TAX EXPENDITURES Compendium of Background Material on Individual Provisions

[Senate Prints 109-72]
[From the U.S. Government Publishing Office]

109th Congress
2d Session COMMITTEE PRINT S. Prt.
109-072
_______________________________________________________________________

TAX EXPENDITURES

Compendium of Background Material on Individual Provisions

----------

COMMITTEE ON THE BUDGET

UNITED STATES SENATE

[GRAPHIC] [TIFF OMITTED] TONGRESS.#13

DECEMBER 2006

PREPARED BY THE

Congressional Research Service

Prepared for the use of the Committee on the Budget by the
Congressional Research Service. This document has not been officially
approved by the Committee and may not reflect the views of its members.

TAX EXPENDITURES--Compendium of Background Material on Individual
Provisions

109th Congress
2d Session COMMITTEE PRINT S. Prt.
109-072
_______________________________________________________________________

TAX EXPENDITURES

Compendium of Background Material on Individual Provisions

__________

COMMITTEE ON THE BUDGET

UNITED STATES SENATE

[GRAPHIC] [TIFF OMITTED] TONGRESS.#13

DECEMBER 2006

PREPARED BY THE

Congressional Research Service

U.S. GOVERNMENT PRINTING OFFICE
31-188 WASHINGTON : 2006
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COMMITTEE ON THE BUDGET

JUDD GREGG, New Hampshire, Chairman
PETE V. DOMENICI, New Mexico KENT CONRAD, North Dakota
CHARLES E. GRASSLEY, Iowa PAUL S. SARBANES, Maryland
WAYNE ALLARD, Colorado PATTY MURRAY, Washington
CONRAD BURNS, Montana RON WYDEN, Oregon
MICHAEL ENZI, Wyoming RUSSELL D. FEINGOLD, Wisconsin
JEFF SESSIONS, Alabama TIM JOHNSON, South Dakota
JIM BUNNING, Kentucky ROBERT C. BYRD, West Virginia
MIKE CRAPO, Idaho BILL NELSON, Florida
JOHN ENSIGN, Nevada DEBBIE STABENOW, Michigan
JOHN CORNYN, Texas JON S. CORZINE, New Jersey
LAMAR ALEXANDER, Tennessee
LINDSEY O. GRAHAM, South Carolina
Scott Gudes, Majority Staff Director
Mary Ann Naylor, Staff Director

LETTER OF TRANSMITTAL

December 20, 2006

UNITED STATES SENATE
COMMITTEE ON THE BUDGET
WASHINGTON, DC

To the Members of the Committee on the Budget:

The Congressional Budget and Impoundment and Control Act of 1974
(as amended) requires the Budget Committees to examine tax expenditures
as they develop the Congressional Budget Resolution. There are over 160
separate tax expenditures in current law. Section 3(3) of the Budget Act of
1974 defines tax expenditures as those revenue losses attributable to
provisions of the Federal tax laws which allow a special exclusion,
exemption, or deduction from gross income or provide a special credit, a
preferential rate of tax, or a deferral of tax liability.

Tax expenditures are becoming increasingly important when
considering the budget. They are often enacted as permanent legislation and
can be compared to direct spending on entitlement programs. Both tax
expenditures and entitlement spending have received, as they should in the
current budget environment, increased scrutiny.

This print was prepared by the Congressional Research Service (CRS)
and was coordinated by Daniel Brandt and Cheri Reidy of the Senate Budget
Committee staff. All tax code changes through the end of the 109th
Congress are included.

The CRS has produced an extraordinarily useful document which
incorporates not only a description of each provision and an estimate of its
revenue cost, but also a discussion of its impact, a review of its underlying
rationale, an assessment which addresses the arguments for and against the
provision, and a set of bibliographic references. Nothing in this print should
be interpreted as representing the views or recommendations of the Senate
Budget Committee or any of its members.

Judd Gregg
Chairman

LETTER OF SUBMITTAL

CONGRESSIONAL RESEARCH SERVICE
THE LIBRARY OF CONGRESS
Washington, D.C., December 15, 2006

Honorable Judd Gregg
Chairman, Committee on the Budget
U.S. Senate
Washington, DC 20510.

Dear Mr. Chairman:

I am pleased to submit a revision of the December 2004 Committee
Print on Tax Expenditures.

As in earlier versions, each entry includes an estimate of each tax
expenditure's revenue cost, its legal authorization, a description of the tax
provision and its impact, the rationale at the time of adoption, an assessment,
and bibliographic citations. The impact section includes quantitative data on
the distribution of tax expenditures across income classes where such data
are relevant and available. The rationale section contains some detail about
the historical development of each provision. The assessment section
summarizes major issues surrounding each tax expenditure.

The revision was written under the general direction of Jane G.
Gravelle, Senior Specialist in Economic Policy. Contributors of individual
entries include Andrew Austin, James M. Bickley, David L. Brumbaugh,
Gregg A. Esenwein, Jane G. Gravelle, Gary Guenther, Thomas Hungerford,
Pamela Jackson, Steven Maguire, Nonna Noto, and Maxim Shvedov of the
Government and Finance Division; Linda Levine, Robert F. Lyke, Edward
B. Rappaport, Christine Scott, and David Smole of the Domestic Social
Policy Division; and Salvatore Lazzari of the Resources, Science and
Industry Division. Dee Gray, Rosslyn Richardson, and LaTanya Winston
provided editorial assistance and prepared the document for publication.

DANIEL P. MULHOLLAN, Director

CONTENTS

Letter of Transmittal III
Letter of Submittal V
Introduction 1
National Defense
Exclusion of Benefits and Allowances to
Armed Forces Personnel 13
Exclusion of Military Disability Benefits 19
Deduction for Overnight-Travel Expenses of National
Guard and Reserve Members 23
International Affairs
Exclusion of Income Earned Abroad by U.S. Citizens 27
Exclusion of Certain Allowances for Federal Employees
Abroad 33
Exclusion of Extraterritorial Income 37
Deferral of Active Income of Controlled Foreign
Corporations 43
Inventory Property Sales Source Rule Exception 49
Deferral of Certain Financing Income 53
General Science, Space, and Technology
Tax Credit for Increasing Research Expenditures 57
Expensing of Research and Experimental Expenditures 65
Energy
Expensing of Exploration and Development Costs;
Amortization of Geological and Geophysical Costs:
Oil, Gas, and Other Fuels 69
Excess of Percentage over Cost Depletion: Oil, Gas, and
Other Fuels 75
Tax Credit for Production of Non-Conventional Fuels 83
Tax Credits for Alcohol and Biodiesel Fuels 91
Exclusion of Interest on State and Local Government
Qualified Private Activity Bonds for Energy
Production Facilities 101
Exclusion of Energy Conservation Subsidies Provided
by Public Utilities 105
Tax Credit for Investments in Solar, Geothermal,
Fuel Cells, and Microturbines 109
Tax Credits for Electricity Production from Renewable
Resources 117
Tax Credit and Deduction for Small Refiners with
Capital Costs Associated with EPA Sulfur
Regulation Compliance 125
Deferral of Gain from the Disposition of Electric
Transmission Property to Implement Federal
Energy Regulatory Commission Restructuring Policy 129
Tax Credit for Holders of Clean Renewable Energy Bonds 133
Tax Credits For Investments In Clean Coal Power
Generation Facilities 137
Expensing of the Cost of Property Used in the Refiners
of Liquid Fuels 141
Deduction of Expenditures on Energy-Efficient
Commercial Building Property 145
Tax Credit for the Purchase of Qualified Energy
Efficiency Improvements to Homes 151
Tax Credit for the Production of Energy-Efficient
Appliances 157
Tax Credits for Alternative Technology Vehicles 163
Tax Credit for Clean Fuel Vehicle Refueling Property 173
Five-Year Carryback Period for Certain Net Operating
Losses of Electric Utility Companies 179
Natural Resources and Environment
Excess of Percentage Over Cost Depletion: Nonfuel
Minerals 183
Expensing of Multiperiod Timber-Growing Costs;
Amortization and Expensing of Reforestation
Expenses 189
Expensing of Exploration and Development Costs:
Nonfuel Minerals 193
Exclusion of Interest on State and Local Government
Sewage, Water, and Hazardous Waste
Facilities Bonds 197
Special Rules for Mining Reclamation Reserves 201
Special Tax Rate for Nuclear Decommissioning
Reserve Fund 203
Exclusion of Contributions in Aid of Construction
for Water and Sewer Utilities 207
Amortization of Certified Pollution Control Facilities 211
Agriculture
Exclusion of Cost-Sharing Payments 215
Exclusion of Cancellation of Indebtedness Income
of Farmers 219
Cash Accounting for Agriculture 223
Income Averaging for Farmers and Fishermen 227
Five-Year Carryback Period for Net Operating Losses
Attributable to Farming 231
Commerce and Housing
Exemption of Credit Union Income 235
Exclusion of Investment Income on Life Insurance and
Annuity Contracts 239
Small Life Insurance Company Taxable Income
Adjustment 245
Special Treatment of Life Insurance Company Reserves 249
Deduction of Unpaid Property Loss Reserves for
Property and Casualty Insurance Companies 253
Special Deduction for Blue Cross and Blue Shield
Companies 257
Deduction for Mortgage Interest on Owner-Occupied
Residences 261
Deduction for Property Taxes on Owner-Occupied
Residences 267
Exclusion of Capital Gains on Sales of Principal
Residences 273
Exclusion of Interest on State and Local
Government Bonds for Owner-Occupied Housing 277
Exclusion of Interest on State and Local
Government Bonds for Rental Housing 281
Tax Credit for First-Time Homebuyers in the
District of Columbia 285
Additional Exemption for Housing Provided to
Individuals Displaced by Hurricane Katrina 289
Employer Housing for Individuals Affected by
Hurricane Katrina 293
Depreciation of Rental Housing in Excess of
Alternative Depreciation System 297
Tax Credit for Low-Income Housing 303
Tax Credit for Rehabilitation of Historic Structures 309
Investment Credit for Rehabilitation of Structures
Other Than Historic Structures 313
Reduced Rates of Tax on Dividends and Long-Term
Capital Gains 317
Exclusion of Capital Gains at Death Carryover Basis of
Capital Gains on Gifts 325
Deferral of Gain on Non-Dealer Installment Sales 331
Deferral of Gain on Like-Kind Exchanges 335
Depreciation of Buildings Other than Rental Housing
in Excess of Alternative Depreciation System 339
Depreciation on Equipment in Excess of Alternative
Depreciation System 345
Expensing of Depreciable Business Property 351
Amortization of Business Start-Up Costs 357
Reduced Rates on First $10,000,000 of Corporate
Taxable Income 361
Permanent Exemption from Imputed Interest Rules 365
Expensing of Magazine Circulation Expenditures 369
Special Rules for Magazine, Paperback Book, and
Record Returns 373
Completed Contract Rules 377
Cash Accounting, Other than Agriculture 381
Exclusion of Interest on State and Local Government
Small-Issue Qualified Private Activity Bonds 385
Exception from Net Operating Loss Limitations for
Corporations in Bankruptcy Proceedings 389
Tax Credit for Employer-Paid FICA Taxes on Tips 393
Production Activity Reduction 397
Deduction for Certain Film and Television Production Costs 401
Tax Credit for the Cost of Carrying Tax-Paid Distilled
Spirits in Wholesale Inventories . . . . . . . . . . . . . . . . . . . . . .405
Tax Benefits Related to 2005 Hurricane Disaster Costs:
Expensing of Clean-up Costs, Additional First Year
Depreciation, Carryback of Losses, Tax Credit for
Employee Retention 409
Transportation
Exclusion of Interest on State and Local Government Bonds
for Highway Projects and Rail-Truck Transfer Facilities 413
Tax Credit for Certain Railroad Track Maintenance 417
Deferral of Tax on Capital Construction Funds of Shipping Companies 421
Exclusion of Employer-Paid Transportation Benefits 425
Community and Regional Development
New York City Liberty Zone Tax Incentives 429
Empowerment Zone Tax Incentives, District of Columbia Tax
Incentives, and Indian Reservation Tax Incentives 433
New Markets Tax Credit and Renewal Community Tax
Incentives 439
Expensing of Redevelopment Costs in Certain Environmentally
Contaminated Areas ("Brownfields") 443
Exclusion of Interest on State and Local Government Bonds
for Private Airports, Docks, and Mass Commuting
Facilities 447
Qualified Green Building and Sustainable Design Project
Bonds 451
Education, Training, Employment, and Social Services
Exclusion of Income Attributable to the Discharge of
Certain Student Loan Debt and NHSC Educational
Loan Repayments 455
Deduction for Classroom Expenses of Elementary and
Secondary School Educators 459
Tax Credits for Tuition for Post-Secondary Education 463
Deduction for Interest on Student Loans 467
Exclusion of Earnings of Coverdell Educational
Savings Accounts 471
Exclusion of Interest on Education Savings Bonds 475
Deduction for Higher Education Expenses 479
Exclusion of Tax on Earnings of Qualified Tuition Programs 483
Exclusion of Scholarship and Fellowship Income 487
Exclusion of Employer-Provided Education Assistance
Benefits 491
Exclusion of Employer-Provided Tuition Reduction 493
Parental Personal Exemption for Students Age 19-23 497
Exclusion of Interest on State and Local Government
Student Loan Bonds 501
Exclusion of Interest on State and Local Government
Bonds for Private Nonprofit and Qualified Public
Educational Facilities 507
Tax Credit for Holders of Qualified Zone Academy Bonds 511
Deduction for Charitable Contributions to Educational
Institutions 515
Exclusion of Employee Meals and Lodging (Other
than Military) 523
Exclusion of Benefits Provided under Cafeteria Plans 527
Exclusion of Housing Allowances for Ministers 533
Exclusion of Miscellaneous Fringe Benefits 539
Exclusion of Employee Awards 543
Exclusion of Income Earned by Voluntary Employees'
Beneficiary Associations 547
Special Tax Provisions for Employee Stock Ownership
Plans (ESOPs) 555
Work Opportunity Tax Credit 561
Welfare-to-Work Tax Credit 565
Deferral of Taxation on Spread on Acquisition of Stock
Under Incentive Stock Option Plans and Employee
Stock Purchase Plans 569
Tax Credit for Children Under Age 17 573
Tax Credit for Child and Dependent Care and Exclusion
of Employer-Provided Child Care 577
Tax Credit for Employer-Provided Child Care 585
Exclusion of Certain Foster Care Payments 589
Adoption Credit and Employee Adoption Benefits Exclusion 593
Deduction for Charitable Contributions, Other than for
Education and Health 599
Tax Credit for Disabled Access Expenditures 607
Health
Exclusion of Employer Contributions for Health Care,
Health Insurance Premiums, and Long-Term Care
Insurance Premiums 611
Exclusion of Medical Care and CHAMPUS/TRICARE,
Medical Insurance for Military Dependents, Retirees,
and Retiree Dependents 619
Deduction for Health Insurance Premiums and Long-Term
Care Insurance Premiums Paid by the Self-Employed 623
Deduction for Medical Expenses and Long-Term
Care Expenses 629
Exclusion of Workers' Compensation Benefits
(Medical Benefits) 637
Health Savings Accounts 641
Exclusion of Interest on State and Local Government Bonds
for Private Nonprofit Hospital Facilities 647
Deduction for Charitable Contributions to Health
Organizations 651
Tax Credit for Orphan Drug Research 659
Tax Credit for Purchase of Health Insurance by Certain
Displaced Persons 665
Medicare
Exclusion of Untaxed Medicare Benefits: Hospital Insurance 671
Exclusion of Medicare Benefits: Supplementary Medical
Insurance 675
Exclusion of Subsidy Payments to Employers Offering
Certain Prescription Drug Benefits to Retirees Eligible
for Medicare 679
Income Security
Exclusion of Workers' Compensation Benefits
(Disability and Survivors Payments) 685
Exclusion of Damages on Account of Personal Physical
Injuries or Physical Sickness 689
Exclusion of Special Benefits for Disabled Coal Miners 693
Exclusion of Cash Public Assistance Benefits 697
Net Exclusion of Pension Contributions and Earnings Plans
for Employees and Self-Employed Individuals (Keoghs) 701
Net Exclusion of Pension Contributions and Earnings:
Individual Retirement Plans 709
Tax Credit for Certain Individuals for Elective Deferrals
and IRA Contributions 715
Tax Credit for New Retirement Plan Expenses of Small
Businesses 719
Exclusion of Other Employee Benefits: Premiums on
Group Term Life Insurance 723
Exclusion of Other Employee Benefits: Premiums on
Accident and Disability Insurance 727
Additional Standard Deduction for the Blind and the Elderly 729
Tax Credit for the Elderly and Disabled 733
Deductibility for Casualty and Theft Losses 737
Earned Income Credit (EIC) 741
Exclusion of Cancellation of Indebtedness Income of
Hurricane Katrina Victims 747
Social Security and Railroad Retirement
Exclusion of Untaxed Social Security and Railroad
Retirement Benefits 749
Veterans' Benefits and Services
Exclusion of Veterans' Benefits and Services:
(1) Exclusion of Veterans' Disability Compensation;
(2) Exclusion of Veterans' Pensions;
(3) Exclusion of Readjustment Benefits 755
Exclusion of Interest on State and Local Government Bonds
for Veterans' Housing 759
General Purpose Fiscal Assistance
Exclusion of Interest on Public Purpose State and Local Government Debt 763
Deduction of Nonbusiness State and Local Government
Income and Personal Property Taxes 769
Tax Credit for Puerto Rico and Possession Income and
Puerto Rico Economic Activity 773
Interest
Deferral of Interest on Savings Bonds 779
Appendixes

A. Forms of Tax Expenditures 783
B. Relationship Between Tax Expenditures and
Limited Tax Benefits Subject to Line Item Veto 787

INTRODUCTION

This compendium gathers basic information concerning 160 Federal tax
provisions currently treated as tax expenditures. They include those listed in
Tax Expenditure Budgets prepared for fiscal years 2006-2010 by the Joint
Committee on Taxation, although certain separate items that are closely
related and are within a major function may be combined.

With respect to each tax expenditure, this compendium provides:

The estimated Federal revenue loss associated with the provision
for individual and corporate taxpayers, for fiscal years 2006-2010,
as estimated by the Joint Committee on Taxation;

The legal authorization for the provision (e.g., Internal Revenue
Code section, Treasury Department regulation, or Treasury
ruling);

A description of the tax expenditure, including an example of its
operation where this is useful;

A brief analysis of the impact of the provision, including
information on the distribution of benefits where data are
available;

A brief statement of the rationale for the adoption of the tax
expenditure where it is known, including relevant legislative
history;

An assessment, which addresses the arguments for and against the
provision; and

References to selected bibliography.

The information presented for each tax expenditure is not intended to be
exhaustive or definitive. Rather, it is intended to provide an introductory
understanding of the nature, effect, and background of each provision. Good
starting points for further research are listed in the selected bibliography
following each provision.

Defining Tax Expenditures

Tax expenditures are revenue losses resulting from Federal tax
provisions that grant special tax relief designed to encourage certain kinds of
behavior by taxpayers or to aid taxpayers in special circumstances. These
provisions may, in effect, be viewed as spending programs channeled through
the tax system. They are, in fact, classified in the same functional categories
as the U.S. budget.

Section 3(3) of the Congressional Budget and Impoundment Control
Act of 1974 specifically defines tax expenditures as:

. . . those revenue losses attributable to provisions of the Federal tax laws which
allow a special exclusion, exemption, or deduction from gross income or which
provide a special credit, a preferential rate of tax, or a deferral of tax liability; . . .

In the legislative history of the Congressional Budget Act, provisions
classified as tax expenditures are contrasted with those provisions which are
part of the "normal structure" of the individual and corporate income tax
necessary to collect government revenues.

The listing of a provision as a tax expenditure in no way implies any
judgment about its desirability or effectiveness relative to other tax or non-tax
provisions that provide benefits to specific classes of individuals and
corporations. Rather, the listing of tax expenditures, taken in conjunction
with the listing of direct spending programs, is intended to allow Congress to
scrutinize all Federal programs relating to the same goals--both non-tax and
tax--when developing its annual budget. Only when tax expenditures are
considered will congressional budget decisions take into account the full
spectrum of Federal programs.

Because any qualified taxpayer may reduce tax liability through use of a
tax expenditure, such provisions are comparable to entitlement programs
under which benefits are paid to all eligible persons. Since tax expenditures
are generally enacted as permanent legislation, it is important that, as
entitlement programs, they be given thorough periodic consideration to see
whether they are efficiently meeting the national needs and goals for which
they were established.

Tax expenditure budgets which list the estimated annual revenue losses
associated with each tax expenditure first were required to be published in
1975 as part of the Administration budget for fiscal year 1976, and have been
required to be published by the Budget Committees since 1976. The tax
expenditure concept is still being refined, and therefore the classification of
certain provisions as tax expenditures continues to be discussed.
Nevertheless, there has been widespread agreement for the treatment as tax
expenditures of most of the provisions included in this compendium.

As defined in the Congressional Budget Act, the concept of tax
expenditure refers to the corporation and individual income taxes. Other
parts of the Internal Revenue Code--excise taxes, employment taxes, estate
and gift taxes--also have exceptions, exclusions, refunds and credits (such as
a gasoline tax exemptions for non-highway uses) which are not included here
because they are not parts of the income tax.

Administration Fiscal Year 2007 Expenditure Budget

There are several differences between the tax expenditures shown in this
publication and the tax expenditure budget found in the Administration's
FY2007 budget document. In some cases tax expenditures are combined in
one list, but not in the other.

Major Types of Tax Expenditures

Tax expenditures may take any of the following forms:

(1) exclusions, exemptions, and deductions, which reduce taxable
income;

(2) preferential tax rates, which apply lower rates to part or all of a
taxpayer's income;

(3) credits, which are subtracted from taxes as ordinarily computed;

(4) deferrals of tax, which result from delayed recognition of income or
from allowing in the current year deductions that are properly attributable to a
future year.

The amount of tax relief per dollar of each exclusion, exemption, and
deduction increases with the taxpayer's tax rate. A tax credit is subtracted
directly from the tax liability that would otherwise be due; thus the amount of
tax reduction is the amount of the credit--which does not depend on the
marginal tax rate. (See Appendix A for further explanation.)

Order of Presentation

The tax expenditures are presented in an order which generally parallels
the budget functional categories used in the congressional budget, i.e., tax
expenditures related to "national defense" are listed first, and those related to
"international affairs" are listed next. In a few instances, two or three closely
related tax expenditures derived from the same Internal Revenue Code
provision have been combined in a single summary to avoid repetitive
references even though the tax expenditures are related to different functional
categories. This parallel format is consistent with the requirement of section
301(d)(6) of the Budget Act, which requires the tax expenditure budgets
published by the Budget Committees as parts of their April 15 reports to
present the estimated levels of tax expenditures "by major functional
categories."

Impact (Including Distribution)

The impact section includes information on the direct effect of the
provisions and, where available, the distributional effect across individuals.
Unless otherwise specified, distributional tables showing the share of the tax
expenditure received by income class are calculated from data in the Joint
Committee on Taxation's committee print on tax expenditures for 2006-2010.
This distribution uses an expanded income concept that is composed of
adjusted gross income (AGI), plus (1) tax-exempt interest, (2) employer
contributions for health plans and life insurance, (3) employee share of FICA
tax, (4) worker's compensation, (5) nontaxable Social Security benefits, (6)
insurance value of Medicare benefits, (7) corporate income tax liability
passed on to shareholders, (8) alternative minimum tax preferences, and (9)
excluded income of U.S. citizens abroad.

The following table shows the estimated distribution of returns by
income class, for comparison with those tax expenditure distributions:

Distribution by Income Class of Tax Returns at 2005
Income Levels

Income Class
(in thousands of $)

Percentage
Distribution

Below $10

15.0

$10 to $20

13.9

$20 to $30

12.2

$30 to $40

10.7

$40 to $50

9.1

$50 to $75

15.5

$75 to $100

9.4

$100 to $200

11.3

$200 and over

2.9

These estimates were made for nine tax expenditures. For other tax
expenditures, a distributional estimate or information on distributional impact
is provided, when such information could be obtained.

Many tax expenditures are corporate and thus do not directly affect the
taxes of individuals. Most analyses of capital income taxation suggest that
such taxes are likely to be borne by capital given reasonable behavioral
assumptions. Capital income is heavily concentrated in the upper-income
levels. For example, the Congressional Budget Office reports in 2001 that
52 percent of capital income was received by the top 1 percent of the
population, 68 percent was received by the top 5 percent, 75 percent was
received by the top 10 percent, and 83 percent was received by the top 20
percent. The distribution across the first four quintiles was 1, 2, 5, and 8
percent. Corporate tax expenditures would, therefore, tend to benefit higher-
income individuals.

Rationale

Each tax expenditure item contains a brief statement of the rationale for
the adoption of the expenditure, where it is known. They are the principal
rationales publicly given at the time the provisions were enacted. The
rationale also chronicles subsequent major changes in the provisions and the
reasons for the changes.

Assessment

The assessment section summarizes the arguments for and against the
tax expenditures and the issues they raise. These issues include effects on
economic efficiency, on fairness and equity, and on simplicity and tax
administration. Further information can be found in the bibliographic
citations.

Estimating Tax Expenditures

The revenue losses for all the listed tax expenditures are those estimated
by the Joint Committee on Taxation.

In calculating the revenue loss from each tax expenditure, it is assumed
that only the provision in question is deleted and that all other aspects of the
tax system remain the same. In using the tax expenditure estimates, several
points should be noted.

First, in some cases, if two or more items were eliminated, the
combination of changes would probably produce a lesser or greater revenue
effect than the sum of the amounts shown for the individual items. Thus, the
arithmetical sum of all tax expenditures (reported below) may be different
from the actual revenue consequences of eliminating all tax expenditures.

Second, the amounts shown for the various tax expenditure items do not
take into account any effects that the removal of one or more of the items
might have on investment and consumption patterns or on any other aspects
of individual taxpayer behavior, general economic activity, or decisions
regarding other Federal budget outlays or receipts.

Finally, the revenue effect of new tax expenditure items added to the tax
law may not be fully felt for several years. As a result, the eventual annual
cost of some provisions is not fully reflected until some time after enactment.
Similarly, if items now in the law were eliminated, it is unlikely that the full
revenue effects would be immediately realized.

These tax expenditure estimating considerations are, however, similar to
estimating considerations involving entitlement programs. Like tax
expenditures, annual budget estimates for each transfer and income-security
program are computed separately. However, if one program, such as veterans
pensions, were either terminated or increased, this would affect the level of
payments under other programs, such as welfare payments.

Also, like tax expenditure estimates, the elimination or curtailment of a
spending program, such as military spending or unemployment benefits,
would have substantial effects on consumption patterns and economic activity
that would directly affect the levels of other spending programs. Finally, like
tax expenditures, the budgetary effect of terminating certain entitlement
programs would not be fully reflected until several years later because the
termination of benefits is usually only for new recipients, with persons already
receiving benefits continued under "grandfather" provisions.
All revenue loss estimates are based upon the tax law enacted through the end
of the 109th Congress.

The expenditure table below shows an initial declining amount for
corporations. This decline is due to the temporary first year depreciation for
equipment enacted in 2002 that expires in 2004 and largely involves a timing
shift: a loss of revenue in the short run offset by a long run gain.

Sum of Tax Expenditure Estimates by Type of Taxpayer, Fiscal
Years 2006-2010

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

868.5

74.9

943.4

2007

906.8

86.6

993.4

2008

951.6

91.3

1,042.9

2009

1,011.0

98.5

1,109.4

2010

1,049.3

105.9

1,155.2

Note: These totals are the mathematical sum of the estimated fiscal year effect
of each of the tax expenditure items included in this publication as appearing the
Joint Committee on Taxation's April , 2006 list. Legislation passed in the remainder
of 2006 would increase them by a small percentage.

Selected Bibliography

Bartlett, Bruce. "The Flawed Concept of Tax Expenditures." National
Center for Policy Analysis (http:/www.ncpa.org).
Bosworth, Barry P. Tax Incentives and Economic Growth.
Washington, DC: The Brookings Institution, 1984.
Brannon, Gerard M. "Tax Expenditures and Income Distribution: A
Theoretical Analysis of the Upside-Down Subsidy Argument," The
Economics of Taxation, ed. Henry J. Aaron and Michael J. Boskin.
Washington, DC: The Brookings Institution, 1980, pp. 87-98.
Brixi, Hana Polackova, Christian M.A. Valenduc and Zhicheng Li
Swift. Shedding Light on Government Spending Through the Tax System:
Lessons from Developed and Transition Economies. Washington, DC, the
World Bank, 2004.
Browning, Jacqueline, M. "Estimating the Welfare Cost of Tax
Preferences," Public Finance Quarterly, v. 7, no. 2. April 1979, pp. 199-219.
Burman, Leonard E. "Is the Tax Expenditure Concept Still
Relevant?" National Tax Journal 56 (September 2003): 613-628.
The Century Foundation, Bad Breaks All Around, Report of the
Working Group on Tax Expenditures, New York: The Century Foundation
Press, 2002.
Craig, Jon and William Allan. "Fiscal Transparency, Tax Expenditures
and Budget Processes: An International Perspective," Proceedings of the 94th
Annual Conference 2001, Washington, D.C.: National Tax Association,
2002, 258-264.
Edwards, Kimberly K. "Reporting for Tax Expenditure and Tax
Abatement," Government Finance Review, v. 4. August 1988, pp. 13-17.
Freeman, Roger A. Tax Loopholes: The Legend and the Reality.
Washington, DC: American Enterprise Institute for Public Policy Research,
1973.
Fox, John O. "The Untold Story: Congress's Own Calculation of Its
Revenue Losses from Special Provisions of the Tax Laws." Chapter 5 in If
Americans Really Understood the Income Tax. Boulder, Colorado: Westview
Press, 2001.
Goode, Richard. The Individual Income Tax. Washington, DC: The
Brookings Institution, 1976.
Gravelle, Jane G. "Corporate Tax Welfare." Library of Congress,
Congressional Research Service Report 97-308 E, Washington, DC: February
28, 1998.
-. "Tax Expenditures." The Encyclopedia of Taxation and Tax Policy,
edited by Joseph J. Cordes, Robert O. Ebel, and Jane G. Gravelle.
Washington, DC: Urban Institute Press, 1999, pp. 379-380.
Hildred, William M., and James V. Pinto. "Estimates of Passive Tax
Expenditures, 1984," Journal of Economic Issues, v. 23. March 1989, pp.
93-106.

Howard, Christopher. The Hidden Welfare State: Tax Expenditures and
Social Policy in the United States. Princeton, NJ: Princeton Univ. Press,
1997.
King, Ronald F. "Tax Expenditures and Systematic Public Policy: An
Essay on the Political Economy of the Federal Revenue Code," Public
Budgeting and Finance, v. 4. Spring 1984, pp. 14-31.
Klimschot, JoAnn. The Untouchables: A Common Cause Study of the
Federal Tax Expenditure Budget. Washington, DC: Common Cause, 1981.
Ladd, Helen. The Tax Expenditure Concept After 25 Years.
Presidential Address to the National Tax Association. Proceedings of the 86th
Annual Conference 1994, Columbus, Ohio: National Tax Association, 1995,
50-57.
McLure, Charles E., Jr. Must Corporate Income Be Taxed Twice?
Washington, DC: The Brookings Institution, 1979.
Mikesell, John L. "The Tax Expenditure Concept at the State Level:
Conflict Between Fiscal Control and Sound Tax Policy," Proceedings of the
94th Annual Conference 2001, Washington, D.C.: National Tax Association,
2002, 265-272.
Neil, Bruce. "Tax Expenditures and Government Policy." Kingston,
Ontario: John Deutsche Institute for the Study of Economic Policy, 1989.
Noto, Nonna A. "Tax Expenditures: The Link Between Economic
Intent and the Distribution of Benefits Among High, Middle, and Low
Income Groups." Library of Congress, Congressional Research Service
Multilith 80-99E. Washington, DC: May 22, 1980.
Pechman, Joseph A., ed. Comprehensive Income Taxation.
Washington, DC: The Brookings Institution, 1977.
-. Federal Tax Policy: Revised Edition. Washington, DC: The
Brookings Institution, 1980.
-. What Should Be Taxed: Income or Expenditures? Washington, DC:
The Brookings Institution, 1980.
-. Who Paid the Taxes, 1966-85. Washington, DC: The Brookings
Institution, 1985.
Schick, Allen. "Controlling Nonconventional Expenditure: Tax
Expenditures and Loans," Public Budgeting and Finance, v. 6. Spring 1986,
pp. 3-19.
Schroeher, Kathy. Gimme Shelters: A Common Cause Study of the
Review of Tax Expenditures by the Congressional Tax Committees.
Washington, DC: Common Cause, 1978.
Simon, Karla, "The Budget Process and the Tax Law," Tax Notes, v.
40. August 8, 1988, pp. 627-637.
Steuerle, Eugene, and Michael Hartzmark. "Individual Income
Taxation, 1947-79," National Tax Journal, v. 34, no. 2. June 1981, pp.
145-166.
Sugin, Linda. "What is Happening to the Tax Expenditure Budget?"
Tax Notes, August 16, 2004.
Sunley, Emil M. "The Choice Between Deductions and Credits,"
National Tax Journal, v. 30, no. 3. September 1977, pp. 243-247.

Surrey, Stanley S. Pathways to Tax Reform. Cambridge, MA: Harvard
University Press, p. 3.

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Intentionally

National Defense

EXCLUSION OF BENEFITS AND ALLOWANCES
TO ARMED FORCES PERSONNEL

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

2.8

2007

2.8

2008

2.9

2009

3.0

2010

3.0

Authorization

Sections 112 and 134, and court decisions [see Jones v. United States, 60
Ct. Cl. 552 (1925)].

Description

Military personnel are provided with a variety of in-kind benefits (or cash
payments given in lieu of such benefits) that are not taxed. These benefits
include medical and dental benefits, group term life insurance, professional
education and dependent education, moving and storage, premiums for
survivor and retirement protection plans, subsistence allowances, uniform
allowances, housing allowances, overseas cost-of-living allowances,
evacuation allowances, family separation allowances, travel for consecutive
overseas tours, emergency assistance, family counseling and defense counsel,
burial and death services, travel of dependents to a burial site, and a number
of less significant items.

Other benefits include certain combat-zone compensation and combat-
related benefits. In addition, any member of the armed forces who dies while
in active service in a combat zone or as a result of wounds, disease, or injury
incurred while in service is excused from all tax liability. Any unpaid tax due
at the date of the member's death (including interest, additions to the tax, and
additional amounts) is abated. If collected, such amounts are credited or
refunded as an overpayment. (Medical benefits for dependents are discussed
subsequently under the Health function.) Families of members of the armed
forces receive a $12,000 death gratuity payment for deceased members of the
armed forces. The full amount of the death gratuity payment is tax-exempt.

The personal use of an automobile is not excludable as a qualified military
benefit.

The rule that the exclusion for qualified scholarships and qualified tuition
reductions does not apply to amounts received that represent compensation
for services no longer applies in the case of amounts received under the
Armed Forces Health Professions Scholarship and Financial Assistance
Program or the F. Edward Hebert Armed Forces Health Professions
Scholarship and Financial Assistance Program. Recipients of these
scholarships are obligated to serve in the military at an armed forces medical
facility.

Impact

Many military benefits qualify for tax exclusion. That is to say, the value
of the benefit (or cash payment made in lieu of the benefit) is not included in
gross income. Since these exclusions are not counted in income, the tax
savings are a percentage of the amount excluded, dependent upon the
marginal tax bracket of the recipient.

An individual in the 10-percent tax bracket (the lowest income tax bracket)
would not pay taxes equal to $10 for each $100 excluded. Likewise, an
individual in the 35-percent tax bracket (the highest income tax bracket)
would not pay taxes of $35 for each $100 excluded. Hence, the same
exclusion can be worth different amounts to different military personnel,
depending on their marginal tax bracket. By providing military compensation
in a form not subject to tax, the benefits have greater value for members of
the armed services with high income than for those with low income.

The exclusion of qualified medical scholarships will primarily benefit
students, therefore most beneficiaries are likely to have low tax rates. As
noted earlier, the tax benefit of an exclusion varies according to the marginal
tax rate of the individual.

Rationale

In 1925, the United States Court of Claims in Jones v. United States, 60 Ct.
Cl. 552 (1925), drew a distinction between the pay and allowances provided
military personnel. The court found that housing and housing allowances
were reimbursements similar to other non-taxable expenses authorized for the
executive and legislative branches.

Prior to this court decision, the Treasury Department had held that the
rental value of quarters, the value of subsistence, and monetary commutations
were to be included in taxable income. This view was supported by an earlier
income tax law, the Act of August 27, 1894, (later ruled unconstitutional by
the Courts) which provided a two- percent tax "on all salaries of officers, or
payments to persons in the civil, military, naval, or other employment of the
United States."

The principle of exemption of armed forces benefits and allowances
evolved from the precedent set by Jones v. United States, through subsequent
statutes, regulations, or long-standing administrative practices.

The Tax Reform Act of 1986 (P.L. 99-514) consolidated these rules so that
taxpayers and the Internal Revenue Service could clearly understand and
administer the tax law consistent with fringe benefit treatment enacted as part
of the Deficit Reduction Act of 1984 (P.L. 98-369). Provisions added by the
Military Family Tax Relief Act of 2004 (P.L. 108-121) in November 2003
clarified uncertainty concerning the U.S. Treasury Department's authority to
add dependent care assistance programs to the list of qualified military
benefits.

For some benefits, the rationale was a specific desire to reduce tax burdens
of military personnel during wartime (as in the use of combat pay provisions);
other allowances were apparently based on the belief that certain types of
benefits were not strictly compensatory, but rather intrinsic elements in the
military structure.

The Economic Growth and Tax Reconciliation Relief Act (P.L. 107-16)
simplified the definition of earned income by excluding nontaxable employee
compensation, which included combat zone pay, from the definition of earned
income. The amount of earned income that armed forces members reported
for tax purposes was reduced and caused a net loss in tax benefits for some
low-income members of the armed forces. The Working Families Tax Relief
Act of 2004 (P.L. 108-311) provided that combat pay that was otherwise
excluded from gross income could be treated as earned income for the
purpose of calculating the earned income tax credit and the child tax credit,
through 2006, a provision that was extended through 2007 by H.R. 6111,
enacted at the end of December 2006.

