as income, Y, increases the tax 
liability will increase by the statutory tax rate multiplied by one 
plus a fraction determined by the phase-out rate, (.05), (.033 in the 
case of a single filer) the interest rate, and the length of time until 
the account is liquidated.
---------------------------------------------------------------------------
    Because the phaseout does not affect taxpayers filing joint 
returns with AGI in excess of $160,000 or single taxpayers with 
AGI in excess of $110,000, the phaseout provision does not 
affect taxpayers in the 36- or 39.6-percent statutory marginal 
tax bracket. Because the phaseouts begin at AGI of $150,000 for 
joint filers and $95,000 for single filers, taxpayers in the 
15-percent statutory marginal tax bracket are unlikely to be 
affected by the phaseout provision. Generally, the phaseout 
provision will increase the effective marginal tax rate, as 
described above, for taxpayers in the 28- and 31-percent 
statutory marginal tax bracket.
    In addition, the provision does not affect all taxpayers 
with incomes within the phaseout ranges, even if the taxpayers 
make contributions to education savings accounts. The phaseout 
provision does not deny eligible contributions to all taxpayers 
making contributions, but rather reduces the $500 contribution 
limit. Thus, if a married taxpayer has an AGI of $152,500 
($2,500 in the phaseout range) plans to contribute $250 to an 
education IRA, the reduction in the $500 contribution limit is 
not binding on the taxpayer.\49\ As a result, this taxpayer, 
though in the phaseout range, would have an effective marginal 
tax rate equal to the statutory marginal tax rate.
---------------------------------------------------------------------------
    \49\ An income of $2,500 into the phaseout range reduces the 
maximum $500 eligible contribution by one quarter, or $125, making the 
taxpayer's maximum eligible contribution $375 ($500 less $125).
---------------------------------------------------------------------------
                  J. Phaseout of Education Tax Credits

                (HOPE and Lifetime Learning Tax Credits)

                              Present Law

HOPE tax credit

    Allowance of credit.--Individual taxpayers are allowed to 
claim a non-refundable HOPE credit against Federal income taxes 
up to $1,500 per student per year for qualified tuition and 
related expenses paid for the first two years of the student's 
post-secondary education in a degree or certificate program at 
a college, university, and certain vocational 
schools.50 The HOPE credit rate is 100 percent on 
the first $1,000 of qualified tuition and related expenses, and 
50 percent on the next $1,000 of qualified tuition and related 
expenses.51 The maximum HOPE credit amount will be 
indexed for inflation occurring after the year 2000. The 
qualified tuition and related expenses must be incurred on 
behalf of the taxpayer, the taxpayer's spouse, or a dependent. 
The HOPE credit is available with respect to an individual 
student for two taxable years, provided that the student has 
not completed the first two years of post-secondary education 
before the beginning of the second taxable year. To be eligible 
for the HOPE credit, a student must pursue a course of study on 
at least a half-time basis and must not have been convicted of 
a Federal or State felony consisting of the possession or 
distribution of a controlled substance. The HOPE credit is 
available in the taxable year the expenses are paid, subject to 
the requirement that the education commence or continue during 
that year or during the first three months of the next year.
---------------------------------------------------------------------------
    \50\ Charges and fees associated with meals, lodging, student 
activities, athletics, insurance, transportation, and similar personal, 
living or family expenses are not eligible for the HOPE credit. 
Qualified tuition and related expenses eligible for the HOPE credit 
generally include only out-of-pocket expenses, and not expenses covered 
by educational assistance that is not required to be included in the 
gross income of either the student or the taxpayer claiming the credit 
(such as expenses covered by scholarships that are excludable from 
gross income under section 117 and any other tax-free educational 
benefits). No reduction of qualified tuition and related expenses is 
required for a gift, bequest, devise, or inheritance within the meaning 
of section 102(a). A HOPE credit is not allowed with respect to any 
education expense for which a deduction is claimed under section 162 or 
any other section of the Code.
    \51\ Thus, an eligible student who incurs $1,000 of qualified 
tuition and related expenses is eligible (subject to the AGI phaseout) 
for a $1,000 HOPE credit; and if such a student incurs $2,000 of 
qualified tuition and related expenses, then he or she is eligible for 
a $1,500 HOPE credit.
---------------------------------------------------------------------------
    A taxpayer may claim the HOPE credit with respect to an 
eligible student who is not the taxpayer or the taxpayer's 
spouse (e.g., in cases where the student is the taxpayer's 
child) only if the taxpayer claims the student as a dependent 
for the taxable year for which the credit is claimed. If a 
student is claimed as a dependent by the parent or other 
taxpayer, the eligible student him- or herself is not entitled 
to claim a HOPE credit for that taxable year on the student's 
own tax return. If a parent (or other taxpayer) claims a 
student as a dependent, any qualified tuition and related 
expenses paid by the student are treated as paid by the parent 
(or other taxpayer). For each taxable year, a taxpayer may 
elect with respect to an eligible student the HOPE credit or 
the ``Lifetime Learning'' credit (described below), or an 
exclusion from gross income under section 530 for certain 
distributions from an education IRA. The HOPE credit may not be 
claimed against a taxpayer's alternative minimum tax (AMT) 
liability.
    Phase-out range.--The HOPE credit amount that a taxpayer 
may otherwise claim is phased out ratably for taxpayers with 
modified AGI between $40,000 and $50,000 ($80,000 and $100,000 
for joint returns). Modified AGI includes amounts otherwise 
excluded with respect to income earned abroad (or income from 
Puerto Rico or U.S. possessions). The income phase-out ranges 
will be indexed for inflation occurring after the year 2000, 
rounded down to the closest multiple of $1,000. The first 
taxable year for which the inflation adjustment could be made 
to increase the income phase-out ranges will be 
2002.52
---------------------------------------------------------------------------
    \52\ If a taxpayer is married (within the meaning of sec. 7703), 
the HOPE credit may be available only if the taxpayer and his or her 
spouse file a joint return for the taxable year.
---------------------------------------------------------------------------

Lifetime Learning tax credit

    Allowance of credit.--For expenses paid after June 30, 
1998, individual taxpayers will be allowed to claim a 
nonrefundable ``Lifetime Learning'' credit against Federal 
income taxes equal to 20 percent of qualified tuition and 
related expenses incurred during the taxable year on behalf of 
the taxpayer, the taxpayer's spouse, or any 
dependents.53 For expenses paid after June 30, 1998, 
and prior to January 1, 2003, up to $5,000 of qualified tuition 
and related expenses per taxpayer return will be eligible for 
the 20-percent Lifetime Learning credit (i.e., the maximum 
credit per taxpayer return will be $1,000). For expenses paid 
after December 31, 2002, up to $10,000 of qualified tuition and 
related expenses per taxpayer return will be eligible for the 
20-percent Lifetime Learning credit (i.e., the maximum credit 
per taxpayer return will be $2,000). In contrast to the HOPE 
credit, the Lifetime Learning credit is available with respect 
to any course of instruction at an eligible post-secondary 
educational institution, regardless of whether the student is 
enrolled on a full-time, half-time, or less than half-time 
basis.54
---------------------------------------------------------------------------
    \53\ The term ``qualified tuition and related expenses'' for 
purposes of the Lifetime Learning credit generally has the same meaning 
as for purposes of the HOPE credit.
    \54\ In contrast to the HOPE credit, the eligibility of a student 
for the Lifetime Learning credit does not depend on whether or not the 
student has been convicted of a Federal or State felony consisting of 
the possession of distribution of a controlled substance.
---------------------------------------------------------------------------
    As with the HOPE credit, a taxpayer may claim the Lifetime 
Learning credit with respect to a student who is not the 
taxpayer or the taxpayer's spouse (e.g., in cases where the 
student is the taxpayer's child) only if the taxpayer claims 
the student as a dependent for the taxable year for which the 
credit is claimed. If a student is claimed as a dependent by 
the parent or other taxpayer, the student him- or herself is 
not entitled to claim the Lifetime Learning credit for that 
taxable year on the student's own tax return. If a parent (or 
other taxpayer) claims a student as a dependent, any qualified 
tuition and related expenses paid by the student are treated as 
paid by the parent (or other taxpayer). A taxpayer may claim 
the Lifetime Learning credit for a taxable year with respect to 
one or more students, even though the taxpayer also claims a 
HOPE credit (or claims the section-530 exclusion for 
distributions from an education IRA) for that same taxable year 
with respect to other students. The Lifetime Learning credit 
may not be claimed against a taxpayer's alternative minimum tax 
(AMT) liability.
    A taxpayer may claim the Lifetime Learning credit for an 
unlimited number of taxable years, including years when the 
student is enrolled in graduate-level courses. In contrast to 
the HOPE credit, the maximum amount of the Lifetime Learning 
credit that may be claimed on a taxpayer's return will not vary 
based on the number of students in the taxpayer's family--that 
is, the HOPE credit is computed on a per-student basis, while 
the Lifetime Learning credit is computed on a family-wide 
basis.
    Phase-out range.--The Lifetime Learning credit is phased 
out ratably over the same phaseout range that applies for 
purposes of the HOPE credit--i.e., taxpayers with modified AGI 
between $40,000 and $50,000 ($80,000 and $100,000 for joint 
returns). As with the HOPE credit, the income phase-out ranges 
will be indexed for inflation occurring after the year 
2000.55
---------------------------------------------------------------------------
    \55\ If a taxpayer is married (within the meaning of sec. 7703), 
the Lifetime Learning credit may be available only if the taxpayer and 
his or her spouse file a joint return for the taxable year.
---------------------------------------------------------------------------

                          Legislative History

    The HOPE credit was enacted as part of the Taxpayer Relief 
Act of 1997, and is available for expenses paid after December 
31, 1997, for education furnished in academic periods beginning 
after December 31, 1997. The Lifetime Learning credit also was 
enacted as part of the Taxpayer Relief Act of 1997, and is 
available for expenses paid after June 30, 1998, for education 
furnished in academic periods beginning after June 30, 1998.

                                Analysis

    The phase out of the HOPE and lifetime learning credit are 
likely to sharply increase the effective marginal tax rate for 
taxpayers in the phaseout range due to the substantial size of 
the credits and the relatively small range over which the 
credits are phased out. Additionally, because the phase-out 
range for single or head of household filers spans an income 
range that is only half as great as that for married taxpayers, 
the same dollar amount of credit is phased out at a rate that 
is twice as fast for singles as for married taxpayers. This 
implies that the increase in effective marginal tax rates for 
singles in the phase-out range would be twice that for married 
taxpayers in the phase-out range for credits of the same 
magnitude.
    For example, a head of household taxpayer who claims a 
$1,500 HOPE credit for a single child in her first year of 
college and who is in the phase-out range (modified adjusted 
gross income between $40,000 and $50,000), will have an 
effective marginal tax rate that is greater than the statutory 
marginal tax rate by a full 15 percentage points ($1,500/
$10,000). If the same child were in a two-parent family filing 
jointly, and also in the phase-out range, the increase in the 
effective marginal tax rate would be only half as great since 
the credit would then be phased out over a $20,000 income range 
from $80,000 to $100,000. The phase-out rate would then be 
$1,500/$20,000, or 7.5 percent, leading to an effective 
marginal tax rate that is 7.5 percentage points greater than 
the statutory rate.56
---------------------------------------------------------------------------
    \56\ Mathematically, where Y denotes income, C denotes the size of 
the full potential education credits, A denotes the actual credit, I 
denotes the beginning of the phaseout range, L denotes the length of 
the phaseout range, and t denotes the statutory marginal tax rate, the 
taxpayer's total tax liability, T, is given by the following 
expression:

    (1) T = Yt-A, where
        A = Max(0, C-((Y-I)/L)C)

    Substituting the expression for A into (1) for taxpayers in the 
phaseout range yields:
    (2) T = Yt-C+C Y/L-I/LC

    Hence, if Y goes up by $1, T rises by t + C/L. Thus, because the 
phaseout length L for single taxpayers is half that for married 
taxpayers, the same potential credit C will result in an increase in 
the effective tax rate that is twice as large for single taxpayers as 
for married taxpayers.
---------------------------------------------------------------------------
    The effective marginal tax rate for taxpayers in the phase-
out range increases as the total amount of credits claimed 
increases. For example, if the two examples above were each 
modified to allow for a second child receiving a $1,500 HOPE 
credit, then the head of household filer in the phase-out range 
would face an effective marginal tax rate that was 30 
percentage points greater than the statutory marginal tax 
rate--a $3,000 credit phased out over a $10,000 income range 
($3,000 / $10,000 = 30 percent). The married couple would face 
an effective marginal tax rate that was 15 percentage points 
greater than their statutory marginal tax rate--a $3,000 credit 
phased out over a $20,000 income range ($3,000 / $15.000 = 15 
percent).
    For taxpayers in the phase-out range, increasing amounts of 
HOPE or lifetime learning credit will cause the effective 
marginal tax rate to continue to rise increasingly higher 
relative to the statutory marginal tax rate. However, because 
the HOPE and lifetime learning credit are not refundable 
credits, the amount of the credit that can be claimed is 
limited by tax liability. A head of household filer with two 
college age dependent children who takes the standard deduction 
and has an income at the beginning of the phase-out range of 
$40,000 would have a 1998 tax liability of $3,847. Such filer 
could conceivably claim education credits of up to this amount 
if both children qualified for a HOPE credit of $1,500 and the 
parent were potentially eligible for a lifetime learning credit 
of at least $847. Under these circumstances, if the parent 
received an additional $100 dollars of income, the credit would 
decline by $38.47 ($3,847/$10,000). As the taxpayer's statutory 
rate would be 15 percent, their true effective marginal tax 
rate would be 15 percent plus 38.47 percent, or 53.47 percent.
    A married couple filing a joint return would unlikely face 
as large an increase in the effective marginal tax rate as in 
the above example. A married couple that has an income at the 
beginning of the phase-out range of $80,000, files a joint 
return and claims the standard deduction, and has 6 dependent 
children would have a 1998 tax liability of $8,859 before 
credits. It is technically possible, albeit extremely unlikely, 
that each of these children could qualify for a HOPE credit 
totaling the full amount of the tax liability (recall that a 
recipient must be in the first or second year of college, and 
hence it is unlikely that one would have more than two children 
as recipients simultaneously). If this were the case, and the 
parents earn an additional 100 dollars of income, they would 
lose $44.30 in credits ($8,859/$20,000), raising their 
effective marginal tax rate from the 28 percent statutory rate 
to 28 percent plus 44.3 percent, or 62.3 percent. A more 
plausible family structure might lead to $4,000 in credits (two 
HOPE credits and a $1,000 lifetime learning credit--roughly the 
same amount of credits used in the previous example). Under 
these circumstances, the family would lose $20 in credits for 
an additional $100 in income ($4,000/$20,000), raising their 
effective marginal tax rate to 48 percent from 28 percent. This 
20 percentage point rise in the marginal tax rate is roughly 
half that faced by the head of household filer in the previous 
example, who saw an increase in the effective marginal tax rate 
of nearly 40 percentage points for a similar amount of credits.
    As shown in table 11, the Joint Committee staff estimates 
that, in 1998, 1.2 million taxpayers, or 0.9 percent of all 
taxpayers, are in the phase-out range for the HOPE or lifetime 
learning credits out of a total of 8.4 million taxpayers 
claiming the credits. Because the phase out occurs at varying 
but generally middle-income ranges, taxpayers in the phase out 
ranges will be in either the 15 or the 28 percent marginal tax 
rate bracket.