Assessment

Some military benefits are akin to the "for the convenience of the
employer" benefits provided by private enterprise, such as the allowances for
housing, subsistence, payment for moving and storage expenses, overseas
cost-of-living allowances, and uniforms. Other benefits are equivalent to
employer-provided fringe benefits such as medical and dental benefits,
education assistance, group term life insurance, and disability and retirement
benefits.

Some see the provision of compensation in a tax-exempt form as an unfair
substitute for additional taxable compensation. The tax benefits that flow
from an exclusion do provide the greatest benefits to high- rather than low-
income military personnel. Administrative difficulties and complications
could be encountered in taxing some military benefits and allowances that
currently have exempt status; for example, it could be difficult to value meals
and lodging when the option to receive cash is not available. By eliminating
exclusions and adjusting military pay scales accordingly, a result might be to
simplify decision-making about military pay levels and make "actual" salary
more apparent and satisfying to armed forces personnel. If military pay scales
were to be adjusted upward, it could increase the retirement income of
military personnel. However, elimination of the tax exclusions could also
lead service members to think their benefits were being cut, or provide an
excuse in the "simplification" process to actually cut benefits, affecting
recruiting and retention negatively.

Selected Bibliography

Steurle, Gene. "Tax Relief and Combat Pay," Tax Notes, v. 50, January
28, 1991, pp. 405-406.
U.S. Congress, Congressional Budget Office. Military Family Housing in
the United States., Washington, DC, September 1993. p. 67.
U.S. Congress, House Committee on Veterans' Affairs, Subcommittee on
Education, Training and Employment. Transition Assistance Program,
Hearing, 102nd Congress, 2nd session, Serial no. 102-31. Washington, DC:
U.S. Government Printing Office, March 19, 1992.
-, House Committee on Ways and Means. Tax Benefits for Individuals
Performing Services in Certain Hazardous Duty Areas; Report to Accompany
H.R. 2778 including Cost Estimate of the Congressional Budget Office, 104th
Congress, 2nd Session. Washington, DC: U.S. Government Printing Office,
1996. 14pp.
-, Joint Committee on Taxation. General Explanation of the Tax Reform
Act of 1986, H.R. 3838, 99th Congress, Public Law 99-514. Washington,
DC: U.S. Government Printing Office, 1987, pp. 828-830.
-, Joint Committee on Taxation. Technical Explanation of H.R. 3365, The
Military Family Tax Relief Act of 2003," as Passed by the House of
Representatives and the Senate. Washington, DC: U.S. Government Printing
Office, 2003, pp. 1-19.
U.S. Dept. of Defense. Report and Staff Analysis of the Seventh
Quadrennial Review of Military Compensation. Washington, DC: 7 volumes,
August 21, 1992.
U.S. Dept. of the Treasury, Office of the Secretary. Tax Reform for
Fairness, Simplicity, and Economic Growth; the Treasury Department
Report to the President. Washington, DC: November 1984, pp. 47-48.
U.S. General Accounting Office, "Military Compensation: Active Duty
Compensation and Its Tax Treatment," GAO Report GAO-04-721R
(Washington, DC: April 2004), pp. 1-32.
- , "Military Personnel: DOD Has Not Implemented the High Deployment
Allowance that Could Compensate Servicemembers Deployed Frequently for
Short Periods," GAO Report GAO-04-805 (Washington, DC: June 2004), pp.
1-27.
- , "Military Personnel: Bankruptcy Filings Among Active Duty
Servicemembers," GAO Report GAO-04-465R (Washington, DC: February
2004), pp. 1-8.
U.S. General Accounting Office, "Military Compensation: Active Duty
Compensation and Its Tax Treatment," GAO Report GAO-04-721R
(Washington, DC: April 2004), pp. 1-32.

National Defense

EXCLUSION OF MILITARY DISABILITY BENEFITS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.1

2007

0.1

2008

0.1

2009

0.1

2010

0.1

Authorization

Section 104(a)(4) or (5) and 104(b).

Description

Members of the armed forces on or before September 24, 1975, are eligible
for tax exclusion of disability pay. The payment from the Department of
Defense is based either on the percentage-of-disability or years-of-service
methods.

In the case of the percentage-of-disability method, the pension is the
percentage of disability multiplied by the terminal monthly basic pay. These
disability pensions are excluded from gross income.

In the years-of-service method, the terminal monthly basic pay is multiplied
by the number of service years times 2.5. Only that portion that would have
been paid under the percentage-of-disability method is excluded from gross
income.

Members of the United States armed forces joining after September 24,
1975, and who retire on disability, may exclude from gross income
Department of Defense disability payments equivalent to disability payments
they could have received from the Veterans Administration. Otherwise,
Department of Defense disability pensions may be excluded only if the
disability is directly attributable to a combat-related injury.

Under the Victims of Terrorism Tax Relief Act of 2001 an exclusion from
gross income for disability income is extended to any individual (civilian or
military) when attributable to a terrorist or military action regardless of where
the activity occurs (inside or outside the United States).

Impact

Disability pension payments that are exempt from tax provide more net
income than taxable pension benefits at the same level. The tax benefit of
this provision increases as the marginal tax rate increases, and is greater for
higher-income individuals.

Rationale

Typically, acts which provided for disability pensions for American
veterans also provided that these payments would be excluded from
individual income tax. In 1942, the provision was broadened to include
disability pensions furnished by other countries (many Americans had joined
the Canadian armed forces). It was argued that disability payments, whether
provided by the United States or by Canadian governments, were made for
essentially the same reasons and that the veteran's disability benefits were
similar to compensation for injuries and sickness, which at that time was
already excludable from income under Internal Revenue Code provisions.

In 1976, the exclusion was repealed, except in certain instances. Congress
sought to eliminate abuses by armed forces personnel who were classified as
disabled shortly before becoming eligible for retirement in order to obtain tax-
exempt treatment for their pension benefits. After retiring from military
service, some individuals would earn income from other employment while
receiving tax-free military disability benefits. Since present armed forces
personnel may have joined or continued their service because of the
expectation of tax-exempt disability benefits, Congress deemed it equitable to
limit changes in the tax treatment of disability payments to those joining after
September 24, 1975.

Assessment

The exclusion of disability benefits paid by the federal government alters
the distribution of net payments to favor higher income individuals. If
individuals had no other outside income, distribution could be altered either
by changing the structure of disability benefits or by changing the tax
treatment.

The exclusion causes the true cost of providing for military personnel to be
understated in the budget.

Selected Bibliography

Bittker, Boris I. "Tax Reform and Disability Pensions-the Equal
Treatment of Equals," Taxes, v. 55. June 1977, pp. 363-367.
Cullinane, Danielle. Compensation for Work-Related Injury and Illness.
Santa Monica, CA: RAND, 1992. 60pp. (RAND Publication Series N-3343-
FMP.)
Ogloblin, Peter K. Military Compensation Background Papers:
Compensation Elements and Related Manpower Cost Items, Their Purposes
and Legislative Backgrounds. Washington, DC: U.S. Government Printing
Office, September 1996, pp. 545-556.
Poulson, Linda L. and Ananth Seetharaman. "Taxes and the Armed
Forces," The CPA Journal, April 1996, pp. 22-26.
U.S. Congress, Joint Committee on Taxation. General Explanation of the
Tax Reform Act of 1976 (H.R. 10612, 94th Congress; Public Law 94-455).
Washington, DC: U.S. Government Printing Office, 1976, pp. 129-131.
U.S. Dept. of the Treasury, Office of the Secretary. Tax Reform for
Fairness, Simplicity, and Economic Growth; the Treasury Department
Report to the President. Washington, DC: November, 1984, pp. 51-57.
U.S. General Accounting Office. Disability Benefits: Selected Data on
Military and VA Recipients; Report to the Committee on Veterans' Affairs,
House of Representatives, GAO/HRD-92-106. Washington, DC: August
1992. 19pp.
-. Disability Compensation: Current Issues and Options for Change.
Washington, DC: 1982.
-. VA Disability Compensation: Comparison of VA Benefits with those of
Workers' Compensation Programs, Report to the Chairman, Subcommittee
on Benefits, Committee on Veterans' Affairs, House of Representatives.
Washington, DC: Government Accounting Office, February 14, 1997
-. VA Disability Compensation: Disability Ratings May Not Reflect
Veterans' Economic Losses, Report to the Chairman, Insurance and Memorial
Affairs, Committee on Veterans' Affairs, House of Representatives.
Washington, DC: Government Accounting Office, January 7, 1997.

-. Military and Veterans' Benefits: Observations on the Concurrent
Receipt of Military Retirement and VA Disability Compensation, Testimony
before the Subcommittee on Personnel, Committee on Armed Services, U.S.
Senate, March 27, 2003.

National Defense

DEDUCTION FOR OVERNIGHT-TRAVEL EXPENSES OF
NATIONAL GUARD AND RESERVE MEMBERS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.1

2007

0.1

2008

0.1

2009

0.1

2010

0.1

Authorization

Section 162.

Description

An above-the-line deduction is available for un-reimbursed overnight
travel, meals, and lodging expenses of National Guard and Reserve members.
In order to qualify for the provision, he or she must have traveled more than
100 miles away from home and stayed overnight as part of an activity while
on official duty. The deduction applies to all amounts paid or incurred in tax
years beginning after December 31, 2002. No deduction is generally
permitted for commuting expenses to and from drill meetings and the amount
of expenses that may be deducted may not exceed the general Federal
Government per diem rate applicable to that locale.

This deduction is available to taxpayers regardless of whether they claim
the standard deduction or itemize deductions when filing their income tax
return. The deduction is not restricted by the overall limitation on itemized
deductions.

Impact

The value of the benefit (or cash payment made in lieu of the benefit) is not
included in gross income. Since these deductions are not counted in income,
the tax savings are a percentage of the amount excluded, dependent upon the
marginal tax bracket of the recipient.

An individual in the 10-percent tax bracket (Federal tax law's lowest tax
bracket) would not pay taxes equal to $10 for each $100 excluded. Likewise,
an individual in the 35-percent tax bracket (Federal law's highest tax bracket)
would not pay taxes of $35 for each $100 excluded. Hence, the same
exclusion can be worth different amounts to different military personnel,
depending on their marginal tax bracket. By providing military compensation
in a form not subject to tax, the benefits have greater value for members of
the armed services with high income than for those with low income.

One of the benefits of an "above-the-line" deduction is that it reduces the
taxpayer's adjusted gross income (AGI). As AGI increases, it can cause other
tax deductions and credits to be reduced or eliminated. Therefore, deductions
that reduce AGI will often provide a greater tax benefit than deductions
"below-the-line" that do not reduce AGI.

Rationale

The deduction was authorized by the Military Family Tax Relief Act of
2003 (P.L. 108-121) which expanded tax incentives for military personnel.
Under previous law, the expenses could have been deducted as itemized
deductions only to the extent that they and other miscellaneous deductions
exceeded 2 percent of adjusted gross income. So reservists who did not
itemize were not able to deduct these expenses and reservists who did itemize
could deduct the expenses only in reduced form.

In enacting the new deduction, Congress identified the increasing role that
Reserve and National Guard members fulfill in defending the nation and a
heavy reliance on service personnel to participate in national defense.
Congress noted that more than 157,000 reservists and National Guard were
on active duty status- most assisting in Operation Iraqi Freedom at the time of
enactment.

Assessment

Selected Bibliography

Garrison, Larry R. "Tax Planning for Armed Forces Personnel (Part I),"
The Tax Advisor, v. 30, December 1999, pp. 838-843.
-, "Tax Planning for Armed Forces Personnel (Part II)," The Tax Advisor,
v. 31, January 2000, pp. 44-47.
Kusiak, Patrick J. "Income Tax Exclusion for Military Personnel During
War: Examining the Historical Development, Discerning Underlying
Principles, and Identifying Areas for Change," Federal Bar News and
Journal, v. 39, February 1992, pp. 146-151.
Ogloblin, Peter K. Military Compensation Background Papers:
Compensation Elements and Related Manpower Cost Items, Their Purposes
and Legislative Backgrounds. Washington, DC: Department of Defense,
Office of the Secretary of Defense, September 1996, pp. 137-149.
Poulson, Linda L. and Ananth Seetharaman. "Taxes and the Armed
Forces," The CPA Journal, April 1996, pp. 22-26.
U.S. Congress, House Committee on Veterans' Affairs, Subcommittee on
Education, Training and Employment. Transition Assistance Program,
Hearing, 102nd Congress, 2nd session, Serial no. 102-31. Washington, DC:
U.S. Government Printing Office, 1992.
-, House Committee on Ways and Means. Tax Benefits for Individuals
Performing Services in Certain Hazardous Duty Areas; Report to Accompany
H.R. 2778 including Cost Estimate of the Congressional Budget Office, 104th
Congress, 2nd Session. Washington, DC: U.S. Government Printing Office,
1996.
-, Joint Committee on Taxation. General Explanation of the Tax Reform
Act of 1986, H.R. 3838, 99th Congress, Public Law 99-514. Washington,
DC: U.S. Government Printing Office, 1987, pp. 828-830.
-, Joint Committee on Taxation. Technical Explanation of H.R. 3365, The
"Military Family Tax Relief Act of 2003," as Passed by the House of
Representatives and the Senate. Washington, DC: U.S. Government Printing
Office, 2003, pp. 1-19.
U.S. Dept. of Defense. Report and Staff Analysis of the Seventh
Quadrennial Review of Military Compensation. Washington, 7 volumes,
August 21, 1992.
U.S. Dept. of the Treasury, Internal Revenue Service. Publication 3:
Armed Forces' Tax Guide. Washington, DC: U.S. Government Printing
Office, 2005.
U.S. Dept. of the Treasury, Office of the Secretary. Tax Reform for
Fairness, Simplicity, and Economic Growth; the Treasury Department
Report to the President. Washington, DC: November 1984, pp. 47-48.

U.S. General Accounting Office, Military Compensation: Active Duty
Compensation and Its Tax Treatment, GAO Report GAO-04-721R
(Washington: May 2004), pp. 1-32.

International Affairs

EXCLUSION OF INCOME EARNED ABROAD
BY U.S. CITIZENS

Estimated Revenue Loss*

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

3.8

2007

4.0

2008

4.2

2009

4.4

2010

4.6

* Note: the estimates in the table do not reflect new restrictions on
the earned income exclusion contained in the Taxpayer Increase
Prevention and Reconciliation Act of 2006 (TIPRA; P.L. 109-222).
According to estimates by the Joint Tax Committee, TIPRA's
changes reduced the revenue loss from the exclusion by the
following amounts: FY2006: $15 million; FY2007: $261 million;
FY2008: $199 million; FY2009: $206 million; and FY2010: $222
million.

Authorization

Section 911.

Description

U.S. citizens are generally subject to U.S. taxes on their foreign- as well as
domestic-source income. However, section 911 of the tax code permits U.S.
citizens (other than Federal employees) who live and work abroad an
exclusion of wage and salary income from taxable income. (Foreign tax
credits, however, cannot be claimed for foreign taxes paid on excluded
income.) The amount that can be excluded is indexed for U.S. inflation,
beginning with tax year 2006; in 2006, the exclusion is $82,400. The
exclusion is scheduled to be indexed for U.S. inflation, beginning in 2008.
Qualifying individuals can also exclude certain expenditures for overseas
housing. To qualify for either exclusion, a person must be a U.S. citizen,
must have their tax home in a foreign country, and must either be a bona fide
resident of a foreign country or have lived abroad for at least 330 days of any
12 consecutive months. Qualified income must be "earned" income rather
than investment income. If a person qualifies for the exclusion for only part
of the tax year, only part of the exclusion can be claimed. The housing
exclusion is designed to approximate the extra housing costs of living abroad.
It is equal to the excess of actual foreign housing costs over 16 percent of the
applicable year's earned income exclusion amount, but is capped at 30
percent of the taxpayer's maximum foreign earned income exclusion. While
a taxpayer can claim both the housing and the income exclusion, the
combined exclusions cannot exceed total foreign earned income, including
housing allowances.

Impact

The exclusion's impact depends partly on whether foreign taxes paid are
higher or lower than U.S. taxes. If an expatriate pays high foreign taxes, the
exclusion has little importance; the U.S. person can use foreign tax credits to
offset any U.S. taxes. For expatriates who pay little or no foreign taxes,
however, the exclusion reduces or eliminates U.S. taxes. Available data
suggest that U.S. citizens who work abroad have higher real incomes, on
average, than persons working in the United States. Thus, where it does
reduce taxes the exclusion reduces tax progressivity.

The exclusion's effect on horizontal equity is more complicated. Because
foreign countries have costs of living that differ from that of the United
States, the tax liabilities of U.S. persons working abroad differ from the tax
burdens of persons with identical real incomes living in the United States. A
person working in a high-cost country needs a higher nominal income to
match the real income of a person in the United States; an expatriate in a low-
cost country needs a lower nominal income. Since tax brackets, exemptions,
and the standard deduction are expressed in terms of nominal dollars, persons
living in low-cost countries generally have lower tax burdens than persons
with identical real incomes living in the United States. Similarly, if not for
the foreign earned income exclusion, U.S. citizens working in high-cost
countries would pay higher taxes than their U.S. counterparts.

Because the maximum income exclusion is not linked to the actual cost of
living, the provision overcompensates for the cost of living abroad in some
cases. Indeed, some have argued that because the tax code does not take into
account variations in living costs within the United States, the appropriate
equity comparison is between expatriates and a person living in the highest
cost area within the United States. In this case, the likelihood that the
exclusion reduces rather than improves horizontal equity is increased.

Rationale

The Revenue Act of 1926 provided an unlimited exclusion of earned
income for persons residing abroad for an entire tax year. Supporters of the
exclusion argued that the provision would bolster U.S. trade performance,
since it would provide tax relief to U.S. expatriates engaged in trade
promotion.

The subsequent history of the exclusion shows a continuing attempt by
policymakers to find a balance between the provision's perceived beneficial
effects on U.S. trade and economic performance and perceptions of tax
equity. In 1962, the Kennedy Administration recommended eliminating the
exclusion in some cases and scaling it back in others in order to "support the
general principles of equity and neutrality in the taxation of U.S. citizens at
home and abroad." The final version of the Revenue Act of 1962 simply
capped the exclusion in all cases at $20,000. The Tax Reform Act of 1976
would have pared the exclusion further (to $15,000), again for reasons of tax
equity.

However, the Foreign Earned Income Act of 1978 completely revamped
the exclusion so that the 1976 provisions never went into effect. The 1978
Act sought to provide tax relief more closely tied to the actual costs of living
abroad. It replaced the single exclusion with a set of separate deductions that
were linked to various components of the cost of living abroad, such as the
excess cost of living in general, excess housing expenses, schooling expenses,
and home-leave expenses.

In 1981, however, the emphasis again shifted to the perceived beneficial
effects of encouraging U.S. employment abroad; the Economic Recovery Tax
Act (ERTA) provided a large flat exclusion and a separate housing exclusion.
ERTA's income exclusion was $75,000 for 1982, but was to increase to
$95,000 by 1986. However, concern about the revenue consequences of the
increased exclusion led Congress to temporarily freeze the exclusion at
$80,000 under the Deficit Reduction Act of 1984; annual $5,000 increases
were to resume in 1988. In 1986, as part of its general program of broadening
the tax base, the Tax Reform Act fixed the exclusion at the $70,000 level.
The Taxpayer Relief Act of 1997 provided the gradual increase of the
exclusion to $80,000 by 2002, as well as indexing for U.S. inflation,
beginning in 2008.

The Taxpayer Increase Prevention and Reconciliation Act of 2006
(TIPRA; P.L. 109-222) contained new restrictions on both the housing and
earned income exclusions as a revenue-raising element designed to partly
offset unrelated revenue-losing items in the act. The act contained four
principal changes. First, it moved up to 2006 the scheduled indexation of the
exclusion. (While the combined, net impact of TIPRA's changes is expected
to reduce the benefit's revenue loss, the indexation provision, taken alone,
will likely increase it.) Second, TIPRA changed the way tax rates apply to a
taxpayer's income that exceeds the exclusion. Under prior law, if a person
had income in excess of the maximum exclusion, tax rates applied to the
addition income beginning with the lowest marginal rate. Under TIPRA,
marginal rates apply beginning with the rate that would apply if the taxpayer
had not used the exclusion. Third, TIPRA changed the "base amount" related
to the housing exclusion. Under prior law, the housing exclusion applied to
housing exceeding 16 percent of the salary level applicable to the GS-14
federal grade level; TIPRA set the base amount at 16 percent of the foreign
earning income exclusion amount ($82,400 for 2006). In addition, TIPRA
capped the housing exclusion at 30 percent of excluded income; no cap
applied under prior law.

Assessment

The foreign earned income exclusion has the effect of increasing the
number of Americans working overseas in countries where foreign taxes are
low. This effect differs across countries. As noted above, without section
911 or a similar provision, U.S. taxes would generally be high relative to
domestic U.S. taxes and employment abroad would be discouraged in
countries where living costs are high. While the flat exclusion eases this
distortion in the case of some countries, it also overcompensates in others,
thereby introducing new distortions.

The foreign earned income exclusion has been defended on the grounds
that it helps U.S. exports; it is argued that U.S. persons working abroad play
an important role in promoting the sale of U.S. goods abroad. The impact of
the provision is uncertain. If employment of U.S. labor abroad is a
complement to investment by U.S. firms abroad--for example, if U.S.
multinationals depend on expertise that can only be provided by U.S.
managers or technicians--then it is possible that the exclusion has the indirect
effect of increasing flows of U.S. capital abroad.

The increased flow of investment abroad, in turn, could trigger exchange-
rate adjustments that would increase U.S. net exports. On the other hand, if
the exclusion's increase in U.S. employment overseas is not accompanied by
larger flows of investment, it is likely that exchange rate adjustments negate
any possible effect section 911 has on net exports. Moreover, there is no
obvious economic rationale for promoting exports.

Selected Bibliography

Association of the Bar of the City of New York, Committee on Taxation of
International Transactions. "The Effect of Changes in the Type of United
States Tax Jurisdiction Over Individuals and Corporations: Residence, Source
and Doing Business." Record of the Association of the Bar of the City of New
York 46 (December 1991): 914-925.
Curry, Jeff, Maureen Keenan Kahr, "Individual Foreign-Earned Income
and Foreign Tax Credit, 2001." IRS Statistics of Income Bulletin (Spring
2004): 98-120.
Evans, Jeffrey. "911: The Foreign Earned Income Exclusion-Policy and
Enforcement." Virginia Journal of International Law 37 (Summer 1997):
891-918.
Gravelle, Jane G., and Donald W. Kiefer. U.S. Taxation of Citizens
Working in Other Countries: An Economic Analysis. Library of Congress,
Congressional Research Service Report 78-91 E. Washington, DC: 1978.
Hrechak, Andrew, and Richard J. Hunter, Jr. "Several Tax Breaks
Available for those Working Abroad." Taxation for Accountants 52 (May
1994): 282-286.
Oliver, Joseph R. "The Foreign Earned Income Exclusion: An Update"
CPA Journal 69 (August 1999): 46-50.
U.S. Congress, Conference Committees, 2006. Tax Increase Prevention
and Reconciliation Act of 2005. Conference report to accompany H.R. 4297.
H. Rpt. 109-455, 109th Cong., 2nd sess. Washington, U.S. Government
Printing Office, 2006. pp. 307-310.
U.S. Congress, Senate, Committee on Finance. Background Fact Sheet on
Section 911 Prepared by Chairman Grassley's Finance Committee Staff.
Washington, May 25, 2006. Posted on the committee's web site, at
[http://finance.senate.gov/sitepages/grassley.htm]. (Visited Oct. 12, 2006.)
U.S. Congress, Joint Committee on Taxation. Options to Improve Tax
Compliance and Reform Tax Expenditures. Prepared by the Staff of the Joint
Committee on Taxation. Publication JCS-02-05. Washington, Jan. 27, 2005.
pp. 174-177.
U.S. Department of the Treasury. Taxation of Americans Working
Overseas: the Operation of the Foreign Earned Income Exclusion in 1987.
Washington, DC: 1993.

International Affairs

EXCLUSION OF CERTAIN ALLOWANCES
FOR FEDERAL EMPLOYEES ABROAD

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.6

2007

0.6

2008

0.7

2009

0.7

2010

0.8

Authorization

Section 912.

Description

U.S. Federal civilian employees who work abroad are allowed to exclude
from income certain special allowances that are generally linked to the cost of
living. They are not eligible for the foreign earned income or housing
exclusion provided to private-sector individuals under section 911. (Like
other U.S. citizens, they are subject to U.S. taxes and can credit foreign taxes
against their U.S. taxes. Federal employees are, however, usually exempt
from foreign taxes.)

Specifically, section 912 excludes certain amounts received under the
Foreign Service Act of 1980, the Central Intelligence Act of 1949, the
Overseas Differentials and Allowances Act, and the Administrative Expenses
Act of 1946. The allowances are primarily for the general cost of living
abroad, housing, education, and travel. Special allowances for hardship posts
are not eligible for exclusion. Section 912 also excludes cost-of-living
allowances received by Federal employees stationed in U.S. possessions,
Hawaii, and Alaska. In addition, travel, housing, food, clothing, and certain
other allowances received by members of the Peace Corps are excluded.

Impact

Federal employees abroad may receive a significant portion of their
compensation in the form of housing allowances, cost-of-living differentials,
and other allowances. Section 912 can thus reduce taxes significantly. Since
the available data suggest real incomes for Federal workers abroad are
generally higher than real incomes in the United States, section 912 probably
reduces the tax system's progressivity.

Section 912's impact on horizontal equity (the equal treatment of equals) is
more ambiguous. Without it or a similar provision, Federal employees in
high-cost countries would likely pay higher taxes than persons in the United
States with identical real incomes, because the higher nominal incomes
necessary to offset higher living costs would place these employee stationed
abroad in a higher tax bracket and would reduce the value of personal
exemptions and the standard deduction.

The complete exemption of cost-of-living allowances, however, probably
overcompensates for this effect. It is thus uncertain whether the relative
treatment of Federal workers abroad and their U.S. counterparts is more or
less uneven with section 912. U.S. citizens employed abroad in the private
sector are permitted to exclude up to $80,000 per year, rather than an amount
explicitly linked to cost-of-living allowances. Given that flat amount,
whether the tax treatment of federal workers is more or less favorable than
that of private sector workers depends of the size of the federal workers' cost-
of-living allowance.

Some have argued that because no tax relief is provided for persons in high
cost areas in the United States, horizontal equity requires only that persons
abroad be taxed no more heavily than a person in the highest-cost U.S. area.
It might also be argued that the cost of living exclusion for employees in
Alaska and Hawaii violates horizontal equity, since private-sector persons in
those areas do not receive a tax exclusion for cost-of-living allowances.

Rationale

Section 912's exclusions were first enacted with the Revenue Act of 1943.
The costs of living abroad were apparently rising, and Congress determined
that because the allowances merely offset the extra costs of working abroad
and since overseas personnel were engaged in "highly important" duties, the
Government should bear the full burden of the excess living costs, including
any taxes that would otherwise be imposed on cost-of-living allowances.

The Foreign Service Act of 1946 expanded the list of excluded allowances
beyond cost-of-living allowances to include housing, travel, and certain other
allowances. In 1960, exemptions were further expanded to include
allowances received under the Central Intelligence Agency Act and, in 1961,
certain allowances received by Peace Corps members were added.

Assessment

The benefit is largest for employees who receive a large part of their
incomes as cost-of-living, housing, education, or other allowances. Beyond
this, the effects of the exclusions are uncertain. For example, it might be
argued that because the Federal Government bears the cost of the exclusion in
terms of forgone tax revenues, the measure does not change the Government's
demand for personnel abroad and has little impact on the Government's work
force overseas.

On the other hand, it could be argued that an agency that employs a person
who claims the exclusion does not bear the exclusion's full cost. While the
provision's revenue cost may reduce Government outlays in general, an
agency that employs a citizen abroad probably does not register a cut in its
budget equal to the full amount of tax revenue loss that the employee
generates. If this is true, section 912 may enable agencies to employ
additional U.S. citizens abroad.

Selected Bibliography

Field, Marcia, and Brian Gregg. U.S. Taxation of Allowances Paid to U.S.
Government Employees. In Essays in International Taxation: 1976 (U.S.
Department of the Treasury). Washington, DC: Government Printing Office,
1976, pp. 128-150.
U.S. Internal Revenue Service. U.S. Government Civilian Employees
Stationed Abroad. Publication 516. Washington, DC: Government Printing
Office, 2005.

International Affairs

EXCLUSION OF EXTRATERRITORIAL INCOME

Estimated Revenue Loss*

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.1

3.9

4.0

2007

(1)

1.9

2008

(1)

0.1

2009

(1)

0.1

2010

(1)

0.1

(1) Less than $50 million

*The estimates in the table do not reflect the impact of the Tax Increase
Prevention and Reconciliation Act of 2006 (TIPRA; P.L. 109-222), which
rescinded transition rules related to the exclusion's repeal. According to
estimates by the Joint Committee on Taxation, TIPRA's changes will reduce
the provision's revenue loss by the following amounts: $6 million in FY2006;
$209 million in FY2007; $144 million in FY2008; $72 million in FY2009;
and $36 million in FY2010.

Authorization

Sections 114 and 941-2.

Description

Prior to enactment of the American Jobs Creation Act of 2004 (AJCA), the
tax code's extraterritorial income (ETI) provisions permitted U.S. exporters to
exclude between 15% and 30% of their export income from U.S. tax. The
provisions also effectively permitted exporters to exclude a certain amount of
income from foreign operations from tax - generally, an amount equal to the
amount of export income that is excluded. The AJCA, however, provided for
the phase-out of the benefit beginning in 2005, with exporters permitted to
use 80% of the benefit they could otherwise claim in 2005, and 60% in 2006.
The ETI benefit is generally not available in 2007 and thereafter.

Repeal of the ETI provisions was intended to resolve a long-running
controversy between the United States and the European Union (EU). The
ETI provisions were enacted as a replacement for the Foreign Sales
Corporation (FSC) tax benefit for exporting, which (in response to a
complaint by the EU) was found by a World Trade Organization (WTO)
panel to be in violation of the WTO agreements' strictures against export
subsidies. However, WTO panels also found the ETI provisions to be non-
compliant and the WTO authorized the countries of the EU to apply
retaliatory tariffs to items imported from the United States. The EU began to
phase in its tariffs in March, 2004, but suspended their application upon
enactment of the AJCA.

The statutory mechanics of the ETI benefit worked by defining
"extraterritorial income" and excluding that income from tax. Extraterritorial
income, in turn, was generally defined as a specified portion of income from
the sale of property produced either within the United States or abroad, with
the added proviso that no more than 50% of the value of the property can be
attributable to foreign products or to labor performed outside the United
States. The part of extraterritorial income that was exempt varied, depending
on which of several alternative calculation rules a taxpayer used; the
exemption could be as small as 15% of qualified income or as large as 30%.

For exports, the size of the ETI tax benefit was the same as the FSC
benefit it replaced. Again, however, the ETI exclusion could apply to a
certain amount of income from foreign operations where the FSC benefit did
not, so the total tax benefit a particular firm could obtain was potentially
larger under the ETI exclusion than it was under FSC. Also, to use the FSC
benefit exporters were required to sell their goods through specially-defined
subsidiary sales corporations (FSCs). A firm could use the ETI benefit by
selling its exports directly.

Impact

The ETI exclusion increased the after-tax return on investment in export-
producing property, and to the extent it applied to foreign operations, the
exclusion increased the after-tax return to investment abroad. The tax benefit
therefore accrued, in part, to owners of firms that export and firms that both
export and conduct foreign operations. However, in the long run, the burden
of the corporate income tax - and the benefit of corporate tax exclusions -
probably spreads beyond corporate stockholders to owners of capital in
general, including, for example, unincorporated businesses and owner-
occupied housing.

The ETI benefit is therefore probably shared by U.S. capital in general.
And because capital tends to be owned by upper-income individuals, the
distributional effect of the provision probably reduced the progressivity of the
tax system. Also, because part of the export benefit was passed on to foreign
consumers in the form of lower prices, a part of the ETI benefit probably
accrues to foreign consumers of U.S. exports.

Rationale

While the ETI benefit was intended as a WTO-compliant replacement for
FSC, FSC itself was enacted as a replacement for another tax benefit that
encountered difficulties with U.S. trading partners: the Domestic International
Sales Corporation (DISC) provisions. DISC was enacted with the Revenue
Act of 1971, and was intended to increase U.S. exports and to pose a tax
incentive for firms to locate their operations in the United States rather than
abroad. DISC thus was thought to provide a counterweight to the tax code's
deferral incentive for overseas investment.

Soon after DISC was enacted, a number of U.S. trading partners -
including what was then the European Economic Community, or EEC -
charged that the provision was an export subsidy and so violated the General
Agreement on Tariffs and Trade (GATT), a multilateral trade agreement to
which the United States was signatory. In response to the complaints, the
Deficit Reduction Act of 1984 largely replaced DISC with FSC, which
contained a number of features designed to ensure GATT-legality. An
understanding adopted by the GATT Council had held that a country need not
tax economic processes occurring beyond its own borders. With this in mind,
the FSC provisions included requirements that the FSC sales subsidiaries be
incorporated abroad or in a U.S. possession and likewise conduct certain
minimal economic processes overseas.

The countries of the EEC were still not fully satisfied of FSC's GATT-
legality. Still, the controversy was generally below the surface until 1998,
when what had become the European Union (EU) lodged a complaint with
the World Trade Organization (WTO, GATT's successor) arguing that FSC
violated the agreements on which the WTO is based. A WTO panel
subsequently upheld the EC's position, and under WTO procedures, the
United States was required to make its laws WTO-compliant or face either
retaliatory tariffs or compensatory payments. As 2000 drew to a close, the
United States enacted the FSC Repeal and Extraterritorial Income Exclusion
Act containing the ETI exclusion. The European countries, however,
maintained that the ETI provisions are themselves not WTO compliant and
asked the WTO to rule on the WTO-legality of ET provisions. The EU also
asked the WTO to approve retaliatory tariffs, should the ETI regime prove to
be non-compliant. In August, 2001, a WTO panel ruled against the ETI
provisions, and in January, 2002, the WTO Appellate Body rejected a U.S.
appeal. In August 2002 the WTO set the amount of sanctions that can be
applied by the EU at $4 billion. The EU delayed in implementing its tariffs
while legislation addressing the controversy was considered by the U.S.
Congress. In March, 2004, however, the EU began to phase in its tariffs.

While AJCA provided for ETI's ultimate repeal, the act also contained
transition rules to which the EU also objected. In part, the transition rules
provided that exporters could still claim part of the benefit for two years:
80% of the exclusion in 2005 and 60% in 2006, before the provision's
ultimate phase out in 2007 and after. In addition, the rules provided that the
full exclusion was to remain in effect for binding contracts existing on
September 17, 2003. The EU filed a new WTO complaint, arguing that
because of the transition rules, the United States continued to maintain a
prohibited export subsidy. A WTO panel supported the EU, and in May 2006
TIPRA repealed the transition rule for binding contracts. The 60% phase-out
percentage, however, remains in effect for 2006.

Assessment

Because the ETI exclusion increased the after-tax return from investment
in exporting, it posed a tax incentive to export. Its supporters argued that the
provision did indeed boost U.S. exports and thus had a beneficial effect on
U.S. employment. Economic analysis, however, suggests that the provision's
effects were not what might be expected from an export incentive. The ETI
exclusion probably triggered exchange-rate adjustments that ensured that U.S.
imports expanded along with any increase the exclusion might have caused in
exports; it probably produced little direct improvement in the U.S. balance of
trade. Instead, as the provision probably increased both imports and exports,
it likely increased the overall level of U.S. trade.

Economic theory suggests that another effect of the ETI exclusion was
probably to shift economic welfare from the United States to foreign
consumers. This occurred when part of the tax benefit was passed on to
foreign consumers in the form of reduced prices for U.S. goods. The
provision also likely reduced economic efficiency by inducing the United
States to trade more than it otherwise would.

Selected Bibliography

Ahearn, Raymond J. European Trade Retaliation: The FSC-ETI Case.
Library of Congress, Congressional Research Service Report RS21742.
Baldwin, Robert E. "Are Economist's Traditional Trade Policy Views
Still Valid?" Journal of Economic Literature 30 (June 1992), pp. 804-829.

Brumbaugh, David. The Foreign Sales Corporation (FSC) Tax Benefit for
Exporting and the WTO. Library of Congress, Congressional Research
Service Report RS20571.
- . The Foreign Sales Corporation (FSC) Tax Benefit for Exporting: WTO
Issues and an Economic Analysis. Library of Congress, Congressional
Research Service Report RL30684.
Byrd, Kristin. "Can We Provide a Level Playing Field for U.S.
Corporations and Increase U.S. Jobs While Repealing the Extraterritorial
Income Act?" Houston Business and Tax Law Journal 5 (2005), p. 338.
Desai, Mihir A. and James R. Hines. The Uneasy Marriage of Export
Subsidies and the Income Tax. NBER Working Paper No. 8009. Cambridge,
MA: National Bureau of Economic Research, 2000.
Funk, William M. "The Thirty-Years Tax War." Tax Notes 93 (Oct. 8,
2001), pp. 271-281.
Krugman, Paul R. and Maurice Obstfeld. "Export Subsidies: Theory," In
International Economics: Theory and Policy, 3rd ed. New York: Harper
Collins, 1994.
Rousslang, Donald J. and Stephen P. Tokarick. "The Trade and Welfare
Consequences of U.S. Export-Enhancing Tax Provisions." IMF Staff Papers
41 (December 1994), pp. 675-686.
U.S. Congress, Joint Committee on Taxation. "Foreign Sales
Corporations." In General Explanation of the Revenue Provisions of the
Deficit Reduction Act of 1984. Committee Print, 98th Congress, 2nd Session.
Washington, DC: Government Printing Office (1984), pp. 1037-1070.
-. "FSC Repeal and Extraterritorial Income Exclusion Act of 2000 (Public
Law 106-519)." In General Explanation of Tax Legislation Enacted in the
106th Congress. Joint Committee Print, 107th Congress, 1st Session.
Washington, DC: Government Printing Office, April 19, 2001, pp. 84-113.
U.S. Department of the Treasury. The Operation and Effect of the Foreign
Sales Corporation Legislation: January 1, 1985 to June 30, 1988.
Washington, DC: 1993.

International Affairs

DEFERRAL OF ACTIVE INCOME OF CONTROLLED
FOREIGN CORPORATIONS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

3.4

2007

5.8

2008

6.4

2009

7.0

2010

7.5

Authorization

Sections 11(d), 882, and 951-964.

Description

The United States taxes firms incorporated in the United States on their
worldwide income but taxes foreign-chartered corporations only on their
U.S.-source income. Thus, when a U.S. firm earns foreign-source income
through a foreign subsidiary, U.S. taxes apply to the income only when it is
repatriated to the U.S. parent firm as dividends or other income; the income is
exempt from U.S. taxes as long as it remains in the hands of the foreign
subsidiary. At the time the foreign income is repatriated, the U.S. parent
corporation can credit foreign taxes the subsidiary has paid on the remitted
income against U.S. taxes, subject to certain limitations. Because the deferral
principle permits U.S. firms to delay any residual U.S. taxes that may be due
after foreign tax credits, it provides a tax benefit for firms that invest in
countries with low tax rates.

Subpart F of the Internal Revenue Code (sections 951-964) provides an
exception to the general deferral principle. Under its provisions, certain
income earned by foreign corporations controlled by U.S. shareholders is
deemed to be distributed whether or not it actually is, and U.S. taxes are
assessed on a current basis rather than deferred. Income subject to Subpart F
is generally income related to passive investment rather than income from
active business operations. Also, certain types of sales, services, and other
income whose geographic source is relatively easily shifted is included in
Subpart F.

While U.S. tax (less foreign tax credits) generally applies when tax-
deferred income is ultimately repatriated to the United States, a provision of
the American Jobs Creation Act of 2004 (P.L. 108-357) provided a temporary
(one-year) 85% deduction for repatriated dividends. For a corporation subject
to the top corporate tax rate of 35%, the deduction had an effect similar to a
reduction in the tax rate on repatriations to 5.25%. The deduction applied to
a one-year period consisting (at the taxpayer's election) of either the first tax
year beginning on or after P.L. 108-357's date of enactment (October 22,
2004) or the taxpayer's last tax year beginning before the date of enactment.

Impact

Deferral provides an incentive for U.S. firms to invest in active business
operations in low-tax foreign countries rather than the United States, and thus
probably reduces the stock of capital located in the United States. Because
the U.S. capital-labor ratio is therefore probably lower than it otherwise
would be and U.S. labor has less capital with which to work, deferral likely
reduces the general U.S. wage level. At the same time, U.S. capital and
foreign labor probably gain from deferral. Deferral also probably reduces
world economic efficiency by distorting the allocation of capital in favor of
investment abroad.

The one-year deduction for repatriations enacted in 2004 is likely to have
increased the repatriation of funds from foreign subsidiaries. However, at
least part of the increase has likely consisted of a shift in the timing of
repatriations from future periods towards the present, as firms take advantage
of the one-year window. While the provision was intended, in part, to
increase domestic investment - its supporters argued that repatriated funds
would be invested in the United States - firms disposition of the
repatriations is not certain.

Rationale

Deferral has been part of the U.S. tax system since the origin of the
corporate income tax in 1909. While deferral was subject to little debate in
its early years, it later became controversial. In 1962, the Kennedy
Administration proposed a substantial scaling-back of deferral in order to
reduce outflows of U.S. capital. Congress, however, was concerned about the
potential effect of such a step on the position of U.S. multinationals vis- a-vis
firms from other countries and on U.S exports. Instead of repealing deferral,
the Subpart F provisions were adopted in 1962, and were aimed at taxpayers
who used deferral to accumulate funds in so-called "tax haven" countries.
(Hence, Subpart F's concern with income whose source can be easily
manipulated.)

In 1975, Congress again considered eliminating deferral, and in 1978
President Carter proposed its repeal, but on both occasions the provision was
left essentially intact. Subpart F, however, was broadened by the Tax
Reduction Act of 1975, the Tax Reform Act of 1976, the Tax Equity and
Fiscal Responsibility Act of 1982, the Deficit Reduction Act of 1984, the Tax
Reform Act of 1986, and the Omnibus Reconciliation Act of 1993
(OBRA93). OBRA93 added section 956A to the tax code, which expanded
Subpart F to include foreign earnings that firms retain abroad and invest in
passive assets beyond a certain threshold.

In recent years, however, the trend has been incremental restrictions of
Subpart F and expansions of deferral. For example, the Small Business Job
Protection Act of 1996 repealed section 956A. And the Tax Relief Extension
Act of 1999 (P.L. 106-170) extended a temporary exemption from Subpart F
for financial services income. In 2004, the American Jobs Creation Act
relaxed Subpart F in the area of shipping income and provided a one-year
temporary tax reduction for income repatriated to U.S. parents from overseas
subsidiaries.

Assessment

The U.S. method of taxing overseas investment, with its worldwide
taxation of branch income, limited foreign tax credit, and the deferral
principle, can either pose a disincentive, present an incentive, or be neutral
towards investment abroad, depending on the form and location of the
investment. For its part, deferral provides an incentive to invest in countries
with tax rates that are lower than those of the United States.

Defenders of deferral argue that the provision is necessary to allow U.S.
multinationals to compete with firms from foreign countries; they also
maintain that the provision boosts U.S. exports. However, economic theory
suggests that a tax incentive such as deferral does not promote the efficient
allocation of investment. Rather, capital is allocated most efficiently--and
world economic welfare is maximized--when taxes are neutral and do not
distort the distribution of investment between the United States and abroad.
Economic theory also holds that while world welfare may be maximized by
neutral taxes, the economic welfare of the United States would be maximized
by a policy that goes beyond neutrality and poses a disincentive for U.S.
investment abroad.

Supporters of a "territorial" tax system would permanently exempt U.S.
tax on repatriated dividends, thus eliminating U.S. tax even on a postponed
basis. Several arguments have been made in support of territorial taxation.
One is based on the notion that changes in the international economy have
made economic theory's traditional notions of efficiency and neutrality
obsolete. (This analysis, however, is not the consensus views of economists
expert in the area.) This argument maintains that efficiency is promoted if
taxes do not inhibit U.S. multinationals' ability to compete for foreign
production opportunities or interfere with their ability to exploit the returns to
research and development. Another argument holds that the current tax
system produces so many distortions in multinationals' behavior that simply
exempting foreign-source business income from tax would improve economic
efficiency.

Selected Bibliography

Altshuler, Rosanne. "Recent Developments in the Debate on Deferral."
Tax Notes 20 (April 3, 2000): p. 1579.
Ault, Hugh J., and David F. Bradford. "Taxing International Income: An
Analysis of the U.S. System and Its Economic Premises." In Taxation in the
Global Economy, ed. Assaf Razin and Joel Slemrod, 11-52. Chicago:
University of Chicago Press, 1990.
Bergsten, C. Fred, Thomas Horst, and Theodore H. Moran. "Tax Issues."
In American Multinationals and American Interests. Washington, DC: The
Brookings Institution, 1977.
Brumbaugh, David L. U.S. Taxation of Overseas Investment and Income:
Background and Issues in 2005. Library of Congress, Congressional
Research Service Report RL32749.
-. Tax Exemption for Repatriated Earnings: Proposals and Analysis.
Library of Congress, Congressional Research Service Report RL32125.
Desai, Mihir, and James Hines, "Old Rules and New Realities: Corporate
Tax Policy in a Global Setting," National Tax Journal 57 (December 2004),
pp. 937-960.
Engel, Keith. "Tax Neutrality to the Left, International Competitiveness to
the Right, Stuck in the Middle with Subpart F." Texas Law Review 79 (May
2001), pp. 1525-1606.
Frisch, Daniel J. "The Economics of International Tax Policy: Some Old
and New Approaches." Tax Notes 47 (April 30, 1990) , pp. 581-591.
Gourevitch, Harry G. Anti-Tax Deferral Measures in the United States
and Other Countries. Library of Congress, Congressional Research Service
Report 95-1143 A.
Graetz, Michael J., and Paul W. Oosterhuis, "Structuring an Exemption
System for Foreign Income of U.S. Corporations," National Tax Journal
54(December 2001), pp. 771-786.
Gravelle, Jane G. "Issues in International Tax Policy." National Tax
Journal 57 (September 2004), pp. 773-778.

Grubert, Harry, "Comment on Desai and Hines, 'Old Rules and New
Realities: Corporate Tax Policy in a Global Setting," National Tax Journal,
vol. 58, Jun. 2005, pp. 263-278.
_. and John Mutti, Taxing International Business Income: Dividend
Exemption versus the Current System (Washington: American Enterprise
Inst., 2001), 67 pp.
Hartman, David G. "Deferral of Taxes on Foreign Source Income,"
National Tax Journal 30 (December 1977), pp. 457-462.
-. "Tax Policy and Foreign Direct Investment." Journal of Public
Economics 26 (February 1985), pp. 107-121.
Rousslang, Donald. "Deferral and the Optimal Taxation of International
Investment Income." National Tax Journal 53 (September 2000), pp. 589-
601.
Slemrod, Joel. "Effect of Taxation with International Capital Mobility."
In Uneasy Compromise: Problems of a Hybrid Income-Consumption Tax,
ed. Henry J. Aaron, et al., 115-147. Washington, DC: The Brookings
Institution, 1988.
U.S. Congress. Joint Committee on Taxation. Factors Affecting the
International Competitiveness of the United States. Joint Committee Print.
102nd Congress, 1st session. Washington, DC: Government Printing Office,
May 30, 1991.
U.S. Department of the Treasury, Office of Tax Policy. The Deferral of
Income Earned Through U.S. Controlled Foreign Corporations.
Washington, DC: December, 2002.
Yoder, Llowell D. "Subpart F in Turmoil: Low Taxed Active Income
Under Siege." Taxes 77 (March 1999), pp. 142-166.

International Affairs

INVENTORY PROPERTY SALES SOURCE RULE EXCEPTION

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

6.2

2007

6.4

2008

6.6

2009

6.8

2010

7.0

Authorization

Sections 861, 862, 863, and 865.

Description

The tax code's rules governing the source of inventory sales interact with
its foreign tax credit provisions in a way that can effectively exempt a portion
of a firm's export income from U.S. taxation.

In general, the United States taxes U.S. corporations on their worldwide
income. The United States also permits firms to credit foreign taxes they pay
against U.S. taxes they would otherwise owe.

Foreign taxes, however, are only permitted to offset the portion of U.S.
taxes due on foreign-source income. Foreign taxes that exceed this limitation
are not creditable and become so-called "excess credits." It is here that the
source of income becomes important: firms that have excess foreign tax
credits can use these credits to reduce U.S. taxes if they can shift income from
the U.S. to the foreign operation. This treatment effectively exempts such
income from U.S. taxes.

The tax code contains a set of rules for determining the source ("sourcing")
of various items of income and deduction. In the case of sales of personal
property, gross income is generally sourced on the basis of the residence of
the seller. U.S. exports covered by this general rule thus generate U.S.-rather
than foreign-source income.

The tax code provides an important exception, however, in the case of
sales of inventory property. Inventory that is purchased and then resold is
governed by the so-called "title passage" rule: the income is sourced in the
country where the sale occurs. Since the country of title passage is generally
quite flexible, sales governed by the title passage rules can easily be arranged
so that the income they produce is sourced abroad.

Inventory that is both manufactured and sold by the taxpayer is treated as
having a divided source. Unless an independent factory price can be
established for such property, half of the income it produces is assigned a
U.S. source and half is governed by the title passage rule. As a result of the
special rules for inventory, up to 50 percent of the combined income from
export manufacture and sale can be effectively exempted from U.S. taxes. A
complete tax exemption can apply to export income that is solely from sales
activity.

Impact

When a taxpayer with excess foreign credits is able to allocate an item of
income to foreign rather than domestic sources, the amount of foreign taxes
that can be credited is increased and the effect is identical to a tax exemption
for a like amount of income. The effective exemption that the source rule
provides for inventory property thus increases the after-tax return on
investment in exporting. In the long run, however, the burden of the
corporate income tax (and the benefit of corporate tax exemptions) probably
spreads beyond corporate stockholders to owners of capital in general.

Thus, the source-rule benefit is probably shared by U.S. capital in general,
and therefore probably disproportionately benefits upper-income individuals.
To the extent that the rule results in lower prices for U.S. exports, a part of the
benefit probably accrues to foreign consumers of U.S. products.

Rationale

The tax code has contained rules governing the source of income since the
foreign tax credit limitation was first enacted as part of the Revenue Act of
1921. Under the 1921 provisions, the title passage rule applied to sales of
personal property in general; income from exports was thus generally
assigned a foreign source if title passage occurred abroad. In the particular
case of property both manufactured and sold by the taxpayer, income was
treated then, as now, as having a divided source.

The source rules remained essentially unchanged until the advent of tax
reform in the 1980s. In 1986, the Tax Reform Act's statutory tax rate
reduction was expected to increase the number of firms with excess foreign
tax credit positions and thus increase the incentive to use the title passage rule
to source income abroad.

Congress was also concerned that the source of income be the location
where the underlying economic activity occurs. The Tax Reform Act of 1986
thus provided that income from the sale of personal property was generally to
be sourced according to the residence of the seller. Sales of property by U.S.
persons or firms were to have a U.S. source.

Congress was also concerned, however, that the new residence rule would
create difficulties for U.S. businesses engaged in international trade. The Act
thus made an exception for inventory property, and retained the title passage
rule for purchased-and-resold items and the divided-source rule for goods
manufactured and sold by the taxpayer.

More recently, the Omnibus Budget Reconciliation Act of 1993 repealed
the source rule exception for exports of raw timber.

Assessment

Like other tax benefits for exporting, the inventory source-rule exception
probably increases exports. At the same time, however, exchange rate
adjustments probably ensure that imports increase also. Thus, while the
source rule probably increases the volume of U.S. trade, it probably does not
improve the U.S. trade balance. Indeed, to the extent that the source rule
increases the Federal budget deficit, the provision may actually expand the
U.S. trade deficit by generating inflows of foreign capital and their
accompanying exchange rate effects. In addition, the source-rule exception
probably reduces U.S. economic welfare by transferring part of its tax benefit
to foreign consumers.

Selected Bibliography

Brumbaugh, David L. "Export Tax Subsidies," in Cordes, et al, eds., The
Encyclopedia of Taxation and Tax Policy, 2nd edition. Washington: Urban
Institute, 2005. pp. 130-133.
-. Tax Benefit for Exports: The Inventory Source Rules. Library of
Congress, Congressional Research Service Report 97-414 E. April 2, 1997.
-. Taxes and International Competitiveness. Library of Congress,
Congressional Research Service Report RS22445.

Hammer, Richard M., and James D. Tapper. The Foreign Tax Credit
Provisions of the Tax Reform Act of 1986. Tax Adviser 18 (February 1987),
pp. 76-80, 82-89.
Krugman, Paul R. and Maurice Obstfeld. "Export Subsidies: Theory," In
International Economics: Theory and Policy, 3rd ed. New York: Harper
Collins, 1994.
Maloney, David M., and Terry C. Inscoe. A Post-Reformation Analysis of
the Foreign Tax Credit Limitations. International Tax Journal 13 (Spring
1987), pp. 111-127.
Rousslang, Donald J. "The Sales Source Rules for U.S. Exports: How
Much Do They Cost? Tax Notes International 8 (February 21, 1994), pp.
527-535.
- , and Stephen P. Tokarick. The Trade and Welfare Consequences of
U.S. Export-Enhancing Tax Provisions. IMF Staff Papers 41 (December
1994), pp. 675-686.
U.S. Congress, Joint Committee on Taxation. Factors Affecting the
International Competitiveness of the United States. Joint Committee Print.
98th Congress, 2nd session. Washington, DC: May 30, 1991.
-. "Determination of Source in Case of Sales of Personal Property." In
General Explanation of the Tax Reform Act of 1986. Joint Committee Print,
100th Congress, 1st session. May 4, 1987.
U.S. Congressional Budget Office. "Options to Increase Revenues:
Eliminate the Source Rules Exception for Inventory Sales." In Budget
Options. Washington, DC: 2003.
U.S. Department of the Treasury. Report to the Congress on the Sales
Source Rules. Washington, DC: 1993.

International Affairs

DEFERRAL OF CERTAIN FINANCING INCOME

Estimated Revenue Loss*

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

1.1

2007

1.7

2008

2009

2010

*The estimates do not include the impact of the Tax Increase Prevention
and Reconciliation Act of 2006 (TIPRA; P.L. 109-222), which extended this
provision beyond its previously scheduled expiration date. According to
estimates by the Joint Tax Committee, TIPRA's extension will increase the
provision's revenue loss by $775 million in FY2007, $2,339 million in
FY2008, and $1,682 million in FY2009.

Authorization

Sections 953 and 954.

Description

Under the U.S. method of taxing overseas investment, income earned
abroad by foreign-chartered subsidiary corporations that are owned and
controlled by U.S. investors or firms is generally not taxed if it is reinvested
abroad. Instead, a tax benefit known as "deferral" applies: U.S. taxes on the
income are postponed until the income is repatriated to the U.S. parent as
dividends or other income.

The deferral benefit is circumscribed by several tax code provisions; the
broadest in scope is provided by the tax code's Subpart F. Under Subpart F,
certain types of income earned by certain types of foreign subsidiaries are
taxed by the United States on a current basis, even if the income is not
actually remitted to the firm's U.S. owners. Foreign corporations potentially
subject to Subpart F are termed Controlled Foreign Corporations (CFCs); they
are firms that are more than 50% owned by U.S. stockholders, each of whom
own at least 10% of the CFC's stock. Subpart F subjects each 10%
shareholder to U.S. tax on some (but not all) types of income earned by the
CFC. In general, the types of income subject to Subpart F are income from a
CFC's passive investment - for example, interest, dividends, and gains from
the sale of stock and securities - and a variety of types of income whose
geographic source is thought to be easily manipulated.

Ordinarily, income from banking and insurance could in some cases be
included in Subpart F. Much of banking income, for example, consists of
interest; investment income of insurance companies could also ordinarily be
taxed as passive income under Subpart F. Certain insurance income is also
explicitly included in Subpart F, including income from the insurance of risks
located outside a CFC's country of incorporation. However, Congress
enacted a temporary exception from Subpart F for income derived in the
active conduct of a banking, financing, or similar business by a CFC
predominantly engaged in such a business. Congress also enacted a
temporary exception for investment income of an insurance company earned
on risks located within its country of incorporation.

In short, Subpart F is an exception to the deferral tax benefit, and the tax
expenditure at hand is an exception to Subpart F itself for a range of certain
financial services income. Prior to enactment of the Tax Increase Prevention
and Reconciliation Act of 2006 (TIPRA; P.L. 109-222), the exception was
scheduled to expire at the end of 2006. TIPRA extended the provision for
two years, through 2008.

Impact

The temporary exceptions pose an incentive in certain cases for firms to
invest abroad; in this regard its effect is parallel to that of the more general
deferral principle, which the exception restores in the case of certain banking
and insurance income.

The provision only poses an incentive to invest in countries with tax rates
lower than those of the United States; in other countries, the high foreign tax
rates generally negate the U.S. tax benefit provided by deferral. In addition,
the provision is moot (and provides no incentive) even in low-tax countries
for U.S. firms that pay foreign taxes at high rates on other banking and
insurance income. In such cases, the firms have sufficient foreign tax credits
to offset U.S. taxes that would be due in the absence of deferral. (In the case
of banking and insurance income, creditable foreign taxes must have been
paid with respect to other banking and insurance income. This may
accentuate the importance of the exception to Subpart F.)

Rationale

Subpart F itself was enacted in 1962 as an effort to curtail the use of tax
havens by U.S. investors who sought to accumulate funds in countries with
low tax rates - hence Subpart F's emphasis on passive income and income
whose source can be manipulated. The exception for banking and insurance
was likewise in the original 1962 legislation (though not in precisely the same
form as the current version). The stated rationale for the exception was that
interest, dividends, and like income were not thought to be "passive" income
in the hands of banking and insurance firms.

The exceptions for banking and insurance were removed as part of the
broad Tax Reform Act of 1986 (Public Law 99-514). In removing the
exception (along with several others), Congress believed they enabled firms
to locate income in tax haven countries that have little "substantive economic
relation" to the income. As passed by Congress, the Taxpayer Relief Act of
1997 (Public Law 105-34) generally restored the exceptions with minor
modifications. In making the restoration, Congress expressed concern that
without them, Subpart F extended to income that was neither passive nor
easily movable. However, the Act provided for only a temporary restoration,
applicable to 1998. Additionally, the Joint Committee on Taxation identified
the exceptions' restoration as a provision susceptible to line-item veto under
the provisions of the 1996 Line-Item Veto Act because of its applicability to
only a few taxpaying entities, and President Clinton subsequently vetoed the
exceptions' restoration. The Supreme Court, however, ruled the line-item
veto to be unconstitutional, thus making the temporary restoration effective
for 1998, as enacted.

The banking and insurance exceptions to Subpart F were extended with a
few modifications for one year by the Tax and Trade Relief Extension Act of
1998. (The Act was part of Public Law 105-277, the omnibus budget bill
passed in October, 1998.) The modifications include one generally designed
to require that firms using the exceptions conduct "substantial activity" with
respect to the financial service business in question and added a "nexus"
requirement under which activities generating eligible income must take place
within the CFC's home country. In 1999, Public Law 106-170 extended the
provision through 2001. In 2002, Public Law 107-147 extended the
provision for five additional years, through 2006. The American Jobs
Creation Act of 2004 (P.L. 108-357) added rules permitting, in some
circumstances, certain qualifying activities to be undertaken by related
entities. In 2006, TIPRA (P.L. 109-222) extended the provision for two
years, through 2008.

Assessment

Subpart F attempts to deny the benefits of tax deferral to income that is
passive in nature or that is easily movable. It has been argued that the
competitive concerns of U.S. firms are not as much an issue in such cases as
they are with direct overseas investment. Such income is also thought to be
easy to locate artificially in tax haven countries with low tax rates. But banks
and insurance firms present an almost insoluble technical problem; the types
of income generated by passive investment and income whose source is easily
manipulated are also the types of income financial firms earn in the course of
their active business. The choice confronting policymakers, then, is whether
to establish an approximation that is fiscally conservative or one that places
most emphasis on protecting active business income from Subpart F. The
exceptions' repeal by the Tax Reform Act of 1986 appeared to do the former,
while the recent restoration of the exceptions appears to do the latter.

It should be noted that traditional economic theory questions the merits of
the deferral tax benefit itself. Its tax incentive for investment abroad
generally results in an allocation of investment capital that is inefficient from
the point of view of both the capital exporting country (in this case the United
States) and the world economy in general. Economic theory instead
recommends a policy known as "capital export neutrality" under which
marginal investments face the same tax burden at home and abroad. From
that vantage, then, the exceptions to Subpart F likewise impair efficiency.

Selected Bibliography

McLaughlin, Megan. "Truly a Wolf, Or Just a Sheep in Wolf's Clothing?
The Active Finance Exception to Subpart F." Virginia Tax Review 21
(Spring 2002) : 649
Sullivan, Martin A. "Economic Analysis: Large U.S. Banks Keeping
More Profits in Tax Havens." Tax Notes, 14 June, 2004, 1340.
U.S. Congress, Joint Committee on Taxation. "Extension and
Modification of Exceptions under Subpart F for Active Financing Income." In
General Explanation of Tax Legislation Enacted in the 107th Congress. Joint
Committee Print. 107th Congress, 2nd session. Washington, DC: U.S.
Government Printing Office, 2003. Pp. 279-283.
U.S. Department of the Treasury, Office of Tax Policy. The Deferral of
Income Earned Through U.S. Controlled Foreign Corporations.
Washington, DC: December, 2002.
Yoder, Lowell D. "The Subpart F Exception for Active Financing
Income." Tax Management International Journal 31 (June 14, 2002) : 283-
303.

General Science, Space, and Technology

TAX CREDIT FOR
INCREASING RESEARCH EXPENDITURES

Estimated Revenue Loss*

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

2007

2008

2009

2010

*This provision expired on December 31, 2005 and was modified
and extended through 2007 by H.R. 6111 in December 2006. If
permanently reinstated in its 2005 form, the annual cost would be about
$8.6 billion, according to the Treasury Department. The December
2006 revisions resulted a a projected cost for fiscal years 2007-2010 of
$7.5, $4,2, $2.2, and $1.6 billion; FY2006 would presumably be about
the same magnitude as FY2007.

Authorization

Section 41.

Description

A non-refundable, 20-percent tax credit is allowed for certain research
expenditures paid or incurred in carrying on the trade or business of a
taxpayer. In reality, this credit is the sum of three separate and distinct
credits: a regular or alternative incremental credit, a basic research credit, and
a credit for energy research.

The regular credit applies only to the taxpayer's qualified research
expenditures for a tax year in excess of a base amount. This amount is
computed by multiplying a fixed ratio-which for so-called established
corporations is total research expenditures divided by total gross receipts in
1984-1988-by average gross receipts for the past four years. The base
amount cannot be less than 50 percent of current-year qualified research
expenditures, and the fixed ratio may not exceed 0.16. Firms not considered
established are assigned an initial fixed ratio of 0.03 during the first five tax
years in which they have both gross receipts and qualified research expenses.

Firms also have the option of claiming an alternative incremental research
tax credit. It is equal to the sum of 2.65 percent of a firm's qualified research
expenditures above 1 percent but not greater than 1.5 percent of its average
gross receipts in the four previous years, 3.2 percent of its qualified research
expenditures above 1.5 percent but not greater than 2.0 percent of the same
receipts, and 3.75 percent of its qualified research expenditures that exceed
2.0 percent of the same receipts. (These credit rates are increased to 3, 4, and
5 percent respectively for 2007). In general, firms are likely to benefit more
from the alternative credit than the regular credit if their qualified research
expenditures in the current tax year are somewhat greater than their base
amounts for the regular credit. Firms can also elect an alternative simplified
credit of 12% of expenses that exceed 50% of spending in the last three years
(6% if there are no expenditures in any one of those years).

The definition of research that qualifies for the credit has been a
contentious and unresolved issue since the credit first entered the tax code in
July 1981. As it now stands, research must satisfy three criteria in order to
qualify for the credit. First, the research must relate to activities that can be
expensed under section 174, which is to say that the research must be
"experimental" in the laboratory sense. Second, the research must be
undertaken to discover information that is "technological in nature" and
useful in the development of a new or improved product, process, computer
software technique, formula, or invention that is to be sold, leased, licensed,
or used by the firm performing the research. Finally, the research must relate
to activities that constitute a process of experimentation whose goal is the
development of a product or process with a "new or improved function,
performance, or reliability or quality."

Not all spending on qualified research is eligible for the incremental or
alternative credits. Only outlays for the following purposes can be used to
compute the credit:

(1) wages, salaries, and supplies used in research conducted in house;

(2) certain time-sharing costs for computers used in research, and

(3) 65 percent of amounts paid by the taxpayer for contract research; the
share rises to 75 percent if non-profit scientific research consortia perform
the research, and to 100 percent if the research is performed by qualified
small firms, certain universities, or federal laboratories.

The credit does not apply to expenditures for equipment and structures
used in qualified research, the fringe benefits of employees involved in this
research, and overhead costs related to research activities (e.g., rent, utility
costs, leasing fees, administrative and insurance costs, and property taxes).
Nor can it be claimed for research done after the start of commercial
production, research aimed at adapting existing products for a specific
customer's needs, research that duplicates existing products, surveys, routine
testing, research to modify computer software for internal use, foreign
research, research funded by others, and research in the social sciences, arts,
or humanities.

If a taxpayer claims a research tax credit and a deduction for research
expenditures under section 174, then the deduction must be reduced by the
amount of the credit. This reduction, which is sometimes referred to as a
basis adjustment, has the effect of including the credit in a firm's taxable
income, thereby lowering the marginal effective rate of the credit.

In addition, payments made by most firms for basic research conducted by
universities and non-profit scientific research organizations are eligible for a
basic research tax credit. The credit is equal to 20 percent of these payments
above a base amount, which is defined as the sum of 1 percent of a taxpayer's
in-house and contract research spending in the base period and any excess of
its average non-basic research contributions to qualified organizations in the
base period, adjusted for increases in the cost of living, over its contributions
in the current tax year. Research expenditures used to compute the basic
research credit may not also be used to compute the regular or alternative
research credits.

Firms may also claim a 20 percent credit for any payments they make to an
energy research consortium.

The credit may not be claimed for eligible expenses paid or incurred after
June 30, 1995 and before July 1, 1996, for the reason that the credit was not
in effect during that period and has not been renewed retroactively to cover it.

Impact

The credit reduces the after-tax or net cost to a business of performing
qualified research. Though the statutory rate of the credit is 20 percent for
qualified research expenses above the base amount, the marginal effective
rate is much less in many cases. The reason lies in some of the rules
governing the computation of the credit. One such rule requires that any
deduction claimed for research expenditures under section 174 be reduced by
the amount of any research credit claimed. Doing so lowers the credit's
marginal effective rate to 13 percent: [0.20 x (1-0.35)]. Another rule
stipulates that a firm's base amount for the credit must be equal to 50 percent
or more of qualified research expenses in the current tax year. As a result of
this rule, the marginal effective rate of the credit can fall to 6.5 percent for
research expenditures in excess of double the base amount. This rate can be
even lower when outlays for structures and equipment, which are not eligible
for the credit, account for a large share of the total cost of an R&D
investment.

Because of its design, the credit does not provide benefits to all firms
undertaking qualified research. For instance, it is of no benefit to firms
whose research intensity (i.e., research expenditures as a share of gross
receipts in a certain period) is declining. If the reason for the decline in
research intensity is faster growth in sales than research expenditures, then it
is conceivable that the credit could function as an implicit and slight tax on
sales growth.

At the same time, the credit provides the largest benefits to firms whose
investment in research and development (R&D) is rising faster than their sales
revenue.

Individuals to whom the credit is properly allocated from a partnership or
subchapter S corporation may use the credit in a particular year to offset only
the tax on their taxable income derived from that business. This means that -
owners of partnerships or S corporations cannot use research tax credits
earned by these entities to offset the tax on income from the other sources.

The credit is claimed mostly by C corporations, while its direct tax benefits
accrue largely to higher-income individuals (see discussion in the
Introduction).

Rationale

Section 41 first entered the federal tax code through the Economic
Recovery Tax Act of 1981. Under the act, the credit rate was fixed at 25
percent, there was no basis adjustment, and the base amount was equal to the
average of the past three years of research expenditures. Such a design served
two purposes: (1) to give U.S.-based firms an incentive to invest more in
R&D than they otherwise would, and (2) to offset some of the significant
costs associated with initiating or expanding business R&D programs.

The original credit was supposed to expire at the end of 1985, to give
Congress an opportunity to evaluate its effects before deciding whether or not
to extend it. It was extended retroactively through 1988, at a reduced rate of
20 percent, by the Tax Reform Act of 1986. The Technical and
Miscellaneous Revenue Act of 1988 extended the credit for another year and
a half and added a basis adjustment equal to 50 percent of the credit.

Additional changes were made in the credit through the Omnibus
Reconciliation Act of 1989. Specifically, the act extended the credit through
1990, allowed the base amount to increase in pace with gross receipts rather
than research expenditures, allowed the credit to apply to research intended to
explore future lines of business as well as to develop current ones, and
provided for the full basis adjustment. The Omnibus Reconciliation Act of
1990 extended the credit through the end of 1991, and the Tax Extension Act
of 1991 further extended it through June 1992. After the credit expired and
remained in abeyance for about one year, the Omnibus Budget Reconciliation
Act of 1993 retroactively extended it through June 1995. After the credit
again expired and lapsed for about one year, the Small Business Job
Production Act of 1996 reinstated it retroactively to July 1, 1996 and
extended it through May 31, 1997, leaving a one-year gap in coverage that
still exists. That act also introduced the three-tiered alternative credit and
allowed 75 percent of payments to non-profit research consortia to be eligible
for the credit. The Taxpayer Relief Act of 1997 further extended the credit
through June 1998, and the omnibus budget bill passed in 1998 (P.L. 105-
277) extended the credit through June 1999. After expiring yet again, the
credit was extended to June 30, 2004 by the Ticket to Work and Work
Incentives Improvement Act of 1999 (P.L. 106-170). In October 2004,
President Bush signed into law a tax bill (the Working Families Tax Relief
Act of 2004, P.L. 108-311) that included a provision extending the credit
through December 31, 2005. H.R. 6111, adopted in December 2006,
extended the credit through 2007, increased the alternative rates for 2007, and
added the alternative simplified credit.

Assessment

Among economists and policymakers, there is widespread agreement that
investment in research and development (R&D) exerts a profound influence
on long-term economic growth through the innovations it spawns. At the
same time, it is thought that private R&D investment is bound to be less than
optimal in an economy dominated by competitive markets, mainly because
firms other than the ones financing the R&D may capture some of the
economic benefits from research. This leakage can occur in spite of the
presence of patents and other forms of intellectual property protection. For
example, when a group of research scientists and engineers decides to break
away from a company and start a new company for the purpose of developing
a technology related to technologies owned and sold by their former
employer, some (or even all) of any returns they eventually earn on their
investment could be attributed to the R&D investments made by their former
employer. There is some evidence that the social returns to R&D are much
larger than the private returns. In the absence of government intervention in
the market for R&D, the private sector is likely to invest less in R&D than its
potential social returns would warrant. Public subsidies for R&D (e.g.,
research tax credits) can remedy this market failure, making everyone better
off.

Since its enactment in 1981, the research tax credit has provided over $1
billion a year in tax subsidies for business R&D investment. The credit's
effectiveness hinges on the sensitivity of this investment to declines in its real
after-tax cost. Available evidence suggests that in the 1980s, a decline in this
cost of one dollar was associated with an increase in business R&D
investment of one to two dollars. Because this sensitivity may shift over long
periods, it is not known whether R&D investment remains as responsive
today.

Even though the existing credit can be justified on economic grounds and
is thought to be cost-effective, it is open to several criticisms. First, a tax
subsidy may not be the most efficient way to encourage increased investment
in basic research, since an open-ended subsidy like the credit does not
necessarily target R&D with the greatest social returns. Second, the lack of a
clear and comprehensive definition of the research that qualifies for the credit
makes it easier for firms to claim the credit for expenses that may have little
or nothing to do with R&D. Third, the credit's incentive effect may be too
weak to boost business R&D to levels commensurate with its social benefits.
Fourth, some critics of the credit contend that it mostly subsidizes R&D that
would be done even if the credit did not exist. Finally, the credit's lack of
permanence is thought to deter some R&D investment by heightening the
uncertainty surrounding the expected after-tax returns on prospective R&D
investments.

Selected Bibliography

Altschuler, Rosanne. "A Dynamic Analysis of the Research and
Experimentation Credit," National Tax Journal, v. 41. December 1988, pp.
453-466.
Atkinson, Robert D. The Research and Experimentation Tax Credit: A
Critical Policy Tool for Boosting Research and Enhancing U.S. Economic
Competitiveness. Information Technology and Innovation Foundation.
Washington, D.C.: September 4, 2006.
Baily, Martin Neil, and Robert Z. Lawrence. "Tax Policies for Innovation
and Competitiveness," Paper Commissioned by the Council on Research and
Technology. Washington, DC, April 1987.
-. "Tax Incentives for R&D: What do the Data Tell Use?" Study
Commissioned by the Council on Research and Technology. Washington,
DC, 1992.
Berger, Philip G. "Explicit and Implicit Tax Effects of the R&D Tax
Credit." Journal of Accounting Research, v. 3, August 1993, pp. 131-71.

Bernstein, Jeffry I. and M. Ishaq Nadiri. "Interindustry R&D Spillovers,
Rates of Return, and Production in High Tech Industries," American
Economic Review, v. 76. June 1988, pp. 429-434.
Billings, B. Anthony and Randolph Paschke, "Would H.R. 463 Improve
the Competitiveness of U.S. R&D Tax Incentives?," Tax Notes, June 9, 2003,
pp. 1509-1524.
-. "Permanent Research Tax Credit Could Reverse Offshoring of Jobs,"
Tax Notes, March 29, 2004, pp. 1655-1666.
Brown, Kenneth M., ed. The R&D Tax Credit. Issues in Tax Policy and
Industrial Innovation. Washington, DC: American Enterprise Institute for
Public Policy, 1984.
Busom, Isabel. An Empirical Evaluation of the Effects of R&D Subsidies.
Burch Working Paper No. B99-05. Berkeley, CA, University of California,
Berkeley, May 1999.
Cordes, Joseph J. "Tax Incentives for R&D Spending: A Review of the
Evidence," Research Policy, v. 18. 1989, pp. 119-133.
-. "Research and Experimentation Tax Credit." The Encyclopedia of
Taxation and Tax Policy, edited by Joseph J. Cordes, Robert O. Ebel, and
Jane G. Gravelle. Washington, DC: Urban Institute Press, 2005. pp. 330-332.
Cox, William A. Research and Experimentation Credits: Who Got How
Much? Library of Congress, Congressional Research Service Report 96-505,
June 4, 1996.
Gravelle, Jane G. The Tax Credit for Research and Development: An
Analysis. Library of Congress, Congressional Research Service Report 85-6.
Washington, DC, January 25, 1985.
Grigsby, McGee and John Westmoreland, "The Research Tax Credit: A
Temporary and Incremental Dinosaur." Tax Notes, December 17, 2001, pp.
1627-1640.
Guenther, Gary. Research and Experimentation Tax Credit: Current
Status and Policy Issues for the 108th Congress. Library of Congress,
Congressional Research Service Report No. RL31181. Washington, D.C.,
September 22, 2006.
Guinet, Jean, and Hroko Kamata. "Do Tax Incentives Promote
Innovation?" OECD Observer, no. 202, October-November, 1996, pp. 22-
25.
Hall, Bronwyn H. "R & D Tax Policy During the 1980s," in Tax Policy
and the Economy 7, ed. James M. Poterba. Cambridge, MA: MIT Press,
1993.
-, and John van Reenen. How Effective Are Fiscal Incentives for R&D? A
Review of the Evidence. Working Paper 7098. Cambridge, MA, National
Bureau of Economic Research, April 1999.
Hines, James R. "On the Sensitivity of R&D to Delicate Tax Changes:
The Behavior of U.S. Multinationals in the 1980s." In Studies in
International Taxation in the 1980s," Ed. Alberto Giovanni, R. Glenn
Hubbard, and Joel Slemrod. Chicago: The University of Chicago Press,
1993.