    Table 11.--Distribution by Income of Taxpayers Claiming HOPE and    
        Lifetime Learning Tax Credits and Those in Phaseout Range       
                          [Calendar year 1998]                          
------------------------------------------------------------------------
                                             Taxpayers                  
                                           claiming HOPE                
                                           and lifetime    Taxpayers in 
           Income category \1\               learning     phaseout range
                                              credits        (millions) 
                                            (millions)                  
------------------------------------------------------------------------
Less than $10,000.......................             0.1             0.0
10,000 to 20,000........................             0.6             0.0
20,000 to 30,000........................             1.1             0.0
30,000 to 40,000........................             1.3             0.0
40,000 to 50,000........................             1.1             0.1
50,000 to 75,000........................             2.3             0.1
75,000 to 100,000.......................             1.5             0.4
100,000 to 200,000......................             0.4             0.4
200,000 and over........................           (\2\)           (\2\)
                                         -------------------------------
      Total, all taxpayers..............             8.4             1.2
------------------------------------------------------------------------
\1\ The income concept used to place tax returns into income categories 
  is adjusted gross income plus [1] tax exempt interest, [2] employer   
  contributions for health plans and life insurance, [3] employer share 
  of FICA tax, [4] workers' compensation, [5] nontaxable social security
  benefits, [6] insurance value of Medicare benefits, [7] alternative   
  minimum tax preference items, and [8] excluded income of U.S. citizens
  living abroad. Categories are measured at 1998 levels.                
\2\ Less than 50,000 taxpayers.                                         
                                                                        
Detail may not add to total due to rounding.                            
                                                                        
Source: Joint Committee on Taxation.                                    

  K. Phaseout of Deductibility of Interest on Qualified Student Loans

                              Present Law

    Under the 1997 Act, certain individuals who have paid 
interest on qualified education loans may claim an above-the-
line deduction for such interest expenses, up to a maximum 
deduction of $2,500 per year. The deduction is allowed only 
with respect to interest paid on a qualified education loan 
during the first 60 months in which interest payments are 
required. The maximum deduction is phased in over 4 years, with 
a $1,000 maximum deduction in 1998, $1,500 in 1999, $2,000 in 
2000, and $2,500 in 2001. The provision is effective for 
interest payments due and paid after December 31, 1997, on any 
qualified education loan.
    The student loan interest deduction is phased out ratably 
for individual taxpayers with modified AGI of $40,000-$55,000 
($60,000-$75,000 for joint returns); such income ranges will be 
indexed for inflation occurring after the year 2002, rounded 
down to the closest multiple of $5,000. Thus, the first taxable 
year for which the inflation adjustment could be made will be 
2003. Modified AGI includes amounts otherwise excluded with 
respect to income earned abroad (or income from Puerto Rico or 
U.S. possessions) as well as amounts excludable from gross 
income under section 137 (qualified adoption expenses), and is 
calculated after application of section 86 (income inclusion of 
certain Social Security benefits), section 219 (deductible IRA 
contributions), and section 469 (limitation on passive activity 
losses and credits).

                          Legislative History

    For the 10 years prior to passage of the 1997 Act, student 
loan interest generally was not deductible because the Tax 
Reform Act of 1986 repealed the deduction for personal 
interest. Student loan interest generally is treated as 
personal interest and, thus, was not allowable as an itemized 
deduction from income. Prior to 1987, student loan interest was 
deductible as an itemized deduction.

                                Analysis

    The phaseout of the deduction for interest on qualified 
student loans increases marginal tax rates for taxpayers taking 
advantage of the deduction and having an income in the phase-
out range. The degree to which the phaseout will affect 
marginal tax rates depends on the amount of interest that is 
eligible for the deduction.
    The effective marginal tax rate for taxpayers in the phase-
out range is given by the statutory rate plus the potentially 
excludable interest divided by the length of the phaseout 
range.57 The phase-out range for the deduction spans 
an income range of $15,000 for all taxpayers. Because the 
maximum amount of student loan interest that is potentially 
excludable from income is $2,500 ($1,000 for 1998, rising to 
$2,500 by 2001), the maximum effect of the phaseout on marginal 
tax rates would be to raise them to 116.67 percent of statutory 
rate (statutory rate plus $2,500/$15,000). That is, for each 
additional $100 of income over the beginning of the phase-out 
range, an additional $16.67 would be included in taxable 
income, beyond the $100 itself. If the taxpayer were in the 28-
percent tax bracket, the additional $16.67 that is included in 
income would bear a tax of $16.67 times 28 percent, or $4.67. 
The total additional federal income tax owed on the $100 would 
be $28 for the direct tax on the income itself, plus the $4.67 
owed as a result of the denial of the deduction for $16.67 of 
the interest, for a total tax of $32.67, and hence an effective 
marginal tax rate of 32.67 percent (which, as noted above, is 
116.67 percent of the statutory rate, or 28 percent times 
1.1667). A taxpayer in the 15-percent bracket would see their 
effective marginal tax rate rise to 17.5 percent (15 percent 
times 1.1667) under the same circumstances. Once the taxpayer 
achieved an income level that was $15,000 above the beginning 
of the phase-out range, he or she would be at the end of the 
phaseout and his or her deduction would be fully eliminated.
---------------------------------------------------------------------------
    \57\ Mathematically, where Y denotes income, E denotes the size of 
the full potential deduction, A denotes the actual deduction, I denotes 
the beginning of the phaseout range, L denotes the length of the phase-
out range, and t denotes the statutory marginal tax rate, the 
taxpayer's total tax liability, T, is given by the following 
expression:

        (1) T = (Y-A)t, where

        A = Max(0,E-E(Y-I)/L)

    Substituting the expression for A into (1) for taxpayers in the 
phase-out range yields:

        (2) T = Yt-Et+tEY/
L-tEI/L

    Hence, if Y goes up to $1, T rises by t+tE/L.

  Table 12.--Distribution by Income of Taxpayers Claiming Deduction for 
            Student Loan Interest and Those In Phaseout Range           
                          [Calendar year 1998]                          
------------------------------------------------------------------------
                                             Taxpayer                   
                                             claiming      Taxpayers in 
           Income category \1\             student loan   phaseout range
                                             interest       (millions)  
                                            (millions)                  
------------------------------------------------------------------------
Less than $10,000.......................             0.3             0.0
10,000 to 20,000........................             0.4             0.0
20,000 to 30,000........................             0.4             0.0
30,000 to 40,000........................             0.4             0.0
40,000 to 50,000........................             0.3             0.1
50,000 to 75,000........................             0.5             0.2
75,000 to 100,000.......................             0.1             0.1
100,000 to 200,000......................             0.0             0.0
200,000 to over.........................             0.0             0.0
                                         -------------------------------
      Total, all taxpayers..............             2.3             0.3
------------------------------------------------------------------------
\1\ The income concept used to place tax returns into income categories 
  is adjusted gross income plus [1] tax exempt interest, [2] employer   
  contributions for health plans and life insurance, [3] employer share 
  of FICA tax, [4] workers' compensation [5] nontaxable social security 
  benefits, [6] insurance value of Medicare benefits, [7] alternative   
  minimum tax preference items, and [8] excluded income of U.S. citizens
  living abroad. Categories are measured in 1998 levels.                
                                                                        
Detail may not add to total due to rounding.                            
                                                                        
Source: Joint Committee on Taxation.                                    

   L. Phaseout of Exclusion of Interest from Education Savings Bonds

                              Present Law

    Section 135 provides that interest earned on a qualified 
U.S. Series EE savings bond issued after 1989 is excludable 
from gross income if the proceeds of the bond upon redemption 
do not exceed qualified higher education expenses paid by the 
taxpayer during the taxable year. If the aggregate redemption 
amount (i.e., principal plus interest) of all Series EE bonds 
redeemed by the taxpayer during the taxable year exceeds the 
qualified education expenses incurred, then the excludable 
portion of interest income is based on the ratio that the 
education expenses bears to the aggregate redemption amount 
(sec. 135(b)). ``Qualified higher education expenses'' include 
tuition and fees (but not room and board expenses) required for 
the enrollment or attendance of the taxpayer, the taxpayer's 
spouse, or a dependent of the taxpayer at certain colleges, 
universities, or vocational schools. 58
---------------------------------------------------------------------------
    \58\ The Taxpayer Relief Act of 1997 amended section 135 to allow 
taxpayers to redeem U.S. Savings Bonds and be eligible for the 
exclusion under that section (as if the proceeds were used to pay 
qualified higher education expenses) provided that the proceeds from 
the redemption are contributed to a qualified State tuition program 
defined under section 529, or to an education IRA defined under section 
530, on behalf of the taxpayer, the taxpayer's spouse, or a dependent. 
The Tax Technical Corrections Act of 1997 (Title VI of H.R. 2676), as 
passed by the House on November 5, 1997, includes a technical 
correction provision that conforms the definition of ``eligible 
educational institution'' under section 135 to the broader definition 
of that term under sections 529 and 530. The result of this technical 
correction would be that, for purposes of section 135, as under 
sections 529 and 530, the term ``eligible educational institution'' 
would be defined as an institution which is (1) described in section 
481 of the Higher Education Act of 1965 (20 U.S.C. 1088) and (2) 
eligible to participate in Department of Education student aid 
programs.
---------------------------------------------------------------------------
    The exclusion provided by section 135 is phased out for 
certain higher-income taxpayers, determined by the taxpayer's 
modified AGI during the year the bond is redeemed. For 1998, 
the exclusion is phased out for taxpayers with modified AGI 
between $52,250 and $67,250 ($78,350 and $108,350 for joint 
returns). To prevent taxpayers from effectively avoiding the 
income phaseout limitation through issuance of bonds directly 
in the child's name, section 135(c)(1)(B) provides that the 
interest exclusion is available only with respect to U.S. 
Series EE savings bonds issued to taxpayers who are at least 24 
years old. If a taxpayer is a married individual (within the 
meaning of section 7703), the section 135 exclusion is 
available only if the taxpayer and his or her spouse file a 
joint return for the taxable year the bond is redeemed.

                          Legislative History

    Section 135 was enacted as part of the Technical and 
Miscellaneous Revenue Act of 1988, effective for interest 
earned on United States Series EE savings bonds issued after 
December 31, 1989.

                                Analysis

    The phaseout of the exclusion of interest on U.S. Saving 
Bonds used for qualified education expenses effectively 
increases marginal tax rates for taxpayers taking advantage of 
the exclusion and having an income in the phaseout range. The 
degree to which the phaseout will affect marginal tax rates 
depends on the amount of interest that is eligible for the 
exclusion, which is a function both of the magnitude of 
education expenses and the fraction of Saving Bond redemptions 
that represents accrued interest. The latter in turn will be a 
function of when the savings bonds were purchased--bonds 
purchased longer ago (but no earlier than January 1, 1990 to be 
eligible for the exclusion) will have a higher fraction of 
accrued interest relative to original principal. Conversely, a 
bond purchased last year will have very little accrued interest 
relative to principal. Thus, if a taxpayer has $10,000 in 
qualified education expenses and redeems savings bonds 
purchased 8 years ago for $7,000 dollars whose current value is 
$10,000, then $3,000 of interest is eligible for the exclusion. 
A different taxpayer who redeems $10,000 in bond proceeds but 
who purchased such bonds for $9,000 three years ago, will only 
have $1,000 in interest to deduct.59
---------------------------------------------------------------------------
    \59\ For the purposes of the discussion herein, it is assumed that 
all savings bond proceeds are used for qualified education expenses. 
Recall that both the principal and interest of the saving bond proceeds 
must be used for qualified education expenses for the full amount of 
the interest to qualify for the exclusion. If more savings bonds are 
redeemed than is necessary to pay for education, only a pro-rata share 
of the interest will be potentially eligible for the exclusion.
---------------------------------------------------------------------------
    The effective marginal tax rate for taxpayers in the phase-
out range is given by the statutory rate plus the potentially 
excludable interest divided by the length of the phase-out 
range. For a married taxpayer filing jointly, the length of the 
phase-out range is $30,000. If such a taxpayer has $3,000 in 
potentially excludable interest, then the effective marginal 
tax rate is 110 percent of the statutory rate (statutory rate 
plus $3,000/$30,000). If the taxpayer has only $1,000 in 
potentially excludable interest, then the effective marginal 
tax rate is 103.3 percent of the statutory rate (statutory rate 
plus $1,000/$30,000). For the single or head of household filer 
in the phase-out range, the percentage increases in the 
effective marginal tax rate would be twice as great for the 
same amounts of interest, as the length of the phase-out range 
is only half as large ($15,000). Hence, the $3,000 in 
potentially excludable interest would have to phase out over a 
$15,000 income range, leading to an effective marginal tax rate 
that is 120 percent of the statutory rate (statutory rate plus 
$3,000/$15,000). Similarly, if there were only $1,000 in 
potentially excludable interest, the effective marginal tax 
rates would be 106.7 percent of the statutory rate (statutory 
rate plus $1,000/$15,000).60
---------------------------------------------------------------------------
    \60\ Mathematically, where Y denotes income, E denotes the size of 
the full potential exclusion, A denotes the actual exclusion, I denotes 
the beginning of the phaseout range, L denotes the length of the 
phaseout range, and t denotes the statutory marginal tax rate, the 
taxpayer's total tax liability, T, is given by the following 
expression:

        (1) T = (Y-A)t, where

        A = Max(0, E-E  (Y-I)/L)

    Substituting the expression for A into (1) for taxpayers in the 
phaseout range yields:

        (2) T = Yt-Et+tEY/
L-tEI/L


    Hence, if Y goes up by $1, T rises by t+tE/L. Thus, because 
the phaseout length L for single taxpayers is half that for married 
taxpayers, the same potential exclusion E will result in an increase in 
the effective tax rate that is twice as large for single taxpayers as 
for married taxpayers.
---------------------------------------------------------------------------
    Without adjustments to the length of the phase-out ranges, 
the passage of time will likely lead to situations with 
increasingly higher effective marginal tax rates. The reasons 
for this are twofold: First, qualified education expenses are 
likely to rise as a result of the general rise in education 
costs. Thus, more bond proceeds will be redeemed for education 
expenses, and more interest will be potentially excludable. 
Second, the profile of bonds redeemed for education expenses in 
the future will likely have a greater fraction of accrued 
interest to principal relative to today. The oldest redeemable 
bonds today that are eligible for the exclusion will be only 8 
years old, as they must have been purchased after December 31, 
1989. Ten years from now, the oldest bonds eligible will be 18 
years old, and will thus have a larger fraction of accrued 
interest relative to principal. For example, an 8-year old bond 
with an original principal of $1,000 that has yielded an 
effective 5 percent annual return will be worth $1,477. Hence, 
33 percent of the bond's value is represented by accrued 
interest ($477/$1,477). An 18-year old bond with $1,000 in 
original principal with the same yield would be worth $2,407, 
and hence 58 percent of its value is represented by accrued 
interest ($1,407/$2,407). Hence, 10 years from now it would not 
be unreasonable to expect a single or head of household filer 
to have $15,000 in potentially excludable interest. Since their 
phase-out range for the exclusion is only $15,000 in length, 
each additional dollar in income in the phaseout range will 
cause the loss of a dollar in the savings bond interest 
exclusion, making the effective marginal tax rate equal to 
twice the statutory rate.
    The beginning of the phase-out ranges implies that most 
affected taxpayers are likely to be in the 28 percent statutory 
tax bracket. 61Thus the single or head of household 
taxpayer in the phaseout range with $1,000 of potentially 
excludable interest (which, as previously discussed, produces 
an increase in the effective marginal tax rate of 6.7 percent) 
will have an effective marginal tax rate of 1.067 times 28 
percent, or 29.9 percent. The corresponding married taxpayer 
would face an effective marginal tax rate of 1.033 times 28 
percent, or 28.9 percent. If the potentially excludable 
interest were $3,000, the effective marginal tax rates would be 
33.6 percent and 30.8 percent, respectively.
---------------------------------------------------------------------------
    \61\ For all filing statuses, the beginning of the phase-out ranges 
are well above the bracket break points at which the 28-percent 
statutory rate is effective. Thus, in most cases, unless the taxpayer 
has an unusual number of deductions or exemptions, their taxable income 
will not be reduced below the threshold of the 28-percent bracket. For 
example, for married taxpayers, the beginning of the phase-out range in 
1998 is $78,350. The beginning of the 28-percent bracket is $42,350. 
Thus to be both in the 15-percent bracket and subject to the phaseout, 
the taxpayer would have to have a combination of deductions and 
exemptions of at least $36,000 ($78,350-$42,350). Married taxpayers 
taking the standard deduction of $7,100 would need $28,900 in personal 
exemptions to place them in the 15-percent rate bracket. At $2,700 per 
exemption, this would require 11 personal exemptions. Alternatively, a 
family of four would have $10,800 in personal exemptions. Thus, they 
would need a total of $25,200 in itemized deductions ($36,000-$10,800) 
to be in the 15-percent bracket.
           M. Phaseout of Tax Credit for Elderly and Disabled