Kiley, Michael T. Social and Private Rates of Return to Research and
Development in Industry. Library of Congress, Congressional Research
Service Report 93-770. Washington, DC: August 27, 1993.
KPGM Peat Marwick, LLP, Policy Economics Group, Extending the R&E
Credit: The Importance of Permanence. Prepared for the Working Group on
Research and Development. Washington, DC: November 1994.
Landau, Ralph, and Bruce Hannay, eds. Taxation, Technology and the
US. Economy. NY: Pergamon Press, 1981. See particularly George Carlson,
"Tax Policy and the U.S. Economy," (a version of which was published as
Office of Tax Analysis Paper 45, U.S. Treasury Department, January 1981),
pp. 63-86, and Joseph Cordes, "Tax Policies for Encouraging Innovation: A
Survey," pp. 87-99.
Mamureas, Theofaris P. and M. Ishaq Nadiri. "Public R&D Policies and
Cost Behavior of the U.S. Manufacturing Industries." National Bureau of
Economic Research Working Paper 5059, Cambridge, MA, March 1995.
Mansfield, Edwin, et al. "Social and Private Rates of Return from
Industrial Innovations," Quarterly Journal of Economics, v. 41. March
1977, pp. 221-240.
McIntyre, Bob. Proposed Extension of Corporate Tax Credit: Throwing
Good Money After Bad, Citizens for Tax Justice. Washington, D.C.: May 12,
2006.
Office of Technology Assessment, The Effectiveness of Research and
Experimental Tax Credits, OTA-BRITC-174, September 1995.
Ohmes, Christopher J., David S. Hudson, and Monique J. Migneault,
"Final Research Credit Regulations Expected to Immediately Affect IRS
Examinations," Tax Notes, February 23, 2004, pp. 1015-1024.
Rashkin, Michael D. Research and Development Tax Incentives: Federal,
State, and Foreign. Chicago: CCH Inc., 2003.
Tillinger, Janet W. "An Analysis of the Effectiveness of the Research and
Experimentation Tax Credit in a Q Model of Valuation." The Journal of the
American Taxation Association, Fall 1991, pp. 1-29.
U.S. Congress, House Committee on Ways and Means. Research and Ex-
perimentation Tax Credit Hearing, 98th Congress, 2nd session. August 2,
1984.
-, Joint Committee on Taxation. Description and Analysis of Tax
Provisions Expiring in 1992. January 27, 1992: pp. 59-68.
-, Joint Economic Committee. The R&D Tax Credit: An Evaluation of
Evidence on Its Effectiveness, 99th Congress, 1st Session. Senate Report 99-
73, August 23, 1985.
U.S. General Accounting Office. Additional Information on the Research
Tax Credit. Testimony of Natwar Gandhi Before the House Ways and Means
Subcommittee on Oversight. Publication GGD-95-162, Washington, 1995.
-. Studies of the Effectiveness of the Research Tax Credit. Publication
GGD-96-43. May 1996.
Watson, Harry. "The 1990 R&D Tax Credit: A Uniform Tax on Inputs and
a Subsidy for R&D." National Tax Journal, v. 49, March 1996, pp. 93-103.

General Science, Space, and Technology

EXPENSING OF
RESEARCH AND EXPERIMENTAL EXPENDITURES

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

(1)

2.0

2007

0.1

3.7

3.8

2008

0.1

5.5

5.6

2009

0.1

6.0

6.1

2010

0.1

5.8

5.9

(1)Less than $50 million.

Authorization

Section 174.

Description

As a general rule, business expenditures to acquire an asset with a useful
life extending beyond a single tax year, such as a machine tool or computer
system, must be capitalized and cannot be deducted in the year when the
expenditures are made or incurred. These costs usually are recovered through
depreciation deductions taken over the useful life of the asset, or through the
sale or abandonment of the asset.

Under section 174, however, a business taxpayer may deduct, as a current
expense, certain research expenditures that are paid or incurred in connection
with the taxpayer's trade or business. This treatment is available even though
the research expenditures are likely to generate intangible assets (e.g., patents)
with a useful life extending far beyond a single tax year. Alternatively, a
taxpayer may treat these expenditures as deferred expenses and deduct them
on a straight-line basis over a period of 60 months or more; this treatment is
know as amortization. Treasury regulations define the expenditures eligible
for the section 174 deduction as "research and development costs in the
experimental or laboratory sense." The regulations also specify that eligible
research expenditures include all costs related to "the development of an
experimental or pilot model, a plant process, a product, a formula, an
invention, or similar property, and the improvement of already existing
property."

Expenditures for the acquisition or improvement of land, or for the
acquisition or improvement of depreciable or depletable property to be used
in connection with research, cannot be deducted under section 174. In
practice, this means that outlays for structures and equipment used in research
and development (R&D) must be recovered over 15 years and 3 years,
respectively, using the depreciation schedules allowed under section 167. In
addition, expenditures to determine the existence, location, extent, or quality
of mineral deposits, including oil and gas, may not be deducted under section
174.

To prevent business taxpayers from benefitting twice from the same
research expenditures, the deduction allowed under section 174 must be re-
duced by the amount (if any) of any credit claimed under section 41 for
certain increases in research expenditures.

Impact

The expensing of research spending under section 174 has the effect of
deferring taxes on the return to investment in the assets generated by this
spending. Such a deferral can yield a significant tax savings, after adjustment
for inflation, for a firm over the life of a depreciable asset. For example, if a
profitable corporation were to spend $1 million on wages and supplies related
to R&D in a tax year, it would be able to deduct that amount from its taxable
income, producing an addition to cash flow (at a 35-percent marginal tax rate)
of $350,000. The value to the corporation of such treatment is the amount by
which the present value of the immediate deduction exceeds the present value
of the periodic deductions that otherwise would be taken over the useful life
of any asset (such as a patent) generated by the research expenditures. Under
certain circumstances, expensing is equivalent to taxing the returns to an asset
at a marginal effective rate of zero. In other words, expensing has the
potential to equalize the after-tax and pre-tax returns on an investment.

The direct beneficiaries of the section 174 deduction obviously are firms
that undertake research. For the most part, these tend to be larger
manufacturing corporations engaged in developing, producing, and selling
technologically advanced products. As a corporate tax deduction, the benefits
of expensing any capital cost accrue mainly to upper-income individuals (see
discussion in the Introduction).

Rationale

Section 174 was enacted as part of the Internal Revenue Code of 1954.
The legislative history of the act indicates that Congress was pursuing two
overriding aims in enacting section 174. One was to encourage firms
(especially smaller ones) to invest in R&D. The second aim was to eliminate
the difficulties and uncertainties facing business taxpayers as a result of the
depreciation of research expenditures under previous tax law.

Assessment

There appears to be no controversy over the desirability of the provision,
reflecting a widely held view that its benefits outweigh its costs. Section 174
simplifies tax compliance and accounting for business taxpayers by
eliminating the problems associated with identifying qualified R&D
expenditures and assigning useful lives to any assets created through these
expenditures. It can also be argued that the provision stimulates business
R&D investment by boosting real after-tax returns to such investment and
increasing the cash flow of firms engaged in R&D. This benefit addresses the
perennial concern that firms are inclined to invest too little in R&D in the
absence of government support, mainly because of the spillover effects of
R&D. There is some empirical evidence that the social returns to R&D
exceed the private returns.

While these considerations may constitute a strong economic case for
subsidizing R&D investments, they do not necessarily support the use of a tax
preference like section 174. A principal shortcoming with tax subsidies like
section 174 is that they do not target R&D investments with the largest social
benefits.

Selected Bibliography

Baily, Martin Neil, and Robert Z. Lawrence. "Tax Policies for Innovation
and Competitiveness," Paper Commissioned by the Council on Research and
Technology. April 1987.
Bernstein, Jeffry I., and M. Ishaq Nadiri. "Interindustry R&D Spillovers,
Rates of Return, and Production in High Tech Industries," American
Economic Review, v. 76. June 1988, pp. 429-434.
Cordes, Joseph J. "Tax Incentives for R&D Spending: A Review of the
Evidence," Research Policy, v. 18. 1989, pp. 119-133.

-. "Expensing." The Encyclopedia of Taxation and Tax Policy, edited by
Joseph J. Cordes, Robert O. Ebel, and Jane G. Gravelle. Washington, D.C.:
Urban Institute Press, 2005. pp. 128-130.
Goldbas, Michael and Greg Alan Fairbanks. "The Final Step in
Computing the R&E Credit." Tax Adviser, vol. 36, no. 3, March 1, 2005. p.
136.
Guenther, Gary. Research and Experimentation Tax Credit: Current
Status and Policy Issues for the 108th Congress. Library of Congress,
Congressional Research Service Report RL31181. Washington, updated
September 22, 2006.
Hall, Bronwyn H. and John van Reenen, "How Effective are Fiscal
Incentives for R&D? A Review of the Evidence. Working Paper 7098.
National Bureau of Economic Research, Cambridge, MA, April 1999.
Hudson, David S. "The Tax Concept of Research or Experimentation."
Tax Lawyer, v. 45, Fall 1991, pp. 85-121.
Kiley, Michael T. Social and Private Rates of Return to Research and
Development in Industry. Library of Congress, Congressional Research
Service Report 93-770. Washington, DC: August 27, 1993.
Landau, Ralph, and Bruce Hannay, eds. Taxation, Technology and the
U.S. Economy. New York: Pergamon Press, 1981. See particularly George
Carlson, "Tax Policy and the U.S. Economy" (a version of which was
published as Office of Tax Analysis Paper 45, U.S. Treasury Department,
January 1981), pp. 63-86, and Joseph J. Cordes, "Tax Policies for
Encouraging Innovation: A Survey," pp. 87-99.
Lee, Andrew B., "Section 174: "Just in Time" for Deducting Costs of
Developing New or Improved Manufacturing Processes," The Tax Adviser,
July 1996, p. 401.
Mansfield, Edwin, et al. "Social and Private Rates of Return from
Industrial Innovations," Quarterly Journal of Economics, v. 41. March
1977, pp. 221-240.
McClelland, David Huston, "Deductibility of Contract Development Costs
Under Section 174," The Tax Adviser, January 2000, p. 19.
McConaghy, Mark L. and Richard B. Raye. "Congressional Intent, Long-
Standing Authorities Support Broad Reading of Section 174," Tax Notes,
Feb. 1, 1993, pp. 639-653.
Mamureas, T., and M.J. Nadiri. "Public R&D Policies and Cost Behavior
of the U.S. Manufacturing Industries," Journal of Public Economics, v. 63,
no. 1, pp. 57-83.
Rashin, Michael. D. Research and Development Tax Incentives: Federal,
State, and Foreign. CCH, Inc. Chicago: 2003, pp. 23-44.
Tobin, Brian F., "New Regulations Clarify R&E Definition," The Tax
Adviser, May 1995, p. 287.
U.S. Congress, Congressional Budget Office. Federal Support for R&D
and Innovation, April 1984.

Energy

EXPENSING OF EXPLORATION AND DEVELOPMENT COSTS;
AMORTIZATION OF GEOLOGICAL AND GEOPHYSICAL
COSTS: OIL, GAS, AND OTHER FUELS

Estimated Revenue Loss*

[In billions of dollars]

Individuals

Corporations

Total

Fiscal year

Oil and
Gas

Other
Fuels

Oil and
Gas

Other
Fuels

Oil and
Gas

Other
Fuels

2006

(1)

1.1

(1)

1.1

(1)

2007

(1)

1.7

(1)

1.7

(1)

2008

0.1

(1)

1.9

(1)

2.0

(1)

2009

0.1

(1)

1.0

(1)

1.1

(1)

2010

(1)

0.7

(1)

0.7

(1)

(1)Less than $50 million.
*The Tax Increase Prevention and Reconciliation Act (P.L. 109-222)
increased the recovery period for the amortization of geological and
geophysical costs for major integrated oil companies from 2 to 5 years, which
increased revenues by the following amounts: $5 million in FY2006, $28
million in FY2007, $49 million in FY2008, $48 million in FY2009, and $30
million in FY 2010.

Authorization

Section 263(c), 291, 616-617, 57(a)(2), 59(e) and 1254.

Description

Firms engaged in the exploration and development of oil, gas, or
geothermal properties have the option of expensing (deducting in the year
paid or incurred) rather than capitalizing (i.e., recovering such costs through
depletion or depreciation) certain intangible drilling and development costs
(IDCs). Expensing is an exception to general tax rules that provide for the
capitalization of costs related to generating income from capital assets. In lieu
of expensing, firms have the option of amortizing IDCs in equal amounts over
a five-year period. This option may reduce or eliminate the alternative
minimum tax on the IDCs, which, as discussed below, is a tax preference
item.

IDCs are amounts paid by the operator for fuel, labor, repairs to drilling
equipment, materials, hauling, and supplies. They are expenditures incident
to and necessary for the drilling of wells and preparing a site for the
production of oil, gas, or geothermal energy. IDCs include the cost to
operators of any drilling or development work done by contractors under any
form of contract, including a turnkey contract. Amounts paid for casings,
valves, pipelines, and other tangible equipment that have a salvage value are
capital expenditures and they cannot be expensed; they are recovered through
depreciation. (And as discussed in the subsequent entry on percentage
depletion, amounts expended to purchase a property are depleted using either
percentage or cost depletion.) Geological and geophysical (G&G) costs -
exploratory costs associated with determining the precise location and
potential size of a mineral deposit - are amortized by independents over two
years and by major integrated oil companies over five years.

The option to expense IDCs applies to domestic properties, which include
certain off-shore wells (essentially those within the exclusive economic zone
of the United States), including generally offshore platforms subject to certain
restrictions. Except for IDCs incurred in the North Sea, IDCs on foreign
properties must be either amortized (deducted in equal amounts) over 10
years or added to the adjusted cost basis and recovered through cost
depletion. An integrated oil company, generally a large producer that also has
refining and marketing operations, can expense only 70% of the IDCs - the
remaining 30% must be amortized over a five-year period. Dry hole costs for
either domestic or foreign properties may be expensed or capitalized at the
discretion of the taxpayer.

For integrated producers, the excess of expensed IDCs over the
amortizable value (over a 10-year period) is a tax preference item that is
subject to the alternative minimum tax to the extent that it exceeds 65% of the
net income from the property. Independent (non-integrated) producers
include only 60% of their IDCs as a tax preference item. As noted above,
instead of expensing, a taxpayer may choose to amortize IDCs over a five-
year period and avoid the alternative minimum tax. The amortization claimed
under IRC section 59(e) is not considered a tax preference item for alternative
minimum tax purposes. Prior to 1993, an independent producer's intangible
drilling costs were subject to the alternative minimum tax, and they were
allowed a special "energy deduction" for 100% of certain IDCs, subject to
some limitations. If an operator has elected to amortize IDCs on a well that
proves later to be a dry hole, the operator may deduct such costs as an
ordinary loss. The taxpayer is not required to include these costs as an IDC
tax preference item in computing alternative minimum tax. If a property is
disposed of prior to its exhaustion, any expensed IDCs are recaptured as
ordinary income.

Impact

IDCs and other intangible exploration and development costs represent a
major portion of the costs of finding and developing a mineral reserve. In the
case of oil and gas, which historically accounted for 99% of the revenue loss
from this provision, IDCs typically account for about 66% of the total
exploration and development costs - the cost of creating a mineral asset.

Historically, expensing of IDCs was a major tax subsidy for the oil and gas
industry, and, combined with other tax subsidies such as the depletion
allowance, reduced effective tax rates significantly below tax rates on other
industries. These subsidies provided incentives to increase investment,
exploration, and output, especially of oil and gas. Oil and gas output, for
example, rose from 16% of total U.S. energy production in 1920 to 71.1% in
1970 (the peak year). Coupled with reductions in corporate income tax rates,
increased limits on expensing, and the alternative minimum tax, the value of
this subsidy has declined over time. And, since the early 1970s, domestic
crude oil production has fallen substantially. However, the subsidy still keeps
effective marginal tax rates on oil and gas (especially for independent
producers) somewhat below the marginal effective tax rates on other
industries in most cases.

Unlike percentage depletion, which may only be claimed by independent
producers, this tax expenditure is shared by both independents and by the
integrated oil and gas producers. However, independent oil producers, many
of which are large, drill 80-90% of the wells and undertake the bulk of the
expenditures for exploration and development, thus receiving the bulk of the
benefits from this tax expenditure. The at-risk, recapture, and minimum tax
restrictions that have since been placed on the use of the provision have
primarily limited the ability of high-income taxpayers to shelter their income
from taxation through investment in mineral exploration. However, the
exemption for working interests in oil and gas from the passive loss limitation
rules still creates opportunities for tax shelters in oil and gas investments.

Rationale

Expensing of IDCs was originally established in a 1916 Treasury
regulation (T.D. 45, article 223), with the rationale that such costs were
ordinary operating expenses.

In 1931, a court ruled that IDCs were capital costs, but permitted
expensing, arguing that the 15-year precedent gave the regulation the force of
a statute. In 1942, Treasury recommended that expensing be repealed, but the
Congress did not take action. A 1945 court decision invalidated expensing,
but the Congress endorsed it (on the basis that it reduced uncertainty and
stimulated exploration of a strategic mineral) and codified it as section 263(c)
in 1954. Continuation of expensing has been based on the perceived need to
stimulate exploratory drilling, which can increase domestic oil and gas
reserves, and (eventually) production, reduce imported petroleum, and
enhance energy security. However, none of the four economic rationales for
intervention in the energy markets (the market failures rationales) justify
expensing treatment of IDCs.

The Tax Reform Act of 1976 added expensing of IDCs as a tax preference
item subject to the minimum tax. Expensing of IDCs for geothermal wells
was added by the Energy Tax Act of 1978. The Tax Equity and Fiscal
Responsibility Act of 1982 limited expensing for integrated oil companies to
85%; the remaining 15% of IDCs had to be amortized over 3 years.

The Deficit Reduction Act of 1984 limited expensing for integrated
producers to 80% of IDCs. The Tax Reform Act of 1986 established uniform
capitalization rules for the depreciation of property, but IDCs (as well as mine
development and other exploration costs) are exempt from those rules. The
Tax Reform Act further limited expensing for integrated producers to 70% of
costs, and also repealed expensing of foreign properties.

In 1990, a special energy deduction was introduced, against the alternative
minimum tax, for a portion of the IDCs and other oil and gas industry tax
preference items. For independent producers, the Energy Policy Act of 1992
limited the amount of IDCs subject to the alternative minimum tax to 60%
(70% after 1993) and suspended the special energy deduction through 1998.
The Energy Policy Act of 2005 (P.L. 109-58) included a provision to
amortize geological and geophysical (G&G) costs over two years. The Tax
Increase Prevention and Reconciliation Act (P.L. 109-222) raised the
amortization period to 5 years for major integrated oil companies.

Assessment

IDCs are generally recognized to be capital costs, which, according to
standard economic principles, should be recovered using depletion (cost
depletion adjusted for inflation). Lease bonuses and other exploratory costs
(survey costs, geological and geophysical costs) are properly treated as capital
costs, although they may be recovered through percentage rather than cost
depletion. From an economic perspective, dry hole costs should also be
depleted, rather than expensed, as part of the costs of drilling a successful
well.

Immediate expensing of IDCs provides a tax subsidy for capital invested in
the mineral industry, especially for oil and gas producers, with a relatively
larger subsidy for independent producers. Technological innovation has
reduced the percentage of dry holes in both exploratory and development
drilling, thus reducing the tax benefits from immediate expensing of dry hole
costs.

Expensing rather than capitalizing IDCs allows taxes on income to be
effectively eliminated. As a capital subsidy, however, expensing is
economically inefficient because it promotes investment decisions that are
based on tax considerations rather than inherent economic considerations.

To the extent that IDCs stimulate drilling of successful wells, they reduce
dependence on imported oil in the short run, but contribute to a faster
depletion of the nation's resources in the long run. Arguments have been
made over the years to justify expensing on grounds of unusual risks, national
security, uniqueness of oil as a commodity, the industry's lack of access to
capital, and protection of small producers.

Volatile oil prices make oil and gas investments very risky, but this would
not necessarily justify expensing. The corporate income tax does have
efficiency distortions, but economists argue that income tax integration may
be a more appropriate policy to address this issue; sustained high oil and gas
prices increase profits and provide sufficient financial incentives for
exploration and drilling, making expensing unnecessary. For the goal of
enhancing energy security, one alternative approach is through an oil
stockpile program such as the Strategic Petroleum Reserve.

Selected Bibliography

Congressional Budget Office. Budget Options. Section 28: Repeal the
Expensing of Exploration and Development Costs for Extractive Industries
February 2005.
Eicher, Jeffrey D. And Leo N. Hitt. "The Alternative Minimum Tax
System: A Stealth Tax," Taxes, v. 84 July 2006, pp. 37-45.
Friske, Karyn Bybee. "Alternative Minimum Tax Credit and the
Consolidated Regulations: Is Simplification Possible?" The Oil and Gas and
Energy Quarterly, September 2001, pp.139-145.
Ghiselin, Dick. "Drilling Economics" Oil and Gas Investor, December
2005, pp.13-22.
Gravelle, Jane G. "Effective Federal Tax Rates on Income from New
Investments in Oil and Gas Extraction," The Energy Journal, v. 6 (1985), pp.
145-153.
Lazzari, Salvatore. Energy Tax Policy: History and Current Issues. Library
of Congress, Congressional Research Service, Report RL33578. Washington,
DC: Updated September 23, 2004.

- . Energy Tax Policy: An Economic Analysis. Library of Congress,
Congressional Research Service Report RL30406. Washington, DC: June 28,
2005.
- . Energy Tax Provisions in the Energy Policy Act of 1992. Library of
Congress, Congressional Research Service, Report 94-525 E. Washington,
DC: June 22, 1994. (Archived: Available upon request from the author.)
Lucke, Robert, and Eric Toder. "Assessing the U.S. Federal Tax Burden
on Oil and Gas Extraction," The Energy Journal, v. 8. October 1987, pp. 51-
64.
Rook, Lance W. "The Energy Policy Act of 1992 Changes the Effect of
the AMT on Most Oil and Gas Producers," Tax Adviser, v. 24 (August 1993),
pp. 479-484.
U.S Congress, Senate Committee on Finance. JCT Description of Federal
Energy Tax Provisions, Hearings, 107th Congress, 1st session. Washington,
DC: U.S. Government Printing Office, July 10th and 11, 2001.
U.S. General Accounting Office. Additional Petroleum Production Tax
Incentives Are of Questionable Merit, GAO/GGD-90-75. July 1990.
Washington, DC: U.S. Government Printing Office, July 1990.
U.S. Treasury Department. Tax Reform for Fairness, Simplicity, and
Economic Growth, v. 2. November 1984, Washington, DC: 1984, pp. 229-
231.
U.S. Treasury Department. Internal Revenue Service. Publication 535:
Business Expenses. 2005.
Zlatkovich, Charles P., and Karl B. Putnam. "Economic Trends in the Oil
and Gas Industry and Oil and Gas Taxation," Oil and Gas Quarterly, v. 41.
March, 1993, pp. 347-365.

Energy

EXCESS OF PERCENTAGE OVER COST DEPLETION:
OIL, GAS, AND OTHER FUELS

Estimated Revenue Loss

[In billions of dollars]

Individuals

Corporations

Total

Fiscal year

Oil and
Gas

Other
Fuels

Oil and
Gas

Other
Fuels

Oil and
Gas

Other
Fuels

2006

(1)

1.0

0.1

1.0

0.1

2007

(1)

1.0

0.1

1.0

0.1

2008

(1)

0.9

0.1

0.9

0.1

2009

(1)

0.9

0.1

0.9

0.1

2010

(1)

0.9

0.1

0.9

0.1

(1)Less than $50 million. H.R. 6111, which extended a portion of this
tax benefit cost an additional $0.1 billion in FY2007.

Authorization

Sections 611, 612, 613, 613A, and 291.

Description

Firms that extract oil, gas, or other minerals are permitted a deduction to
recover their capital investment in a mineral reserve, which depreciates due to
the physical and economic depletion or exhaustion as the mineral is
recovered (section 611). Depletion, like depreciation, is a form of capital
recovery: An asset, the mineral reserve itself, is being expended in order to
produce income. Under an income tax, such costs are deductible.

There are two methods of calculating this deduction: cost depletion and
percentage depletion. Cost depletion allows for the recovery of the actual
capital investment - the costs of discovering, purchasing, and developing a
mineral reserve - over the period during which the reserve produces income.
Each year, the taxpayer deducts a portion of the adjusted basis (original
capital investment less previous deductions) equal to the fraction of the
estimated remaining recoverable reserves that have been extracted and sold.
Under this method, the total deductions cannot exceed the original capital
investment.

Under percentage depletion, the deduction for recovery of capital
investment is a fixed percentage of the "gross income"- i.e., revenue -
from the sale of the mineral. Under this method, total deductions typically
exceed, despite the limitations, the capital invested to acquire and develop the
reserve.

Section 613 states that mineral producers must claim the higher of cost or
percentage depletion. The percentage depletion rate for oil and gas is 15%
and is limited to average daily production of 1,000 barrels of oil, or its
equivalent in gas. For producers of both oil and gas, the limit applies on a
combined basis. For example, an oil producing company with 2006 oil
production of 100,000 barrels, and natural gas production of 1.2 billion cubic
feet (the equivalent of 200,000 barrels of oil) has average daily production of
821.92 barrels (300,000 ? 365 days). Percentage depletion is not available to
integrated major oil companies - it is available only for independent
producers and royalty owners. An independent producer is one that does not
have refinery operations that refine more than 75,000 barrels of oil per day,
and does not have retail oil and gas operations grossing more than $5 million
per year. Beginning in 1990, the percentage depletion rate on production from
marginal wells - oil from stripper wells (those producing no more than 15
barrels per day, on average), and heavy oil - was raised. This rate starts at
15% and increases by one percentage point for each whole $1 that the
reference price of oil for the previous calendar years is less than $20 per
barrel (subject to a maximum rate of 25%). This higher rate is also limited to
independent producers and royalty owners, and for up to 1,000 barrels,
determined as before on a combined basis (including non-marginal
production). Small independents operate about 400,000 small stripper wells
in about 28 states, which produce about 1 million barrels of marginal oil/day,
about 20% of domestic production.

Percentage depletion is limited to 65% of the taxable income from all
properties for each producer. A second limitation, the 100% net-income
limitation, which applied to each individual property rather than to all the
properties, was retroactively suspended for oil and gas production from
marginal wells by the Working Families Tax Relief Act of 2004 (P.L. 108-
311) through December 31, 2005. From 1998-2007, the 100% net-income
limitation has also been suspended. Since 1990, transferred properties have
been eligible for percentage depletion. The difference between percentage
depletion and cost depletion is considered a subsidy. It was once a tax
preference item for purposes of the alternative minimum tax, but this was
repealed by the Energy Policy Act of 1992 (P.L. 102-486).

The percentage depletion allowance is available for many other types of
fuel minerals, at rates ranging from 10% (coal, lignite) to 22% (uranium). The
rate for regulated natural gas and gas sold under a fixed contract is 22%; the
rate for geo-pressurized methane gas is 10%. Oil shale and geothermal
deposits qualify for a 15% allowance. The net-income limitation to
percentage depletion for coal and other fuels is 50%, as compared to 100%
for oil and gas. Under code section 291, percentage depletion on coal mined
by corporations is reduced by 20% of the excess of percentage over cost
depletion.

Impact

Historically, generous depletion allowances and other tax benefits reduced
effective tax rates in the fuel minerals industry significantly below tax rates
on other industries, which provided additional incentives to increase
investment, exploration, and output, especially of oil and gas. Oil and gas
output, for example, rose from 16% of total U.S. energy production in 1920 to
71.1% of 1970 (the peak year).

The combination of this subsidy and the deduction of intangible drilling
and other costs (see previous entry) represented a significant boon to mineral
producers who were eligible for both. The deduction of intangible drilling
costs allows up to three-quarters of the original investment to be "written off"
immediately, and under the percentage depletion allowance a portion of gross
revenues can be written off for the life of the investment. It was possible for
cumulative depletion allowances to total many times the amount of the
original investment.

The 1975 repeal of percentage depletion for the major integrated oil
companies, and declining oil production, means that the value of this tax
subsidy has been greatly reduced in the last 30 years. The reduction in the
depletion allowance to 15% in 1984 means that independent producers
benefit from it much less than they used to, although independents have
increased their share of total output, and they qualify for the higher depletion
rate on marginal production. Most recently, high oil and gas prices may have
raised somewhat the subsidy value of percentage depletion to the
independents. In addition, cutbacks in other tax benefits and additional excise
taxes have raised effective tax rates in the mineral industries, although
independent oil and gas producers continue to be favored. However, the
exemption for working interests in oil and gas from the passive loss limitation
rules still creates opportunities for tax shelters in oil and gas investments.
This rule allows losses incurred from exploring for and producing oil and gas
to offset ordinary non oil and gas income.

Undoubtedly, these cutbacks in percentage depletion contributed to the
decline in domestic oil production, which peaked in 1970 and recently
dropped to a 30-year low. Percentage depletion for other mineral deposits
was unaffected by the 1975 legislation. Nevertheless, in an average year
more than half the percent revenue loss is a result of oil and gas depletion.
The value of this expenditure to the taxpayer is the amount of tax savings that
results from using the percentage depletion method instead of the cost
depletion method.

Percentage depletion has little, if any, effect on oil prices, which are
determined by supply and demand in the world oil market. However, it may
encourage higher prices for drilling and mining rights.

Rationale

Provisions for a mineral depletion allowance based on the value of a mine
were made under a 1912 Treasury Department regulation (T.D. 1742) but
were never implemented. A court case resulted in the enactment, as part of
the Tariff Act of 1913, of a "reasonable allowance for depletion" not to
exceed 5% of the value of mineral output. Treasury regulation No. 33 limited
total deductions to the original capital investment.

This system was in effect from 1913 to 1918, although in the Revenue Act
of 1916, depletion was restricted to no more than the total value of output,
and in the aggregate no more than capital originally invested or fair market
value on March 1, 1913 (the latter so that appreciation occurring before
enactment of income taxes would not be taxed).

The 1916 depletion law marked the first time that the tax laws mentioned
oil and gas specifically. On the grounds that the newer discoveries that
contributed to the war effort were treated less favorably, discovery value
depletion was enacted in 1918. Discovery depletion, which was in effect
through 1926, allowed deductions in excess of capital investment because it
was based on the market value of the deposit after discovery. Congress
viewed oil and gas as a strategic mineral, essential to national security, and
wanted to stimulate the wartime supply of oil and gas, compensate producers
for the high risks of prospecting, and relieve the tax burdens of small-scale
producers.

In 1921, because of concern with the size of the allowances, discovery
depletion was limited to net income; it was further limited to 50% of net
income in 1924. Due to the administrative complexity and arbitrariness of the
method, and due to its tendency to establish high discovery values, which
tended to overstate depletion deductions, discovery value depletion was
replaced in 1926 by the percentage depletion allowance, at the rate of 27.5%.

In 1932, percentage depletion was extended to coal and most other
minerals. In 1950, President Truman recommended that the depletion rate be
reduced to 15%, but Congress disagreed. In 1969, the top depletion rates
were reduced from 27.5% to 22%, and in 1970 the allowance was made
subject to the minimum tax.

The Tax Reduction Act of 1975 eliminated the percentage depletion
allowance for major oil and gas companies and reduced the rate for
independents to 15% for 1984 and beyond. This was in response to the Arab
oil embargo of 1973-74, which caused oil prices to rise sharply. The
continuation of percentage depletion for independents was justified by
Congress on the grounds that independents had more difficulty in raising
capital than the major integrated oil companies, that their profits were smaller,
and that they could not compete with the majors.

The Tax Equity and Fiscal Responsibility Act of 1982 limited the
allowance for coal and iron ore. The Tax Reform Act of 1986 denied
percentage depletion for lease bonuses, advance royalties, or other payments
unrelated to actual oil and gas production.

The Omnibus Budget and Reconciliation Act of 1990 introduced the
higher depletion rates on marginal production, raised the net income
limitation from 50% to 100%, and made the allowance available to
transferred properties. These liberalizations were based on energy security
arguments. The Energy Policy Act of 1992 repealed the minimum tax on
percentage depletion. The Taxpayer Relief Act of 1997 suspended the 100%
taxable income limitation for marginal wells for two years, and further
extensions were made by the Ticket to Work and Work Incentives
Improvement Act of 1999 and the Job Creation and Worker Assistance Act of
2002. The Working Families Tax Relief Act of 2004 retroactively suspended
the 100% net-income limitation through December 31, 2005. H.R.
6111extended the suspension of this limitation through 2007.

Assessment

Standard accounting and economic principles state that the appropriate
method of capital recovery in the mineral industry is cost depletion adjusted
for inflation. The percentage depletion allowance permits independent oil and
gas producers, and other mineral producers, to continue to claim a deduction
even after all the investment costs of acquiring and developing the property
have been recovered. Thus it is a mineral production subsidy rather than an
investment subsidy.

As a production subsidy, however, percentage depletion is economically
inefficient. It incorrectly measures the income of qualifying independent oil
and gas producers, and it encourages excessive development of existing
properties - the source of the depletion benefit - over exploration for new
ones, which will not produce a flow of depletion benefits until actual output
results. This tax treatment contrasts with capital subsidies, such as accelerated
depreciation for non-mineral assets. Although accelerated depreciation may
lower effective tax rates by speeding up tax benefits, these assets cannot be
used for depreciation deductions in excess of investment.

Percentage depletion for oil and gas subsidizes independent producers that
are primarily engaged in exploration and production. To the extent that it
stimulates oil production, it reduces dependence on imported oil in the short
run, but it contributes to a faster depletion of the Nation's resources in the
long run, which may increase long-term oil import dependence. Arguments
have been made over the years to justify percentage depletion on grounds of
unusual risks, the distortions in the corporate income tax, national security,
uniqueness of oil as a commodity, the industry's lack of access to capital, and
protection of small producers.

Volatile oil prices make oil and gas investments more risky, but this would
not necessarily justify percentage depletion or other tax subsidies. The
corporate income tax does have efficiency distortions, but from an economic
perspective income tax integration may be a more appropriate policy to
address this problem.

To address national security concerns, one alternative is an oil stockpile
program such as the Strategic Petroleum Reserve.

Selected Bibliography

Congressional Budget Office. Budget Options. Section 31: Curtail Income
Tax Preferences for Businesses and Other Entities. February 2001.
Edmunds, Mark A. "Economic Justification for Expensing IDC and
Percentage Depletion Allowance," Oil & Gas Tax Quarterly, v. 36.
September 1987, pp. 1-11.
Energy Information Administration. Accelerated Depletion: Assessing the
Impact on Domestic Oil and Natural Gas Prices and Production.
SR/OIAF/2000-04. July 2000.
Fenton, Edmund D. "Percentage Depletion, RMFP, and the Exxon
Cases," Oil and Gas Tax Quarterly, v.52. September 2003, pp. 1-17.
Frazier, Jessica, and Edmund D. Fenton. "The Interesting Beginnings of
the Percentage Depletion Allowance," Oil and Gas Tax Quarterly, v. 38.
June 1990, pp. 697-712.
Ghiselin, Dick. "Drilling Economics" Oil and Gas Investor, December
2005, pp.13-22.
Gravelle, Jane G. "Effective Federal Tax Rates on Income from New
Investments in Oil and Gas Extraction," The Energy Journal, v.6. 1985, pp.
145-153.
Harberger, Arnold G. Taxation and Welfare. Chicago: Univ. of Chicago
Press, 1974, pp. 218-226.

Hennessee, Patrick A. Percentage Depletion - How Natural Gas
Producers Can Avoid the Retailer Exclusion of 613A. The Journal of
Taxation. July 2005, pp. 39-46.
Lazzari, Salvatore. Energy Tax Policy: History and Current Issues.
Library of Congress, Congressional Research Service, CRS Report RL33578.
Washington, DC: Updated July 28, 2006.
- . Energy Tax Policy: An Economic Analysis. Library of Congress,
Congressional Research Service, Report RL 30406. Washington, DC: June
28, 2005.
Lucke, Robert, and Eric Toder. "Assessing the U.S. Federal Tax Burden
on Oil and Gas Extraction," The Energy Journal, v. 8. October 1987, pp. 51-
64.
Lyon, Andrew B. "The Effect of Changes in the Percentage Depletion
Allowance on Oil Firm Stock Prices," The Energy Journal, v.10. October
1989, pp.101-116.
McDonald, Stephen L. Federal Tax Treatment of Income from Oil and
Gas. The Brookings Institution, 1963.
Rook, Lance W. "The Energy Policy Act of 1992 Changes the Effect of
the AMT on Most Oil Producers," Tax Advisor, v. 24. August 1993, pp. 479-
484.
Thomas, Christopher, Maurice, S. Charles, Crumbley, D. Larry. Vertical
Integration, Price Squeezing, and Percentage Depletion Allowance. The
Quarterly Review of Economics and Business, v. 29. Winter 1989, pp26-37.
U.S. General Accounting Office. Additional Petroleum Production Tax
Incentives Are of Questionable Merit, GAO/GGD-90-75. Washington, DC:
July 1990.
U.S. Treasury Department. Tax Reform for Fairness, Simplicity, and
Economic Growth, v. 2. Washington, DC: November 1984, pp. 229-231.
U.S. Treasury Department. Internal Revenue Service. IRS Audit Guide:
Oil and Gas Industry, Market Segmentation Specialization Program. 2006.

Energy

TAX CREDIT FOR
PRODUCTION OF NON-CONVENTIONAL FUELS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

1.0

2.7

3.7

2007

1.0

3.2

4.2

2008

0.2

1.2

1.4

2009

(1)

2010

(1)

(1) Less than $50 million

Authorization

Section 45K.