                              Present Law

    Individuals who are age 65 or older may claim a 
nonrefundable income tax credit equal to 15 percent of a base 
amount. The credit also is available to an individual, 
regardless of age, who is retired on disability and who was 
permanently and totally disabled at retirement. For this 
purpose, an individual is considered permanently and totally 
disabled if he or she is unable to engage in any substantial 
gainful activity by reason of any medically determinable 
physical or mental impairment that can be expected to result in 
death, or that has lasted or can be expected to last for a 
continuous period of not less than 12 months. The individual 
must furnish proof of disability to the IRS.
    The maximum base amount for the credit is $5,000 for 
unmarried elderly or disabled individuals and for married 
couples filing a joint return if only one spouse is eligible; 
$7,500 for married couples filing a joint return with both 
spouses eligible; or $3,750 for married couples filing separate 
returns. The maximum bases amounts are not indexed for 
inflation. For a nonelderly, disabled individual the initial 
base amount is the lesser of the applicable specified amount or 
the individual's disability income for the year. Consequently, 
the maximum credit available is $750 (15 percent of $5,000), 
$1,125 (15 percent of $7,500), or $562.50 (15 percent of 
$3,750).
    The maximum base amount is reduced by the amount of certain 
nontaxable income of the taxpayer, such as nontaxable pension 
and annuity income or nontaxable Social Security, railroad 
retirement, or veterans' nonservice-related disability 
benefits. In addition, the base amount is reduced by one-half 
of the taxpayer's AGI in excess of certain limits: $7,500 for a 
single individual, $10,000 for married taxpayers filing a joint 
return, or $5,000 for married taxpayers filing separate 
returns. These are also not indexed for inflation. These 
computational rules reflect that the credit is designed to 
provide tax benefits to individuals who receive only taxable 
retirement or disability income, or who receive a combination 
of taxable retirement or disability income plus Social Security 
benefits that generally are comparable to the tax benefits 
provided to individuals who receive only Social Security 
benefits (including Social Security disability benefits).

                          Legislative History

    The present tax credit for individuals who are age 65 or 
over, or who have retired on permanent and total disability, 
was enacted in the Social Security Amendments of 1983 (Code 
sec. 22). This credit replaced the previous credit for the 
elderly, which had been enacted in the Tax Reform Act of 1976. 
Prior to that provision, the tax law provided a retirement 
income credit, which initially was enacted in the Internal 
Revenue Code of 1954.

                                Analysis

    The phaseout of the maximum base amount that determines the 
credit effectively raises marginal tax rates for the affected 
taxpayers in the phase-out range. Because the base amount for 
the 15 percent credit is reduced by $1 for every $2 in AGI 
above certain thresholds, the effective marginal tax rate is 
increased for such individuals by 7.5 percentage points (one-
half of 15 percent). Thus, if the affected taxpayer earns an 
additional dollar of income, the base amount of the credit 
falls by 50 percent. Because the credit is 15 percent of the 
base, the decline in the base by 50 cents causes the credit 
itself to decline by 15 percent of 50 cents, or 7.5 cents. The 
decline in the credit is identical to an increase in tax, and 
the taxpayer thus faces an effective marginal tax rate that is 
7.5 percentage points higher than the statutory 
rate.62 The taxpayers affected by this provision 
will exclusively be in the 15-percent statutory bracket as a 
result of the low income levels at which the credit is phased 
out ($7,500-$17,500 for singles and $10,000-$20,000 for married 
filing jointly).63 Thus, the effective marginal tax 
rate for these taxpayers will be 15 percent plus 7.5 percent or 
22.5 percent.
---------------------------------------------------------------------------
    \62\ Mathematically, where Y denotes income, M denotes the maximum 
base amount, B denotes the actual base amount, I denotes the beginning 
of the phaseout range, and t denotes the statutory marginal tax rate, 
the taxpayer's total liability, T, is given by the following 
expression:

        (1) T = Yt-.15B, where

        B = M-.5(Y-I) for taxpayers in the phaseout range.

    Substituting the expression for B into (1) for taxpayers in the 
phaseout range yields:

        (2) T = Yt-.15M+.075Y-.075I

    Hence, if Y goes up by $1, T rises by t+.075.
    \63\ In order to be eligible for the credit (a necessary condition 
to be affected by a phaseout), one must have positive regular tax 
liability since the credit is a non-refundable credit. Thus, despite 
the relatively low income range of the phaseout of this credit, one 
could not be in the 0 percent bracket and be affected by the phaseout.
---------------------------------------------------------------------------
    In addition to the phaseout of the maximum base amount due 
to increases in AGI above certain levels, the maximum base 
amount phases out dollar for dollar for each additional dollar 
of nontaxable income such as nontaxable pensions, annuity or 
social security income. This dollar for dollar phaseout, as 
opposed to the $1 phaseout for each $2 increase in AGI, would 
increase marginal tax rates by twice as much, or the full 15 
percent, for any additional income in the nontaxable form. 
Unlike AGI, these forms of income tend to be predetermined and 
inflexible. As a result, it is probably incorrect to think of 
this provision as increasing effective marginal tax rates by 15 
percentage points, because it is difficult for the taxpayer to 
marginally increase such income.
    The Joint Committee staff estimates that approximately 
200,000 taxpayers, or less than two-tenths of one percent of 
all taxpayers, are affected by the phaseout.
   N. Phaseout of the Adoption Tax Credit and Exclusion for Adoption 
                                Expenses

                              Present Law

Tax credit

    Present law provides taxpayers with a maximum nonrefundable 
tax credit against income tax liability of $5,000 per child for 
qualified adoption expenses paid or incurred by the taxpayer. 
In the case of a special needs adoption, the maximum credit 
amount is $6,000 ($5,000 in the case of a foreign special needs 
adoption). A special needs child is a child who the State has 
determined: (1) cannot or should not be returned to the home of 
the birth parents, and (2) has a specific factor or condition 
because of which the child cannot be placed with adoptive 
parents without adoption assistance 64. Examples of 
factors or conditions are the child's ethnic background, age, 
membership in a minority or sibling group, medical conditions, 
or physical, mental, or emotional handicaps. To the extent the 
otherwise allowable credit exceeds the tax liability limitation 
of section 26 (reduced by other personal credits) the excess 
shall be carried forward as an adoption credit into the next 
taxable year, up to a maximum of five taxable years.
---------------------------------------------------------------------------
    \64\ After December 31, 2001, for purposes of the credit, only 
domestic special needs adoptions will qualify as special needs 
adoptions.
---------------------------------------------------------------------------
    Qualified adoption expenses are reasonable and necessary 
adoption fees, court costs, attorneys' fees, and other expenses 
that are directly related to the legal adoption of an eligible 
child. All reasonable and necessary expenses required by a 
State as a condition of adoption are qualified adoption 
expenses. In the case of an adoption of a child who is not a 
citizen or a resident of the United States (foreign adoption), 
the credit is not available unless the adoption is finalized. 
In the case of otherwise qualified expenses that are incurred 
in an adoption that is not yet identified as either a domestic 
or a foreign adoption, the credit is not available until the 
expenses are identified as either relating to a domestic 
adoption (whether or not finalized) or to a finalized foreign 
adoption. In some instances that may require the filing of an 
amended tax return.
    An eligible child is an individual (1) who has not attained 
age 18 or (2) who is physically or mentally incapable of caring 
for himself or herself. After December 31, 2001, the credit 
will be available only for domestic special needs adoptions. No 
credit is allowed for expenses incurred (1) in violation of 
State or Federal law, (2) in carrying out any surrogate 
parenting arrangement, (3) in connection with the adoption of a 
child of the taxpayer's spouse, or (4) that are reimbursed 
under an employer adoption assistance program or otherwise.
    The credit is phased out ratably for taxpayers with 
modified adjusted gross income (AGI) above $75,000, and is 
fully phased out at $115,000 of modified AGI. For these 
purposes modified AGI is computed by increasing the taxpayer's 
AGI by the amount otherwise excluded from gross income under 
Code sections 911, 931, or 933 (relating to the exclusion of 
income of U.S. citizens or residents living abroad; residents 
of Guam, American Samoa, and the Northern Mariana Islands, and 
residents of Puerto Rico, respectively).
    The $5,000 limit is a per child limit, not an annual 
limitation. For example, if in the case of an attempt to adopt 
a child a taxpayer pays or incurs $3,000 of qualified adoption 
expenses in year one and $3,000 of qualified adoption expenses 
in year two, then the taxpayer would receive $5,000 not $6,000 
of credit. To illustrate further, if a taxpayer pays or incurs 
$1,000 of otherwise qualified adoption expenses at each of 
three agencies in unsuccessful attempts to adopt a child before 
paying or incurring $4,000 of otherwise qualified adoption 
expenses in a successful domestic adoption, the taxpayer's 
maximum adoption credit is $5,000, not $7,000. The credit may 
be less than $5,000 because of other limitations. When more 
than one taxpayer (e.g., more than one unmarried individual) 
who are parties to an adoption pays or incurs qualified 
adoption expenses for the adoption of the same child, the total 
adoption credit claimed by all parties shall not exceed $5,000.
    Otherwise qualified adoption expenses paid or incurred in 
one taxable year are not taken into account for purposes of the 
credit until the next taxable year unless the expenses are paid 
or incurred in the year the adoption becomes final or any year 
thereafter. To illustrate this rule, consider again the example 
of a taxpayer who pays or incurs $3,000 of qualified adoption 
expenses in year one and $3,000 of qualified adoption expenses 
in year two for a domestic adoption. Assume the adoption is not 
finalized until year three. Under this general rule, the $3,000 
of qualified expenses paid or incurred in year one would be 
allowed in year two and $2,000 of the $3,000 paid or incurred 
in year two would be allowed in year three. Alternatively, if 
the adoption was finalized in year two, then $5,000 of 
qualified expenses would be allowed in year two.
    To avoid a double benefit, the credit is denied to 
taxpayers to the extent the taxpayer may use otherwise 
qualified adoption expenses as the basis of another credit or 
deduction. Similarly, the credit is not allowed for any 
expenses for which a grant is received under any Federal, 
State, or local program. This denial of the credit also applies 
in the case of special needs adoptions. Also, when the adoption 
credit is allowed because the taxpayer expends amounts 
chargeable to a capital account (e.g., the costs of 
constructing a ramp at the taxpayer's house to accommodate a 
wheelchair that is required as a condition of the adoption), 
the taxpayer is not allowed additional basis in the house to 
the extent of the adoption credit allowed. Where the amount of 
qualified adoption expenses exceeds $5,000, (e.g., $5,000 of 
legal fees and $5,000 of ramp construction costs) it is 
intended that the amounts not chargeable to a capital account 
(the legal fees) are treated as the basis of the credit before 
any amounts that are chargeable to a capital account. In this 
way, for example, the taxpayer may satisfy the requirements of 
the adoption credit with the legal fees and may add the ramp 
construction costs to the basis in the house.
    Individuals who are married at the end of the taxable year 
must file a joint return to receive the credit unless they 
lived apart from each other for the last six months of the 
taxable year and the individual claiming the credit (1) 
maintained as his or her home a household for the child for 
more than one-half of the taxable year and (2) furnished over 
one-half of the cost of maintaining that household in that 
taxable year. An individual legally separated from his or her 
spouse under a decree of divorce or separate maintenance is not 
considered married for purposes of this provision.

Exclusion from income

    Present law provides a maximum $5,000 exclusion from the 
gross income of an employee for qualified adoption expenses (as 
defined above) paid by the employer. The $5,000 limit is a per 
child limit, not an annual limitation. In the case of a special 
needs adoption, the maximum exclusion from income is $6,000 
($5,000 in the case of foreign special needs adoptions). No 
exclusion is allowed for amounts paid or incurred by an 
employer after December 31, 2001. In order for the exclusion to 
apply, the expenses would have to be paid under an adoption 
assistance program in connection with an adoption of an 
eligible child (as described above) by an employee.
    An adoption assistance program is a nondiscriminatory plan 
of an employer under which the employer provides employees with 
adoption assistance. Also, not more than 5 percent of the 
benefits under the program for any year may benefit a class of 
individuals consisting of more than 5-percent owners of the 
employer and the spouses or dependents of such more than 5-
percent owners. An adoption assistance program is not required 
to be funded but must provide reasonable notification of the 
availability and terms of the program to eligible employees. An 
adoption reimbursement program operated under section 1052 of 
title 10 of the U.S. Code (relating to the armed forces) or 
section 514 of title 14 of the U.S. Code (relating to members 
of the Coast Guard) is treated as an adoption assistance 
program for these purposes. Adoption assistance is a qualified 
benefit under a cafeteria plan. The exclusion is phased out 
ratably for taxpayers with modified AGI above $75,000 and is 
fully phased out at $115,000 of modified AGI (in the same 
manner as the adoption credit). Adoption expenses paid or 
reimbursed under an adoption assistance program may not be 
taken into account in determining the adoption credit. A 
taxpayer may, however, satisfy the requirements of the adoption 
credit and exclusion with different expenses paid or incurred 
by the taxpayer and employer respectively. For example, in the 
case of an adoption that costs $10,000 with $5,000 of expenses 
paid by the taxpayer and $5,000 paid by the taxpayer's employer 
under an adoption assistance program, the taxpayer may qualify 
for the adoption credit and the exclusion.
    In the case of amounts paid or expenses incurred under an 
adoption assistance program that may otherwise be chargeable to 
a capital account, an ordering rule similar to the one for the 
adoption credit applies.

                          Legislative History

    The adoption tax credit and the exclusion were enacted in 
the Small Business Job Protection Act of 1996.

                                Analysis

    The phaseout of the adoption credit and exclusion affects 
marginal tax rates in the same manner as the previously 
discussed phaseouts of other credits and exclusions. Both the 
credit and the exclusion are phased out over the same income 
range for all taxpayers (beginning at $75,000 in modified 
adjusted gross income and ending at $115,000), or a range of 
$40,000. The operation of the phaseout implies that for each 
$1,000 of income over the phaseout range, 2.5 percent ($1,000 / 
$40,000) of the credit or exclusion is disallowed. Hence, the 
increment to effective marginal tax rates that the phaseout 
implies depends on the size of the credit or exclusion itself. 
For a $5,000 credit, 2.5 percent of the credit is $125. The 
loss of such amounts of credit for earning an additional $1,000 
of income implies an effective marginal tax rate with respect 
to the phaseout alone of 12.5 percent ($125 / $1000). If the 
affected taxpayer is in the 28 percent rate bracket, which is 
likely given the phase-out range, the taxpayer's total 
effective marginal tax rate will be 28 percent plus 12.5 
percent, or 40.5 percent. For a potential $5,000 exclusion, the 
loss of the exclusion is also $125, but the loss of an 
exclusion is not as harmful as the loss of a credit, because 
the exclusion is less valuable than the credit. The loss of 
$125 in exclusions, for a taxpayer in the 28 percent bracket, 
will cause taxes to rise by only 28 percent of the lost 
exclusion, whereas the taxes would rise by the full amount of a 
lost credit. The value of the lost exclusion of $125 for a 
taxpayer in the 28 percent bracket is $35 (28 percent of $125). 
The rise in taxes of $35 (from the lost exclusion alone) as a 
result of an increase in modified adjusted gross income of 
$1,000 implies an increase in the effective marginal tax rate 
of 3.5 percentage points ($35 / $1000). Of course, such 
taxpayer would also owe an additional $280 on the increase in 
income itself. In total, such taxpayer's effective marginal tax 
rate would be 31.5 percent (28 percent plus 3.5 percent). As 
noted above, the taxpayer that lost a credit of the same 
magnitude would face an effective marginal tax rate of 40.5 
percent.65
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    \65\ With respect to the exclusion: Let Y denote income, E denote 
the size of the full potential exclusion, A denote the actual 
exclusion, I denote the beginning of the phaseout range, L denote the 
length of the phaseout range, and t denote the statutory marginal tax 
rate. The taxpayer's total tax liability, T, is given by the following 
expression:

      (1) T = (Y-A)t, where

        A = Max(0, E-E(Y-I)/L)

    Substituting the expression for A into (1) for taxpayers in the 
phaseout range yields:

      (2) T = Yt-Et+tEY/
L-tEI/L

    Hence, if Y goes up by $1, T rises by t+tE/L.