Description

Section 45K provides for a production tax credit of $3 per barrel of
oil-equivalent (in 1979 dollars) for certain types of liquid, gaseous, and solid
fuels produced from selected types of alternative energy sources (so called
"non-conventional fuels"), and sold to unrelated parties. The full credit is
available if oil prices fall below $23.50 per barrel (in 1979 dollars); the credit
is phased out as oil prices rise above $23.50 (in 1979 dollars) over a $6 range
(i.e., the inflation-adjusted $23.50 plus $6). The phase out limit does not
apply to coke or coke gas.

Both the credit and the phase-out range are adjusted for inflation
(multiplied by an inflation adjustment factor) since 1979. With an inflation
adjustment factor of 2.264 (meaning that inflation, as measured by the Gross
National Product deflator, has more than doubled since 1979), the credit for
2005 production was $6.79 per barrel of oil equivalent, which is the amount
of the qualifying fuel that has a British thermal unit content of 5.8 million.
The credit for gaseous fuels was $1.23 per thousand cubic feet (mcf). The
credit for tight sands gas is not indexed to inflation; it is fixed at the 1979
level of $3 per barrel of oil equivalent (about $0.50 per mcf). With the
reference price of oil, which was $50.76/barrel for 2005, still below the
inflation adjustment phase-out threshold oil price of $53.20 for 2005 ($23.50
multiplied by 2.264), the full credit of $6.56 per barrel of equivalent was
available for qualifying fuels.

Qualifying fuels include synthetic fuels (either liquid, gaseous, or solid)
produced from coal, and gas produced from either geopressurized brine,
Devonian shale, tight formations, or biomass. Synthetic fuels from coal, either
liquid, gaseous, or solid, are also qualifying fuels provided that they meet the
statutory and regulatory requirement that they undergo a significant chemical
transformation, defined as a measurable and reproducible change in the
chemical bonding of the initial components. In most cases, producers apply a
liquid bonding agent to the coal or coal waste (coal fines), such as diesel fuel
emulsions, pine tar, or latex, to produce the solid synthetic fuel. The coke
made from coal and used as a feedstock, or raw material, in steel-making
operations also qualifies as a synthetic fuel as does the breeze (which are
small pieces of coke) and the coke gas (which is produced during the coking
process). Depending on the precise Btu content of these synfuels, the section
29 tax credit could be as high as $26/ton or more, which is a significant
fraction of the market price of coal. Qualifying fuels must be produced within
the United States. The credit for coke and coke gas is also $3/barrel of oil
equivalent and is also adjusted for inflation, but the credit is set to a base year
of 2004, making the nominal unadjusted tax credit less than for other fuels.

The section 45K credit for gas produced from biomass, and synthetic fuels
produced from coal or lignite, is available through December 31, 2007,
provided that the production facility was placed in service before July 1,
1998, pursuant to a binding contract entered into before January 1, 1997. The
credit for coke and coke gas is available through December 31, 2009, for
plants placed in service before January 1, 1992, and after June 30, 1998. The
section 45K credit used to apply to oil produced from shale or tar sands, and
coalbed methane (a colorless and odorless natural gas that permeates coal
seams and that is virtually identical to conventional natural gas). But for these
fuels the credit terminated on December 31, 2002 (and the facilities had to
have been placed in service (or wells drilled) by December 31, 1992).

The section 45K credit is part of the general business credit. It is not
claimed separately; it is added together with several other business credits,
and is also subject to the limitations of that credit. The section 45K credit is
also offset (or reduced) by other types of government subsidies that a taxpayer
may benefit from: government grants, subsidized or tax-exempt financing,
energy investment credits, and the enhanced oil recovery tax credit that may
be claimed with respect to such project. Finally, the credit is nonrefundable
and cannot be used to offset a taxpayer's alternative minimum tax liability.
Any unused section 45K credits generally may not be carried forward or back
to another taxable year. (However, under the minimum tax section 53, a
taxpayer receives a credit for prior-year minimum tax liability to the extent
that a section 45K credit is disallowed as a result of the operation of the
alternative minimum tax.)

Impact

The production tax credit is intended to reduce the marginal (and average)
costs of producing the qualifying non-conventional fuels so as to be profitable
enough to compete with conventional fuels. For those fuels whose cost
reductions (and increased rates of return) are sufficiently large, the resulting
price effects could encourage increased production of the subsidized non-
conventional fuels for the more conventional fuels. To the extent that these
effects stimulate the supply of fuels such as shale oil or heavy oil, the
resulting substitution effects lead to a reduction in the demand for petroleum,
and a reduction in imported petroleum (the marginal source of oil), which
would work toward the credit's original purpose: enhancing energy security.

However, to date, the credits have not stimulated production of fuels, such
as shale oil or heavy oil, that would substitute for petroleum. These and other
non-conventional fuels are still generally too costly to be profitably produced.
With the exception of coalbed methane, tight sands gas, and "synfuels" from
coal, the credit's effects have, generally, not been sufficient to offset the
disincentive effects of previously low and unstable oil prices, and the high
cost of non-conventional fuels mining and production. Recently high crude
oil prices (over $70/barrel in 2006) might, if they remain high and stable,
render some of the non-conventional petroleum fuels (such as oil shale and tar
sands) competitive, which might stimulate production even without a tax
credit. However, variable oil prices add to the risk of these and other types of
energy ventures and investments, and undermine profitability and investments
in these areas.

The primary supply effects of the section 45K tax credit have been on non-
conventional gases, particularly of coalbed methane, tight sands gas, and
shale gas. The credit has increased drilling for these gases, and added to total
natural gas reserves. In the case of coalbed methane, the combined effect of
the large tax credit (the credit of $1.00 per mcf was, at times, 100% of natural
gas prices) and declining production costs (due to technological advances in
drilling and production techniques) has helped boost production from 0.1
billion cubic feet in 1980 to 1.6 trillion cubic feet in 2003. More recently,
favorable rulings by the Internal Revenue Service have increased the
production of solid "synthetic" fuels from coal, increasing the supply of these
fuels for use as a feedstock in steel-making operations and in electricity
generation. The credit for coalbed methane benefits largely oil and gas
producers, both independent producers and major integrated oil companies,
and coal companies. Many oil and gas companies, such as DTE Energy,
Phillips Petroleum, and the Enron Corporation, used section 45K tax credits
to help reduce their effective tax rates.

Rationale

The original concept for the alternative fuels production tax credit goes
back to an amendment by Senator Talmadge to H.R. 5263 (95th Congress),
the Senate's version of the Energy Tax Act of 1978 (P.L. 95-618), one of five
public laws in President Carter's National Energy Plan. H.R. 5263 provided
for a $3.00 per barrel tax credit or equivalent, but only for production of shale
oil, gas from geopressurized brine, and gas from tight rock formations.

The final version of the Energy Tax Act did not include the production tax
credit. The original concept was resuscitated in 1979 by Senator Talmadge as
S. 847 and S. 848, which became part of the Crude Oil Windfall Profit Tax
Act of 1980 (P.L. 96-223).

The purpose of the credits was to provide incentives for the private sector
to increase the development of alternative domestic energy resources because
of concern over oil import dependence and national security. The United
States has a large resource base of unconventional energy resources, including
shale oil and unconventional gases such as tight sands gas and coalbed
methane. According to the U.S. Geological Survey and the Minerals
Management Service, estimated U.S. recoverable reserves of unconventional
gases exceed those of any other category of gas, including estimates of
conventional reserves, comprising 35% of the total.

The section 45K credit's "placed-in-service" rule has been amended
several times in recent years. The original 1980 windfall profit tax law
established a placed-in-service deadline of December 31, 1989. This was
extended by one year to December 31, 1990, by the Technical and
Miscellaneous Revenue Act of 1988 (P.L. 100-647). That deadline was
extended to December 31, 1991, as part of OBRA, the Omnibus Budget
Reconciliation Act of 1990 (P.L.101-508). The Energy Policy Act of 1992
(P.L.102-486) extended coverage for facilities for biomass and fuels produced
from coal through 1997 and extended the credit on production from these
facilities through 2007. The Small Business Jobs Protection Act of 1996
(P.L. 104-188) further extended the placed-in-service rule by an additional
eighteen months. In Rev. Proc. 2001-30 and 2001-34, the Internal Revenue
Service implemented regulations that permitted greater production of solid
synthetic fuels from coal to qualify for the section 45K credit. Some have
questioned the scientific validity of these rules and have christened the
process "spray and pray."

The American Jobs Creation Act of 2004 (P.L. 108-357) provided a
production tax credit for refined coal. The production tax credit's provisions
were inserted in section 45 of the tax code, the section that provides a tax
credit for electricity produced from renewable energy resources. (A
discussion of the section 45 tax credit appears elsewhere in the Energy section
of this compendium.)

The Energy Policy Act of 2005 (P.L. 109-58) made several amendments to
the section 45K tax credit. First, the credit's provisions were moved from
section 29 of the tax code to new 45K. Before this, this credit was
commonly known as the "section 29 credit." Second, the credit was made
available for qualified facilities that produce coke or coke gas that were
placed in service before January 1, 1993, or after June 30, 1998, and before
January 1, 2010. Coke and coke gas produced and sold during the period
beginning on the later of January 1, 2006, or the date the facility is placed in
service, and ending on the date which is four years after such period begins,
would be eligible for the production credit, but at a reduced rate and only for
a limited quantity of fuel. The tax credit for coke and coke gas would be
$3.00/barrel of oil equivalent, but the credit would be indexed for inflation
starting with a 2004 base year as compared with a 1979 base year for other
fuels. A facility producing coke or coke gas and receiving a tax credit under
the previous section 29 rules would not be eligible to claim the credit under
the new section 45K. The new provision also requires that the amount of
credit-eligible coke produced not exceed an average barrel-of-oil equivalent
of 4,000 barrels per day. Third, the 2005 Act provided that, with respect to
the IRS moratorium on taxpayer-specific guidance concerning the credit, the
IRS should consider issuing rulings and guidance on an expedited basis to
those taxpayers who had pending ruling requests at the time that the IRS
implemented the moratorium. Finally, the 2005 legislation made the general
business limitations applicable to the tax credit. Any unused credits could be
carried back one year and forward 20 years, except that the credit could not be
carried back to a taxable year ending before January 1, 2006. These new
rules were made effective for fuel produced and sold after December 31,
2005, in taxable years ending after such date.

H.R. 6111 (December 2006) eliminated the phase out limit for coke and
coke gas, and clarified that petroleum based coke or coke gas does not
qualify.

Assessment

The section 45K credit has significantly reduced the cost and stimulated
the supply of unconventional gases - particularly of coalbed methane from
coal seams not likely to be mined for coal in the foreseeable future, and of
tight sands gas and shale gas. Due to recently tight natural gas markets and
relatively high prices, these additional supplies might have kept natural gas
prices from rising even more. In general, much of the added gas output has
substituted for domestic and imported (i.e., Canadian) conventional natural
gas rather than for imported petroleum, meaning that the credit has basically
not achieved its underlying energy policy objective of enhancing energy
security by reducing imported petroleum. More recently, additional supplies
of domestic unconventional gases may be substituting for imported LNG
(liquefied natural gas). Declining conventional natural gas production in
Texas, New Mexico, Oklahoma, Louisiana, and the Gulf of Mexico has been
partially offset by increases in Colorado and Wyoming, reflecting the growing
prominence of unconventional sources such as tight sands, shales, and
coalbeds. Unconventional gas production, currently at nearly 5 trillion cubic
feet (1/4 of total domestic production), is projected to increase at the fastest
rate of any other type of natural gas, largely because of expansion of
unconventional gases from the Rocky Mountain region.

Economists see little justification for such a credit on grounds of allocative
efficiency, distributional equity, or macroeconomic stability. From an
economic perspective, although tax incentives are generally less distortionary
than mandates and standards, critics maintain that the section 45K tax credit
compounds distortions in the energy markets, rather than correcting for
preexisting distortions due to pollution, oil import dependence, "excessive"
market risk, and other factors. Such distortions may be addressed by other
policies: Pollution and other environmental externalities may be dealt with by
differential taxes positively related to the external cost; excessive dependence
on imported petroleum and vulnerability to embargoes and price shocks have
led to calls for either an oil import tax or a petroleum stockpile such as the
Strategic Petroleum Reserve.

The credit has not encouraged the collection of coalbed methane from
active coal mines, which continues to be vented and which contributes a
potent greenhouse gas linked to possible global warming. Hydraulic
fracturing of coal beds, and other environmental effects from the production
of coalbed methane and other unconventional gases, is coming under greater
scrutiny.

In recent years, much of the benefits of the tax credits has accrued to coal
producers and users, who spray the coal with a fuel and sell it as a solid
"synthetic fuel." The coal industry has also benefitted from the expansion of
the credit to coke and coke gas. Under the original statute and regulations,
such conversion of coal into a synthetic fuel was premised on a significant
chemical transformation that would increase the energy content of the
resulting fuel.

Selected Bibliography

Andrews, Anthony. Oil Shale: History, Incentives, and Policy. Library of
Congress. Congressional Research Service Report RL33359, Washington,
D.C. April 13, 2006.
Bryner, Gary C. "Coalbed Methane Development: The Costs and Benefits
of an Emerging Energy Resource." Natural Resource Journal, v. 43, Spring
2003. pp. 519-560.
Clark, Judy. "Geopolitics, Unconventional Fuels to Reshape Industry," Oil
and Gas Journal, April 25, 2005, pp 44-44
Crow, Patrick, and A.D. Koen. "Tight Gas Sands Drilling Buoying U.S. E
& D Activity." Oil and Gas Journal, v. 90. November 2, 1992, pp. 21-27.
Fletcher, Sam. "Major U.S. Supply Role Seen for Unconventional Gas,"
Oil and Gas Journal, December 20, 2004, pp. 32-34.
Kuuskraa, Vello A., and Charles F. Brandenburg. "Coalbed Methane
Sparks New Energy Industry," Oil and Gas Journal, v. 87. October 9, 1989,
pp. 49-56.
Lazzari, Salvatore. Economic Analysis of the Section 29 Tax Credit for
Unconventional Fuels, Library of Congress, Congressional Research Service
Report 97-679 E. Washington, DC: July 7, 1997.
-. "Energy Taxation: Subsidies for Biomass," Encyclopedia of Energy
Technology and the Environment, John Wiley & Sons, 1995, pp. 1238-1245.
-. Energy Tax Policy: History and Current Issues. Library of Congress,
Congressional Research Service Report RL33578, Washington, D.C. July 28,
2006.
_. Energy Tax Policy: An Economic Analysis. Library of Congress,
Congressional Research Service Report RL 30406. Washington, DC: June
28, 2005.
Lemons, Bruce N. and Larry Nemirow. "Maximizing the Section 29 Credit
in Coal Seam Methane Transactions," The Journal of Taxation. April 1989,
pp. 238-245.
Matlock, Judith M. and Laurence E. Nemirow. "Section 29 Credits: The
Case Against Requiring an NGPA Well-Category Determination," Journal of
Taxation, v. 85. August 1996, pp. 102-107.
McIntire Robert, and T.D. Coo Nguyen. Corporate Income Taxes in the
1990s. Citizens for Tax Justice. October 2000.
McKinnon, John D. "Washington Alchemy Turns Coal Products Into Big
Tax Credits." The Wall Street Journal, v. 238, July 12, 2001.
Morgan, Dan. "Coal State Senators Question Tax Audits: IRS Reviews
Use of Synthetic Fuel Credits." The Washington Post, September 13, 2003. p.
A-3.
Schraufnagel, D. G. Hill and R. A. McBane. Coalbed Methane: A Decade
of Success. Paper Presented at the Conference of the Society of Petroleum
Engineers. 1994.
Wills, Irene Y, and Norman A. Sunderman. "Section 29 Tax Credit Still
Available," Oil and Gas Tax Quarterly, v. 40. December 1991.

Energy

TAX CREDITS FOR ALCOHOL AND BIODIESEL FUELS

Estimated Revenue Loss*

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

(1)

2007

0.1

2008

0.1

2009

(1)

2010

(1)

* The figures exclude the revenue loss from the equivalent excise tax
credit. The JCT estimates that the credits result in a reduction in excise tax
receipts, net of income tax effect, of $11.15 billion over the FY2006-2010
period.
(1)Less than $50 million.

Authorization

Section 38, 40, 40A, 87, 196, 6426.

Description

There are three income tax credits for alcohol-based motor fuels: the
alcohol mixtures credit, the pure alcohol fuel credit, and the small ethanol
producer credit. The existing alcohol mixture (or blender's) credit and the
pure alcohol fuel credit is 51� per gallon of ethanol (60� for methanol) of at
least 190 proof, and 37.78� for each gallon of alcohol between 150 and 190
proof (45� for methanol). No credit is available for alcohol that is less than
150 proof. The 51� credit was reduced from 52� on January 1, 2005. The
alcohol mixtures credit is available to the blender (who typically is either the
refiner, wholesale distributor or marketer); the pure (or "neat") alcohol credit
may only be claimed by the consumer or retail seller.

The alcohol fuels mixtures tax credit is typically claimed as an instant
excise tax credit that is equivalent to the excise tax exemption, and which
may be claimed in lieu of the income tax credits. For 90/10 mixtures (90%
gasoline, 10% ethanol) the excise tax credit is 5.1� per gallon of the blend -
the blend is taxed at 13.3� per gallon, 5.1� less than the full rate of 18.4� per
gallon on gasoline blends. The current 5.1� credit, which is equivalent to 51�
per gallon of ethanol, is generally claimed up front on sales of gasoline loaded
onto tanker trucks. Blenders prefer to claim the excise tax credit, rather than
the income tax credit, because its benefits accrue immediately upon the
purchase of the fuels for blending rather than when the tax return is filed.
Also, the excise tax credit is not treated as taxable income, whereas the
income tax credits have to be reported as taxable income, and are thus taxed.
Before January 1, 2005, the primary tax subsidy for alcohol fuel
blends was an excise tax exemption (at the rate of 5.2�/gallon of
blended fuels (mixtures of 10% ethanol, and 90% gasoline). This
exemption was taken against the excise taxes otherwise due on each
gallon of blended mixtures. This exemption, which was scheduled to
decline to 5.1� on January 1, 2005, reduced the gasoline excise tax
for "gasohol," from 18.4� to 13.2�/gallon. Because the primary benefits
from alcohol fuels were realized through an exemption rather than a tax
credit, revenue losses (or reduced excise taxes) accrued to the Highway Trust
Fund (HTF) rather than the general fund.

For fuel ethanol, current law also provides for a production tax credit in
the amount of 10� per gallon of ethanol produced and sold for use as a
transportation fuel. This credit, called the "small ethanol producer credit," is
limited to the first 15 million gallons of annual alcohol production for each
small producer, defined as one with an annual production capacity of under
60 million gallons. This is in addition to any blender's tax credit claimed on
the same fuel. The small ethanol producer's tax credit currently flows
through to the members of a farmers' cooperative, which means that the
current system of ethanol incentives effectively is of no benefit to such
cooperatives.

A 1990 IRS ruling allowed mixtures of gasoline and ETBE (Ethyl Tertiary
Butyl Ether) to qualify for the 52� blender's credit. ETBE is a compound that
results from a chemical reaction between ethanol (which must be produced
from renewables under this ruling) and isobutylene. ETBE is technically
feasible as a substitute for ethanol or MTBE (Methyl Tertiary Butyl Ether) as
a source of oxygen in gasoline regulated under the Clean Air Act (CAA). Up
until recently, MTBE was the preferred oxygenate, although ethanol was also
used in some regions of the United States, particularly in the Midwest. MTBE
has, however, been linked to groundwater contamination and has been banned
in many states. The Energy Policy Act of 2005 (P.L. 109-58) repealed the
oxygenate requirement for reformulated gasoline and imposed a renewable
fuel standard, which effectively stimulates the use of ethanol in place of
MTBE as a fuel additive.

The alcohol fuels income tax credits must be included as income, and are
taxable, under IRC 87. Also, the alcohol credits are components of the
general business credit and are subject to the limitations and the carry-back
and carry-forward rules of that credit. Under tax code section 196, any credit
amount that is unused because of these limitations may be claimed as a
deduction in the subsequent tax year.

For biodiesel fuel, the structure of the tax subsidies is similar to those for
fuel ethanol, although very little of these blends is actually produced. There
are essentially three new tax credits: a credit for biodiesel fuel mixtures
(blends of biodiesel and petroleum diesel), a credit for unblended (pure)
biodiesel either used or sold at retail by the taxpayer, and a small biodiesel
producer credit. The biodiesel mixtures credit and pure biodiesel credit is 50�
per gallon of biodiesel made from recycled oils and $1.00 per gallon of
biodiesel made from virgin oils - so called "agri"-biodiesel. The mixtures
tax credit may also be claimed as an instant excise tax credit against the 24.4�
per gallon tax on diesel blends. The mixtures credit is proportionate to the
fraction of biodiesel in the mixture- a blend of 80% diesel with 20% virgin
biodiesel would qualify for a 20�/gallon tax credit against the 24.4� tax.

Also, effective on August 9, 2005, an "eligible small agri-biodiesel
producer credit" of 10� is available for each gallon of "qualified
agri-biodiesel production." An eligible "small agri-biodiesel producer" is
defined as any person who, at all times during the taxable year, has annual
productive capacity for agri-biodiesel not in excess of 60,000,000 gallons.
The term "qualified agri-biodiesel production" would be defined as any
agri-biodiesel, not to exceed 15,000,000 gallons, that: (1) the producer sells
during the taxable year for use by the purchaser (a) in the production of a
qualified biodiesel mixture in the purchaser's trade or business, (b) as a fuel in
a trade or business, or (c) for sale at retail to another person who places the
agri-biodiesel in that person's fuel tank; or (2) the producer uses or sells for
any of such purposes. Aggregation rules are provided for determining the
15,000,000 and 60,000,000 gallon limits, for applying the limits to
passthrough entities, and for allocating productive capacity among multiple
persons with interests in one facility, and authorize anti-abuse regulations.
The section also permits IRC 1381(a) cooperative organizations to elect to
apportion the eligible small agri-biodiesel producer credit among their
patrons, and would set forth the election procedure. The eligible small
agri-biodiesel producer credit is effective for taxable years ending after
August 8, 2005 and sunsets after December 31, 2008.

Thus, as of January 1, 2005, the reduced rates of excise taxes (i.e., the
exemptions) for alcohol-blended fuels that were the principal tax incentives
are repealed. Blenders instead will pay the full rate of tax on gasoline and
diesel purchases (18.4� and 24.4�, respectively) - and claim the respective
tax credits on each gallon of ethanol and biodiesel intended to be blended
with gasoline and petroleum diesel, respectively. Taxpayers are to file a claim
for a refund of these tax credits, which must be paid by the IRS within 45
days, after which interest begins to accrue. Both the restructured fuel ethanol
tax credits and the new biodiesel tax credits are part of the general business
credit and subject to its limits. The provisions restructuring the tax incentives
for fuel ethanol and introducing the biodiesel tax credits are effective for fuel
produced, sold, or used after December 31, 2004, and before January 1, 2011,
for both biodiesel and fuel ethanol. This means that the biodiesel tax credits
and the fuel ethanol blender's tax credits expire on these dates, respectively.

In all cases, the alcohol fuels tax credits apply to biomass ethanol (alcohol
from renewable resources such as vegetative matter), and to methanol derived
from biomass, including wood. Alcohol derived from petroleum, natural gas,
or coal (including peat) does not qualify for either the current (or the
restructured) tax credits or the current exemption. Most economically feasible
methanol is derived primarily from natural gas; methanol from renewable
resources is generally too costly to produce economically. The effect of this
is to exclude most of actual methanol production from the tax incentives.
However, methanol derived from methane gas produced from landfills is not
alcohol produced from natural gas, and is included for credit purposes. About
90% of current biomass ethanol production is derived from corn. Most
biodiesel is made from either recycled or virgin vegetable oil, but biodiesel
made from animal fats also qualifies for the biodiesel tax credits. Agri-
biodiesel is derived from virgin oils including esters derived from corn,
soybeans, sunflower seeds, and other agricultural products.

Impact

The fuel ethanol tax subsidies increase the demand for ethanol, which
further raises its price (on a before-tax basis) and increases the output of
ethanol. After taxes, however, the net price of ethanol to the blender is
comparable to the wholesale price of gasoline and to other blending
components. Thus, the effect of the subsidies is to create a market for ethanol
producers, such as Archer Daniels Midland, who supply the ethanol to the
blenders. It should be noted that although ethanol producers do not claim the
tax credits, the economic benefit of the subsidies accrues primarily to them.
Most of the alcohol fuel produced in the United States is ethanol; about 90%
of it is produced from corn, which is the cheapest feedstock..

Production of ethanol as a motor fuel, most of which is a gasoline blend,
has increased from about 40 million gallons in 1979 to 1.7 billion gallons in
2001, 2.8 billion gallons in 2003, and 3.9 billion gallons in 2005. Ethanol
production for 2006 is estimated to reach 5 billion gallons. This represents
about 3.0% of the gasoline consumption of about 140 billion gallons, but at
10% blends, ethanol is now used in a significant fraction of the total gasoline
market (currently about 30% of the gasoline sold in the United States contains
10% ethanol). The initial growth in ethanol production was mostly due to the
federal excise tax exemption, the excise tax exemptions at the state and local
level, tariffs on imported ethanol, and the high oil prices in the late 1970s and
early 1980s, rather than to the alcohol fuels tax credits, which have been little
used. More recently environmental policy - Clean Air Act requirements for
reformulated and oxygenated fuels, the widespread banning of MTBE, and
the establishment of a renewable fuels standard - have also increased
demand for fuel ethanol. In addition to the various tax and regulatory
subsidies for fuel ethanol, the Energy Policy Act of 2005 also established a
mandate (the "renewable fuels standard") for refiners to use ethanol in certain
proportions in place of other oxygenates such as MTBE. The standard for
2006 is 4.0 billion gallons of ethanol, increasing to 7.5 billion gallons in
2012.

The banning of MTBE by many states and the repeal of the Clean Air
Act's oxygenate requirement, and the renewable fuels standard are projected
to further stimulate the production of ethanol for use as an oxygen source for
reformulated gasoline, and thus to reduce the production and importation of
alternate oxygen sources. As this occurs, it will increase the share of the U.S.
corn crop allocated to ethanol production (13% in 2004). It is expected also
to increase federal revenue losses from the alcohol fuels credits, which
heretofore have been negligible due to blenders' use of the exemption over
the credit.

Under the modified tax incentives, the ethanol blender's tax credits against
the excise tax are roughly equivalent to the value of the excise tax exemption
on each gallon of ethanol, but the tax restrictions under the general business
credit, and the inclusion of the credit itself in income, will reduce the
economic value of the tax credits. For biodiesel, however, which had no tax
subsidies prior to the restructuring, the new tax credits are potentially of
significant economic benefit, even with the requirement that they be taxable
income.

Rationale

The alcohol fuels tax credits enacted in 1980 were intended to complement
the excise-tax exemptions for alcohol fuels enacted in 1978. These
exemptions provided the maximum tax benefit when the gasohol mixture was
90% gasoline and 10% alcohol. Subsequent tax law changes provided a
prorated exemption to blends of 7.7% and 5.7% alcohol, so that ethanol used
to meet the former CAA requirement for reformulated and the continuing
requirement for oxygenated gasoline receives the maximum tax benefit.
Under the restructured incentives and the mandate, these prorated exemptions
will no longer be used.

The Congress wanted the credits to provide incentives for the production
and use of alcohol fuels in mixtures that contained less than 10% alcohol. The
Congress also wanted to give tax-exempt users (such as farmers) an incentive
to use alcohol fuel mixtures instead of tax-exempt gasoline and diesel.
Ethanol-blended gasoline leads to greater reductions in carbon monoxide than
does MTBE-blended gasoline. Ethanol-blended gasoline, however, has
relatively higher evaporative emissions, as compared with reformulated
gasoline with MTBE, which cause increases in the ozone-forming potential of
volatile organic compounds, which leads to increased ozone (smog)
formation.

Both the credits and excise-tax exemptions were enacted to encourage the
substitution of alcohol fuels produced from renewables for petroleum-based
gasoline and diesel. The underlying policy objective is, as with many other
energy tax incentives, to reduce reliance on imported petroleum. In addition,
the Congress wanted to help support farm incomes by finding another market
for corn, sugar, and other agricultural products that are the basic raw materials
for alcohol production. About 1.6 billion bushels of corn were used in 2005 to
produce fuel ethanol, over 15% of the total corn crop. The increased demand
for corn will raise the price of all corn and may increase annual income from
corn farming by $5 billion or more. The rationale for the biodiesel tax credits
is to provide tax incentives to create an environmentally friendly substitute for
conventional diesel fuel, while also creating additional markets for farm
products.

The alcohol fuels mixture credit and the pure alcohol fuels credit were
enacted as part of the Crude Oil Windfall Profit Tax Act of 1980 (P.L. 96-
223), at the rate of 40� per gallon for alcohol that was 190 proof or more, and
30� per gallon for alcohol between 150 and 190 proof. The credits were
increased in 1982 and 1984. The Omnibus Reconciliation Act of 1990 (P.L.
101-508) reduced the credits to 54� and 40� and introduced the 10� per-
gallon small ethanol producer credit. The Transportation Equity Act for the
21st Century (P.L. 105-178) reduced the blender's tax credit from 54� to its
current rate of 52�, and to 51� beginning in 2005.

The American Jobs Creation Act of 2004 (P.L. 108-357) reformed the tax
incentives for fuel ethanol, by, in effect, treating the tax credits as if they were
payments of excise tax liability. The rationale for the restructuring was to
increase revenues for the Highway Trust Fund (HTF). Consumption of fuel
ethanol blends results in revenue losses to the HTF in the amount of the 5.2�
exemption times the quantity of fuel ethanol blends used. In addition, under
tax code sections enacted in 1990, 2.5� of the taxable portion of the tax (the
13.2� for 90/10 fuel ethanol blends) was retained in the general fund. Thus,
in total, the HTF lost, under previous law, 7.7�/gallon of fuel ethanol blends
(5.2� plus 2.5�). Under the restructured incentives, tax revenue losses accrue
to the general fund, rather than the HTF. The American Jobs Creation Act of
2004 also introduced the biodiesel fuel tax credits, and allowed, for the first
time, the small ethanol producer's tax credit to flow through to members of a
farmers' cooperative.

The Energy Policy Act of 2005 made several amendments to the tax
subsidies for ethanol and biodiesel fuels. First, it raised the maximum annual
alcohol production capacity for an eligible small ethanol producer from 30
million gallons to 60 million gallons. The provision also modified the election
by a cooperative to allocate the credit to its patrons by conditioning the
validity of the election on the cooperative's mailing a written notice of the
allocation to its patrons during the period beginning on the first day of the
taxable year covered by the election and ending with the fifteenth day of the
ninth month following the close of that taxable year. Second, the Energy
Policy Act of 2005 added the 10�/gallon "eligible small agri-biodiesel
producer credit" to the list of credits that comprise the biodiesel fuels credit.
The Energy Policy Act also permitted cooperative organizations to elect to
apportion the eligible small agri-biodiesel producer credit among their
patrons, and set forth the election procedure. Another provision extended the
existing income tax credit, excise tax credit, and payment incentives for
biodiesel (which were enacted in 2004 under the "Jobs Bill") through
December 31, 2010.

Assessment

The alcohol fuels tax credits were enacted as part of President Carter's
National Energy Program to increase the development and use of a domestic
renewable fuel as a substitute for imported petroleum motor fuels, which
account for the bulk of petroleum consumption and imports. The subsidies
lower the cost of producing and marketing ethanol fuels that would otherwise
not be competitive. They target one specific alternative fuel over many others
- such as methanol, liquefied petroleum gas, compressed natural gas, or
electricity - that could theoretically substitute for gasoline and diesel.
Alcohol fuel is a more costly fuel or fuel additive, as compared with
alternatives such as MTBE, especially when total resource costs, including
revenue losses, are factored in. Alcohol fuels also require substantial energy
to produce, thereby diminishing the net overall conservation effect.

These incentives originated as energy security measures - reducing
dependence on petroleum imports - but their effect in expanding farm
incomes (due to the increase in corn demand, and a higher corn price for all
corn output) has not been overlooked by policymakers. To the extent that the
credits induce a substitution of domestically produced ethanol for petroleum-
based motor fuels, they reduce petroleum imports and provide some
environmental gains, although not necessarily more than other alternative
fuels. So far, it is the excise tax exemptions, rather than the blender's credits,
that have provided these stimulative effects.

At 51� per gallon of alcohol, the ethanol subsidy is approximately $22 per
barrel of oil displaced (43% of the average domestic oil price of $51 in 2005);
at $1.00/gallon of virgin biodiesel, the biodiesel subsidy is $42/barrel of
displaced oil (82% of the 2005 crude price). Tax subsidies are generally an
inefficient way of dealing with energy security or environmental concerns,
and this is also the case with the alcohol and biodiesel fuels tax subsidies,
which do not directly address the external costs of petroleum motor fuels
production, use, and importation. Providing tax subsidies for one type of fuel
over others could further distort market decisions and engender an inefficient
allocation of resources, even if doing so produces some energy security and
environmental benefits.

With a renewable fuels standard the tax credits no longer become
incentives for demand and production, but increase profits for ethanol
producers and farmers, raise costs for refiners (as ethanol prices increase), and
increase fuel prices for consumers. This leads to not just substantial losses in
federal tax revenue, but additional economic distortions in fuels and
agricultural markets.

Selected Bibliography

Congressional Budget Office. Budget Options. Section 31: Curtail Income
Tax Preferences for Businesses and Other Entities. February 2001.
Consumer Reports. The Ethanol Myth. Consumers Union of U.S., Inc.
October 2006.
Downstream Alternatives, Inc. Infrastructure Requirements for an
Expanded Fuel Ethanol Industry. January 15, 2002.
Evans, Michael K. Economic Impact of the Demand for Ethanol.
Midwestern Governors' Conference. February 1997.
Fischer, Carolyn and Michael Toman. Environmentally and Economically
Damaging Subsidies: Concepts and Illustrations (Climate Issue Brief #14).
Resources for the Future, 2000.
Kane, Sally, John Reilly, Michael LeBlanc, and James Hrubovcak.
"Ethanol's Role: An Economic Assessment," Agribusiness, v. 5. September
1989, pp. 505-522.
Lareau, Thomas J. "The Economics of Alternative Fuel Use: Substituting
Methanol for Gasoline." Contemporary Policy Issues, v. 8. October 1990,
pp. 138-155.
Lazzari, Salvatore. Alcohol Fuels Tax Incentives. Library of Congress,
Congressional Research Service Report RL 32979. Washington, DC: July 6,
2005.
Lazzari, Salvatore. Energy Tax Policy: An Economic Analysis. Library of
Congress, Congressional Research Service Report RL 30406. Washington,
DC: June 28, 2005.
The Renewable Fuels Association. Industry Outlook: 2006. February
2006.
U.S. Congress. House. Committee on Ways and Means. Certain Tax and
Trade Alcohol Fuel Initiatives, Hearing, 101st Congress, 2nd session.
Washington, DC: U.S. Government Printing Office, February 1, 1990.

-. Joint Committee on Taxation. General Explanation of the Crude Oil
Windfall Profit Tax Act of 1980 (H.R. 3919, P.L. 96-233), 96th Congress,
2nd session. Washington, DC: U.S. Government Printing Office.
U.S. Department of Energy. Breaking the Biological Barriers to Cellulosic
Ethanol: A Joint Research Agenda. DOE/SC-0095. June 2006.
U.S. General Accounting Office. Effects of the Alcohol Fuels Tax
Incentives, GAO/GGD-97-41. March 6, 1997.
Womach, Jasper, and Brent Yacobucci. Fuel Ethanol: Background and
Public Policy Issues. Library of Congress, Congressional Research Service
Report RL30369, Washington, DC: October 19, 2006.
Yacobucci, Brent. Biofuels Incentives: A Summary of Federal Programs.
Library of Congress, Congressional Research Service Report RL33572,
Washington, DC: July 25, 2006.
Yacobucci, Brent. "Boutique Fuels" and Reformulated Gasolines:
Harmonization of Fuel Standards. Library of Congress, Congressional
Research Service Report RL31361, Washington, DC: May 10, 2006.

Energy

EXCLUSION OF INTEREST ON STATE AND LOCAL
GOVERNMENT QUALIFIED PRIVATE ACTIVITY BONDS
FOR ENERGY PRODUCTION FACILITIES

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.1

(1)

0.1

2007

0.1

(1)

0.1

2008

0.1

(1)

0.1

2009

0.1

(1)

0.1

2010

0.1

(1)

0.1

(1) Less than $50 million.

Authorization

Sections 103, 141, 142, and 146.

Description

Interest income on State and local bonds used to finance the construction
of certain energy facilities for a city and one contiguous county or two
contiguous counties, is tax exempt. These energy facility bonds are classified
as private-activity bonds, rather than as governmental bonds, because a
substantial portion of their benefits accrues to individuals or business rather
than to the general public. For more discussion of the distinction between
governmental bonds and private-activity bonds, see the entry under General
Purpose Public Assistance: Exclusion of Interest on Public Purpose State
and Local Debt.

These bonds may be issued to finance the construction of hydroelectric
generating facilities at dam sites constructed before March 18, 1979, or at
sites without dams that require no impoundment of water. Bonds may also be
issued to finance solid waste disposal facilities that produce electric energy.
These exempt facility bonds generally are subject to the State private-activity
bond annual volume cap. Bonds issued for government-owned solid waste
disposal facilities, a different category of private activity bond, are not,
however, subject to the volume cap.

Impact

Some of the benefits of the tax exemption also flow to bondholders. For a
discussion of the factors that determine the shares of benefits going to
bondholders and users of the energy facilities, and estimates of the
distribution of tax-exempt interest income by income class, see the "Impact"
discussion under General Purpose Public Assistance: Exclusion of Interest on
Public Purpose State and Local Debt.

Rationale

The Crude Oil Windfall Profits Tax Act of 1980 used tax credits to
encourage the private sector to invest in renewable energy sources. Because
State and local governments pay no Federal income tax, Congress in this Act
authorized governmental entities to use tax-exempt bonds to reduce the cost
of investing in hydroelectric generating facilities. The portion of the facility
eligible for tax-exempt financing ranged from 100 percent for 25-megawatt
facilities to zero percent for 125-megawatt facilities.