    With respect to the credit: Let Y, I, L and t be as above. Also let 
C denote the size of the full potential credit and A denote the actual 
credit. The taxpayer's total tax liability, T, is given by the 
following expression:

      (1) T = Tt-A, where
        A = Max(0, C-{(Y-I)/L}C)

    Substituting the expression for A into (1) for taxpayers in the 
phaseout range yields:

      (2) T = Yt-C+CY/P-I/LC

    Hence, if Y goes up by $1, T rises by t+C/L.
---------------------------------------------------------------------------
    If the taxpayer were eligible for both the credit and the 
exclusion, the increase in the effective marginal tax rate 
would be additive, since both the credit and exclusion are 
phased out over the same income range. Thus, if both a $5,000 
credit and a $5,000 exclusion were applicable, the taxpayer's 
effective marginal tax rate in the phaseout range would be 28 
percent plus the increment to the effective marginal tax rate 
due to the credit phaseout (12.5 percent) and that due to the 
phaseout of the exclusion (3.5 percent) for a total effective 
marginal tax rate of 44 percent, or 16 percentage points 
greater than the statutory rate. In theory, the effective 
marginal tax rate could rise substantially higher for a 
taxpayer who adopted multiple children in the same year. A 
doubling of the credit or exclusion in the above examples would 
double the increment to the effective marginal tax rate. The 
magnitude of the increment to the effective marginal tax rate 
is limited, however, by the fact that the credit is 
nonrefundable, and thus its maximum size is given by the 
taxpayer's tax liability before credits.
  O. Phaseout of First-Time Homebuyer Tax Credit for the District of 
                                Columbia

                              Present Law

    First-time homebuyers of a principal residence in the 
District of Columbia may be eligible for a tax credit of up to 
$5,000 of the amount of the purchase price. The $5,000 maximum 
credit amount applies both to individuals and married couples. 
Married individuals filing separately can claim a maximum 
credit of $2,500 each. The first-time homebuyer credit is 
available only for property purchased after August 4, 1997, and 
before January 1, 2001.
    The credit phases out for individual taxpayers with 
modified AGI between $70,000 and $90,000 ($110,000-$130,000 for 
joint filers). For this purpose, modified AGI means adjusted 
gross income increased by any amount excluded under section 911 
(certain foreign earned income), section 931 (income from 
sources within Guam, American Samoa, or the Northern Mariana 
Islands), or section 933 (income from sources within Puerto 
Rico).

                          Legislative History

    The tax credit for first-time homebuyers in the District of 
Columbia was enacted as part of the Taxpayer Relief Act of 
1997.

                                Analysis

    The District of Columbia first-time home buyer credit 
phases out at a rate of 25 percent for taxpayers within the 
phase-out ranges.66 For a taxpayer who would 
otherwise claim the maximum $5,000 credit, and whose income is 
within the phase-out range, an increase in income of $1,000 
reduces the maximum amount of credit that he or she may claim 
by $250. Because this is a tax credit that is reduced, rather 
than a deduction, the taxpayer's tax liability increases by 
$250. This increase in tax liability is in addition to the tax 
liability that the taxpayer would incur by the application of 
the statutory marginal tax rates to the increase in income of 
$1,000. Thus, the phaseout of the District of Columbia first-
time home buyer credit creates effective marginal tax rates 
that equal the taxpayer's statutory marginal tax rate plus 25 
percentage points. For taxpayers in the 28-percent statutory 
marginal tax rate bracket, the effective marginal tax rate 
becomes 53 percent (28 percent plus 25 percent).67
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    \66\ Because the income phase-out range of single taxpayers ranges 
from AGI of $70,000 through $90,000, while that of married taxpayers 
who file a joint return ranges from $110,000 through $130,000, a 
marriage penalty effectively exists on single individuals who might 
contemplate marrying and making a first-time purchase of a home in the 
District of Columbia. In addition, because the maximum credit is $5,000 
for both single and married individuals, a separate marriage penalty 
may exist even for taxpayers whose income would place them below the 
phase-out range. See discussion in Joint Committee on Taxation, Present 
Law and Background Relating to Proposals to Reduce the Marriage Tax 
Penalty (JCX-1-98), January 27, 1998.
    \67\ Mathematically, let T be tax liability, t the taxpayer's 
statutory marginal tax rate, $5,000 the District of Columbia first-time 
homebuyer credit that the taxpayer intends to claim, and I the income 
threshold. If the taxpayer's income is less than the threshold level, 
one can write the taxpayer's tax liability as

        (1) T = Yt-5,000

    If the taxpayer is in the phase-out range then the taxpayer's tax 
liability is

        T = Yt-(5,000-(Y-I)(.25))

    which simplifies to equation (2).
        (2) T = Y (t+.25)-5,000-I(.25)

    Thus, for every $1.00 increase in income, Y, the taxpayer's tax 
liability increases by his or her statutory marginal tax rate phases 25 
percentage points, t+.25.
---------------------------------------------------------------------------
    The increase in effective marginal tax rates that results 
from the phaseout of the District of Columbia first-time home 
buyer credit affects only those taxpayers who qualify as a 
first-time home buyer and who purchase a residence within the 
District of Columbia between August 5, 1997 and December 31, 
2000. The increase in effective marginal tax rates would be 
expected to affect all qualifying buyers whose income places 
them in the phaseout, because all such buyers may claim the 
full $5,000 credit. Certain buyers may have insufficient income 
tax liability to claim this nonrefundable credit in the current 
year, but, as described above, unused credit may be carried 
forward indefinitely. By denying credit in a future year, there 
would be no effect on current year effective marginal tax 
rates, but the future year's effective marginal tax rate would 
equal the future year's statutory marginal tax rate plus 25 
percentage points.68 The credit also may not be 
claimed against alternative minimum tax liability. If a 
taxpayer were otherwise subject to the alternative minimum tax, 
the phaseout of the credit would have no effect on the 
taxpayer's effective marginal tax rate in that year.
---------------------------------------------------------------------------
    \68\ Taxpayers who claim the credit must reduce their basis in the 
property by the amount of the credit claimed. This may increase their 
future tax liability when they sell the property because under Code 
sec. 121 gain on the sale of a principal residence, above certain 
amounts, is subject to tax. Most analysts believe that the number of 
sales of principal residences that will give rise to any income tax 
will be small. However, if a subsequent sale were taxable and the 
taxpayer had some of the credit denied by virtue of the phaseout, then 
the taxpayer's basis would be larger than it otherwise would have been 
and, consequently, his or her taxable gain would be reduced. Thus, to 
calculate the true effective marginal tax rate created by the phaseout, 
the calculation in the text should be reduced by the expected present 
value of reduced future tax liability upon sale of the residence. 
Accounting for this possible future effect, the taxpayer's effective 
marginal tax rate is greater than the statutory marginal tax rate, but 
less than the statutory marginal tax rate plus 25 percentage points.
---------------------------------------------------------------------------
    Because the phaseout does not affect single taxpayers with 
AGI greater than $90,000, nor married taxpayers with AGI 
greater than $130,000, the provision generally does not affect 
taxpayers in the 36- or 39.6-percent statutory marginal tax 
rate brackets. Nor would the provision be expected to affect 
many eligible taxpayers in the 31-percent statutory marginal 
tax rate bracket. Because the phaseout does not affect single 
taxpayers with AGI less than $70,000, nor married taxpayers 
with AGI less than $110,000, the provision is not likely to 
affect taxpayers in the 15-percent marginal tax bracket. 
Taxpayers most likely to be affected are those in the 28-
percent statutory marginal tax bracket. As the analysis above 
suggests, some of these taxpayers may face effective marginal 
tax rates of 53 percent (28 plus 25). However, the provision is 
limited to taxpayers who purchase a qualifying residence in the 
District of Columbia. The number of taxpayers who will face an 
effective marginal tax rate in excess of their statutory 
marginal tax rate due to this provision is likely to be small.
P. Phaseout of Allowance of Certain Rental Real Estate Losses Under the 
                           Passive Loss Rules

                              Present Law

In general

    The passive loss rules were enacted in 1986 to curb the 
expansion of tax sheltering. These rules limit deductions and 
credits from passive trade or business activities (Code sec. 
469). Deductions attributable to passive activities, to the 
extent they exceed income from passive activities, generally 
may not be deducted against other income, such as wages, 
portfolio income, or business income that is not derived from a 
passive activity. A similar rule applies to credits.
    Deductions and credits that are suspended under these rules 
are carried forward and treated as deductions and credits from 
passive activities in the next year. The suspended losses from 
a passive activity are allowed in full when a taxpayer disposes 
of his entire interest in the passive activity to an unrelated 
person.
    The passive loss rules apply to individuals, estates and 
trusts, closely held C corporations, and personal service 
corporations. A special rule permits closely held C 
corporations to apply passive activity losses and credits 
against active business income (or tax liability allocable 
thereto) but not against portfolio income.
    Passive activities are defined to include trade or business 
activities in which the taxpayer does not materially 
participate. Rental activities (generally including rental real 
estate activities) are also treated as passive activities, 
regardless of the level of the taxpayer's participation.\69\
---------------------------------------------------------------------------
    \69\ A special rule provides that a taxpayer's rental real estate 
activities in which he materially participates are not subject to 
limitation under the passive loss rules, if the taxpayer meets certain 
eligibility requirements relating to real property trades or businesses 
in which the taxpayer performs services.
---------------------------------------------------------------------------

$25,000 allowance of rental real estate losses and phaseout

    A special rule permits the deduction of up to $25,000 of 
losses from rental real estate activities (even though such 
activities are generally considered passive), if the taxpayer 
actively participates in them. This $25,000 amount is allowed 
for taxpayers with adjusted gross incomes (AGI) of $100,000 or 
less. The $25,000 amount is phased out ratably as AGI increases 
from $100,000 to $150,000. The $100,000 and $150,000 amounts 
are not indexed.
    In the case of the rehabilitation credit and the low-income 
housing credit, generally a $25,000 deduction-equivalent amount 
is allowed without regard to whether the taxpayer actively 
participates in the rental real estate activity. In the case of 
the rehabilitation credit, the $25,000 amount is phased out 
ratably as AGI increases from $200,000 to $250,000. The $25,000 
deduction-equivalent amount is not phased out in the case of 
the low-income housing credit.

                          Legislative History

    The passive loss rules were enacted in the Tax Reform Act 
of 1986. As originally enacted, the phaseout rule provided that 
the $25,000 allowance generally was phased out for taxpayers 
with AGI between $100,000 and $150,000 (which is still present 
law). However, the AGI range for the phaseout was $200,000 to 
$250,000 for rehabilitation and low-income housing credits, as 
the rule was originally enacted. Present-law treatment for low-
income housing credits was enacted in the Omnibus Budget 
Reconciliation Act of 1989, which repealed the phaseout for the 
low-income housing credit.

                                Analysis

    As explained above, the allowance of up to $25,000 of 
passive losses accrued by individual taxpayers is phased out 
for taxpayers with AGI in excess of $100,000 ($200,000 in the 
case of the rehabilitation credit), regardless of whether the 
taxpayer's filing status is married filing jointly, single, or 
head of household.\70\ The phaseout has the effect of 
increasing the taxpayer's effective marginal tax rate above his 
or her statutory marginal tax rate. However, the phaseout 
provisions alter effective marginal tax rates differently than 
most of the other provisions discussed in this pamphlet. First, 
not all taxpayers with AGI that is within the phaseout range 
are affected. Second, while the effect of the provisions 
phasing out the allowance of $25,000 of passive losses raises 
the taxpayer's tax liability in the current year, the phaseout 
does not permanently deny these deductions. It suspends the 
deductions. Allowing the suspended deductions in a future 
taxable year (when the taxpayer disposes of the passive 
activity) reduces the taxpayer's future tax liability. The 
analysis below discuses the current- and future-year effects in 
turn.
---------------------------------------------------------------------------
    \70\ The presence of an income threshold that is invariant across 
filing status creates a marriage penalty that is specific to that 
provision. See the discussion in Joint Committee on Taxation, Present 
Law and Background Relating to Proposals to Reduce the Marriage Tax 
Penalty (JCX-1-98), January 27, 1998. In addition, the present 
discussion will ignore taxpayers who are married, but choose to file 
separately. Because both the $25,000 amount and the income limitations 
are halved for married individuals filing separately, the effective 
marginal tax rates for such individuals generally are no different than 
for married taxpayers who choose to file jointly.
---------------------------------------------------------------------------
    The phase-out rate of 50 percent has the effect of 
increasing the taxpayer's marginal tax in the current year to 
150 percent of the statutory tax rate. The phase-out rate 
implies that for each dollar of additional income earned from 
any taxable source beyond $100,000, the $25,000 exemption is 
reduced by 50 cents. This means that the taxpayer's taxable 
income in the current year increases by $1.50. One dollar of 
the increase is from the additional dollar of income and 50 
cents of the increase occurs because the taxpayer can no longer 
currently deduct 50 cents worth of otherwise deductible passive 
losses. Thus, if $1.00 of additional income increases taxable 
income by $1.50, the additional tax owed in the current year 
will be 1.50 times the statutory marginal tax rate. That is, 
the taxpayer's effective marginal tax rate is 150 percent of 
the statutory marginal tax rate.\71\ Because the phaseout is at 
a 50 percent rate, the $25,000 allowable amount is completely 
phased out at AGI of $150,000 ($250,000 in the case of the 
rehabilitation credit), above which point the effective 
marginal tax rate would again be the statutory marginal tax 
rate.
---------------------------------------------------------------------------
    \71\ Mathematically, when Y denotes income, D denotes deductible 
passive losses, and t denotes the marginal tax rate, the taxpayer's 
total tax liability, T is given by the following expression:

      (1) T = (Y-D)t = Yt-Dt

    If Y increases by $1.00, tax liability increases by t.
    Assume the taxpayer has $25,000 in passive losses. For taxpayers 
with AGI in excess of $100,000, the amount of deductible passive 
losses, D,  is given by the equation (2).

      (2) D = $25,000-(.5)(Y-$100,000)

    To determine the tax liability of taxpayers with AGI in excess of 
$100,000, one must substitute equation (2) into equation (1). The 
result follows.