The definition of solid waste plants eligible for tax-exempt financing was
expanded by the 1980 Act because the Treasury regulations then existing
denied such financing to many of the most technologically efficient methods
of converting waste to energy. This expansion of eligibility included plants
that generated steam or produced alcohol. Tax exemption for steam
generation and alcohol production facilities bonds were eliminated by the
1986 Tax Act.

Assessment

Any decision about changing the status of these two eligible private
activities would likely consider the Nation's need for renewable energy
sources to replace fossil fuels, and the importance of solid waste disposal in
contributing to environmental goals.

Even if a case can be made for a Federal subsidy of energy production
facilities based on underinvestment at the State and local level, it is important
to recognize the potential costs. As one of many categories of tax-exempt
private-activity bonds, those issued for energy production facilities increase
the financing cost of bonds issued for other public capital. With a greater
supply of public bonds, the interest rate on the bonds necessarily increases to
lure investors. In addition, expanding the availability of tax-exempt bonds
increases the range of assets available to individuals and corporations to
shelter their income from taxation.

Selected Bibliography

Maguire, Steven. Private Activity Bonds: An Introduction. Library of
Congress, Congressional Research Service Report RL31457. June 9, 2006.
-. Tax-Exempt Bonds: A Description of State and Local Government
Debt. Library of Congress, Congressional Research Service Report
RL30638. March 10, 2006.
U.S. Congress, Joint Committee on Taxation, Present Law and
Background Related to State and Local Government Bonds, Joint Committee
Print JCX-14-06, March 16, 2006.
U.S. Congress, Joint Committee on Internal Revenue Taxation. General
Explanation of the Crude Oil Windfall Profits Tax Act of 1980. 96th
Congress, 2nd session, 1980.
U.S. Department of Treasury, Internal Revenue Service. Tax-Exempt
Private Activity Bonds, Publication 4078, June 2004.
Zimmerman, Dennis. Electricity Restructuring and Tax-Exempt Bonds:
Economic Analysis of Legislative Proposals, Library of Congress,
Congressional Research Service Report RL30411.
-. The Private Use of Tax-Exempt Bonds: Controlling Public Subsidy of
Private Activity. Washington, DC: The Urban Institute Press, 1991.

Energy

EXCLUSION OF ENERGY CONSERVATION SUBSIDIES
PROVIDED BY PUBLIC UTILITIES

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

(1)

2007

(1)

2008

(1)

2009

(1)

2010

(1)

(1)Less than $50 million.

Authorization

Section 136.

Description

Gross income does not include the value of any subsidy provided (directly
or indirectly) by a public utility to a customer for the purchase or installation
of any energy conservation measure. An energy conservation measure is any
installation or modification primarily designed to reduce consumption of
electricity or natural gas or to improve the management of energy demand
with respect to a dwelling unit. To the extent that an energy conservation
expenditure by a taxpayer qualifies for this exclusion, tax law denies any
other tax benefits on the same expenditure, and requires a reduction in the
adjusted basis of the property to which the energy conservation devices were
added.

Impact

The exclusion reduces the total cost of energy-efficiency devices provided
under programs by utilities to conserve energy, since, absent such provisions,
the value of the rebates or other incentives provided by the utility would be
included in the customer's gross income and subject to tax. Depending on the
marginal tax rate of the customer, the tax saving could be as much as one-
third the value of the subsidy. While beneficiaries will be primarily residential
customers, the exclusion applies to dwelling units and so could also be
claimed by businesses that own condominiums or apartments, for example.

Rationale

An exclusion for residential customers had originally been enacted as part
of the National Energy Conservation Policy Act of 1978 (P.L. 95-619). This
exclusion was amended by Title V of the Energy Security Act of 1980 (P.L.
96-294), but had expired in mid-1989. The current provision was adopted as
part of the Energy Policy Act of 1992 (P.L. 102-486), to encourage residential
and business customers of public utilities to participate in energy conservation
programs sponsored by the utility. The goal was to enhance the energy
efficiency of dwelling units and encourage energy conservation in residential
and commercial buildings. The Small Business Job Protection Act of 1996
(P.L. 104-188) repealed the partial exclusion with respect to business
property, effective on January 1, 1997, unless pursuant to a binding contract
in effect on September 13, 1995. In addition, the 1996 amendments dropped a
part of section 136 that allowed the exclusion to apply to industrial energy
conservation devices and technologies.

Assessment

Utilities sometimes use rebates and other incentives to induce their
customers to invest in more energy efficient heating and cooling equipment,
and other energy-saving devices. Such a program might be justified on the
grounds of conservation, if consumption of energy resulted in negative effects
on society, such as pollution. In general, however, it would be more efficient
to directly tax energy fuels than to subsidize a particular method of achieving
conservation. From an economic perspective, allowing special tax benefits
for certain types of investment or consumption results in a misallocation of
resources.

There may be a market failure in tenant-occupied homes, if the tenant pays
for electricity separately. In rental housing, the tenant and the landlord lack
strong financial incentives to invest in energy conservation equipment and
materials, even when the benefits clearly outweigh the costs, because the
benefits from such conservation may not entirely accrue to the party
undertaking the energy-saving expenditure and effort. Builders and buyers
may also lack sufficient information, a problem which is discussed below.

As a general rule, tenants are not going to improve the energy efficiency of
a residence that does not belong to them, even if the unit is metered. They
might if the rate of return (or payback) is sufficiently large, but most tenants
do not occupy rental housing long enough to reap the full benefits of the
energy conservation investments. Part of the problem is also that it is not
always easy to calculate the energy savings potential (hence rates of return)
from the various retrofitting investments. Landlords may not be able to
control the energy consumption habits of renters to sufficiently recover the
full cost of the energy conservation expenditures, regardless of whether the
units are individually metered. If the units are individually metered, then the
landlord would not undertake such investments since all the benefits
therefrom would accrue to the renters, unless a landlord could charge higher
rents on apartments with lower utility costs. If the units are not individually
metered, but under centralized control, the benefits of conservation measures
may accrue largely to the landlord, but even here the tenants may have
sufficient control over energy use to subvert the accrual of any gains to the
landlord. In such cases, from the landlord's perspective, it may be easier and
cheaper to forgo the conservation investments and simply pass on energy
costs as part of the rents. Individual metering can be quite costly, and while
it may reduce some of the distortions, it is not likely to completely eliminate
them, because even if the landlord can charge higher rents, he may not be able
to recover the costs of energy conservation efforts or investments.

These market failures may lead to underinvestment in conservation
measures in rental housing and provide the economic rationale for Internal
Revenue Code (IRC) 136. Without such explicit exclusion, such subsidies
would be treated as gross income and subject to tax. This exclusion,
however, applies both to owner-occupied and to rental housing.

Selected Bibliography

Bird, Bruce, Steven M. Platau, and Warren A. Beatty. "Excluding Utility
Rebates from Gross Income." The CPA Journal, v. 63, March 1993.
Brown, Marilyn "Market Failures and Barriers as a Basis for Clean
Energy Policies," Energy Policy, v. 29. November 2001, pp. 1197-1207.
Fisher, Anthony C., and Michael H. Rothkopf. "Market Failure and
Energy Policy: A Rationale for Selective Conservation," Energy Policy, v. 17.
August 1989, pp. 397-406.
Hahn, Robert W. "Energy Conservation: An Economic Perspective."
American Enterprise Institute, October 2005.
Hassett, Kevin A., and Gilbert E. Metcalf. "Energy Conservation
Investment: Do Consumers Discount the Future Correctly?" Energy Policy,
v. 21. June 1993, pp. 710-716.

Howarth, Richard B. and Bo Anderson. "Market Barriers to Energy
Efficiency." Energy Economics, October, 1993. pp. 262-292.
Lazzari, Salvatore. Energy Tax Policy: History and Current Issues.
Library of Congress, Congressional Research Service Report RL33578.
Washington, DC: July 28, 2006.
_. Energy Tax Policy: An Economic Analysis. Library of Congress,
Congressional Research Service Report RL 30406. Washington, DC: June
28, 2005.
_. Energy Tax Provisions in the Energy Policy Act of 1992. Library of
Congress, Congressional Research Service Report 94-525. Washington, DC:
June 22, 1994.
Loskamp, Wendy. Energy, Water Efficiencies and Savings Come From
Meter Data Management. Energy Pulse. Insight Analysis and Commentary
on the Global Power Industry. http\www.energypulse.net.
Pauley, Patricia, et al. "The Energy Policy Act of 1992: Provisions
Affecting Individuals." Taxes, February, 1993, pp. 91-96.
Metcalf, Gilbert E. "Economics and Rational Conservation Policy."
Energy Policy, v. 22. October 1994, pp. 819-825.
Sutherland, Ronald J. "Energy Efficiency or the Efficient Use of Energy
Resources." Energy Sources, v. 16, pp. 257-268.
Sutherland, Ronald J. "The Economics of Energy Conservation Policy."
Energy Policy, v. 24. April 1996, pp. 361-370.
U.S. Congress, House. Report to Accompany H.R. 776, the Comprehensive
Energy Policy Act. Washington, DC: U.S. Government Printing Office,
Report 102-474, Part 6, pp. 35-37.
-. House. Committee on Energy and Commerce. National Energy Policy:
Conservation and Energy Efficiency. Hearings Before the Subcommittee on
Energy and Air Quality. Washington, DC: U.S. Government Printing Office,
June 22, 2001.
U.S. Department of Energy. Lawrence Berkeley National Laboratory.
"Energy Efficiency, Market Failures, and Government Policy." Levine, Mark
D. et al. March 1994.

Energy

TAX CREDIT FOR INVESTMENTS
IN SOLAR, GEOTHERMAL, FUEL CELLS, AND
MICROTURBINES

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

(1)

2007

(1)

0.1

2008

(1)

2009

(1)

2010

(1)

(1) Less than $50 million.

Authorization

Sections 46 and 48.

Description

Sections 46 and 48 provide a non-refundable income-tax credit for
business investment in solar and geothermal energy equipment, fuel cells, and
microturbines. The energy credit percentage is 30% for solar and fuel cell
equipment, and 10% for geothermal and microturbine energy equipment. The
30% business energy credit for the purchase of qualified fuel cells applies to
the costs of the power plants subject to a limit of $1,000 for each kilowatt of
capacity. The power plant must have an electricity-only generation efficiency
of greater than 30% and generation capacity of at least 0.5 kilowatt of
electricity. For microturbines, the system must have an electricity-only
generation efficiency of not less that 26% at International Standard
Organization conditions and a capacity of less than 2,000 kilowatts. The
microturbine credit is 10% of the equipment costs (or basis) subject to a limit
of $200 for each kilowatt of capacity.

Solar equipment is defined as a system that generates electricity directly
(photovoltaic systems), or that heats, cools, or provides hot water in a
building. It also includes equipment that illuminates the inside of a structure
using fiber-optic distributed sunlight. Solar property used for heating a
swimming pool is not eligible for the solar credit. Geothermal equipment
includes systems used to produce, distribute, or use energy from a natural
underground deposit of hot water, heat, or steam (such as geysers). In the case
of geothermal equipment used to generate electricity, only equipment up to
the transmission stage qualifies for the credit. A qualified fuel cell power
plant is an integrated system comprised of a fuel cell stack assembly and
associated balance of plant components that converts a fuel (usually natural
gas) into electricity using electrochemical means, and which has an
electricity-only generation efficiency of greater than 30%. The 10% credit for
microturbines applies to the purchase of stationary microturbine power plants,
including secondary components located between the existing infrastructure
for fuel delivery and the existing infrastructure for power distribution.

The 30% credit for solar, and the credits for fuel cells and microturbines,
are effective for property placed in service periods after December 31, 2005,
and before January 1, 2009. On January 1, 2009, the credit for solar reverts
back to 10% - the credit rate for solar and geothermal before expansion
under the Energy Policy Act of 2005 (P.L. 109-58).

Investment in solar and wind energy equipment may also be recovered
over 5 years, which provides for more accelerated depreciation deductions,
and, therefore, lower effective tax rates, than under the more standard
depreciation guidelines. However, the taxpayer's property costs for purposes
of depreciation would be reduced by the amount of the investment tax credit
claimed. As of January 1, 2005, electricity generated by solar and geothermal
technologies has qualified for the section 45 production tax credit (as
described in a separate entry in the Energy section of this compendium).
However, if an investment tax credit is claimed under sections 46 and 48,
then rules against double-dipping prevent a section 45 production tax credit
from being claimed for power generated from the equipment that would
receive the investment tax credit.

The business tax credits for solar, geothermal, fuel cell, and microturbine
technologies are components of the general business credits and are thus
subject to the restrictions, limitations, and carryover provisions of those
credits.

Impact

The energy tax credits lower the cost of, and increase the rate of return to,
investing in solar and geothermal equipment, whose return is generally much
lower due to significantly higher capital costs, as compared to conventional
energy equipment. Even with a 10% credit, and the recent technological
innovations that have reduced costs, solar, geothermal, and other renewable
energy technologies require relatively high and stable real oil prices in order
to realize rates of return high enough to justify private investment. However,
the quality of, and access to, a geothermal deposit can, in specialized cases,
lower the production costs to below the costs of conventional energy.
Sustained high real crude oil prices - both in nominal and real terms such
prices have, recently, been the highest since the early 1980s - would render
these technologies more competitive.

Even during the early 1980s, when oil prices were higher than today in real
terms, and effective tax rates on these types of equipment were sometimes
negative (due to the combined effect of the energy tax credits, the regular
10% investment tax credit, and accelerated depreciation), business
investment in these technologies was negligible. It is not clear how much
these credits encourage additional investment as opposed to subsidizing
investment that would have been made anyway.

Renewable energy resources are, by definition, naturally replenished in a
relatively short period of time. They include biomass, hydro power,
geothermal energy, wind energy, and solar energy. In 2005, about 6% of all
energy consumed, and about 9% of total electricity production was from
renewable energy sources. About half of renewable energy is consumed by
the electric power sector to generate electricity, derived mostly from
hydroelectric (45%), wood (31%), geothermal (6%), and wind (2.5%).
According to the Energy Information Administration (EIA), solar power
accounts for 1% of total renewable energy consumption, used mostly in
personal residences. Due primarily to high capital costs and low (or even
negative) rates of return of solar systems, this still accounts for a negligible
fraction of total residential energy use. Most solar thermal collectors are used
for heating water and pools in residences. Geothermal energy consumption
increased slightly from 2004 to 2005 (about 3%). Electricity generated from
wind turbines has recently increased, mostly in response to a combination of
federal and state incentives, but also due to the recent high energy prices.
Wind power, which is virtually all electric, has been rising rapidly recently,
increasing from negligible amounts in 1988 to about 15 kWhrs in 2005.
However, EIA says wind still accounts for only 2.5% of renewable energy,
and for only 0.36% of total U.S. electricity generation. Electricity from wind
receives a production tax credit, but wind equipment does not qualify for an
investment tax credit. There is little energy generated from fuel cells or
microturbines, as these technologies are in their infancy. But these
technologies - particularly microturbines - are frequently mentioned
among the newly emerging high-efficiency advanced energy technologies.

Despite this, however, production and use of solar thermal collectors and
photovoltaic systems has increased significantly over the last 20 years. 2005
was a big year for photovoltaic (PV) cells and modules, returning to the
pattern of strong growth seen between 2000 and 2002. For 2005, EIA reports
that total shipments of PV cells and modules reached a record high of
226,916 peak kilowatts, a 25% increase from the 2004 level (181,116 peak
kilowatts), but 108% more than the 2003 level (109,357 peak kilowatts). The
total value of photovoltaic cell and module shipments grew around 40% to
$702 million in 2005. The average price for modules and cells (dollars per
peak watt) has declined significantly over the years. The impressive gains in
production and use of photovoltaic systems, some of which are exported, has
been driven primarily by declines in manufacturing costs, and the high price
of conventional energy, but government policies promoting renewable energy
have undoubtedly also played a significant role.

The demand for solar thermal collectors (measured in square feet) has also
increased in recent years, although demand is still below the levels of the late
1970s and early 1980s - both the number of manufacturers and their
shipments of collectors reached a peak in the early 1980s coincident with the
peak in oil prices. The 1986 drop in oil prices and the termination of the
original residential solar credit in 1985 led to a decline in solar collector
shipments for the next 10 years. Total shipments began to increase again in
1997 and in 2005 were more than double the amount in 1996. The residential
sector continued to be the prime market for solar thermal collectors, totaling
14.7 million square feet in 2005, or 92% of total shipments. The largest end
use for solar collectors shipped in 2004 was for heating swimming pools,
consuming 15 million square feet in 2005 (94% of total shipments). As a
result, the vast majority of solar thermal collector shipments were not eligible
for the tax credits. The most recent data available shows that geothermal heat
pump manufacturers shipped 43,806 geothermal heat pumps in 2004, a 20%
increase over the 2003 total of 36,439. The total rated capacity of heat pumps
shipped in 2004 was 144,301 tons of capacity (one ton of capacity = 12,000
Btu's per-hour), compared to 124,438 tons in 2003. The average unit size
shipped in 2004 was 3.29 tons, compared to an average unit size of 3.41 tons
in 2003.

Rationale

The business energy tax credits were established as part of the Energy Tax
Act of 1978 (P.L. 95-618), which was one of five public laws enacted as part
of President Carter's National Energy Plan. The rationale behind the credits
was primarily to reduce U.S. consumption of oil and natural gas by
encouraging the commercialization of renewable energy technologies, to
reduce dependence on imported oil and enhance national security. The larger
credit for solar and the fuel cell credit were extended through 2008 by H.R.
6111 enacted in December 2006.

Under the original 1978 law, which also provided for tax credits for solar
and geothermal equipment used in residences, several other types of
equipment qualified for tax credits: shale oil equipment, recycling equipment,
wind energy equipment, synthetic fuels equipment, and others. For some
types of equipment, the credits expired on December 31, 1982; others were
extended by the Crude Oil Windfall Profit Tax Act of 1980 (P.L. 96-223)
through 1985.

The 1980 Windfall Profit Tax Act extended the credit for solar and
geothermal equipment, raised their credit rates from 10% to 15%, repealed
the refundability of the credit for solar and wind energy equipment, and
extended the credit beyond 1985 for certain long-term projects. The Tax
Reform Act of 1986 (P.L. 99-514) retroactively extended the credits for solar,
geothermal, ocean thermal, and biomass equipment through 1988, at lower
rates.

The Miscellaneous Revenue Act of 1988 (P.L. 100-647) extended the
solar, geothermal, and biomass credits at their 1988 rates - ocean thermal
was not extended. The Omnibus Budget Reconciliation Act of 1989 (P.L.
101-239) extended the credits for solar and geothermal and reinstated the
credit for ocean thermal equipment, through December 31, 1991. The credit
for biomass equipment was not extended. The Tax Extension Act of 1991
(P.L. 102-227) extended the credits for solar and geothermal through June 30,
1992. The Energy Policy Act of 1992 (P.L. 102-486) made the credits for
solar and geothermal equipment permanent. The American Jobs Creation Act
of 2004 (P.L. 108-357) allowed solar, geothermal, and other types of
renewable energy technologies to qualify for the section 45 electricity
production tax credit.

Thus, the credits for solar and geothermal equipment are what remained of
the business energy tax credits enacted under the Energy Tax Act of 1978.
Prior to the Energy Policy Act of 2005, and with the reforestation credit and
the rehabilitation credit, they were the sole exceptions to the repeal of the
investment tax credits under the Tax Reform Act of 1986. The Energy Policy
Act of 2005 raised the credit rate for solar equipment from 10% to 30%, and
expanded it to fiber optic distributed sunlighting, fuel cells, and
microturbines.

Assessment

The business energy tax credits encourage investments in technologies that
rely on clean, abundant, and, in the case of solar energy, unlimited renewable
energy as substitutes for conventional fossil-fuel technologies that pollute the
environment and contribute to dependence on imported petroleum. A major
policy question is the cost - in terms of foregone federal tax revenue and
distortions to the allocation of resources - in relation to the relatively small
fossil fuels savings and environmental gains.

In the aggregate, the credits don't lose much federal tax revenue, but in
relation to the small amounts of fossil energy they save the revenue loss per
barrel of displaced energy response to the credits is low. They also subsidize
two specific technologies where others arguably might provide greater benefit
if they were subsidized instead. The environmental and security problems
associated with production and consumption of fossil fuels could also be
addressed with emissions taxes or emissions trading rights - such as those in
the Clean Air Act - in lieu of tax subsidies which are not only costly, but
distortionary.

The high capital costs for renewable and alternative energy technologies,
and market uncertainty, are not evidence of energy market failure, although
they do act as barriers to the development and commercialization of these
technologies. However, the incentive effects of the investment tax credits
might lead to technological innovations that may reduce the costs of the
subsidized technologies and (eventually) make them more competitive (or at
least, less uneconomical).

Selected Bibliography

Congressional Budget Office. Prospects for Distributed Electricity
Generation. A CBO Paper. Washington, DC: September 2003.
Fisher, Anthony C., and Michael H. Rothkopf. "Market Failure and Energy
Policy: A Rationale for Selective Conservation," Energy Policy, v. 17.
August 1989, pp. 397-406.
Hoerner, J. Andrew and Avery P. Gilbert. Assessing Tax Incentives for
Clean Energy Technologies: A Survey of Experts Approach. Center for a
Sustainable Economy. Washington, DC: April 2000.
Inyan,S., L. Sunganthi, and Anand A. Samuel. "Energy Models for
Commercial Energy Production and Substitution of Renewable Energy
Resources." Energy Policy, v.34. November 2006, pp. 26-40.
Kobos, Peter H., Jon D. Erickson, and Thomas E. Drennen.
"Technological Learning and Renewable Energy Costs: Implications for US
Renewable Energy Policy." Energy Policy, v. 34, September 2006, pp.16-45.
Lazzari, Salvatore. Energy Tax Policy: History and Current Issues.
Library of Congress, Congressional Research Service Report RL33578.
Washington, DC: July 28, 2006.
Lazzari, Salvatore. Energy Tax Policy: An Economic Analysis. Library of
Congress, Congressional Research Service Report RL 30406. Washington,
DC: June 28, 2005.

Sav, G. Thomas. "Tax Incentives for Innovative Energy Sources:
Extensions of E-K Complementarity," Public Finance Quarterly, v. 15.
October 1987, pp. 417-427.
Rich, Daniel, and J. David Roessner. "Tax Credits and U.S. Solar
Commercialization Policy," Energy Policy, v. 18. March 1990, pp. 186-198.
-. House Committee on Ways and Means. Tax Credits for Electricity
Production from Renewable Energy Resources. Hearing Before the
Subcommittee on Select Revenue Measures, 109th Congress, 1st session,
May 24, 2005.
-. Senate Committee on Energy and Natural Resources. Power Generation
Resource Incentives and Diversity. Hearings, 109rd Congress, 1st session.
Washington, DC: U.S. Government Printing Office, March 8, 2005.
Sissine, Fred. Renewable Energy Policy: Tax Credit, Budget, and
Regulatory Issues. Congressional Research Service Report RL33588.
Washington, DC: July 28, 2006
U.S. Department of Energy. Energy Information Administration. Survey
of Geothermal Heat Pump Shipments: 2004. Spring 2006.
U.S. Department of Energy. Energy Information Administration.
Renewable Energy Annual: 2004. June 2006.
U.S. Department of Energy. Energy Information Administration. Solar
Thermal and Photovoltaic Collector Manufacturing Activities: 2005. August
2006.
U.S. Department of Energy. Energy Information Administration.
Legislation Affecting the Renewable Energy Marketplace: 2006.

Energy

TAX CREDITS FOR ELECTRICITY PRODUCTION
FROM RENEWABLE RESOURCES

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.9

(1)

0.9

2007

0.9

(1)

3.8

2008

1.0

(1)

5.6

2009

1.6

0.1

6.1

2010

1.2

0.1

5.9

(1) Positive tax expenditure less than $50,000. H.R. 6111 adopted in
December 2006 extended deadlines, adding a revenue cost for fiscal years
2008, 2009, and 2010 of $0.1, $0.3, and $0.3 billion respectively.

Authorization

Section 45.

Description

Taxpayers are allowed a 1.9� credit for 2006 per kilowatt-hour of
electricity produced from qualified wind energy, "closed-loop" biomass,
geothermal, and solar. Taxpayers are also allowed a 1.0�/kWh. credit for
electricity produced from open-loop biomass (including poultry and other
livestock waste), small irrigation power, and municipal solid waste. In
addition, section 45 provides a tax credit of $5.68/ton in 2006 ($4.375/ton, in
1992 dollars), for production of refined coal - not for the electricity
produced from the coal. Municipal solid waste covers two types of power
facilities: trash combustion facilities that burn trash directly to generate
power, and landfill gas facilities that first produce methane, which is then
burned to generate electricity. The 1.9� and 1.0� tax credits are values for
2006, which equal the to 1992 base credits of 1.5� and 0.75� adjusted for
inflation. In the case of both types of municipal waste facilities, small
irrigation power, and open-loop biomass facilities, the credit was established
at half, in base 1992 dollars, the credit for the other types of renewables. The
electricity must be produced from a facility owned by a taxpayer and it must
be sold to an unrelated third party.

Closed-loop biomass involves the use of plant matter, where plants are
grown solely as fuel to produce electricity, and can be combined with either
coal or open-loop biomass in a co-fired system. Open-loop biomass refers to a
variety of waste materials and by-product sources, such as scrap wood or
agricultural livestock waste and crop wastes, or timber wastes such as mill
and harvesting residues, pre-commercial thinnings, slash, and brush. Poultry
waste is defined as poultry manure and litter, but it also includes wood
shavings, straw, rice hulls, and other bedding materials for the disposition of
manure. Small irrigation power is a hydro-power system without a dam or
water impoundment ranging in size between 150 kilowatts and 5 megawatts
of power. It uses ditches and canals to generate power. The definition of
municipal solid waste is taken from the Solid Waste Disposal Act. This
basically includes most types of organic waste or garbage in landfills and
municipal biosolids, sludge, and other residues removed by a municipal
wastewater treatment facility. Refined coal is defined as a liquid, gaseous, or
solid synthetic fuel produced from coal (and lignite) or high carbon fly ash,
including such fuel used as a feedstock. Qualifying coal must emit 20% less
sulfur dioxide, and either 20% less mercury or nitrous oxide, than comparable
coal sources.

Generally, the credits are available for ten years beginning on the date the
facility is first placed into service, which varies by type of qualifying property.
However, in the case of open-loop biomass, geothermal energy, solar energy,
small irrigation power, landfill gas facilities, and trash combustion facilities,
the credit is available for only 5 years from the placed-in-service date. The
property must be placed in service by December 31, 2008.

Both the 1.5� electricity credit and the $4.375 coal credit are phased out as
reference energy prices exceed certain thresholds. The 1.5� electricity credit
(adjusted for post-1992 inflation) is phased out as the reference price of
electricity - the average annual contract price of electricity from the
renewable source - rises over a 3� range, beginning with an inflation-
adjusted threshold of 8� per kilowatt hour (kWh). For example, if the
reference price of electricity were 9.5�, the 1.5� tax credit would be reduced
by � [( .095-.08)/3 = .5] to .75�/ kWh. Each of these amounts, except the 3�,
have been adjusted for inflation since 1992. For 2006, the reference price for
wind electricity was 2.89� per kWh; the reference price for such electricity
was 8� x 1.2981 (the inflation adjustment), which equals10.4�. Because the
reference price (2.89�) was less than 10.4�, there was no phase-out and the
full credit of 1.5� x 1.2981 = 1.95�/ kWh is available in 2006. For
comparison, the IRS said the credit for 2004 was 1.8�. For electricity
produced from all other renewables other than wind, the full credit is also
available, although the IRS has not yet calculated reference prices. IRS is
currently working on determining reference prices and phase-out calculations
for 2007.

The $4.375 refined coal credit is phased out as the market price of refined
coal exceeds certain threshold levels. The threshold levels are defined by
reference to the price of feedstock fuel used to produce the refined coal,
which has been annually adjusted for inflation beginning in 2002. Thus, if a
producer of refined coal uses Powder River Basin coal as a feedstock, the
threshold price is determined by reference to the price of that coal; if the
producer uses Appalachian coal, the threshold price is determined by
reference to prices of Appalachian coal. The $4.375 refined coal credit is also
adjusted for inflation since 1992. With an inflation-adjusted factor of 1.2981
for 2006, the credit is $5.68 per ton (it was $5.84/ton in 2005). Because the
reference price of $42.78/ton was less than the inflation-adjusted base price,
the full credit was available in 2006.

Cooperatives that are eligible for the 45 credit may elect to pass through
any portion of the credit to their patrons. To be eligible for this election, the
cooperative would have to be more than 50%-owned by agricultural
producers or entities owned by agricultural producers. The election would be
made on an annual basis, and it would be irrevocable once made.

A facility that qualifies for the section 45 credit may also claim other
government benefits, including the business energy credit or investment credit
and the tax benefits under the tax-exempt clean renewable energy bond
provisions. However, in all cases except for co-fired facilities, the section 45
credits are reduced by half - no such reduction is required of co-fired
facilities, which means that qualifying systems may "double dip." In all cases,
the credit is available to the owner of the facilities that produce the electricity
or refined coal. In two exceptions - in the case of open-loop biomass, and
co-firing facilities - the lessee operator may also claim the tax credit in lieu
of the facility's owner.

The section 45 tax credits are components of the general business credit,
and are subject to the rules governing the restrictions and carry-overs of that
section of the tax code. Additionally, the section 45 tax credits may be
claimed against the alternative minimum tax.

Impact

Both the renewable electricity credit and the new refined coal credit are
production incentives - the former reduce the marginal and average costs of
generating electricity from renewable energy resources, and latter costs for
producing refined coal. The renewable electricity credit was originally
intended to encourage the generation of electricity from wind and biomass by
making such electricity more competitive with electricity generated from coal
fired power plants and other sources. Until recently, very little electricity was
actually generated from wind and closed-loop (energy coop) biomass,
although substantial electricity is generated from wood, wastes, and other
open-loop biomass - bu this is still a relatively small fraction of total
electricity generation.

Renewable energy resources are, by definition, naturally replenished in a
relatively short period of time. They include biomass, hydro power,
geothermal energy, wind energy, and solar energy. In 2005, about 6% of all
energy consumed, and about 9% of total electricity production was from
renewable energy sources. About half of renewable energy is consumed by
the electric power sector to generate electricity, derived mostly from
hydroelectric (45%), wood (31%), geothermal (6%), and wind (2.5%).
According to the Energy Information Administration (EIA), solar power
accounts for 1% of total renewable energy consumption, used mostly in
personal residences. Due primarily to high capital costs and low (or even
negative) rates of return of solar systems, this still accounts for a negligible
fraction of total residential energy use. Most solar thermal collectors are used
for heating water and pools in residences. Geothermal energy consumption
increased slightly from 2004 to 2005 (about 3%). Electricity generated from
wind turbines has recently increased, mostly in response to a combination of
federal and state incentives, but also due to the recent high energy prices.
Wind power, which is virtually all electric, has been rising rapidly recently,
increasing from negligible amounts in 1988 to about 15 kWhrs in 2005.
However, EIA says wind still accounts for only 2.5% of renewable energy,
and for only 0.36% of total U.S. electricity generation. Electricity from wind
receives a production tax credit, but wind equipment does not qualify for an
investment tax credit The extension and broadening of the renewable
electricity production tax credit will likely support further growth in
generation from wind turbines and may also stimulate biomass co-firing with
coal.

In general, energy from biomass has been declining in recent years
although some types of biomass - landfill gas, and energy from waste - are
used in greater quantities to generate power. Still most biomass electricity is
generated from open-loop sources such as forest/lumber waste, accounting for
70% of the total electricity generated from biomass. There is little, if any,
electricity generated from closed-loop biomass as it is uneconomic to grow
plants exclusively under a "closed-loop" system, but the expansion of the
45 tax credit to "open-loop" biomass, i.e., to various types of agricultural
waste and other biomass products, will likely further increase electricity from
this renewable resource. By allowing existing power plants to claim the
electricity credit for burning open-loop biomass, significant co-firing of
existing coal facilities is possible. Some coal facilities are able to rapidly
convert to co-firing with biomass, while others would take a couple of years
to make the required capital investment for conversion at a cost of about
$200/kilowatt hour, which is lower than most alternatives.

The credit phase-outs are designed to remove the subsidy when the price of
electricity (and refined coal) becomes sufficiently high that a subsidy is no
longer needed. The tonnage credit for refined coal is also a production tax
credit, which reduces the marginal and average costs of producing refined
coal as compared with conventional coal for electricity generation.

Rationale

This provision was adopted as part of the Energy Policy Act of 1992 (P.L.
102-486). Its purpose was to encourage the development and utilization of
electric generating technologies that use specified renewable energy
resources, as opposed to conventional fossil fuels. The Ticket to Work and
Work Incentive Improvement Act of 1999 (P.L. 106-170) extended the
placed-in-service deadline from July 1, 1999, to January 1, 2002. It also
added poultry waste as a qualifying energy resource. The Job Creation and
Worker Assistance Act of 2002 (P.L. 107-147) extended the placed-in-service
deadline to January 1, 2004. The Working Families Tax Relief Act of 2004
(P.L. 108-311) extended the placed-in-service dates for wind, closed-loop
biomass, and poultry waste facilities so that those placed into service after
December 31, 2003, would also qualify for the tax credit. The American Jobs
Creation Act of 2004 (P.L. 108-357) expanded the renewable electricity
credit to open-loop biomass, geothermal, solar, small irrigation power, and
municipal solid waste facilities, and created the production tax credit for
refined coal. (The refined coal tax credit was originally part of the proposed
expansion of the nonconventional fuels production tax credit under initial
comprehensive energy legislation. That provision was dropped from
comprehensive energy legislation and established as part of the American
Jobs Creation Act of 2004.)

The Energy Policy Act of 2005 (P.L. 109-58) extended the placed-in-
service deadline for all facilities except for solar energy facilities described in
45(d)(4) and refined coal production facilities described in 45(d)(8) by two
years to December 31, 2007. In addition, P.L. 109-58 extended the credit
period to 10 years for all qualifying facilities placed in service after the date
of enactment (August 8, 2005), eliminating the five-year credit period to
which some facilities had been subject. Also, the definition of qualified
energy resources that can receive the credit was expanded to include qualified
hydropower production, although a qualified hydroelectric facility would be
entitled to only 50% of the usual credit. P.L. 109-58 also added Indian coal
production facilities to the list of those facilities eligible for the credit. The
credit is available for sales of Indian coal to an unrelated party from a
qualified facility beginning January 1, 2006, and ending December 31, 2012.
The credit is $1.50 per ton during 2006-2009 and increases to $2.00 per ton
in 2110- 2012; the credit amount for Indian coal is to be adjusted for inflation
in calendar years after 2006. H.R. 6111 adopted in December 2005 extended
the placed-in-service date for facilities other than solar, qualified coal and
Indian coal to the end of 2008 for .

Assessment

Federal tax policy, and other federal energy policy, has been critical to the
development of renewable electricity, particularly wind power. In the late
1970's and 1980's the investment tax credits established under President
Carter's National Energy Act (NEA), along with California state tax credits,
helped establish the first installations of wind power generation capacity.
There was a slowdown in wind power investments in response to the sunset
of these investment incentives, and the decline in real oil prices, but a lagged
response after the enactment of the 45 production tax credit in 1992. The
evidence also suggests that termination of the 45 tax credit to wind power
due to the expiration of the placed-in-service date on January 1, 2004, created
policy uncertainty, and probably adversely affected (if only temporarily)
investment in the technology.

In addition to the 45 production tax credit, two other federal policies have
contributed to the development of electricity from wind: PURPA, the Public
Utility Regulatory Policies Act of 1978 (P.L. 95-617, Section 210) as
amended by the Energy Policy Act of 2005, and REPI, the renewable energy
production incentive. PURPA, which was also enacted as part of President
Carter's NEA, required electric utilities to buy electricity from "qualifying
facilities" at the utilities' avoided cost, the cost to the utility to generate or
otherwise purchase electricity from another source. PURPA has been one of
the most significant laws for the development of wind power, landfill gas, and
other renewable energy resources. The Energy Policy Act of 2005 repealed
the mandatory purchase requirement for new contracts if the Federal Energy
Regulatory Commission finds that a competitive electricity market exists and
a qualifying facility has access to independently administered, auction-based,
day-ahead, real-time wholesale markets and long-term wholesale markets.
This amendment may adversely affect renewable energy markets. The REPI,
introduced in 1992 as part of the Energy Policy Act of 1992, is a financial
incentive provided to tax exempt entities - tax exempt utilities
(cooperatives), and state and local governments - for electricity generated
from certain types of renewable energy resources. The incentive, which is
1.9�/kWh of electricity generated, is the grant or spending subsidy equivalent
of the 45 tax credit available for private taxable businesses.

The electricity production tax credit might be justified on the basis of
reducing pollution - generating power from non-polluting energy resources,
such as wind, which emit no pollutants. Generally, however, special tax (as
well as other types of government) subsidies in one market to address external
costs (pollution) created by other markets (the market for conventional fossil
fuels) are seen as being inefficient and costly. Also, providing tax credits and
deductions for certain types of investment or consumption, even if for
environmentally clean energy technologies, depending on other market
distortions and failures, may result in a misallocation of resources. An
alternative way to reduce pollution is by directly taxing either the emissions,
or the conventional energy resources that produce the emissions. Economic
theory holds that this would allow the markets to choose the optimal response.

The provision cannot be justified on the grounds of reducing dependence
on imported oil since virtually none of the renewable electricity substitutes for
petroleum - most of it would substitute for either coal or cleaner, but still
polluting, natural gas. Also, there are more effective and efficient alternatives
to address petroleum import dependence, such as stockpiling.

Selected Bibliography

Dallas Morning News. "U.S. Wind Energy Business Hindered by Federal
Energy Bill Delay." March 2, 2004.
DeCarolis, Joseph F. and David W. Keith. "The Economics of Large-Scale
Wind Power in a Carbon-Constrained World." Energy Policy, v. 34, March
2006, pp. 395-410.
Fisher, Anthony C., and Michael H. Rothkopf. "Market Failure and
Energy Policy: A Rationale for Selective Conservation," Energy Policy, v. 17.
August 1989, pp. 397-406.
Hill, Lawrence J. and Stanton W. Hadley. "Federal Tax Effects on the
Financial Attractiveness of Renewable vs. Conventional Power Plants,"
Energy Policy, v. 23. July 1995, pp. 593-597.
Hoerner, J. Andrew and Avery P. Gilbert. Assessing Tax Incentives for
Clean Energy Technologies: A Survey of Experts Approach. Center for a
Sustainable Economy. Washington, DC: April 2000.
Inyan,S., L. Sunganthi, and Anand A. Samuel. "Energy Models for
Commercial Energy Production and Substitution of Renewable Energy
Resources." Energy Policy, v.34. November 2006, pp. 26-40.
Klass, Donald L. "Biomass Energy in North American Policies," Energy
Policy, v. 23. December 1995, pp. 1035-1048.
Kobos, Peter H., Jon D. Erickson, and Thomas E. Drennen. "Technological
Learning and Renewable Energy Costs: Implications for US Renewable
Energy Policy." Energy Policy, v. 34, September 2006, pp.16-45.
Lazzari, Salvatore. Energy Tax Policy: An Economic Analysis. Library of
Congress, Congressional Research Service Report RL 30406. Washington,
DC: June 28, 2005.
- . Energy Tax Policy: History and Current Issues. Library of Congress,
Congressional Research Service Report RL33578. Washington, DC: July 28,
2006.

-. Energy Tax Subsidies: Biomass vs. Oil and Gas, Library of Congress,
Congressional Research Service Report 93-19 E, Washington, DC: January 5,
1993.
-. "Federal Tax Policy Toward Biomass Energy: History, Current Law, and
Outlook," Biologue. July/August 1989, pp. 8-11.
Grobman, Jeffrey H. and Janis M. Carey. "The Effect of Policy
Uncertainty on Wind-Power Investment." The Journal of Energy And
Development, v. 28, Autumn 2002. pp. 1-14.
Owen, Anthony D. "Environmental Externalities: Market Distortions and
the Economics of Renewable Energy Technologies." The Energy Journal, v.
25. Fall, 2004, pp. 127-156.
Petersilk, Thomas W. Modeling the Costs of U.S. Wind Supply. U.S.
Department of Energy. Energy Information Administration. EIA/DOE-
0607(99).
Price, Jeff. The Production Tax Credit: Getting More Credit Than It's
Due? Public Utilities Fortnightly, May 15, 2002. p. 38-41.
Sissine, Fred. Renewable Energy Policy: Tax Credit, Budget, and
Regulatory Issues. Congressional Research Service Report RL33588.
Washington, DC: July 28, 2006.
Schnepf, Randy. Agriculture-Based Renewable Energy Production.
Congressional Research Service Report RL32712. Washington, DC: August
4, 2006.
Spath, Pamela L., Margaret K. Mann, and Stefanie A. Woodward. "Life
Cycle Assessment of a Biomass-to-Electricity System," Biologue, v. 16, 1st Q,
1998, pp. 16-21.
U.S. Department of Energy. Lawrence Berkeley National Laboratory.
Analyzing the Interaction Between State Tax Incentives and the Federal
Production Tax Credit for Wind Power. [by Wiser, Ryan, et al.] September
2002. 11 p.
U.S. Department of Energy. Energy Information Administration. Summary
Impacts of Modeled Provisions of the 2003 Conference Energy Bill.
SR/OIAF/2004-02. February 2004.
U.S. Department of Energy. Energy Information Administration.
Renewable Energy Annual: 2004. June 2006.
U.S. Department of Energy. Energy Information Administration. Solar
Thermal and Photovoltaic Collector Manufacturing Activities: 2005. August
2006.
U.S. Department of Energy. Energy Information Administration.
Legislation Affecting the Renewable Energy Marketplace: 2006.

Energy

TAX CREDIT AND DEDUCTION FOR SMALL REFINERS
WITH CAPITAL COSTS ASSOCIATED WITH
EPA SULFUR REGULATION COMPLIANCE

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

(1)

2007

(1)

2008

(1)

2009

(1)

2010

(1)

(1) Less than $50 million.

Authorization

Sections 45H and 179B.

Description

Section 45H allows a small refiner to claim a tax credit for the production
of low-sulfur diesel fuel that is in compliance with Environmental Protection
Agency (EPA) sulfur regulations (the Highway Diesel Fuel Sulfur Control
Requirements). The credit is $2.10/barrel of low sulfur diesel fuel produced;
it is limited to 25% of the capital costs incurred by the refiner to produce the
low sulfur diesel fuel. The 25% limit is phased out proportionately as a
refiner's capacity increases from 155,000 to 205,000 barrels per day.

Section 179B allows a small refiner to also claim a current year tax
deduction, i.e., expensing, in lieu of depreciation, for up to 75% of the capital
costs incurred in producing low-sulfur diesel fuel that is in compliance with
EPA sulfur regulations. This incentive is also pro-rated for refining capacity
between 155,000 and 205,000 barrels per day. The taxpayer's basis in the
property that receives the exemption is reduced by the amount of the
production tax credit. In the case of a refinery organized as a cooperative,
both the credit and the expensing deduction may be passed through to
patrons.

For both incentives, a small business refiner is a taxpayer who 1) is in the
business of refining petroleum products, 2) employs not more than 1,500
employees directly in refining, and 3) has less than 205,000 barrels per day
(averaged over the year) of total refining capacity. The incentives took effect
retroactively beginning on January 1, 2003.

Impact

The low-sulfur diesel tax credit lowers the average and marginal cost of
producing low sulfur diesel fuel. Expensing allows capital costs to be
deducted fully in the year incurred rather than over the useful life of the asset
- the time period in which the asset generates returns. Under the current
depreciation system (the Modified Cost Recovery System) refinery assets
have a class life of 16 years and a recovery period - that they would
otherwise be depreciated over - of 10 years. Immediate deduction
(expensing) of capital costs has the effect of deferring tax liability. For any
given expenditure, total tax deductions are the same whether expensed or
capitalized but deductions that are taken immediately, rather than spread out
over time, are more valuable: The present value of the deductions is greater
than the present value of deductions that are capitalized over the production
horizon of the oil or gas well. Expensing rather than capitalizing refinery
costs allows taxes on income to be effectively eliminated - it is equivalent to
a marginal effective tax rate of zero on the returns to the expenditures.
Without expensing (i.e., assuming accelerated depreciation over 10 years), the
marginal effective tax rate on refineries is estimated at about 25%, still below
the marginal statutory rate of 35%. Expensing of refinery capital investments
lowers its cost, and increases the rate of return to, investing in refinery
equipment for refining low sulfur diesel fuel.

The combined effect of these two tax incentives is to increase the demand
for refinery capital, and the supply of low-sulfur diesel fuel. According to
industry figures, refiners currently produce about 2.4 million barrels per day
of low-sulfur diesel fuel, about 90% of total demand (the regulations required
that by October 15, 2006, 80% of diesel fuel had to meet the stringent
standards of 15 parts per million or less for sulfur content). However,
refinery capacity and production is highly concentrated, and most of this is
held by major integrated refiners that do not qualify for the tax incentives;
there are many domestic refineries below the qualification thresholds, but they
refine a small fraction of the total supply of low-sulfur diesel fuel.

Rationale

Both incentives were introduced as part of the energy tax provisions in
comprehensive energy legislation; they were enacted as part of the American
Jobs Creation Act of 2004 (P.L. 108-357). The incentives compensate small
refiners for the costs of complying with EPA's new tougher standards for
diesel fuel under the Highway Diesel Fuel Sulfur Control Requirements,
which begin to take effect in 2006. All refiners of diesel fuel, including
imported diesel, have to comply with the new standards. By reducing
production costs and capital costs of domestic refiners that meet the
standards, the two tax incentives reduce the probability that small refiners
would be forced out of business.

The Energy Policy Act of 2005 (P.L. 109-58) provides that cooperative
refineries that qualify for 179B expensing of capital costs incurred in
complying with EPA sulfur regulations could elect to allocate all or part of
the deduction to their owners, determined on the basis of their ownership
interests. The election would be made on an annual basis and would be
irrevocable once made. This provision was effective retroactively, as if it had
been included in 338(a) of the American Jobs Creation Act of 2004.

Assessment

Under an income tax system, there would be no production tax credits, and
the appropriate method of capital cost recovery would require the taxpayer to
spread out depreciation deductions for the cost of the asset based on its
economic depreciation, i.e., the rate at which the asset depreciates in value
over its useful life. Neither of the tax subsidies correct for market distortions
and are intended only to compensate through the tax system for regulatory
costs imposed by the EPA. They are thus distortionary. In theory, the
distortions resulting from pollution externalities - the damages (health and
environmental) resulting from the production and use of high-sulfur diesel
fuel - would be more efficiently corrected with a tax on the producer of
high-sulfur diesel fuel rather than a subsidy to producers of low-sulfur fuel.

Selected Bibliography

Cordes, Joseph J. "Expensing," in the Encyclopedia of Taxation and Tax
Policy, Joseph J. Cordes, Robert D. Ebel, and Jane G. Gravelle, eds
(Washington: Urban Institute Press, 2005).
Environmental Protection Agency. Summary and Analysis of the 2005
Highway and Non-Road Diesel Fuel Pre-Compliance Reports. EPA 420-R-
06-012. June 2006.

Federal Register. Control of Air Pollution From New Motor Vehicles:
Heavy Duty Engine and Vehicle Standards, and Highway Diesel Fuel Sulfur
Control Requirements; Final Rule. Thursday, January 18, 2001.
Guenther, Gary. Small Business Expensing Allowance: Current Status,
Legislative Proposals, and Economic Effects. CRS Report RL31852,
October 3, 2006.
Sterner, Thomas. Policy Instruments for Environmental and Natural
Resource Management. Resources for the Future, Washington, D.C. 2003.
U.S. Congress, Joint Committee on Taxation. Description and Technical
Explanation of the Conference Agreement of H.R. 6, Title XIII, "The Energy
Tax Incentives Act of 2005." July 27, 2005.
U.S. General Accounting Office. EPA Could Take Additional Steps to
Help Maximize the Benefits from the 2007 Diesel Emissions Standards.
Report to Congressional Requester, GAO-04-313, March 2004.
Yacobucci, Brent D., James E. McCarthy, John W. Fischer, Alejandro E.
Segarra, and Lawrence C. Kumins. Diesel Fuel and Engines: An Analysis of
EPAs New Regulations. CRS Report RL30737, May 1, 2001.

Energy

DEFERRAL OF GAIN FROM THE DISPOSITION OF
ELECTRIC TRANSMISSION PROPERTY TO IMPLEMENT
FEDERAL ENERGY REGULATORY COMMISSION
RESTRUCTURING POLICY

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.6

2007

0.5

2008

(4)

2009

-0.3

2010

-0.3

(4) Negative tax expenditure of less than $50 million.

Authorization

Section 451.

Description

Section 451 permits taxpayers to elect to recognize any capital gain from
the sale of qualifying electricity transmission property to an independent
transmission company (ITC), pursuant to a Federal Energy Regulatory
Commission (FERC) restructuring policy, evenly over eight years beginning
with the year of the sale. The sale proceeds must be reinvested in other
electricity assets within four years. This special tax incentive is available for
sales through December 31, 2007.

Impact

Generally a taxpayer selling property recognizes any profits for tax
purposes in the year of the sale. The recognition of gain over eight years,
rather than in the year of sale, is a deferral, rather than a complete
forgiveness, of tax liability - it is a delay in the recognition of income, hence
in the payment of tax. The economic benefit derives from the reduction in the
present value of the tax owed below what the tax would otherwise be if it
were required to be recognized in the year of sale. Transmission property is
also depreciated over 15 years, which means that depreciation deductions are
taken somewhat faster than economic depreciation. This lowers effective tax
rates on the return to such investments.

Rationale

The deferral of gain on the sale of transmission assets to an ITC is intended
to foster a more competitive industry by facilitating the unbundling of
transmission assets held by vertically integrated utilities. Under restructuring,
states and Congress have considered rules requiring the separate ownership of
generation and distribution and transmission assets. However, vertically
integrated electric utilities still own a large segment of the nation's
transmission infrastructure. The tax provision encourages the sale of
transmission assets by vertically integrated electric utilities - the unbundling
of electricity assets - to independent system operators or regional
transmission organizations, who would own and operate the transmission
lines. The provision is intended to improve transmission management and
service, and facilitate the formation of competitive electricity markets.
Without this incentive, any gain from the forced sale of transmission assets,
pursuant to a FERC (or other regulatory body) restructuring policy would be
taxed as ordinary income (i.e., at the highest rates) all in the year of sale.

This provision is intended to promote restructuring of the electric utility
industry away from the traditional monopoly structure and toward increased
competition. The incentive was introduced as part of the energy tax
provisions in comprehensive energy legislation; it was enacted as part of the
American Jobs Creation Act of 2004 (P.L. 108-357). The Energy Policy Act
of 2005 (P.L. 109-58) extended deferral treatment from December 31, 2006,
to December 31, 2007.

Assessment

The restructuring of the electric power industry has, and may continue to
result in significant reorganization of power assets. In particular, it may result
in a significant disposition of transmission assets and possibly, depending on
the nature of the transaction, trigger an income tax liability and interfere with
industry restructuring. Under an income tax system, the sale for cash of
business assets subject to depreciation deductions triggers a tax on taxable
income in the year of sale to the extent of any gain. Corporations pay capital
gains on sales of capital assets, such as shares of other corporations. But gains
on the sale of depreciable assets involve other rules. For example, sales of
personal property, such as machinery, are taxed partly as capital gains and
partly as ordinary income. The overall taxable amount is the difference
between the sales price and basis, which is generally the original cost minus
accumulated depreciation. That amount is taxed as ordinary income to the
extent of previous depreciation allowances (depreciation is "recaptured").

Selected Bibliography

Abel, Amy. Electric Reliability: Options for Electric Transmission
Infrastructure Improvements. Library of Congress. Congressional Research
Service Report RL32075. Washington, DC: September 20, 2006.
Abel, Amy. Energy Policy Act of 2005, P.L. 109-58: Electricity
Provisions. Congressional Research Service Report RL33248. Washington,
DC: January 24, 2006.
Boyce, John R. and Aidan Hollis. "Governance of Electricity Transmission
Systems." Energy Economics, v. 27, March 2005.
Desay, Mihir and William Gentry. "The Character and Determinants of
Corporate Capital Gains," The National Bureau of Economic Research,
NBER Working Paper #w10153, December 2003.
Joskow, Paul L. "Competitive Electricity Markets and Investment in New
Generating Capacity," MIT Research Paper. April, 28, 2006.
Joskow, Paul L. Transmission Policy in the United States. AEI-Brookings
Joint Center for Regulatory Studies. October 2004.
Joskow, Paul L. "Restructuring, Competition, and Regulatory Reform in
the U.S. Electricity Sector," Journal of Economic Perspectives. Summer
1997. pp. 119-138.
U.S. Congress, Joint Committee on Taxation. Federal Tax Issues Relating
to Restructuring of the Electric Power Industry. Hearing before the
Subcommittee on Long-Term Growth and Debt Reduction of the Senate
Finance Committee, October 15, 1999. JCX 72-99.
Vogelsang, Ingo. "Electricity Transmission Pricing and Performance-based
Regulation." Energy Journal, v.27, 2006, pp. 97-127.

Energy

TAX CREDIT FOR HOLDERS OF
CLEAN RENEWABLE ENERGY BONDS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

(1)

2007

(1)

2008

(1)

2009

(1)

2010

(1)

(1) Less than $50 million.

Authorization

Section 54.

Description

Clean renewable energy bonds (CREBs) are available for the finance of
qualified energy production projects which include: (1) wind facilities, (2)
closed-loop bio-mass facilities, (3) open-loop bio-mass facilities, (4)
geothermal or solar energy facilities, (5) small irrigation power facilities, (6)
landfill gas facilities, (7) trash combustion facilities, and (8) refined coal
production facilities. Holders of CREBs can claim a credit equal to the dollar
value of the bonds held multiplied by a credit rate determined by the
Secretary of the Treasury. The credit rate is equal to the percentage that will
permit the bonds to be issued without discount and without interest cost to the
issuer. The national limit on the bonds was $1.2 billion, of which a
maximum of $750 million could be granted to governmental bodies (the
remainder would go to utilities). The bonds must be issued before January 1,
2009. The credit rate is equal to the rate that will permit the bonds to be
issued without discount and without interest cost to the issuer. The maximum
maturity of the bonds is that which will set the present value of the obligation
to repay the principal equal to 50 percent of the face amount of the bond
issue. The discount rate for the calculation is the average annual interest rate
on tax-exempt bonds issued in the preceding month, having a term of at least
10 years. CREBs are subject to arbitrage rules that require the issuer to spend
95 percent of the proceeds within five years of issuance.

Impact

The interest income on bonds issued by State and local governments
usually is excluded from Federal income tax (see the entry "Exclusion of
Interest on Public Purpose State and Local Debt"). Such bonds result in the
Federal government paying a portion (approximately 25 percent) of the
issuer's interest costs. CREBs are structured to have the entire interest cost of
the State or local government paid by the Federal Government in the form of
a tax credit to the bond holders. CREBs are not tax-exempt bonds. The cost
has been capped at the value of Federal tax credits generated by the $800
million volume cap.

Rationale

Proponents of CREBs argue that the Federal subsidy is necessary because
private investors are unwilling to accept the risk and relatively low return
associated with renewable energy projects. Proponents argue that the market
has failed to produce investment in renewable energy because the benefits of
these projects extend well beyond the service jurisdiction to the surrounding
community and to the environment more generally. The rate payers of the
utility are not compensated for these external benefits, and it is unlikely,
proponents argue, that private investors would agree to provide them without
some type of inducement. The program was introduced in 2005 (P.L. 109-
58); H.R. 6111, adopted in December of 2006, increased the amount to be
issued by $400 billion and extended issuance authority through 2008.

Assessment

The legislation (P.L. 109-58) that created these bonds was enacted on
August 8, 2005, and the potential success of the program is still uncertain.
One way to think of this alternative subsidy is that investors can be induced to
purchase these bonds if they receive the same after-tax return from the credit
that they would from the purchase of tax-exempt bonds. The value of the
credit is included in taxable income, but is used to reduce regular or
alternative minimum tax liability. Assuming the taxpayer is subject to the
regular corporate income tax, the credit rate should equal the ratio of the
purchaser's forgone market interest rate on tax-exempt bonds divided by one
minus the corporate tax rate. For example, if the tax-exempt interest rate is 6
percent and the corporate tax rate is 35 percent, the credit rate would have to
be equal to .06/(1-.35), or about 9.2 percent to induce investment. Thus, an
investor purchasing a $1 million CREB would need to receive a $92,000
annual tax credit each year.

With CREBs, the Federal Government pays 100 percent of interest costs.
One alternative, government issued tax-exempt bonds, have only a portion of
interest costs subsidized by the Federal Government. For example, if the
taxable bond rate is 9.2 percent and the tax-exempt rate is 6 percent, the
issuer of the tax-exempt bond receives a subsidy equal to 3.2 percentage
points of the total interest cost, the difference between 9.2 percent and 6
percent. The CREB receives a subsidy equal to all 9.2 percentage points of
the interest cost. Thus, CREBs reduce the price of investing in renewable
energy projects compared to investing in other public services provided by
governments. In addition, with CREBS, the entire subsidy (the cost to the
Federal taxpayer) is received by the issuing government (or utility) through
reduced interest costs. In contrast, with tax-exempt bonds, part of the Federal
revenue loss is a windfall gain for some wealthy investors. The Federal
revenue loss, and thus benefit, is not fully captured by the issuing
government.

Selected Bibliography

Congressional Budget Office, Tax Credit Bonds and the Federal Cost
Financing Public Expenditures, July 2004.
Davie, Bruce, "Tax Credit Bonds for Education: New Financial
Instruments and New Prospects," Proceedings of the 91st Annual Conference
on Taxation, National Tax Association.
Joint Committee on Taxation, General Explanation of Tax Legislation
Enacted in 1997, Joint Committee Print JCS-23-97, December 17, 1997, 40-
41.
Joint Committee on Taxation, Present Law and Background Related to
State and Local Government Bonds, Joint Committee Print JCX-14-06,
March 16, 2006.
Maguire, Steven. Tax Credit Bonds: A Brief Explanation. Library of
Congress, Congressional Research Service Report RS20606. August 21,
2006.
-. Tax-Exempt Bonds: A Description of State and Local Government Debt.
Library of Congress, Congressional Research Service Report RL30638.
March 10, 2006.

Energy

TAX CREDITS FOR INVESTMENTS IN CLEAN
COAL POWER GENERATION FACILITIES

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

(1)

2007

0.1

2008

0.1

2009

0.2

2010

0.2

(1) Less than $50 million.

Authorization

Sections 48A and 48B.

Description

An investment tax credit is provided for selected types of clean coal
technologies: (1) integrated gasification combined cycle technologies (IGCC)
and other advanced clean coal systems, and (2) qualifying gasification
systems. The credit for IGCC systems is 20 percent of the investment subject
to a total limit of $800 million on the aggregate credits claimed. The credit for
other advanced clean coal systems is 15 percent of the investments subject to
a total credit limit of $300 million. The credit for qualifying gasification
systems is also 20percent of the investment cost, but the aggregate lifetime
limit is $350 million. Each of the credits would be allocated by the Secretary
based on the amount invested. These credits are effective for investments
made after August 8, 2005.

Impact

Clean coal technologies are technologically feasible strategies for
generating electric power from coal efficiently and cleanly. Clean-coal
technologies include the pressurized fluidized-bed combustion-combined
cycle, IGCC, the indirect-fired cycle repowering, the coal diesel-combined
cycle, and slagging technology. Such technologies are significantly more
energy efficient than the conventional coal-fired power plants currently in use,
which have an operating efficiency of about 34 percent (meaning that 66
percent of the energy used is lost in the generation process). Currently, some
of the clean-coal technologies can achieve 45 percent efficiency. Some
clean-coal technologies also reduce emissions of one or more of 4 air
pollutants (NOx SO2,PM, Hg) with CO2, to a greater degree than conventional
coal plants. This technology development is occurring as the Environmental
Protection Agency (EPA) has regulations to further reduce emissions of NOx
and SO2, and to begin reducing Hg emissions. Subbituminous coal can be
used if 99% of the SO2 emissions are removed or an emission limit of 0.04
pounds of SO2 per million Btus over 30 days.

Clean coal systems are, however, very capital intensive and require
relatively large investments in construction and development costs -
basically fixed capital costs. Per kilowatt of capacity, such technologies
currently cost between $2,000 and $3,000. Because of high capital costs, rates
of return are very low or even negative, even with existing accelerated
depreciation provisions. Thus, although clean coal technologies have been
successfully demonstrated, none are commercially viable at the present time,
and none would be commercially viable without additional tax incentives.
The investment tax credits may reduce the after-tax cost of the qualifying
technologies and increase the rates of return sufficiently to overcome the high
fixed capital cost and higher operating costs. This lowers effective tax rates
on the return to such investments. Combined with existing accelerated
depreciation benefits, the investment tax credit would improve the financial
attractiveness of clean coal technologies relative to these alternatives. In
addition, with global warming becoming an important concern, clean coal
technologies, combined with carbon capture and storage (CCS) technology
may be an important option in reducing greenhouse gases. In particular,
IGCC, the one technology targeted by the investment tax credits, may become
(combined with CCS) a cost-effective option for limiting CO2 in the future.

Also, the additional commercialization that may result from the generous
investment tax credits may engender further technological improvements that
could lower the cost of clean coal technologies sufficiently to overcome the
hurdle rate of return (basically the cost of capital) and make them competitive
with advanced combined-cycle natural gas units, the most competitive, and
relatively clean, current generating technology. According to the Coal
Utilization Research Council, by the year 2020 clean coal technologies could
achieve an efficiency of 49 percent and cost an average of $800/KW,
suggesting at least a potential downward trend in cost. If cost declines occur
- or if the capital costs of the next best alternative technology (probably the
advanced natural gas combined cycle units) were to increase in the long term
(or both) - some clean coal technologies might become more competitive
without tax credits.

Clean coal technologies might also become more competitive if, for
example, the price of natural gas were to increase either as a result of the
additional use of advanced natural gas technologies or due to some unrelated
market factor. However, electric utilities would have to make investment
decisions based on current technologies and reasonable assessment of relative
fuel prices in the near future. Without the investment tax credits, these
considerations would seem to favor advanced natural gas combined-cycle
units, and possibly some types of renewables such as wind power.

Uncertainty in commercial viability is another key factor inhibiting
investment in these technologies. Costs are not likely to decline if risk
remains high. Even if capital costs would fall, there is the additional problem
of the risk of clean-coal technologies.

Rationale

The investment tax credits for clean coal technologies were established by
the Energy Policy Act of 2005 (P.L. 109-58). Congress has, since 1986,
authorized billions of dollars to the Department of Energy (DOE) to
demonstrate emerging clean coal technologies, particularly those that can
substantially reduce SO2 and NOx to further control acid rain. The Energy
Policy Act of 2005 also created a new loan guarantee program for clean coal
technologies, and other clean energy technologies. They were intended to
promote a technologically feasible electric generating technology that is
efficient, is environmentally less harmful than conventional coal fired
generators, and relies on an abundant domestic energy resource. The
provision relating to subbituminous coal was added by H.R. 6111 in
December 2006.

Assessment

The 20 percent investment tax credit reduces the levelized costs of the
IGCC clean coal technology from $4.80/kWh to $4.15/kWh (in 2004 dollars).
This is somewhat lower than the levelized costs of many other types of
generating technologies, including conventional coal-fired units ($4.32/kWh).
Despite some successful demonstrations, clean coal technologies are still
generally economically unproven technologies in the sense that none have
become commercial without significant subsidies. As a result, utilities may
not have the confidence in them as compared to conventional systems or
advanced natural gas combined cycle systems, which have a proven track
record. Even if capital costs were lower, the unpredictability of the clean coal
systems increases risks and possibly operating and maintenance costs to the
utility, which may inhibit investment. Thus, even after they become
competitively priced, it may take time - some estimate 5-10 years or more -
to penetrate the market. Finally, even if the tax credits were to be effective in
stimulating investment in clean coal technologies, such subsidies are an
economically inefficient way of addressing either energy or environmental
externalities.

Selected Bibliography

Brown, Marilyn, Benjamin K. Sovacool, and Richard F. Hirsh. "Assessing
U.S. Energy Policy." Daedalus v. 135. Summer 2006. Boston: pp. 5- 12.
Fri, Robert W. "From Energy Wish Lists to Technological Realities."
Issues in Science and Technology, v. 23, Fall 2006; Washington: pp. 63-69.
Metcalf, Gilbert E. Federal Tax Policy Towards Energy. Paper prepared
for the NBER conference on Tax Policy and the Economy. September 14,
2006.
Lackner Klaus F. "The Conundrum of Sustainable Energy: Clean Coal as
One Possible Answer." Asian Economic Papers v. 4. Fall 2005.
Lazzari, Salvatore. Energy Tax Policy: History and Current Issues.
Library of Congress, Congressional Research Service Report RL33578.
Washington, DC: July 28, 2006.
_. Energy Tax Policy: An Economic Analysis. Library of Congress,
Congressional Research Service Report RL30406. Washington, DC: June 28,
2005.
U.S. Congress, Joint Committee on Taxation. Description and Technical
Explanation of the Conference Agreement of H.R. 6, Title XIII, "The Energy
Tax Incentives Act of 2005." July 27, 2005.
U.S. Department of Energy. Office of Fossil Energy. Clean Coal Today.
DOE/FE-0215P. Summer, 1998.
U.S. General Accounting Office. Outlook for Utilities' Potential Use of
Clean Coal Technologies. GAO/RCED-90-165, May 1990, p.3.
U.S. Treasury Department. Internal Revenue Service. "Establishing
Qualifying Advanced Coal Project Program." IRS Notice 2006-24. Internal
Revenue Bulletin. March 13, 2006.

Energy

EXPENSING OF THE COST OF PROPERTY USED IN THE
REFINERS OF LIQUID FUELS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

(1)

2007

(1)

2008

0.1

2009

0.2

2010

0.3

(1) Less than $50 million.

Authorization

Section 168(l), 179C.

Description

Oil refineries are allowed to irrevocably elect to expense 50 percent of the
cost of qualified refinery property, with no limitation on the amount of the
deduction. The deduction would be allowed in the taxable year in which the
refinery property is placed in service. The remaining 50 percent of the cost
would remain eligible for regular cost recovery provisions. To qualify for the
deduction: (1) original use of the property must commence with the taxpayer;
(2) construction must be pursuant to a binding construction contract entered
into after June 14, 2005, and before January 1, 2008, (ii) in the case of
self-constructed property, construction began after June 14, 2005, and before
January 1, 2008, or (iii) the refinery property is placed in service before
January 1, 2008; (3) the property must be placed in service before January 1,
2012; (4) the property must meet certain production capacity requirements if
it is an addition to an existing refinery; and (5) the property must meet all
applicable environmental laws when placed in service. Certain types of
refineries, including asphalt plants, would not be eligible for the deduction,
and there is a special rule for sale-leasebacks of qualifying refineries. If the
owner of the refinery is a cooperative, it may elect to allocate all or a part of
the deduction to the cooperative owners, allocated on the basis of ownership
interests. This provision is effective for qualifying refineries placed in service
after date of enactment.

Small refiners are also allowed two other tax incentives (which are
discussed elsewhere in this compendium): a $2.10/barrel tax credit for the
production of low-sulfur diesel fuel that is in compliance with Environmental
Protection Agency (EPA) sulfur regulations (IRC 45H); and expensing, in
lieu of depreciation, for up to 75 percent of the capital costs incurred in
producing low-sulfur diesel fuel that is in compliance with EPA sulfur
regulations.

This benefit is also allowed for property used to produce cellulosic biomass
ethanol through 2012.

Impact

Under current depreciation rules (the Modified Accelerated Cost Recovery
System) refinery assets are generally depreciated over 10 years using the
double declining balance method. Allowing 50 percent of the cost of the
refinery to be deducted immediately (expensed) rather than depreciated over
the normal 10 year life reduces the cost of constructing a refinery by slightly
under 5 percent for a taxpayer in the 35 percent tax bracket. The present
value of a 10-year, double declining balance depreciation per dollar of
investment is $0.74 with an 8 percent nominal discount rate. For every dollar
expensed, the benefit of expensing is to increase the present value of
deductions by $0.26, and since half of the investment is expensed, the value is
$0.13. Multiplying this value by 35 percent leads to a 4.6 percent benefit as a
share of investment. The value would be larger with a higher discount rate.
For example, at a 10 percent discount rate, the benefit would be 5.4 percent.
The benefit is smaller for firms with limited tax liability or lower tax rates.

Since the provision is temporary, there is an incentive to speed up the
investment in refinery capacity so as to qualify it, unless the tax benefit is
expected to be made permanent. Nevertheless, the incentive to speed up
investment is limited, because the effective price discount is small. Investing
in excess capacity that would not otherwise be desirable would either leave
the plant idle or provide too much output and lower prices and profits for a
period of time. The latter cost should be at least as big as the cost of
remaining idle. With a five percent price discount, the interest cost of
carrying excess capacity or losing profits would roughly offset the tax credit's
value within a year.

Refiners will, however, receive a windfall benefit on construction that
would have taken place in the absence of the subsidy.

Rationale

This provision was enacted in the Energy Policy Act of 2005 (P.L. 109-
58). Its purpose is to increase investments in existing refineries so as to
increase petroleum product output, and reduce prices. The provision
extending the benefit to cellulosic biomass ethanol was added by H.R. 6111
in February of 2006.

Assessment

Economic theory suggests that investments should be treated in a neutral
fashion to maximize economic well being. There is no obvious reason that the
price of refined liquids should be subsidized, even for a temporary time.
Indeed, there are pollution, congestion, and other external negative effects of
the consumption of petroleum products that might suggest the reverse of a
subsidy.

The transitory subsidy, if indeed it remains transitory, would not have
lasting effects and would lead to investments being made more quickly,
resulting either in wasted investment or temporarily lower prices. If the
subsidy is continued, as has been the case with other tax provisions, then,
absent other market distortions, overconsumption of petroleum products
would occur.

The effect on refinery construction is difficult to estimate. The precise
effect depends on the price elasticity of investment with respect to changes in
costs. To illustrate, if such an elasticity were 1, then a 5.4 percent reduction
in costs could be expected to increase refinery capital by 5.4 percent, which
would translate into a roughly 900 thousand barrels per day. Such an
increase, if it were to materialize, would increase domestic petroleum output
and reduce prices. However, recent evidence regarding a similar provision
for equipment in general including refineries (bonus depreciation), which
applied from 2002 through 2004, indicated that the response was not as large
as hoped for and that, indeed, many firms did not appear to take advantage of
the provision. In addition, most estimates of the elasticity of investment
response to a permanent change in the cost of capital goods suggest a fairly
low response, on the order of 0.25, although one study has found a higher
response of about 0.66.

Selected Bibliography

Chirinko, Robert S., Steven M. Fazzarri, and Andrew P. Meyer. "How
Responsive is Business Capital Formation to its User Cost? An Exploration
with Micro Data?" Journal of Public Economics vol. 74 (1999), pp. 53-80.
Cohen Darryl and Jason Cummins. A Retrospective Evaluation of the
Effects of Temporary Partial Expensing. Federal Reserve Board Staff
Working Paper 2006-19, April 2006.
Cordes, Joseph J. "Expensing," in the Encyclopedia of Taxation and Tax
Policy, Joseph J. Cordes, Robert D. Ebel, and Jane G. Gravelle, eds
(Washington: Urban Institute Press, 2005).
Jason G. , Kevin A. Hassett, and R. Glen Hubbard, "A Reconsideration of
Behavior Using Tax Reforms as Natural Experiments." Brookings Papers on
Economic Activity, 1994, no. 1, pp. 1-72.
Guenther, Gary. Small Business Expensing Allowance: Current Status,
Legislative Proposals, and Economic Effects. CRS Report RL31852,
October 3, 2006.
Lazzari, Salvatore. Energy Tax Policy: History and Current Issues.
Library of Congress, Congressional Research Service Report RL33578.
Washington, DC: July 28, 2006.
_. Energy Tax Policy: An Economic Analysis. Library of Congress,
Congressional Research Service Report RL30406. Washington, DC: June 28,
2005.
Pirog, Robert L. Petroleum Refining: Economic Performance and
Challenges for the Future. Congressional Research Service Report RL32248.
Washington: May 9, 2005
Sterner, Thomas. Policy Instruments for Environmental and Natural
Resource Management. Resources for the Future, Washington, D.C. 2003.
U.S. Congress, Joint Committee on Taxation. Description and Technical
Explanation of the Conference Agreement of H.R. 6, Title XIII, "The Energy
Tax Incentives Act of 2005." July 27, 2005.

Energy

DEDUCTION OF EXPENDITURES ON ENERGY-EFFICIENT
COMMERCIAL BUILDING PROPERTY

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

(1)

2007

0.1

0.2

2008

(1)

2009

(2)

2010

(2)

(1)Less than $50 million.
(2) Positive tax expenditure of less than $50 million.
This provision was extended through 2008 by H.R. 6111 in December
2006 with a revenue cost in fiscal years 2008 and 2009 of $0.1 billion.

Authorization

Section 179D.

Description

A new formula-based tax deduction is available for energy-efficient
commercial building property expenditures made by the taxpayer, subject to a
limit of $1.80 per square foot of commercial building space. The property
must be installed as part of a plan to reduce the energy and power
consumption of a commercial building by 50 percent. In the case of a building
that does not meet the 50 percent energy savings target, a partial deduction is
allowed. For some property, e.g., lighting systems, the deduction is pro-rated
based on cuts in lighting power density. Qualifying property includes property
installed as part of interior lighting systems, heating, cooling, ventilation and
hot water systems, or the building envelope, to the extent certified as energy
efficient. The cost basis of the property, for purposes of depreciation, would
be reduced by the amount of the deduction.
The provision allows designers of the commercial building to claim this
deduction if the energy efficiency items are installed in the buildings of
nontaxable entities such as public schools. This provision is effective for
property placed in service after December 31, 2005, and prior to January 1,
2009.

Impact

Under current law there is no special tax advantage or break for
expenditures on energy efficiency property used in a business. In general
these types of expenses are part of businesses' assets, and hence are
depreciable in accordance with the guidelines established by law and
regulation, which vary by type of business. Under current depreciation rules
(the Modified Accelerated Cost Recovery System), structures and structural
components - such as heating/cooling systems and lighting - are
depreciated over 39 years using the straight line method. Allowing a current
deduction for energy efficient capital goods that would otherwise be
depreciated over such a long period of time - that is, allowing expensing of
the costs of such property - greatly accelerates, and increases the present
value of, the deductions. This reduces effective tax rates and would normally
encourage investment. However, this deduction is in place for a relatively
short period of time, just over 2 years, and given the 1) the long lead time for
constructing commercial buildings, and 2) the complexity of determining the
deduction, there is some question of its effectiveness in inducing investment
in qualifying property.

Rationale

This deduction was introduced by the Energy Policy Act of 2005 (P.L.
109-58), to encourage businesses to retrofit their commercial buildings with
energy conserving components and equipment. The goal was to enhance the
energy efficiency of commercial buildings. The Energy Tax Act of 1978 (P.L.
96-518) provided for a 10 percent investment tax credit for certain categories
of property that conserved energy in industrial processes, which generally
applied to the manufacturing and agricultural sectors. These types of property
- there were actually 13 categories - were called specially defined energy
property, but none included property for conserving energy in commercial
buildings. These credits generally expired at the end of 1982.
H.R. 6111 in December 2006 extended eligibility through 2008

Assessment

Commercial buildings include a wide variety of building types - such as
offices, hospitals, schools, police stations, places of worship, warehouses,
hotels, barber shops, libraries, shopping malls. These different commercial
activities all have unique energy needs but, as a whole, commercial buildings
use more than half their energy for heating and lighting. Electricity and
natural gas are the most common energy sources used in commercial
buildings, accounting for 90 percent of total commercial sector energy use.
The commercial sector in the United States uses almost as much energy as the
residential sector, about 18 percent in 2005, but yet it has not generally been
the target of energy conservation incentives. As noted above, the (now
expired) energy tax credits of 1978 targeted the industrial energy sector.