      (3) T = (Y-(25,000-(.5)Y+50,000)t

      (4)T = Y(1.5)t-75,000t

    If Y increases by $1.00, tax liability increases by (1.5)t.
---------------------------------------------------------------------------
    As noted above, denial of the deduction in the current year 
generally increases deductions in some future years. While 
$1,000 of additional income in the current year increases 
taxable income by $1,500 for a taxpayer in the phaseout range, 
the $500 of losses suspended (50 percent of $1,000) reduces 
taxable income by $500 in the future when the taxpayer disposes 
of the passive activity. Because of the time value of money, 
the tax benefit of a $500 reduction in income in the future is 
less than the tax cost of a $500 inclusion in income in the 
current year. For example, if the $500 loss is claimed 10 years 
from now and the discount rate is 10 percent,\72\ the present 
value of the suspended loss is $192.77. If the taxpayer has the 
same marginal tax rate in the future as in the current year, 
the additional $1,000 of current year income increases the 
present value of the taxpayer's lifetime tax payments by $1,000 
times the current year statutory marginal tax rate plus $307.23 
($500 minus $192.77) times the statutory marginal tax rate.\73\ 
Thus, under these facts, the phaseout creates an effective 
marginal tax rate equal to 130.1 percent of the statutory 
marginal tax rate.
---------------------------------------------------------------------------
    \72\ The suspended $500 is a nominal dollar value. Nominal values 
should be discounted using a nominal interest rate. Ten percent was 
chosen for simplicity.
    \73\ Mathematically, let to be the taxpayer's current 
year statutory marginal tax rate and tn the taxpayer's 
statutory marginal tax rate in year n in the future. Also let r be the 
discount rate. Then equation (4) of footnote 71 above should be 
modified to let T represent the present value of lifetime tax liability 
as follows:

      (5) T = Y(1.5to-((.5tn)/
(1+r)n))-75,000to+50,000tn/
(1+r)n
---------------------------------------------------------------------------
    In general, the longer the losses remain suspended, 
or the higher the discount rate, the closer the effective 
marginal tax rate is to 150 percent of the current year 
statutory marginal tax rate. The shorter the suspense period or 
the smaller the discount rate, the closer the effective 
marginal tax rate is to the statutory marginal tax rate. If the 
taxpayer's statutory marginal tax rate in the future is greater 
than the taxpayer's current year statutory marginal tax rate, 
the taxpayer's effective marginal tax rate in the current year 
could be less than the taxpayer's current year statutory 
marginal tax rate.\74\ If the taxpayer's statutory marginal tax 
rate in the future is less than the taxpayer's current year 
statutory marginal tax rate, the taxpayer's effective marginal 
tax rate in the current year will be closer to 150 percent of 
the current year statutory marginal tax rate.
---------------------------------------------------------------------------
    \74\ Using the first term of equation (5) of footnote 73, if the 
discount rate is 7 percent, the taxpayer's current year statutory 
marginal tax rate is 28 percent, the taxpayer's future statutory 
marginal tax rate is 36 percent, and the suspense period is three 
years, the taxpayer's effective marginal tax rate is 27.3 percent.
---------------------------------------------------------------------------
    The increase in effective marginal tax rates that results 
from the phaseout of the $25,000 allowance under the passive 
loss limitations may affect a more limited number of taxpayers 
than other phaseout provisions. Generally, taxpayers expecting 
to be above the income levels at which the $25,000 of losses or 
the deduction-equivalent amount of rehabilitation credit is 
allowed will not invest in these projects rather than have the 
losses or credits limited by the passive loss rules.
    Moreover, the provision does not affect all taxpayers with 
incomes between $100,000 and $150,000 even if they have 
qualifying passive losses, because the phaseout does not wholly 
deny passive loss deductions to all taxpayers claiming them, 
but rather reduces the $25,000 amount. Thus, if Taxpayer A and 
Taxpayer B each have an AGI of $130,000, but Taxpayer A has 
$5,000 of eligible passive losses and Taxpayer B has $20,000 of 
eligible passive losses, the phaseout affects only Taxpayer B. 
An AGI of $130,000 reduces the limit on deductible expenses 
from $25,000 to $10,000. Because the limitation is binding on 
the eligible passive losses of Taxpayer B, Taxpayer B will have 
an effective marginal tax rate equal to 1.5 times the statutory 
tax rate.\75\ The limitation is not binding on Taxpayer A. 
Thus, Taxpayer A's effective marginal tax rate will equal the 
statutory marginal tax rate.
---------------------------------------------------------------------------
    \75\ For simplicity, the discussion of this and the subsequent 
paragraph will ignore the effect of the suspended loss deductions on 
the effective marginal tax rate.
---------------------------------------------------------------------------
    Because the phaseout does not affect taxpayers with AGI 
less than $100,000, the provision generally does not affect 
taxpayers in the 15-percent statutory marginal tax rate 
brackets. Some taxpayers in the 28- and 31-percent statutory 
marginal tax rate brackets may experience effective current 
year marginal tax rates of 42 percent and 46.5 percent (1.5 
times 28 and 31). Some taxpayers who file single and head of 
household returns and who are in the 36- percent statutory 
marginal tax rate bracket may experience an effective marginal 
tax rate of 54 percent (1.5 times 36). Because the exemption is 
completely phased out for AGI in excess of $150,000, effective 
marginal tax rates do not differ from statutory marginal tax 
rates for any taxpayer in the 39.6-percent statutory marginal 
tax rate bracket or for married taxpayers in the 36-percent 
statutory marginal tax rate bracket.
    In the case of the rehabilitation tax credit, for which the 
allowance is phased out for AGI between $200,000 and $250,000, 
generally taxpayers in the 15-, 28-, and 39.6-percent brackets 
do not have an effective marginal tax rate different from their 
statutory marginal tax rate. Taxpayers in the 31- and 36-
percent statutory marginal tax rate bracket may experience 
effective marginal tax rates of 46.5 and 54 percent 
respectively.
  Q. Income Phasein of Recapture of Subsidy from the Use of Qualified 
            Mortgage Bonds and Mortgage Credit Certificates

                              Present Law

    Qualified mortgage bonds (``QMBs'') generally are used to 
finance the purchase or qualifying rehabilitation or 
improvement of single family, owner-occupied homes. The 
recipients of QMB-financed loans must meet purchase price, 
income, and other restrictions.
    Qualified governmental units may elect to exchange 
qualified mortgage bond authority for authority to issue 
mortgage credit certificates (``MCCs''). MCCs entitle 
homebuyers to nonrefundable income tax credits for a specified 
percentage of interest paid on mortgage loans on their 
principal residences. Once issued, an MCC generally remains in 
effect as long as the residence being financed continues to be 
the certificate-recipient's principal residence. MCCs generally 
are subject to the same borrower eligibility requirements as 
QMBs.
    A portion of the QMB and MCC subsidy (other than qualified 
home improvement loans) is recaptured upon disposition of a 
house financed with an assisted loan within nine years if the 
borrower has experienced a substantial increase in income over 
that period of time. This recapture provision applies only with 
respect to loans originating after December 31, 1990. The 
amount of the recapture is phased out at a rate of 20 percent 
per year for each year over 5 years that the taxpayer resides 
in the home. The recapture is the lesser of 50 percent of the 
gain realized on disposition or 1.25 percent of the highest 
principal amount multiplied by the number of years (up to a 
maximum of 5 years) that the taxpayer has owned the home. 
Recapture only applies to those recipients whose income rises 
substantially (i.e., more than 5-percent compounded annually) 
after the financing is received relative to the applicable 
family income limit (adjusted for family size) in the year the 
financing was received.

                          Legislative History

    The Mortgage Subsidy Bond Tax Act of 1980 first imposed 
restrictions on the ability of States and local governments to 
issue tax-exempt bonds to finance mortgage loans on single-
family, owner-occupied residences. These restrictions included 
many of the rules applicable under present law.
    The Deficit Reduction Act of 1984 enacted the MCC 
alternative to QMBs. The Tax Reform Act of 1986 imposed a State 
volume limitation on the issuance of QMBs and certain other 
private activity bonds. The Technical and Miscellaneous Revenue 
Act of 1988 (``TAMRA'') enacted substantial modifications to 
the MCC and QMB programs, including imposition of the recapture 
provision described above. Under TAMRA, the recapture provision 
applied to dispositions within ten years after purchase (rather 
than nine years as under present law).
    The Omnibus Budget Reconciliation Act of 1990 (``1990 
Act'') made three principal modifications to the recapture 
provision. First, the maximum recapture period was reduced from 
10 years to 9 years. Second, the amount recaptured was adjusted 
annually throughout this 9-year period rather than monthly. 
Thus, the recapture amount is the lesser of: (1) 50 percent of 
the gain realized on disposition or (2) a percentage of the 
imputed MRB or MCC subsidy (other than qualified home 
improvement loans). The imputed subsidy limitation is 20 
percent for dispositions within one year after a homebuyer 
receives the MRB or MCC financing. The percentage increases to 
40 percent in year two, 60 percent in year three, 80 percent in 
year four, and 100 percent in year five. The imputed subsidy 
limitation then is reduced to 80 percent in year six, 60 
percent in year seven, 40 percent in year eight, 20 percent in 
year nine and zero thereafter. Third, the recapture provision's 
income adjustment exception was liberalized to determine the 5-
percent-per-year inflation adjustment with compounding. These 
modifications were effective as if enacted in the Technical and 
Miscellaneous Revenue Act of 1988 (the Act which originally 
enacted the recapture provisions). The Omnibus Budget 
Reconciliation Act of 1993 (``OBRA 1993'') permanently extended 
the QMB and MCC programs including the recapture provision.

                                Analysis

    Some of the benefits of the implicit subsidy provided to 
certain home buyers through mortgage financing supplied by 
mortgage revenue bonds or mortgage credit certificates is 
recaptured for certain taxpayers. As explained above, the Code 
defines the recapture amount by reference to three factors. The 
size of the initial subsidized mortgage determines the first 
factor, 6.25 multiplied by the size of the subsidized mortgage. 
The taxpayer's duration in the subsidized residence determines 
the second factor. The taxpayer's income determines the third 
factor. To qualify initially for the MRB-subsidized mortgage, 
the taxpayer's income must be lower than certain specified 
levels that vary by region of the country. If the taxpayer's 
income subsequently has grown relative to that initial 
qualifying income, the taxpayer will be partially or wholly 
subject to recapture. The taxpayer's income in the year of sale 
of the residence provides the basis of the phase-in to full 
recapture. This phase-in creates an increase in effective 
marginal tax rates.
    The phase-in uses income to determine the magnitude of the 
recapture amount \76\ for which the taxpayer is liable. In 
general, the recapture amount will be different for each 
taxpayer because each taxpayer will have a different size 
mortgage and a different holding period. In addition, the 
recapture amount is limited to 50 percent of any gain the 
taxpayer may realize on the sale of his or her residence. To 
simplify, assume the recapture amount is $3,000. The portion of 
the recapture amount for which the taxpayer is liable is the 
percentage by which the taxpayer's current modified AGI exceeds 
the adjusted qualifying income divided by $5,000. Thus, if the 
taxpayer's modified AGI exceeds the adjusted qualifying income 
by $1,000, the taxpayer is liable for 20 percent of the 
recapture amount. In this example, if the taxpayer earned an 
additional $1,000, the taxpayer would be liable for an 
additional 20 percent of $3,000 of the recapture amount, or 
$600, in addition to the tax liability that the taxpayer would 
otherwise incur from the application of the statutory marginal 
tax rates. Thus, in this example, if the taxpayer were in the 
15-percent statutory marginal tax rate bracket and the 
additional $1,000 of modified AGI were from taxable sources, 
the taxpayer would owe $150 on the incremental $1,000-increase 
in income and would owe an additional $600 in recapture tax, 
for a combined incremental tax of $750. Thus, in this example, 
the taxpayer would have an effective marginal tax rate of 75 
percent. If the recapture amount were $300, the effective 
marginal tax rate for the taxpayer would be 21 percent. If the 
recapture amount were $6,000, the effective marginal tax rate 
for the taxpayer would be 135 percent. In general, for a 
taxpayer whose modified AGI exceeds his or her adjusted 
qualifying income by less than $5,000, the effective marginal 
tax rate is equal to the taxpayer's marginal tax rate at the 
time of sale of property plus the percentage defined by the 
recapture amount divided by $5,000.\77\ For taxpayers whose 
modified AGI exceeds their adjusted qualifying income by $5,000 
or more, the recapture amount does not vary with income and 
their effective marginal tax rate equals their statutory 
marginal tax rate.
---------------------------------------------------------------------------
    \76\ The Code defines the ``recapture amount'' to be the product of 
the three factors, including the income factor, outlined in the 
preceding paragraph. Because the focus of this analysis is on the 
effect of the phase-in determined by the income factor, this analysis 
will refer to the ``recapture amount'' as the product of the Federally-
subsidized amount with respect to the indebtedness and the holding 
period percentage.
    \77\ Mathematically, let T be total tax liability, t be the 
taxpayer's statutory marginal tax rate, R be the taxpayer's ``recapture 
amount,'' and AQI be the taxpayer's ``adjusted qualifying income.'' 
Then for any taxpayer whose income exceeds his or her adjusted 
qualifying income by less than $5,000, the taxpayer's tax liability, 
including his or her recapture amount, can be given by the following 
equation:

        T = Yt+R((Y-AQI)/5,000)

    This simplifies to equation (1).

      (1) T = Y(t+(R/5,000))-(RAQI/5,000)

    An increase in income, Y, by an additional $1.00, increases the 
taxpayer's tax liability by t, the statutory marginal tax rate, plus R/
5,000 (the recapture amount divided by 5,000).
---------------------------------------------------------------------------
    Because the taxpayer's effective marginal tax rate under 
this phase-in provision is determined by the individual 
taxpayer's financial situation, it is not possible to make 
generalizations about the effective marginal tax rates created 
by this provision. Most analysts do not anticipate that many 
taxpayers are subject to this recapture provision. First, 
taxpayers who might anticipate that their incomes will increase 
relative to income eligibility levels may elect to forgo 
mortgage revenue bond-based financing. Second, a taxpayer who 
might be subject to recapture may defer sale of the residence 
to avoid paying the recapture amount. In general, the larger 
the taxpayer's initial subsidized mortgage, the larger the 
taxpayer's effective marginal tax rate. The effective marginal 
tax rate increases as the taxpayer's duration in the home 
increases through the first five years and then decreases 
through years six through ten. The taxpayer's effective 
marginal tax rate increases the larger the capital gain the 
taxpayer realizes upon sale of the home. However, once the 
capital gain exceeds twice the amount of the recapture amount 
calculated under the three-factor computation, the size of the 
capital gain does not affect the effective marginal tax rate.

                  III. DISCUSSION OF ISSUES GENERALLY

In general
    The preceding analysis establishes that numerous taxpayers 
face effective marginal tax rates that are different from the 
statutory marginal tax rates of the Code. This raises several 
tax policy questions. First, economists argue that effective 
marginal tax rates create incentives, or disincentives, for 
taxpayers to work, save, donate to charity, and engage in other 
types of activities. These incentives may distort taxpayer 
choice. Distorted choice may promote an inefficient allocation 
of society's labor and capital resources.
    Higher marginal tax rates lead to increased aggregate tax 
liabilities. A second question of tax policy is whether these 
increased aggregate tax liabilities are equitably distributed 
across taxpayers.
    A third issue relates to the complexity and lack of clarity 
created by these provisions. The creation of phaseouts adds 
complexity to the Code. Additional instructions are required 
and additional computations must be made. These provisions also 
may create a lack of clarity in taxpayers' minds regarding what 
precisely is the tax base and what sort of preferences exist in 
the Code. Complexity and lack of clarity may promote taxpayer 
disillusionment, a sense of unfairness regarding the Code, and 
reduce compliance.
    The discussion below addresses each of these issues. It 
also discusses certain issues that refine the preceding 
calculations of effective marginal tax rates: the extent to 
which taxpayers may be subject to multiple provisions; the 
determination of effective marginal tax rates when one 
considers that many taxpayers also may be subject to the 
payroll tax; the determination of effective marginal tax rates 
when one considers interaction between the regular tax and the 
alternative minimum tax; and the determination of effective 
marginal tax rates when one considers interaction with State 
income taxes.
Issues of efficiency
    While for the large majority of taxpayers the taxpayer's 
effective marginal tax rate equals the taxpayer's statutory 
marginal tax rate, the analysis of the preceding sections 
documents that there is a sizeable percentage and a large 
absolute number of taxpayers for whom the taxpayer's effective 
marginal tax rate is different from, and generally larger than, 
the taxpayer's statutory marginal tax rate. Economists often 
emphasize the importance of effective marginal tax rates 
because, they argue, it is effective marginal tax rates that 
create incentives, or disincentives, for taxpayers to work, to 
save, or to take advantage of various tax preferences. These 
incentives may distort taxpayer choice. Distorted choice may 
promote an inefficient allocation of society's labor and 
capital resources. A more efficient allocation of labor and 
capital resources would leave society with the same output of 
goods and services as it has today, plus additional resources 
which could be devoted to satisfying private wants or providing 
additional public goods.
    Some analysts have suggested that high effective marginal 
tax rates may alter taxpayers' decisions to work. For example, 
assume a married couple with two dependent children currently 
in the 31-percent tax bracket has an AGI of $186,800. This AGI 
would place the couple at the bottom of the phaseout range of 
the personal exemption phaseout. Further assume that one of the 
couple has an opportunity to take on an additional project at 
work that will increase the couple's net income by $2,500. As 
was established in Part II.D, above, the additional $2,500 in 
income to this couple will increase the couple's tax liability 
by $842, leaving the couple an after tax net addition to income 
of $1,648.\78\ The taxpayer may feel net remuneration of $1,648 
is insufficient to offset the loss of leisure time and the 
effort that would be expended to complete the project. If the 
taxpayer chooses not to work, society loses the benefit of his 
or her labor.
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    \78\ As explained in Part II.D, an additional $2,500 in income of 
this couple results in an effective marginal tax rate that is equal to 
the couple's statutory tax rate (31 percent) multiplied by one plus 
0.0216 times the number of personal exemptions the couple many claim 
(four), or 31 percent multiplied by 1.0864, resulting in an effective 
marginal tax rate of 33.68 percent.
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    There is disagreement among economists on the extent to 
which labor supply decisions are affected by the effective 
marginal tax rate. Empirical evidence indicates that taxpayer 
response is likely to vary depending upon a number of taxpayer 
specific factors. In general, findings indicate that the labor 
supply of so-called ``primary earners'' tends to be less 
responsive to changes in effective marginal tax rates than is 
the labor supply of ``secondary earners.'' \79\ Some have 
suggested that the labor supply decision of the lower earner or 
``secondary earner'' in married households may be quite 
sensitive to the household's effective marginal tax rate.\80\ 
Other evidence suggests the decision to work additional hours 
may be less sensitive to changes in the effective marginal tax 
rate than the decision to enter the labor force.\81\ That is, 
there may be more effect on an individual currently not in the 
labor force than on an individual already in the labor force.
---------------------------------------------------------------------------
    \79\ The phrase ``primary earner'' refers to the individual in the 
household who is responsible for providing the largest portion of 
household income. ``Secondary earners'' are earners other then the 
primary earner.
    \80\ See, Charles L. Ballard, John B. Shoven, and John Whalley, 
``General Equilibrium Computations of the Marginal Welfare Costs of 
Taxes in the United States,'' American Economic Review, 75, March 1985, 
for a review of econometric studies on labor supply of so-called 
primary and secondary earners. United States Congress, Congressional 
Budget Office, For Better or For Worse: Marriage and the Federal Income 
Tax, June 1997, pp. 10-12, also reviews this literature.
    \81\ Robert K. Triest, ``The Effect of Income Taxation on Labor 
Supply in the United States,'' The Journal of Human Resources, 25, 
1990. More recently, Nada Eissa, ``Tax Reforms and Labor Supply,'' in 
James M. Poterba, editor, Tax Policy and the Economy, 10, (Cambridge: 
The MIT press), 1996, reviews this literature with particular emphasis 
on the labor supply of women. Her evidence suggests that marginal tax 
rates may be an important determinant of labor force participation.
---------------------------------------------------------------------------
    However, the importance of the personal exemption phaseout 
to the labor supply decision in the example crafted above is 
not in the total effective marginal tax rate, but only in the 
incremental effect of the personal exemption phaseout 
provision. Because the couple is otherwise in the 31-percent 
statutory marginal tax bracket, in the absence of the personal 
exemption phaseout, an additional $2,500 of income would 
provide a net increase in after-tax income of $1,725 ($2,500 in 
gross income less $775 in income taxes that would result from 
the 31-percent statutory marginal tax rate). The personal 
exemption phaseout reduces the net after-tax income by an 
additional $127. One might conclude from this comparison that 
whatever marginal disincentive effect there might be is largely 
due to the statutory rate and that the incremental efficiency 
loss from the provisions by which the effective marginal tax 
rate deviates from the statutory marginal tax rate may be 
relatively small. That conclusion may not be correct in all 
circumstances. The efficiency loss increases as the effective 
marginal tax rate increases. That is, an increase in an 
effective marginal tax rate from 30 percent to 31 percent 
creates a greater efficiency loss per dollar of additional tax 
revenue than an increase in an effective marginal tax rate from 
20 percent to 21 percent.\82\ Without specific information 
regarding taxpayer behaviorial response, it is not possible to 
quantify the magnitude of the efficiency loss that might be 
created.
---------------------------------------------------------------------------
    \82\ In fact, the magnitude of the efficiency loss from taxation 
depends upon a measure of the taxpayer's behavioral response, or the 
elasticity, and the square of the total effective marginal tax rate. 
Hence, a small change in an effective tax rate can create an efficiency 
loss that is large in relation to the change in revenue. For a detailed 
discussion of this point, see Joint Committee on Taxation, Methodology 
and Issues in Measuring Changes in the Distribution of Tax Burdens 
(JCS-7-93) June 14, 1993, pp. 20-31 and Harvey S. Rosen, Public 
Finance, second edition, (Homewood, Illinois: Richard D. Irwin), 1988, 
pp. 291-314.
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    Economists have undertaken special study of the effect of 
effective marginal tax rates that are created by the earned 
income credit.\83\ Because, as Figures 1-3 in Part II.E., 
above, show, the EIC creates varying effective marginal tax 
rates, the aggregate effect on the economy from the EIC's 
structure is difficult to determine. In theory, for a taxpayer 
in the phase-in range, the EIC may either increase or decrease 
his or her labor supply. While the higher net return to 
additional work made possible by the phase-in makes more work 
attractive, the taxpayer's greater total income as a result of 
the subsidy makes leisure time attractive as well. A taxpayer 
in the flat range has no marginal inducement to increase work 
and, by having increased the taxpayer's net income, the EIC may 
make leisure time more appealing. In the phaseout range, the 
higher effective marginal tax rate combined with the increase 
in net income provided by the EIC makes additional work less 
appealing than additional leisure time. With more taxpayers in 
the phaseout and flat ranges, one might expect the EIC has a 
negative aggregate effect on labor supply. The aggregate effect 
depends on the strength of the offsetting incentives. Using 
empirical data, analysts disagree regarding the aggregate 
effects.\84\
---------------------------------------------------------------------------
    \83\ For a review of this literature, see Stacy Dickert, Scott 
Houser, and John Karl Scholz, ``The Earned Income Tax Credit and 
Transfer Programs: A Study of Labor Market and Program Participation,'' 
in James M. Poterba, editor, Tax Policy and the Economy, 9, Cambridge: 
The MIT Press), 1995. Eissa, ``Tax Reforms and Labor Supply,'' also 
reviews the effects of the EIC on female labor supply.
    \84\ Dickert, Houser, and Scholz, ``The Earned Income Tax Credit 
and Transfer Programs,'' estimated that the 1993 expansion of the EIC 
would have the effect of reducing hours worked by families already in 
the labor force, but that that loss would be more than offset by 
increased labor force participation by low-income individuals not 
previously in the labor force.
---------------------------------------------------------------------------
    The distorted choices that may result from increased 
effective marginal tax rates are not limited to decisions to 
work. By reducing the after-tax return to saving, increased 
effective marginal tax rates may distort taxpayers' decisions 
to save. Substantial disagreement exists among economists as to 
the effect on saving of changes in the net return to saving. 
Empirical investigation of the responsiveness of personal 
saving to after-tax returns provides no conclusive results. If 
saving is reduced, future productivity and income is lost to 
society. Additionally, increased effective marginal tax rates 
may encourage taxpayers to seek compensation in the form of 
tax-free fringe benefits rather than taxable compensation. Such 
distortions in consumption represent an efficiency loss to the 
economy. Increased effective marginal tax rates also may alter 
taxpayers' decisions regarding when to recognize income or 
claim expenses. Any such tax motivated changes in the timing of 
income or expense generally require time and expense by the 
taxpayer. Such time and expense represents an efficiency loss 
to the economy.\85\ As noted above in the context of labor 
supply, it is difficult to determine the magnitude of potential 
efficiency loss that may arise from provisions that create an 
effective marginal tax rate that deviates from the statutory 
marginal tax rate without information regarding the taxpayers' 
responses to changes in tax rates.
---------------------------------------------------------------------------
    \85\ For a recent review of some of the economic literature 
relating to taxes and labor supply, consumption distortions, and the 
timing of income recognition see, John F. Navratil, Essays on the 
Impact of Marginal Tax Rate Reductions on the Reporting of Taxable 
Income on Individual Income Tax Returns, unpublished Harvard University 
Ph.D. Thesis, 1995.
---------------------------------------------------------------------------
    For some provisions, the one-time or temporary nature of a 
provision may limit taxpayer behavioral response to the 
deviation in the effective marginal tax rate from the statutory 
marginal tax rate. If taxpayer behavioral response is limited, 
efficiency loss is limited. For example, itemized deductions 
for unusually large medical expenses, itemized deductions for 
unreimbursed casualty losses, the adoption credit or exclusion, 
the recapture of interest from a qualified mortgage bond, and 
the first-time purchase of a home in the District of Columbia 
tend to be events that happen once or infrequently. If a 
taxpayer is subject to the effective marginal tax rate created 
by these provisions for only one year, the taxpayer is less 
likely to reduce labor supply, change the type of compensation 
they receive, or reduce saving. On the other hand, if the 
taxpayer has the opportunity to plan in advance, the one-time 
nature of these events may induce the taxpayer to shift the 
timing of income or expense. Similarly, expenditures on college 
tuition and repayment of student loans are of limited duration. 
In such circumstances, the increase in effective marginal tax 
rates above the statutory tax rates may not lead to a reduction 
in the labor supply of the taxpayer. Other provisions such as 
the phaseout of personal exemptions and the general limitation 
on itemized deductions might be expected to affect the same 
taxpayers year after year. These provisions may be more likely 
to create efficiency loss.
    Some observers note that a benefit of phaseout provisions 
is that they reduce the revenue cost of the tax benefit to the 
Federal government by limiting the number of taxpayers who can 
take advantage of the benefit. They note that reduction in 
revenue cost may be efficiency improving. In the absence of 
these provisions, if the Federal government were to maintain 
the same revenue, statutory marginal tax rates might be raised. 
An increase in marginal tax rates, whether by altering the rate 
table or by creating a phaseout, creates the potential for 
efficiency loss. As an alternative, statutory rates could be 
left unchanged and the income tax could yield less revenue. If 
this leads to deficits and borrowing, interest costs economy-
wide could be increased, which may create a drag on future 
economic growth. To put potential efficiency losses from the 
provisions analyzed in this pamphlet in context, one should 
compare them to the efficiency of the alternative tax system 
that did not include such provisions.
    Other observers note that an alternative to phase-out 
ranges is to have a ``cliff.'' That is, a tax benefit could be 
claimed by all taxpayers with incomes below some level, say 
$50,000, and the tax benefit would be denied to all taxpayers 
with income equal to or greater than $50,000. The effective 
marginal tax rate on the dollar earned that takes the 
taxpayer's income from $49,999 to $50,000 would be very large. 
A cliff creates all of the same issues of distorted taxpayer 
behavior as does a phase-out range. The advantage of the cliff 
is that the number of taxpayers who would have an effective 
marginal tax rate that deviates from the statutory marginal tax 
rate would be smaller. In simple terms, a cliff trades off 
higher effective marginal tax rates for fewer affected 
taxpayers. As explained above, the efficiency cost of the 
higher effective marginal tax rates may be quite high. However, 
if the efficiency loss results from the distorted behavior of 
relatively few taxpayers, the aggregate efficiency loss to the 
economy may be less. Some think that whatever the efficiency 
arguments, cliffs are unfair and serve as traps for unwary 
taxpayers. As is common in tax policy, policy design involves 
tradeoffs of efficiency, equity, and complexity. The next 
section discusses some of the equity issues related to 
provisions that cause effective marginal tax rates to deviate 
from statutory marginal rates.

Issues of equity

    Analysts generally apply two concepts when assessing the 
equity, or fairness, of a tax system: vertical equity and 
horizontal equity. The concept of vertical equity compares the 
tax burdens of taxpayers at different levels of income and asks 
how the tax burdens of lower-income taxpayers compare to the 
tax burdens of higher-income taxpayers. There is no agreed upon 
standard as to what is the most fair distribution of tax 
burdens in comparison to the taxpayer's income. Vertical equity 
is usually discussed in terms of the progressivity or 
regressivity of the tax system. The concept of horizontal 
equity asks whether taxpayers who otherwise are similarly 
situated bear the same tax burden. A taxpayer's income usually 
is used as the measure to assess equality of economic 
circumstances.
    Overall, the Federal individual income tax is a progressive 
tax. That is, the average tax rate increases as taxpayers' 
incomes increase. The existence of phaseouts and other 
provisions that create effective marginal tax rates that differ 
from statutory marginal tax rates do not make the Federal 
individual income tax a regressive or proportional tax. The 
phaseout and other provisions identified in this pamphlet 
generally operate to increase the overall progressivity of the 
income tax. The majority of the provisions deny tax benefits to 
higher-income taxpayers, while preserving tax benefits to low-
income and middle-income taxpayers. Indeed, the legislative 
rationale underlying some of the phase-out provisions was to 
deny tax benefits to taxpayers with incomes above some 
specified level. For example, the earned income credit reduces 
the income tax liabilities of certain low-income taxpayers, and 
its phaseout denies the same benefits to middle-income and 
higher-income taxpayers. As a result, the tax burden as a 
proportion of income rises as taxpayers' incomes increase. 
Similarly, the phaseout of the personal exemptions maintains 
the tax benefit of the personal exemptions for all taxpayers 
with incomes below the phaseout range, denies the tax benefit 
to all taxpayers with income above the phase-out range, and 
partially denies the tax benefit within the phase-out range. In 
this way, the phaseout increases the overall progressivity of 
the income tax.
    As noted in Part II.A., above, the statutory marginal tax 
rate exceeds the average tax rate for almost all taxpayers. The 
preceding analysis of the various provisions shows that in most 
cases these provisions cause effective marginal tax rates to 
exceed statutory marginal tax rates. When a taxpayer's marginal 
tax rate exceeds the taxpayer's average tax rate, the 
taxpayer's average tax rate rises. Thus, by raising effective 
marginal tax rates these provisions cause average tax rates to 
rise as income rises. The result is a progressive tax system.
    While the phaseouts and other provisions may help create a 
progressive individual income tax, they appear to fail the test 
of horizontal equity. Because the phaseouts and other 
provisions relate to specific provisions of the Code and 
specific defined economic activities, two different taxpayers 
may have the same income and one can be subject to a phase-out 
provision while another is not. For example, two married 
couples may have identical modified AGI of $85,000, the same 
number of children, and other identical economic 
characteristics. However, if the Smith family has a daughter in 
college while the Jones family daughter forgoes college, the 
Smiths and the Jones will have different Federal income tax 
liabilities. The Smiths will be able to claim a tax credit for 
a portion of their daughter's college expenses. The Jones 
family will not. The Smiths will have a smaller tax burden. 
However, the family income of $85,000 puts the Smith family in 
the phase-out range for the HOPE or Lifetime Learning credits, 
so the Smith family will have an effective marginal tax rate 
greater than that of the Jones family, but will be able to 
claim some education credits against their income tax 
liability. Some observers find it unfair that the Smith family 
has a higher effective marginal tax rate than does the Jones 
family, but, in fact, the Smith family has the lower aggregate 
tax burden. Other observers would find it unfair that the Jones 
family has a higher aggregate tax burden because they are not 
treated equally to the Smiths. This would appear to violate the 
concept of horizontal equity. However, the apparent horizontal 
inequity is not created by the phase-out provision. If, in the 
example above, Smith and Jones had each had incomes of $60,000, 
beneath the phase-out range, it would remain the case that 
Smith's tax liability is less than Jones's by reason of the 
credit.\86\
---------------------------------------------------------------------------
    \86\ In this case, both Smith and Jones would have the same 
effective marginal tax rate.
---------------------------------------------------------------------------
    One rationale for creating the education credits was a 
belief that the burdens of paying for a college education imply 
that two families cannot be considered to be similarly situated 
if, though all else is equal, one is paying college expenses 
while the other is not. Advocates of this position would aver 
that horizontal equity is not violated. They would note that 
the education credits apply equally in the sense of horizontal 
equity to all taxpayers incurring college education expenses.
    Almost all of the provisions reviewed in this pamphlet 
might be argued to create horizontal inequities similar to the 
example of the education credits. Only the phase-out of the 
personal exemptions clearly maintains horizontal equity as 
almost all taxpayers claim personal exemptions. The inclusion 
of social security benefits in the individual income tax, the 
general limitation on itemized deductions, and the earned 
income credit also may preserve horizontal equity as in 
practice almost all taxpayers over the age of 65 receive social 
security benefits, the vast majority of higher-income taxpayers 
itemize deductions, and the majority of lower-income taxpayers 
have wage income, so such provisions apply to all similarly 
situated taxpayers.

Complexity and clarity

    Many of the provisions identified in this pamphlet require 
additional computations by taxpayers, marginally increasing 
both the time required of the taxpayer and the probability of 
making an error. Some provisions, such as the phase-out of 
deductibility of contributions to IRAs, may require additional 
record keeping by the taxpayer. Other provisions, such as the 
limitation on itemized deductions and the phase-out of personal 
exemptions, do not require additional record keeping. As 
reported in Table 2 in Part II.A., above, the Joint Committee 
staff estimates that approximately 33 million taxpayers are 
subject to these provisions.87 The provisions 
affecting the most taxpayers are the phase-out of the EIC, the 
2-percent floor on miscellaneous deductions, and the phaseout 
of the exclusion of social security benefits.
---------------------------------------------------------------------------
    \87\ The estimate in Table 2 does not include certain provisions.
---------------------------------------------------------------------------
    In addition to whatever additional complexity they create, 
such provisions may make the Code less clear and lead to 
taxpayer confusion regarding the nature of the individual 
income tax. As noted above, these provisions act like increases 
in marginal tax rates, but are not stated as statutory rates. 
Likewise, taxpayers generally understand that certain 
deductible expenditures are ``favored'' and reduce their tax 
liability or that certain credits may be claimed for specified 
expenditures. Because taxpayers do not always know what their 
annual income will be or do not always know all of the 
requirements of the Code, these provisions may make it harder 
for taxpayers to plan to take advantage of certain tax-favored 
activities.
    On the other hand, by limiting the number of taxpayers 
eligible to qualify for certain tax benefits, some of the 
provisions reduce computations, possibility of error, and 
record keeping. For example, the 7.5-percent of AGI floor on 
deductible medical expenditures eliminates the need for record 
keeping and computation for the approximately 30 million 
taxpayers who claim itemized deductions other than for medical 
expenses. It also may induce some taxpayers to claim the 
standard deduction which provides significant simplification.
    Complexity and lack of clarity may promote taxpayer 
disillusionment and a sense of unfairness regarding the Code, 
and may reduce compliance. It probably is impossible to discern 
the extent, if any, to which compliance rates have been 
affected by the existence of the provisions described in this 
pamphlet.

Layering of provisions

    It is possible for taxpayers to be subject to more than one 
of the phase-outs or phase-ins simultaneously. Certain of the 
phaseouts are mutually exclusive--for example, one could not 
simultaneously be subject to the personal exemptions phase-out 
and the phaseout for the deductibility of interest on qualified 
student loans, as the income ranges of the separate phaseouts 
do not overlap. However, other phaseouts can overlap. Chart 2 
can be used as a general guide to the income levels where 
multiple phaseouts can overlap. Some care must be used in 
interpreting the chart, however. For example, the chart shows 
that taxpayers in the $20,000 to $30,000 AGI range could be 
subject to a combination of the EIC and dependent care credit 
phaseouts and the phase-in of Social Security benefits. 
However, one is unlikely to be subject to the Social Security 
inclusion and receive either the EIC or the dependent care 
credit, given the distinctly different demographics of the 
taxpayers that benefit from Social Security as compared to the 
other provisions. Additionally, not all phaseouts that could 
conceivably affect a given AGI class will necessarily have been 
listed; rather, the provisions were listed in the income 
classes that they would most commonly affect. For a more 
detailed and complete description of the effective marginal tax 
rates that are listed in the chart, refer to the specific 
section of this report that discusses that provision.
    Taxpayers who are simultaneously subject to multiple 
phaseouts will face higher effective marginal tax rates than if 
subject to one or no phaseouts. For example, if a taxpayer with 
two qualifying children receives an EIC on $25,000 in wage 
income, that taxpayer will be subject to the phase-out of the 
EIC (phaseout range is $12,260-$30,095). If the taxpayer also 
claims the dependent care credit, he or she will also be in the 
phase-down range for that credit ($20,000-$30,000). As a 
result, on an additional $1,000 of income, this taxpayer would 
lose $210.60 in EIC benefits and $24 in the dependent care 
credit. Additionally, the taxpayer would owe $150 in Federal 
income taxes. The additional $1,000 would result in additional 
tax of $384.60, for a combined effective marginal rate of 38.5 
percent.
    Another example of overlapping credits could occur at 
higher income levels. For example, a married couple with an AGI 
of $125,000 and three children would be in the phase-out range 
of the child credit, which begins at $110,000. They would also 
be subject to the limitation on itemized deductions, which 
begins at $124,500. As previously discussed, the limitation on 
itemized deductions increases the effective marginal rate to 
103 percent of the statutory rate, and the child credit adds 5 
percentage points to the effective marginal tax rate. Because 
the couple will likely be in the 28-percent statutory tax rate 
bracket, their effective marginal tax rate from the itemized 
deduction limitation will be 28.84 percent (28 percent times 
1.03). With the addition of the effect of the child credit 
phaseout, their true effective marginal tax rate will be 33.84 
(28.84 plus 5) percent. However, it should be pointed out that 
this couple would be completely phased out of their child 
credits when their AGI hit $134,000, and then they would only 
be affected by the itemized deduction limitation, implying 
their effective marginal tax rate would fall back to 28.84 
percent.
    It is possible for the interactions of the phaseouts to 
create marginal tax rates that many would think of as 
excessive. For example, consider the following conceivable 
scenario: A 62-year-old head of household retiree with two 
children in college who both would qualify for a HOPE credit, 
$10,000 in Social Security benefits, $10,000 in labor income, 
and $23,000 in taxable pensions, dividends, etc., could face an 
effective marginal tax rate as high as 90 percent. If this 
taxpayer were to earn an additional $100 in wage income, he 
would owe $7.65 in additional social security 
taxes.88 Additionally, this taxpayer would have 
income and social security benefits that would place him in the 
situation of having an additional 85 cents of social security 
benefits included in taxable income for each dollar of 
additional non-social security income. Hence, the taxpayer 
would see his taxable income rise by $185 as a result of the 
additional $100 in wage income. This taxpayer would be in the 
15 percent statutory bracket assuming they claimed the standard 
deduction. Hence, the additional income would imply additional 
federal income taxes of $27.75 (185 percent times 15 percent 
times $100). If the two children each qualified for the full 
$1,500 HOPE credit, the taxpayer would have $3,000 in potential 
credits. However, under the above income circumstances, the 
taxpayer would be in the phase-out range for the HOPE credit 
(AGI of $40,000-$50,000 for head of household filers). Because 
the length of the phase-out range is only $10,000, the $3,000 
credit is phased out at a rate of 30 percent for each dollar 
increase in AGI in the phaseout range (see previous discussion 
of the phaseout of the HOPE credit in Part II.J). Ordinarily, 
then, this taxpayer would experience an additional 30 
percentage point increase in his statutory marginal tax rate--
the additional $100 in wage income would cause a loss of $30 in 
credits. However, the phaseout of HOPE credit is based on AGI, 
not the wage income itself, and because of the social security 
provision that also affects this taxpayer, AGI rises by $185 
for each dollar of wage income. Hence, rather than lose $30 in 
HOPE credits, the taxpayer would lose $55.50 (30 percent of 
$185) in credits. In the end, this taxpayer would owe $90.90 in 
additional federal taxes for the additional $100 in wage 
income. It is possible that State and local income taxes could 
push this taxpayer into a situation where the taxes owed as a 
result of the additional income could exceed the full amount of 
the income.89
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    \88\ The employer share of social security taxes is ignored for 
this example.
    \89\ The taxpayer of this example also would be subject to 
reduction in his actual social security benefits as a result of the 
social security earnings test, which would push his effective marginal 
tax rate over 100 percent. The taxpayer would lose $1 in social 
security benefits for each two dollars of earnings above a certain 
threshold ($9,120 in 1998) The $100 increase in wage income (setting 
aside the loss in Social Security benefits for the moment) causes AGI 
and taxable income to rise $185. The loss of $50 in Social Security 
benefits causes AGI and taxable income to fall by only $21.25 (this 
equals 85 percent of $25--since only one-half of SS is added to other 
income to determine the income level that establishes the share of SS 
that is taxable). On net then, the $100 in wages causes AGI to rise 
$185-$21.25=$163.75. The retiree's federal income tax liability before 
credits thus rises 1.637515%$100 or $24.56. His $100 of 
labor income causes his AGI to rise $163.75, and thus his credit 
declines by 1.6375$30, or $49.13. The full Federal tax on the 
$100 in wage income is thus $7.65+$50+$24.56+$49.13=$131.34. For State 
income taxes that piggy-back on the Federal income tax, one should add 
the State marginal tax rate times 1.6375 to these figures.
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    In general, the phase-out provisions that affect the 
greatest numbers of taxpayers do not have phaseouts that 
overlap. For example, a married couple in the phase-out range 
for the HOPE credit ($80,000-$100,000) could not be eligible 
for the EIC (phased out by $30,095), will have already have had 
any dependent care credit phased down (phase down is complete 
by $30,000), and would not yet be in the phase-out range for 
the child credit (phaseout starts at $110,000), the limitation 
on itemized deductions (limitation starts at $124,500), or the 
personal exemptions phaseout (phaseout starts at $186,800).

           Chart 2.--Potential Overlapping Provisions Creating Different Effective Marginal Tax Rates           
----------------------------------------------------------------------------------------------------------------
                                                 Provision creating effective                                   
                   AGI \1\                     marginal tax rate different from    Effective marginal tax rate  
                                                        statutory rate                                          
----------------------------------------------------------------------------------------------------------------
$0-$10,000                                     Earned income credit............  No children: Phasein--Statutory
                                                                                  rate minus 7.65; phaseout--   
                                                                                  Statutory rate plus 7.65.     
                                                                                 One child: Phasein--Statutory  
                                                                                  rate minus 34 percentage      
                                                                                  points.                       
                                                                                 Two children: Phasein--        
                                                                                  Statutory rate minus 40       
                                                                                  percentage points.            
                                                                                                                
$10,000-$20,000                                Earned income credit............  One child: Statutory rate plus 
                                                                                  15.98 percentage points.      
                                                                                 Two children: Statutory rate   
                                                                                  plus 21.06 percentage points. 
                                               7.5-percent floor on medical      1.075 times statutory rate.    
                                                expense deductions.                                             
                                               2-percent floor on miscellaneous  1.02 times statutory rate.     
                                                deductions.                                                     
                                               10-percent floor on casualty      1.1 times statutory rate.      
                                                loss deduction.                                                 
                                               Elderly/disabled credit.........  Statutory rate plus 7.5        
                                                                                  percentage points.            
                                               Dependent care credit...........  Statutory rate plus 2.4        
                                                                                  percentage points.            
                                                                                                                
$20,000-$30,000                                Earned income credit............  One child: Statutory rate plus 
                                                                                  15.98 percentage points.      
                                                                                 Two children: Statutory rate   
                                                                                  plus 21.06 percentage points. 
                                               Social Security inclusion         1.5 times statutory rate.      
                                                (single filer).                                                 
                                               7.5-percent floor on medical      1.075 times statutory rate.    
                                                expense deductions.                                             
                                               2-percent floor on miscellaneous  1.02 times statutory rate.     
                                                deductions.                                                     
                                               10-percent floor on casualty      1.1 times statutory rate.      
                                                loss deduction.                                                 
                                               Dependent care credit...........  Statutory rate plus 2.4        
                                                                                  percentage points.            
                                                                                                                
$30,000-$40,000                                Social Security inclusion.......  1.5 and 1.85 times statutory   
                                                                                  rate.                         
                                               7.5-percent floor on medical      1.075 times statutory rate.    
                                                expense deductions.                                             
                                               2-percent floor on miscellaneous  1.02 times statutory rate.     
                                                deductions.                                                     
                                               10-percent floor on casualty      1.1 times statutory rate.      
                                                loss deduction.                                                 
                                               IRA deductibility (single filer)  Up to 1.2 times statutory rate.
                                                                                                                
$40,000-$50,000                                Social Security inclusion.......  1.85 times statutory rate.     
                                               HOPE credit (single filer)......  Statutory rate plus 15         
                                                                                  percentage points.            
                                               Lifetime Learning credit (single  Statutory rate plus 15         
                                                filer).                           percentage points.            
                                               Student loan interest...........  1.167 times statutory rate.    
                                               7.5-percent floor on medical      1.075 times statutory rate.    
                                                expense deductions.                                             
                                               2-percent floor on miscellaneous  1.02 times statutory rate.     
                                                deductions.                                                     
                                               10-percent floor on casualty      1.1 times statutory rate.      
                                                loss deduction.                                                 
                                                                                                                
$50,000-$75,000                                IRA deductibility...............  Up to 1.2 times statutory rate.
                                               Student loan interest...........  1.167 times statutory rate.    
                                               Exclusion of interest from        (1.0 + exclusion/$15,000) times
                                                education savings bond (single    statutory rate.               
                                                filer).                                                         
                                               7.5-percent floor on medical      1.075 times statutory rate.    
                                                expense deductions.                                             
                                               2-percent floor on miscellaneous  1.02 times statutory rate.     
                                                deductions.                                                     
                                               10-percent floor on casualty      1.1 times statutory rate.      
                                                loss deduction.                                                 
                                               First time D.C. homebuyer credit  Statutory rate plus 25         
                                                (single filer).                   percentage points.            
                                                                                                                
$75,000-$100,000                               Child tax credit (single filer).  Statutory rate plus 5          
                                                                                  percentage points.            
                                               Eligibility for Roth IRA (single  1.0 to 1.133 times statutory   
                                                filer).                           rate.                         
                                               Eligibility for education IRA     Not precisely determinable.    
                                                (single filer).                                                 
                                               HOPE credit (joint filer).......  Statutory rate plus 7.5        
                                                                                  percentage points.            
                                               Lifetime learning credit (joint   Statutory rate plus 7.5        
                                                filer).                           percentage points.            
                                               Exclusion of interest from        (1.0 + exclusion/$30,000) times
                                                education savings bond (joint     statutory rate.               
                                                filer).                                                         
                                               Adoption credit/exclusion.......  Statutory rate plus (credit/   
                                                                                  $40,000), or (1.0 + exclusion/
                                                                                  $40,000) times statutory rate.
                                               First time D.C. homebuyer credit  Statutory rate plus 25         
                                                (single filer).                   percentage points.            
                                               7.50-percent floor on medical     1.075 times statutory rate.    
                                                expense deductions.                                             
                                               2-percent floor on miscellaneous  1.02 times statutory rate.     
                                                deductions.                                                     
                                               10-percent floor on casualty      1.1 times statutory rate.      
                                                loss deduction.                                                 
                                                                                                                
$100,000-$150,000                              Pease limitation on itemized      1.03 times statutory rate.     
                                                deductions.                                                     
                                               Personal exemption phaseout       1.0216 times statutory rate.   
                                                (single filer).                                                 
                                               Child tax credit (joint filer)..  Statutory rate plus 5          
                                                                                  percentage points.            
                                               Eligibility for Roth IRA (single  1.0 to 1.133 times statutory   
                                                filer).                           rate.                         
                                               Eligibility for education IRA     Not precisely determinable.    
                                                (single filer).                                                 
                                               Exclusion of interest from        (1.0+exclusion/$30,000) times  
                                                education savings bond (joint     statutory rate.               
                                                filer).                                                         
                                               Adoption credit/exclusion.......  Statutory rate plus (credit/   
                                                                                  $40,000), or (1.0+exclusion/  
                                                                                  $40,000) times statutory rate.
                                               First time D.C. homebuyer (joint  Statutory rate plus 25         
                                                filer).                           percentage points.            
                                               Rental real estate losses.......  1.0 to 1.5 times statutory     
                                                                                  rate.                         
                                               7.5-percent floor on medical      1.075 times statutory rate.    
                                                expense deductions.                                             
                                               2-percent floor on miscellaneous  1.02 times statutory rate.     
                                                deductions.                                                     
                                               10-percent floor on casualty      1.1 times statutory rate.      
                                                loss deduction.                                                 
                                                                                                                
$150,000-$200,000                              Pease limitation on itemized      1.03 times statutory rate.     
                                                deductions.                                                     
                                               Personal exemption phaseout       1.0216 times statutory rate.   
                                                (single).                                                       
                                               Personal exemption phaseout (H/   Statutory rate multiplied by   
                                                H).                               1.0 plus 0.0216 for each      
                                                                                  exemption.                    
                                               Personal exemption phaseout       Statutory rate multiplied by   
                                                (joint).                          1.0 plus 0.0216 for each      
                                                                                  exemption.                    
                                               Eligibility for Roth IRA (joint)  1.0 to 1.2 times statutory     
                                                                                  rate.                         
                                               Eligibility for education IRA     Not precisely determinable.    
                                                (joint).                                                        
                                               7.5-percent floor on medical      1.075 times statutory rate.    
                                                expense deductions.                                             
                                               2-percent floor on miscellaneous  1.02 times statutory rate.     
                                                deductions.                                                     
                                               10-percent floor on casualty      1.1 times statutory rate.      
                                                loss deduction.                                                 
                                                                                                                
Over $200,000                                  Rehabilitation tax credit.......  1.5 times statutory rate.      
                                               Pease limitation on itemized      1.03 times statutory rate.     
                                                deductions.                                                     
                                               Personal exemption phaseout.....  Statutory rate multiplied by   
                                                                                  1.0 plus 0.0216 for each      
                                                                                  exemption.                    
                                               7.5-percent floor on medical      1.075 times statutory rate.    
                                                expense deductions.                                             
                                               2-percent floor on miscellaneous  1.02 times statutory rate.     
                                                deductions.                                                     
                                               10-percent floor on casualty      1.1 times statutory rate.      
                                                loss deduction.                                                 
----------------------------------------------------------------------------------------------------------------
Footnote to chart 2:                                                                                            
\1\ This column is based on AGI. Several of the phaseout provisions are based on ``modified AGI.'' See chart 1  
  and the text for details.                                                                                     
                                                                                                                
Source: Joint Committee on Taxation.                                                                            

Effective marginal tax rates, the Federal individual income tax and 
        Federal payroll taxes

    This pamphlet's analysis has discussed statutory and 
effective marginal tax rates in terms of the Federal individual 
income tax. The majority of taxpayers also are subject to the 
payroll tax either at a rate of 7.65 percent (OASDI and HI 
combined), at a rate of 1.45 percent (HIcomponent only), or at 
a rate of 15.30 percent (self-employment tax 90). For these 
taxpayers, an additional $1.00 of wage income generally will increase 
the taxpayer's income tax liability by the taxpayer's effective 
marginal income tax rate and, in addition, will increase the taxpayer's 
combined (income and payroll) tax liability by the sum of the 
taxpayer's effective marginal income tax rate and the taxpayer's 
applicable marginal payroll tax rate. For example, for the taxpayer 
with wage earnings less than $68,400 in 1998, an additional $1.00 of 
wages will increase his or her combined tax liability by his or her 
effective marginal income tax rate plus 7.65 percent.91 
Moreover, most analysts conclude that both the employee's and 
employer's share of the payroll tax is borne by the employee and that 
therefore the marginal payroll tax rate would include both the 
employee's and employer's share. However, such a computation is more 
subtle than merely adding the employer's share of 7.65 percent to the 
employee rate of 7.65 percent. If the employer's share is to be added, 
that amount also should be accounted as wage compensation to the 
employee, as it represents additional compensation paid that is taxed 
away at the employer level. Accordingly, an additional $1.00 of wage 
income paid to the employee actually represents gross compensation of 
$1.0765 when the employer's payroll tax share is taken into 
consideration. Thus, the effective marginal payroll tax rate would be 
14.21 percent (the sum of the employee's 7.65 cents plus the employer's 
7.65 cents divided by the employee's additional total wage compensation 
of $1.0765). In short, for those taxpayers subject to the payroll tax, 
the analysis of this pamphlet will understate their effective combined 
marginal tax rate.92
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    \90\ The 15.3-percent self employment tax rate equals the sum of 
the employee's and employer's share of the payroll tax. One-half of a 
self-employed individual's self-employment tax for the taxable year is 
allowed as an above-the-line deduction for the individual's Federal 
individual income tax. A self-employed taxpayer with self-employment 
income in excess of $68,400 in 1998 would be subject to a 2.9-percent 
HI tax rate only.
    \91\ For employees with wages above $68,400, only the HI component 
of the payroll tax applies. The HI component is imposed at a rate of 
1.45 percent on the employee's wages plus 1.45 percent on the employer. 
Analysis of effective marginal tax rates comparable to that of the 
subsequent text would apply to those taxpayers for whom additional 
wages are subject only to the HI component of the payroll tax.
    \92\ In calculating an effective combined marginal tax rate 
applicable to an additional $1.00 of wage income for a taxpayer subject 
to the payroll tax, not only should the effective marginal payroll tax 
rate be adjusted for the additional amount of compensation that is 
taxed away at the employer level, but the effective marginal income tax 
rate also should be adjusted for the additional amount of compensation 
that is taxed away at the employer level.
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The alternative minimum tax and effective marginal tax rates

    Thus far, the analysis of this pamphlet has considered only 
the effective marginal tax rates that arise for taxpayers 
subject to the regular individual income tax. The AMT presents 
several issues in trying to determine the marginal effective 
tax rate applicable to an individual. First, if an individual 
is subject to the AMT, the statutory tax rates that one should 
focus on in determining the effective marginal tax rate 
generally are the AMT rates. However, if a taxpayer who 
otherwise would be subject to the AMT generates sufficient 
additional income, the taxpayer may become subject to the 
regular tax. In such a case, the regular tax rates would 
determine the taxpayer's effective marginal tax rate. For 
example, assume that a married couple filing a joint return 
have a large number of dependents and a large amount of State 
and local property and income taxes so that their taxable 
income for regular tax purposes is $42,520 (resulting in a 
regular tax liability of $6,400), but their AMTI (before their 
$45,000 exemption amount) is $70,000 (resulting in a tentative 
minimum tax of $6,500). Their marginal tax rates are 28 percent 
for regular tax purposes and 26 percent for AMT purposes. In 
this case, the taxpayers are subject to AMT ($6,500 being 
greater than $6,400). If the taxpayers generate an additional 
$6,000 of income, their regular tax liability becomes $8,080 
and their tentative minimum tax becomes $8,060, and the 
taxpayers are no longer subject to the AMT. Their effective 
marginal tax rate for the additional $6,000 in taxable income 
is 26.33 percent ($1,580/$6,000), which is a blended rate 
comprised of both the 28-percent regular tax rate and the 26-
percent AMT rate. Any additional marginal income in excess of 
this $6,000 will be subject to the 28-percent marginal rate.
    In addition, to the extent that an individual's AMT 
liability gives rise to the AMT credit that may be used by the 
taxpayer in the future to reduce his or her regular tax 
liability, the effect of marginal income on the present value 
of such credit also must be taken into account.93 
Finally, because the AMT exemption amount is phased out as the 
taxpayer's AMTI increases, the marginal effective AMT rate for 
a taxpayer within the phaseout range is higher than the 
applicable statutory AMT rate. The effective marginal AMT rates 
are 32.5 percent at the beginning of the phaseout range and 35 
percent at the end of the phaseout range.
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    \93\ The analysis would be similar to that presented above in the 
discussion of IRAs and education IRAs in Parts II. H. and I., 
respectively, and the passive loss exemption in Part II.P.
---------------------------------------------------------------------------
    The AMT may also provide an opportunity for an individual 
to experience what some may consider a zero or negative 
effective marginal tax rate. This occurs if the taxpayer's 
tentative minimum tax is less than the taxpayer's regular tax 
liability before credits, but more than the taxpayer's regular 
tax liability reduced by credits. In such case, under present 
law, the taxpayer may only claim an amount of tax credits that 
reduces his or her regular tax liability to an amount equal to 
his or her tentative minimum tax liability. A taxpayer 
confronted with this fact pattern may wish to recognize 
additional taxable income in order to increase his or her 
before-credit regular tax liability by an amount greater than 
his or her tentative minimum tax. This allows the individual to 
use more tax credits that would otherwise expire unutilized. 
The recognition of the additional income may increase current 
year tax liability as the additional income may increase both 
the taxpayer's regular tax liability before credits and the 
taxpayer's tentative minimum tax liability. However, to the 
extent that the additional taxable income is income that the 
taxpayer would otherwise recognize in a future year, the 
taxpayer may be able to reduce future tax liability by an 
amount greater than the increase in current year tax liability. 
In present value terms, the taxpayer may be considered to have 
a negative effective marginal tax rate on the additional 
income. It is possible for a taxpayer to increase current-year 
regular tax liability and reduce future-year regular tax 
liability without changing his or her tentative minimum tax in 
either period.94
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    \94\ For example, if the married couple in the preceding example 
postponed paying some of their State and local taxes, they would 
increase their current-year regular tax liability and reduce their 
future-year regular tax liability without changing their tentative 
minimum tax in either period because such taxes are deductible only for 
regular tax purposes.
---------------------------------------------------------------------------
    For example, assume a single individual is in the highest 
marginal tax rate bracket for both regular tax and AMT purposes 
(marginal tax rates of 39.6 and 28 percent, respectively). 
Further assume that the individual's regular tax liability 
before credits is $90,000, his tentative minimum tax is 
$89,000, and he has $2,200 of available credits that cannot be 
carried forward to a future taxable year. Under present law, 
the taxpayer can only use $1,000 of credits, resulting in a tax 
liability of $89,000. However, assume the taxpayer can 
accelerate $10,000 of additional taxable income otherwise 
recognizable next year into the current year. In such case, his 
regular tax liability before credits rises to $93,960, his 
tentative minimum tax rises to $91,800, and he can use $2,160 
of available credits, resulting in a tax liability of $91,800. 
Even though the taxpayer's current year tax liability increases 
by $2,800 ($91,800 less $89,000), his future tax liability is 
reduced by $3,960 ($10,000 times 39.6 percent), assuming the 
taxpayer would be subject to the regular income tax next year 
at the highest marginal rate. If the discount rate were 10 
percent, the present value of the $3,960 savings would equal 
$3,600 which is $800 greater than the $2,800 of increased 
current liability, resulting in an effective marginal tax on 
the $10,000 of additional income of -8.0 percent. Assuming a 
lower discount rate, the effective marginal tax rate would be 
more negative.95 Assuming a longer period of 
deferral, the effective marginal tax rate would be less 
negative, or positive, but even if positive it would be below 
the taxpayer's current statutory marginal tax rate. 
96
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    \95\ Assuming a discount rate of 5 percent, the effective marginal 
tax rate would be -9.7 percent.
    \96\ Assuming a discount rate of 10 percent, but a deferral period 
of ten years, the present value of $3,960 equals $1,527. Accelerating 
the $10,000 of income to the present year would lead to an increase in 
the present value of taxes on the income of $2,800 in the current year 
less the present value of $1,527 saved ten years from now, or a net 
present value increase of $1,273. This implies the effective marginal 
tax rate on the $10,000 of income is 12.7 percent, a rate substantially 
lower than the taxpayer's regular income statutory marginal tax rate.
---------------------------------------------------------------------------

Effective marginal tax rates and other taxes or programs

    In addition to payroll taxes and the AMT, other taxes that 
the taxpayer may be obligated to pay increase the overall 
effective marginal tax rate. For example, as was noted above 
when the effect of inclusion of Social Security benefits in the 
income tax are combined with the effects of the Social Security 
earnings test applicable to certain retirees, effective 
marginal tax rates may be higher than those calculated in this 
pamphlet. For some retirees an additional consideration might 
be the Federal estate tax. If the senior citizen is 
contemplating working in part to leave a bequest, then the 
individual would consider the estate tax to increase the 
effective marginal tax rate applicable to additional dollars of 
income. Likewise, if a taxpayer sought to earn additional 
income to purchase a good that is taxable under a State sales 
tax or a Federal excise tax, the taxpayer might have an 
effective marginal tax rate on the additional earnings greater 
than that calculated here.
    Most State individual income taxes adopt Federal individual 
income tax definitions of AGI and taxable income. As a result, 
the provisions analyzed above that change the taxpayer's 
effective marginal tax rate by increasing the taxpayer's 
taxable income subject to tax at the Federal statutory marginal 
tax rates generally will increase the taxpayer's taxable income 
subject to State statutory marginal income tax rates. This 
would create an effective State marginal tax rate in excess of 
State statutory marginal tax rates. Considering State income 
taxes would imply that this pamphlet's analysis of effective 
marginal income tax rates would understate the magnitude of 
effective marginal tax rates. However, some of the provisions 
analyzed above, such as the earned income credit, the dependent 
care credit, and the child tax credit do not alter the 
taxpayer's Federal taxable income, only the taxpayer's Federal 
tax liability. Consideration of State income taxes generally 
would not alter this pamphlet's analysis of effective marginal 
income tax rates created by those provisions.
    The effective marginal tax rates calculated here also do 
not consider the effects of certain government programs that 
also implicitly create effective marginal tax rates that 
deviate from the statutory marginal tax rates in the Code. For 
example, beneficiaries of food stamp benefits, medicaid 
benefits, low-income housing subsidies, and subsidized student 
loans generally are subject to income or asset tests. The 
benefits of these programs generally are phased out as the 
individual crosses certain income or asset thresholds. These 
phaseouts create an implicit marginal tax on additional income 
earned by the individual.97 These implicit taxes are 
in addition to those imposed by the Code and may overlap with 
some of the provisions analyzed in this pamphlet. To the extent 
there is overlap of this sort, the analysis here will 
understate the aggregate effective marginal tax rate.
---------------------------------------------------------------------------
    \97\ For a brief discussion of the implicit taxes created by the 
food stamp program and AFDC see, Dickert, Houser, and Scholz, ``The 
Earned Income Tax Credit and Transfer Programs.''
---------------------------------------------------------------------------