There is no generally acknowledged market failure in the use of energy in
commercial buildings or the production and investment in energy
using/saving capital goods in such buildings that requires government
intervention via subsidies. The business profit maximizing (and cost
minimizing) objective is generally sufficient to invest in energy-saving capital
when the rate of return on such investments is above the opportunity cost.
From an economic perspective, allowing special tax benefits for certain types
of investment or consumption can result in a misallocation of resources. The
deduction under IRC 179D might be justified on the grounds of
conservation, if consumption of energy resulted in negative effects on society,
such as pollution. In general, however, it would be more economically
efficient to directly tax energy fuels than to subsidize a particular method of
achieving conservation.

As a general rule, tenants are not going to improve the energy efficiency of
a residence that does not belong to them, even if the unit is metered. They
sometimes make such improvements if the rate of return (or payback) is
sufficiently large, but most tenants do not occupy rental housing long enough
to reap the full benefits of the energy conservation investments. Part of the
problem is also that it is not always easy to calculate the energy savings
potential (hence rates of return) from the various retrofitting investments.
Landlords may not be able to control the energy consumption habits of renters
to sufficiently recover the full cost of the energy conservation expenditures,
regardless of whether the units are individually metered. If the units are
individually metered, then the landlord would generally not undertake such
investments since all the benefits therefrom would accrue to the renters,
unless a landlord could charge higher rents on apartments with lower utility
costs. If the units are not individually metered, but under centralized control,
the benefits of conservation measures may accrue largely to the landlord, but
even here the tenants may have sufficient control over energy use to subvert
the accrual of any gains to the landlord. In such cases, from the landlord's
perspective, it may be easier and cheaper to forgo the conservation
investments and simply pass on energy costs as part of the rents. Individual
metering can be quite costly, and while it may reduce some of the distortions,
it is not likely to completely eliminate them, because even if the landlord can
charge higher rents, he may not be able to recover the costs of energy
conservation efforts or investments.

These market failures may lead to underinvestment in conservation
measures in rental housing and provide the economic rationale for gross
income exclusion under Internal Revenue Code (IRC) 136, as discussed
elsewhere in this compendium. Without such explicit exclusion, such
subsidies would be treated as gross income and subject to tax. This exclusion,
however, applies both to owner-occupied and to rental housing.

Selected Bibliography

Brown, Marilyn "Market Failures and Barriers as a Basis for Clean Energy
Policies," Energy Policy, v. 29. November 2001, pp. 1197-1207.
Fisher, Anthony C., and Michael H. Rothkopf. "Market Failure and Energy
Policy: A Rationale for Selective Conservation," Energy Policy, v. 17.
August 1989, pp. 397-406.
Hahn, Robert W. "Energy Conservation: An Economic Perspective."
American Enterprise Institute, October 2005.
Hassett, Kevin A., and Gilbert E. Metcalf. "Energy Conservation
Investment: Do Consumers Discount the Future Correctly?" Energy Policy,
v. 21. June 1993, pp. 710-716.
Howarth, Richard B. and Bo Anderson. "Market Barriers to Energy
Efficiency." Energy Economics, October, 1993. pp. 262-292.
Lazzari, Salvatore. Energy Tax Policy: History and Current Issues.
Library of Congress, Congressional Research Service Report RL33578.
Washington, DC: July 28, 2006.
_. Energy Tax Policy: An Economic Analysis. Library of Congress,
Congressional Research Service Report RL 30406. Washington, DC: June
28, 2005.
Loskamp, Wendy. "Energy, Water Efficiencies and Savings Come From
Meter Data Management." Energy Pulse. Insight Analysis and Commentary
on the Global Power Industry. 2006
Metcalf, Gilbert E. "Economics and Rational Conservation Policy."
Energy Policy, v. 22. October 1994, pp. 819-825.
Sutherland, Ronald J. "Energy Efficiency or the Efficient Use of Energy
Resources." Energy Sources, v. 16, pp. 257-268.

Sutherland, Ronald J. "The Economics of Energy Conservation Policy."
Energy Policy, v. 24. April 1996, pp. 361-370.
U.S. Congress. House. Committee on Energy and Commerce. National
Energy Policy: Conservation and Energy Efficiency. Hearings Before the
Subcommittee on Energy and Air Quality. Washington, DC: U.S.
Government Printing Office, June 22, 2001.
U.S. Department of Energy. Lawrence Berkeley National Laboratory.
"Energy Efficiency, Market Failures, and Government Policy." Levine, Mark
D. et al. March 1994.
U.S. Department of Energy. Energy Information Administration. 1999
Commercial Buildings Energy Consumption Survey-Commercial Buildings
Characteristics. May 2006.
U.S. Department of Energy. Energy Information Administration. 2003
Commercial Buildings Energy Consumption Survey-Overview of
Commercial Buildings Characteristics. May 2002.
U.S. Department of Energy. Monthly Energy Review. October 2006.
U.S. Department of Treasury. Internal Revenue Service. "Deduction for
Energy Efficient Commercial Buildings." Internal Revenue Bulletin. Notice
2006-52, June 26, 2006.

Energy

TAX CREDIT FOR THE PURCHASE OF QUALIFIED ENERGY
EFFICIENCY IMPROVEMENTS TO EXISTING HOMES

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.1

2007

0.3

2008

0.2

2009

(1)

2010

(1)

(1)Less than $50 million.

Authorization

Section 25C, 25D, and 45L.

Description

A 10% tax credit is provided to home owners for the installation of
qualified energy efficiency improvements and residential energy property
expenditures. The maximum credit for a taxpayer with respect to the same
dwelling is $500 for all taxable years, of which no more than $200 may be
attributable to expenditures on windows. Qualified improvements are defined
as any energy efficient building envelope component that meets the criteria
set by the 2000 International Energy Conservation Code and is installed in or
on a dwelling unit owned and used as the taxpayer's principal residence.
Building envelope components include: (1) insulation materials or other
systems designed to reduce the heat loss or gain, (2) exterior windows
(including skylights), (3) exterior doors, and (4) any metal roof that has
coatings designed to reduce heat gain.

There are also tax credits for residential energy efficient property,
including: a $50 credit for each advanced main air circulating fan; a $150 tax
credit for each qualified natural gas, propane, or oil furnace or hot water
boiler; and a $300 credit each for qualifying electric heat pump water heaters,
electric heat pumps, geothermal heat pumps, central air conditioners, and
natural gas, propane or oil water heaters.

The basis of the property would be required to be reduced by the amount
of the credit. Special proration rules are applied for jointly owned property,
condominiums, and cooperative housing corporations, and where less than
80% of the property is used for nonbusiness purposes. Also, certain
expenditures for labor are eligible.

A 30% credit, not to exceed $2,000, is provided for home owners that
purchase photovoltaic property used exclusively for residential purposes. A
separate 30% credit is provided for residential solar water heating property
other than property heating swimming pools and hot tubs. At least half of the
energy produced by the solar water heating property must be derived from the
sun. Also a 30% tax credit is provided for fuel cell power plants, not to
exceed $1,000 for each kilowatt of capacity. The power equipment must have
a generation efficiency greater than 30% and a capacity of at least 0.5
kilowatts. The power plant must also be installed on or in connection with a
dwelling unit located in the United States and that is used by the taxpayer as a
principal residence. The depreciable basis of the property must be reduced by
the amount of the credit. In addition, the credit applies to the basis remaining
after subtracting any state subsidies (such as grants) or utility incentives
claimed on the same property. Expenditures for labor costs are included.
Certain equipment safety requirements must be met to qualify for the credit
and special proration rules apply for jointly owned property, condominiums,
and cooperative housing corporations, and where less than 80 percent of the
property is used for nonbusiness purposes. All residential energy tax credits
are effective for periods after December 31, 2005, and before January 1,
2009.

Finally, a new general business tax credit is available for the construction
of qualified new energy-efficient homes if the homes achieve an energy
savings of 50% over the 2003 International Energy Conservation Code. For
manufactured homes, the required standard is a 30% energy savings. A
$1,000 credit would be available for each manufactured home that is certified
as having an annual heating and cooling energy consumption level that is at
least 30% below the annual energy consumption level of a comparable
dwelling unit, and $2,000 for a new home that has an annual heating and
cooling energy consumption level that is at least 50% below the annual
energy consumption level of a comparable dwelling unit. This credit is
available only to contractors, and it is effective for homes whose construction
is substantially completed after December 31, 2005, and which are purchased
after December 31, 2005, and prior to January 1, 2009.

Impact

These tax credits provide an investment subsidy to homeowners who
invest in a variety of home energy conserving equipment and materials,
including (1) more energy-efficient heating or cooling systems, water heaters,
or envelope component materials such as insulation and storm windows or (2)
energy production systems such as solar or fuel cell systems. This subsidy
helps to offset some of the purchase cost, which is generally higher than
conventional energy equipment. The idea is to reduce the purchase price of
qualifying equipment and thereby increase the rate of return or reduce its
payback time. If the credits are to be effective, then the net present value of
expected energy savings should equal the purchase price, net of the tax credits
(or equivalently, the rate of return on the net purchase price should be higher
than the opportunity cost of capital - the rate of return on the best alternative
use of the capital outlay).

Rationale

These provisions were established by the Energy Policy Act of 2005 (P.L.
109-58) to encourage homeowners to retrofit their homes with energy
efficient materials - materials and property that reduce the heat loss during
winter and cooling loss during summer - and replace their energy using
systems with either more energy efficient conventional systems or with solar
energy or fuel cell systems. These tax credits are very similar to those enacted
under the Energy Tax Act of 1978 (P.L. 96-518) and which expired at the end
of 1985. The 1978 tax credits were part of President Carter's National
Energy Program. H.R. 6111 extended the 30% credit and the credit for new
homes through 2008.

More specifically, residential energy use for heating and cooling
constitutes a significant fraction of total U.S. energy consumption, and
therefore, measures to reduce heating and cooling requirements have the
potential to reduce such consumption. Further, the Congress believed that
many existing homes are not adequately insulated. The tax credit for the
construction of energy efficient homes is premised on the belief that the most
cost-effective time to equip a home with energy efficient property is when it is
under construction, and that the most effective mechanism to encourage the
use of energy-efficient components in the construction of new homes is
through an incentive to the builder. Reduced home energy consumption will
reduce imported oil and pollution.

Assessment

From an economic perspective, allowing special tax credits for certain
targeted activities can distort the allocation of resources, encouraging
investments that would not otherwise be economical at current and expected
prices and rates of return. Conversely, when home energy prices are high,
many homeowners have sufficient financial incentives to undertake energy
efficiency improvements without tax credits. This results in a windfall for
many households - a financial reward for doing something that the person
would have done anyway - at taxpayers' expense. This may not be a good
use of taxpayer revenues, particularly during times of large budget deficits.
Some recent data suggest that the demand for building insulation has
increased rapidly due primarily to higher energy prices.

The credits for solar and fuel cells tend to favor middle and upper income
households as the technologies are expensive and require large outlays of
capital. Thus, they may be questionable on distributional grounds. Generally,
these technologies require grid backup in most areas where they are installed,
and their return may be low or even negative. Such tax credits are often
justified on the grounds of energy conservation, where consumption of energy
results in negative effects on society, such as pollution. In general, however, it
would be more economically efficient to directly tax energy fuels than to
subsidize a particular method of achieving conservation measures.

There are generally no acknowledged market failures in personal decisions
to invest in energy efficient capital goods or property for the home; nor is
there a market failure to provide or supply such goods or property by the
business sector. The market generally works to supply such products and
consumers readily invest in them as long as the rate of return is sufficient,
which tends to be the case when home energy prices are high. There may be a
market failure in decisions by builders to invest in appliances and other
energy-using systems that equip a new home or building. The builder's
incentive is to use the least costly, i.e., what may be the least energy efficient,
appliance since this leads to a lower price and more profit for each dwelling
unit sold; this could leave the home buyer or investor with higher monthly
energy bills. Such a buyer of the new home might otherwise invest in the
more expensive, but more energy saving appliances.

There may be a market failure in tenant-occupied homes, if the tenant pays
energy bills separately. In rental housing, the tenant and the landlord lack
strong financial incentives to invest in energy conservation equipment and
materials, even when the benefits clearly outweigh the costs, because the
benefits from such conservation may not entirely accrue to the party
undertaking the energy-saving expenditure and effort. Builders and buyers
may also lack sufficient information (a problem which is discussed in more
detail in Lazzari, CRS Report RL30406).

Selected Bibliography

Brown, Marilyn. "Market Failures and Barriers as a Basis for Clean
Energy Policies," Energy Policy, v. 29. November 2001, pp. 1197-1207.
Clinch, J. Peter, and John D. Healy. "Cost-Benefit Analysis of Domestic
Energy Efficiency." Energy Policy, v. 29. January 2000. pp.113-124.
Fisher, Anthony C., and Michael H. Rothkopf. "Market Failure and
Energy Policy: A Rationale for Selective Conservation," Energy Policy, v. 17.
August 1989, pp. 397-406.
Hahn, Robert W. "Energy Conservation: An Economic Perspective."
American Enterprise Institute, October 2005.
Hassett, Kevin A., and Gilbert E. Metcalf. "Energy Conservation
Investment: Do Consumers Discount the Future Correctly?" Energy Policy,
v. 21. June 1993, pp. 710-716.
Howarth, Richard B., and Bo Anderson. "Market Barriers to Energy
Efficiency." Energy Economics, October, 1993. pp. 262-292.
Lazzari, Salvatore. Energy Tax Policy: History and Current Issues.
Library of Congress, Congressional Research Service Report RL33578.
Washington, DC: July 28, 2006.
_. Energy Tax Policy: An Economic Analysis. Library of Congress,
Congressional Research Service Report RL 30406. Washington, DC: June
28, 2005.
_. Energy Tax Provisions in the Energy Policy Act of 1992. Library of
Congress, Congressional Research Service Report 94-525. Washington, DC:
June 22, 1994.
Metcalf, Gilbert E. "Economics and Rational Conservation Policy."
Energy Policy, v. 22. October 1994, pp. 819-825.
Pimental, D., A. Pleasant, et al. "U.S. Energy Conservation and
Efficiency: Benefits and Costs." Energy, Development, and Sustainability. v.
6, September 2004. pp. 279-306.
Scafidi, Catina M., and Anthony P. Curatola. "ETIA of 2005 and New
Energy-Efficient Appliances." Strategic Finance. V. 87, June 2006.
Montvale: pp. 16-18.
Stern, Paul C. "Blind Spots in Policy Analysis: What Economics Doesn't
Say About Energy Use." Journal of Policy Analysis and Management, v.5.
April 1986. Pp200-227.
Sutherland, Ronald J. "Energy Efficiency or the Efficient Use of Energy
Resources." Energy Sources, v. 16, 1996. pp. 257-268.
Sutherland, Ronald J. "The Economics of Energy Conservation Policy."
Energy Policy, v. 24. April 1996, pp. 361-370.
U.S. Congress, House. Report to Accompany H.R. 776, the Comprehensive
Energy Policy Act. Washington, DC: U.S. Government Printing Office,
Report 102-474, Part 6, pp. 35-37.
-. House. Committee on Energy and Commerce. National Energy Policy:
Conservation and Energy Efficiency. Hearings Before the Subcommittee on
Energy and Air Quality. Washington, DC: U.S. Government Printing Office,
June 22, 2001.

U.S. Department of Energy. Lawrence Berkeley National Laboratory.
"Energy Efficiency, Market Failures, and Government Policy." Levine, Mark
D. et al. March 1994.
U.S. Department of the Treasury. Internal Revenue Service. Credit for
Nonbusiness Energy Property. Notice 2006-26. March 13, 2006.

Energy

TAX CREDIT FOR THE PRODUCTION OF ENERGY-
EFFICIENT APPLIANCES

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

(1)

0.1

2007

(1)

0.1

2008

(1)

2009

(1)

2010

(1)

(1)Less than $50 million.

Authorization

Section 45M.

Description

Internal Revenue Code section 45M provides a tax credit for the eligible
production (manufacture) of certain energy-efficient dishwashers, clothes
washers, and refrigerators. The credit for dishwashers is $3/dishwasher
multiplied by the percentage by which the energy efficiency of the 2007
standards (not yet known) exceeds that of the 2005 standards. The maximum
credit is $100 per dishwasher. For example, if the 2007 standards exceed the
2005 standards by 30%, the credit would be $90 per dishwasher. The credit
for dishwashers would apply to dishwashers produced in 2006 and 2007 that
meet the Energy Star standards for 2007. Any residential dishwasher that
exceeds the energy conservation standards established by the Department of
Energy qualifies for the credit.

The credit for clothes washers ranges from $50 to $200 per unit,
depending on when the units were manufactured and the average water and
energy savings. The credits would be at least $100 for washers manufactured
in 2006 and 2007 that meet the requirements of the Energy Star program in
effect for clothes washers in 2007. A clothes washer would be any residential
clothes washer, including a residential style coin operated washer, that
satisfies the relevant efficiency standard.

The credit for refrigerators ranges from $75-$150 each based on the
amount of energy savings and the year of manufacture. The energy savings
are determined relative to the energy conservation standards promulgated by
the Department of Energy that took effect on July 1, 2001. Refrigerators that
achieve a 15 percent to 20 percent energy saving and that are manufactured in
2006 receive a $75 credit. Refrigerators that achieve a 20 percent to 25
percent energy saving receive a $125 credit if manufactured in 2006 or 2007.
Refrigerators that achieve at least a 25 percent energy saving receive a $175
credit if manufactured in 2006 or 2007. A refrigerator must be an automatic
defrost refrigerator-freezer with an internal volume of at least 16.5 cubic feet
to qualify for the credit.

In all cases, appliances eligible for the credit would include only those that
exceed the average amount of production from the three prior calendar years
for each category of appliance. Eligible production of refrigerators would be
production that exceeds 110 percent of the average amount of production
from the three prior calendar years. An eligible manufacturer (the taxpayer)
may not claim credits in excess of $75 million for all taxable years, and may
not claim credits in excess of $20 million with respect to refrigerators eligible
for the $75 credit. The credit allowed in a taxable year for all appliances may
not exceed 2% of the average annual gross receipts of the taxpayer for the
three taxable years preceding the taxable year in which the credit is
determined. The appliance credit is part of the general business credit. It is
claimed in concert with a variety of other business tax credits, and it is subject
to the limits of those credits as well. This provision became effective for
appliances produced after December 31, 2005, and it ends on December 31,
2007.

Impact

The appliance tax credits provide a per-unit subsidy to those domestic
companies (Whirlpool, General Electric, etc.) that manufacture energy-
efficient appliances that qualify for the Energy Star program. Appliances and
other energy using items receive an Energy Star label from the Department of
Energy if they use less energy than the minimum federal standard for that
item. This subsidy helps to offset some of the cost of manufacturing such
appliances, which are generally more costly than less energy efficient ones. In
general, most of the energy saving appliances are also the more expensive and
purchased more by relatively higher income households. The credit thus
lowers the marginal and average costs of producing the more energy efficient
appliances, which shifts production of such upscale appliances (and producers
of such appliances) at the expense of the lower end models. This would
generally lead to a lower market price to consumers - i.e., part of the
production subsidy is shifted forward to consumers as a lower price net of the
subsidy - but an increase in the total resource costs of producing the
appliances inclusive of the subsidy. This may raise questions about the
distributional impacts of the appliance tax credits. It also shifts what are
otherwise private production costs onto taxpayers.

While not directly affecting consumers, manufacturers of energy efficient
clothes washers, dishwashers and refrigerators are eligible for tax breaks
themselves. The combination of production credits and energy savings from
use of the more energy efficient products might spur additional sales and use.
For example, homeowners might be induced to upgrade to the more energy-
efficient appliances that qualify for the credit.

Rationale

Section 45M was established by the Energy Policy Act of 2005 (P.L. 109-
58) to encourage production of appliances that exceed the minimum federal
energy-efficiency standards, and thus qualify for the federal Energy Star
energy-efficiency program.

Assessment

From an economic perspective, allowing special tax credits for certain
targeted activities distorts the allocation of resources, encouraging companies
to undertake certain types of investments and production that would not
otherwise be economical at current and expected prices and rates of return.
For instance, the credits are targeted for only three of the many home
appliances - they exclude, for instance, clothes dryers and range ovens.
Studies have shown that clothes dryers consume four times as much energy
(in kilowatts per hour) than a refrigerator and 10 times more energy than a
clothes washer. Also, since appliance manufacturers also have to comply with
federal energy efficiency standards, the tax credits act as incentives to shift
resources toward the more expensive and least economical appliance. Some
of the tax credits accrue to the manufacturer as increased profits and
economic rents. The credits, thus, may be viewed as a form of corporate
welfare, and are questionable on distributional grounds - they may provide
more benefits to upper income households than to lower income ones. Such a
program is often justified on the grounds of energy conservation, if
consumption of energy resulted in negative effects on society, such as
pollution. In general, however, it would be more efficient to directly tax
energy fuels than to subsidize a particular method of achieving conservation.

There are no generally acknowledged market failures in the production of
energy efficient appliances and other capital goods. There may be a market
failure in decisions by builders to invest in appliances and other energy using
equipment to equip a building. The builder's incentive is to use the least
costly, i.e., what may be the least energy efficient, appliance since this leads
to a lower price and more profit for each dwelling unit sold, but whereas the
builder does not have to pay the energy bills, the home buyer or investor has
to make such monthly payments. Such a buyer of the new home might
otherwise invest in the more expensive, but more energy saving, appliances.
There are market failures in research and development and which serve as the
economic rationale for the various tax subsidies for R&D expenditures as
discussed elsewhere in this compendium. R&D for energy-saving devices
also qualifies for such subsidies.

Selected Bibliography

Brown, Marilyn. "Market Failures and Barriers as a Basis for Clean
Energy Policies," Energy Policy, v. 29. November 2001, pp. 1197-1207.
Fisher, Anthony C., and Michael H. Rothkopf. "Market Failure and
Energy Policy: A Rationale for Selective Conservation," Energy Policy, v. 17.
August 1989, pp. 397-406.
Hahn, Robert W. "Energy Conservation: An Economic Perspective."
American Enterprise Institute, October 2005.
Hassett, Kevin A., and Gilbert E. Metcalf. "Energy Conservation
Investment: Do Consumers Discount the Future Correctly?" Energy Policy,
v. 21. June 1993, pp. 710-716.
Howarth, Richard B. and Bo Anderson. "Market Barriers to Energy
Efficiency." Energy Economics, October, 1993. pp. 262-292.
Lazzari, Salvatore. Energy Tax Policy: History and Current Issues.
Library of Congress, Congressional Research Service Report RL33578.
Washington, DC: July 28, 2006.
_. Energy Tax Policy: An Economic Analysis. Library of Congress,
Congressional Research Service Report RL 30406. Washington, DC: June
28, 2005.
_. Energy Tax Provisions in the Energy Policy Act of 1992. Library of
Congress, Congressional Research Service Report 94-525. Washington, DC:
June 22, 1994.
Loskamp, Wendy. "Energy, Water Efficiencies and Savings Come From
Meter Data Management. Energy Pulse." Insight Analysis and Commentary
on the Global Power Industry. http\www.energypulse.net.
Metcalf, Gilbert E. "Economics and Rational Conservation Policy."
Energy Policy, v. 22. October 1994, pp. 819-825.

Pimental, D., A. Pleasant, et al. "U.S. Energy Conservation and
Efficiency." Energy, Development, and Sustainability. V. 6, September 2004.
pp. 279-306.
Scafidi, Catina M., and Anthony P. Curatola. "ETIA of 2005 and New
Energy-Efficient Appliances." Strategic Finance. V. 87, June 2006.
Montvale: pp. 16-18.
Sutherland, Ronald J. "Energy Efficiency or the Efficient Use of Energy
Resources." Energy Sources, v. 16, 1994. pp. 257-268.
Sutherland, Ronald J. "The Economics of Energy Conservation Policy."
Energy Policy, v. 24. April 1996, pp. 361-370.
U.S. Congress, House. Committee on Energy and Commerce. National
Energy Policy: Conservation and Energy Efficiency. Hearings Before the
Subcommittee on Energy and Air Quality. Washington, DC: U.S.
Government Printing Office, June 22, 2001.
U.S. Department of Energy. Lawrence Berkeley National Laboratory.
"Energy Efficiency, Market Failures, and Government Policy." Levine, Mark
D. et al. March 1994.

Energy

TAX CREDITS FOR ALTERNATIVE TECHNOLOGY
VEHICLES

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.2

0.1

0.3

2007

0.2

0.1

0.3

2008

0.1

(1)

0.1

2009

0.1

(1)

0.1

2010

(1)

(1)Less than $50 million.

Authorization

Section 30 and 30B.

Description

Section 30B provides for a new system of nonrefundable tax credits for
four types of so-called alternative technology motor vehicles: hybrid vehicles,
advanced lean-burn technology vehicles, alternative fuel vehicles, and fuel
cell vehicles. Advanced technology vehicles (ATVs) may use either an
alternative fuel or a conventional fuel (such as diesel) more efficiently. In
general, they are less polluting than standard (non- advanced) motor vehicles.
For each of the four vehicle types, the amount of the credits depend on
vehicle weight class (passenger and light truck vs. heavy duty trucks) and
either estimated lifetime fuel savings or the incremental (marginal) cost of the
technology.

Hybrid Vehicles and Advanced Lean-Burn Technology Vehicles. For
hybrid and advanced lean- burn technology vehicles weighing less than 8,500
pounds (i.e., for passenger cars or light trucks), the total credit consists of two
components: a fuel economy credit, which ranges from $400-$2,400
depending on the rated city fuel economy of the vehicle, and a conservation
credit, which ranges from $250-$1,000 depending on estimated lifetime fuel
savings. For both components, the comparison is made with a comparable
2002 model year standard gasoline powered vehicle. In addition, the
conservation credit is based on the estimated lifetime fuel savings between the
two vehicles assumed to travel 120,000 miles.

For qualified hybrid and advanced lean-burn technology vehicles weighing
8,500 lbs or more, the credit is either 20, 30, or 40 percent of the marginal
cost of the vehicle's advanced technology, subject to certain limits based on
the precise vehicle weight. The precise percentage depends on the vehicle's
fuel economy relative to a comparable gasoline or diesel powered vehicle.
The marginal cost of the hybrid vehicle is the difference in the suggested
manufacturer selling price between the hybrid vehicle and a gasoline or diesel
powered vehicle comparable in weight, size, and use, as determined and
certified by the manufacturer.

In the case of hybrids and advanced lean-burn vehicles, there is a
cumulative 60,000 limit imposed on the number of vehicles (all models of the
hybrid or lean-burn type) sold by each manufacturer that are eligible for the
credit. Once the cumulative limit is reached for either technology, the credit
for that manufacturer begins to phase out during the second quarter after the
limit is reached and is completely phased out - no credit is available - after
the sixth quarter (the fourth quarter after the phase-out begins). The credit is
available for imported vehicles, but no credit is allowed for any vehicle used
outside of the United States.

Hybrid vehicles are defined as motor vehicles that draw propulsion energy
from two onboard sources of stored energy: an internal combustion or heat
engine using consumable fuel, and a rechargeable energy storage system. A
qualifying hybrid vehicle must meet the applicable regulations under the
Clean Air Act. For a vehicle with a gross vehicle weight rating of 6,000
pounds or less (passenger cars and many light trucks), the applicable
emissions standards are the Bin 5 Tier II emissions standards of the Clean Air
Act. For a vehicle with a gross vehicle weight rating greater than 6,000
pounds and less than or equal to 8,500 pounds, the applicable emissions
standards are the Bin 8 Tier II emissions standards. The tax credit for hybrid
vehicles is available for vehicles purchased after December 31, 2005, and
before January 1, 2010. A qualifying advanced lean-burn technology motor
vehicle is one that incorporates direct injection, and achieves at least 125
percent of the 2002 model year city fuel economy. The 2004 and later model
vehicles must meet or exceed certain Environmental Protection Agency
emissions standards. A qualifying advanced lean- burn technology motor
vehicle must be placed in service before January 1, 2011.

Alternative Fuel Vehicles. The credit for new qualified alternative fuel
motor vehicles is generally equal to 50 percent of the incremental cost of the
technology, relative to a conventionally powered vehicle of the same class and
size. The incremental cost depends on the vehicle's weight. However, a bonus
credit of 30 percent is also provided for alternative fuel vehicles that also
meet certain EPA emission standards. In all cases, the credit cannot exceed
$4,000-$32,000 per vehicle depending on vehicle weight. A new qualified
alternative fuel motor vehicle is defined as a motor vehicle that is capable of
operating on an alternative fuel, defined as compressed natural gas, liquefied
natural gas, liquefied petroleum gas, hydrogen, and any liquid at least 85
percent of the volume of which consists of methanol. A reduced credit is
available for mixed-fuel (flexible fuel) vehicles. The vehicle must be new and
acquired by the taxpayer for use or lease, but nor for resale. The new credit
for alternative fuel vehicles applies to purchases made between January 1,
2006, and December 31, 2010. Alternative fuels also receive favorable tax
treatment - a 50�/gallon equivalent of gasoline tax credits - against the
federal excise tax. Automakers also get credit toward meeting fuel economy
standards by producing alternative fuel vehicles.

Fuel Cell Vehicles. The credit for fuel cell vehicles ranges from $8,000
($4,000 if placed in service after 2009) to $40,000, depending on vehicle
weight. If the new qualified fuel cell motor vehicle is a passenger automobile
or light truck, the amount of the credit is increased if certain fuel efficiencies
are met based on the 2002 model year city fuel economy for specified weight
classes. A new qualified fuel cell motor vehicle is defined as a motor vehicle:
(1) that is propelled by power derived from one or more cells that convert
chemical energy into electricity by combining oxygen and hydrogen fuel that
is stored on board the vehicle in any form; (2) that, in the case of a passenger
automobile or light truck, receives an EPA certification; (3) the original use of
which commences with the taxpayer; (4) that is acquired for use or lease by
the taxpayer and not for resale; and (5) is made by a manufacturer. The new
credit for fuel cell vehicles applies to purchases made between January 1,
2006, and December 31, 2014.

For all of the above ATV types, businesses may qualify for the credits and
the vehicles also qualify for depreciation treatment, although there are limits
on the annual depreciation deductions, and the cost basis is reduced by the
credit. Also, while the credits are available for the purchaser, in the event of a
sale to a governmental agency or a tax-exempt organization - entities that
pay no income tax, and therefore cannot benefit from the credits - the seller
of the vehicle would receive the credit.

Electric Vehicles. Finally, a 10 percent tax credit is available for the cost
of an electric vehicle up to a maximum credit of $4,000. However, under
phase-out provisions, only 25 percent of this credit ($1,000) is available in
2006. No credit is available after 2006. This credit has been available since
1992; the above advanced technology vehicles credits were enacted in 2005.

Impact

Substantial economic research over the years has demonstrated that lack of
consumer demand for ATVs is the primary reason for the lack of market for
these types of vehicles. This lack of consumer demand for ATVs, in turn, is
generally due to five variables: 1) the high fixed, up-front costs (or purchase
price) for the vehicle itself relative to the price of conventional vehicles; 2)
the historically low price (real, inflation adjusted prices) of conventional fuels
generally, and in relevant cases, the price of conventional fuels in relationship
to the price of alternative fuels; 3) the variability in the price of oil, which
translates into variability in the price of gasoline and diesel, and which
increases the risk of alternative fuel investment and development,
independent of the level of conventional fuels prices; 4) the additional risks
associated with investing in or purchasing a relatively new, unknown, and
unproven technology; and 5) the utility that consumers derive from an
automobile's features that ATVs generally cannot provide at this time (due in
various cases to poorer acceleration, smaller capacity, fewer refueling
locations, possibly higher maintenance costs, and fewer model options).

The new tax credits for the purchase of ATVs attempt to address one of
these variables: the price of the vehicles. The credits should lead to a
reduction in the price of the vehicles, relative to the price of conventional
vehicles and increase the demand for them. The magnitude of the potential
increase in consumer demand depends upon the magnitude of the price
decline in response to the tax incentives and the price elasticity of demand for
ATVs. These are basically unknown parameters at this time, but it seems
reasonable that given the currently high costs of ATVs, current consumer
demand is probably relatively elastic, which implies a sizeable responsiveness
to potential price declines, if they actually take place.

The new tax credits may also stimulate business investments in ATVs. A
business's decision to invest is determined by three variables: 1) the rate of
depreciation of its existing capital; 2) the demand for its output; and 3) the
rate of return, after tax, on prospective investments. Assuming a given rate of
depreciation and a continued market for its product, the decision to invest in
any particular machine, equipment, or even a vehicle is determined by the
after-tax rate of return on that prospective investment as compared to the cost
of capital (which is basically the opportunity cost of capital, or the return on
the best foregone investment alternative). Tax policy variables - the
marginal statutory tax rate (including the alternative minimum tax), the
effective investment tax credit, the system of depreciation, including any
accelerated depreciation; the fraction of interest payments that are tax
deductible; and effective tax rate on capital gains - all affect investment
decisions through their effect on the marginal effective tax rate. The ATV
credits are thus one of several variables that could affect the effective income
tax rate on the marginal investment. The credit increases the after-tax returns,
which tends to stimulate investment demand, other things being equal. (Note
that in both personal and business ATVs, future price declines in response to
R&D tax incentives could increase the degree of responsiveness to the
demand curve for ATVs.) However, under current depreciation rules there are
two limitations as they apply to automobiles that may reduce the incentive
effects of the ATV credits for businesses. First, there is a limit on the amount
of a passenger vehicle that may be expensed under IRC section 179. Second,
there is a limit on the amount of a luxury automobile - ATVs would be
classified as passenger automobiles for this purpose - that does not apply to
a truck or SUV. Thus, a business taxpayer that buys an SUV is not subject to
these depreciation limits, while one that buys an ATV is.

Finally, to the extent that the credits are effective in increasing demand for
ATVs, there is a decline in petroleum use and importation. Fuel consumed in
conventional motor vehicles accounts for the largest fraction of total
petroleum consumption and is a leading source of dependence on foreign oil.
ATVs are also generally less polluting, producing significantly lower total
fuel cycle emissions when compared to equivalently sized conventional
vehicles.

Rationale

Section 30B was enacted as part of the Energy Policy Act of 2005 (P.L.
109-58) to stimulate the demand for more fuel efficient and environmentally
clean automobiles. The Congress believed that further investments in
alternative fuel and ATVs are necessary to transform the mode of
transportation in the United States toward more clean fuel efficient vehicles,
relying less on petroleum. This would reduce petroleum consumption and
importation, which endangers U. S. energy and economic security. In this
regard, hybrids and alternative fueled vehicles (e.g., ethanol fueled vehicles)
were viewed as the short term options; advanced lean-burn and fuel cell
vehicles were viewed as the long-term options. The Energy Policy Act of
1992 (P.L. 102-486) introduced a $2,000 tax deduction for passenger vehicles
that run on alternative fuels (up to a $50,000 for heavy duty trucks), and also
established a tax credit for electric vehicles. Under an administrative ruling by
the Internal Revenue Service (Revenue Procedure 2002-42), purchasers of
model year 2000-2006 hybrid vehicles were allowed to claim the clean-fuel
vehicle deduction, which expired on January 1, 2006.

Both the $4,000 electric car credit, and the alternative fuel vehicle
deduction were subject to a phase out evenly over a 3-year period beginning
in 2004 and ending in 2006. This original phase-down schedule was
modified in the Job Creation and Worker Assistance Act of 2002, which
extended it from the 2002-2004 period to the 2004-2006 period. Early
versions of the Jobs and Growth Tax Relief Reconciliation Act of 2003
proposed to further extend the phase-down period to the 2005-2007 three-
year period, but the provision was dropped from the bill. The Energy Policy
Act of 2005 allowed the deduction to sunset at the end of 2005; the electric
vehicle tax credit sunsets in 2006.

Assessment

From 2000-2006 the demand for hybrid passenger automobiles
(particularly, the demand for the Toyota Prius and Honda Insight) increased
rapidly, mostly in response to the rapid runup of gasoline prices but also at
least in part due to the incentive effects of the $2,000 federal deduction.
Hybrid vehicles are priced somewhat higher than gasoline-powered cars of
comparable size and quality, but the $2,000 tax deduction reduced the net
price to the point that they became competitive. Also, there are numerous
federal, state, and local government programs (such as fleet requirements) that
have stimulated the use of hybrids (and, in some cases, alternative fuel
vehicles).

As to the effects of the new tax credits, which replaced the deduction, the
presumption is that they have had some stimulative effect. Toyota, for
example, reached the 60,000 vehicle limit by the second quarter of 2006,
three and one-half years before the expiration of the hybrid credit. Still, while
the ATV tax credits had some effect on demand for hybrids, it is difficult (and
probably premature) to assess the relative effects of the tax credits and the
recent high petroleum prices on the demand for hybrids. The importance of
petroleum prices is further suggested, however, by the following evidence: 1)
despite the phase-down of the deduction, which began on January 1, 2004,
the demand for hybrids stayed at fairly sustained levels, and even increased
before January 1, 2006, the date that the new tax credits became effective;
and 2) the demand for the larger, and less fuel efficient, hybrids such as
hybrid Sport Utility Vehicles has been less than the smaller hybrids. With the
exception of hybrid cars, relatively few AFVs have been sold that qualify for
the deduction. The limited availability of fuel cell, advanced lean-burn
vehicles, and other ATVs, and the 60,000 output limit on the number of
creditable hybrids means that the tax credits will likely have little direct
impact on the total U.S. demand for transportation petroleum demand. With
the exception of Toyota, other hybrid manufacturers are nowhere near the
60,000 limit, which means that the tax credits for the purchasers of their
hybrid should continue to be available.

There is also a concern that the credits have favored foreign at the expense
of domestic auto manufactures, because the demand for hybrids has been met
primarily by imports. Very few of the hybrid vehicles receiving the tax
credits have been manufactured by domestic auto companies. In the short run,
domestic automobile companies have favored production of flexible-fuel
vehicles (particularly vehicles that can use E85 - mixtures of 15 percent
gasoline and 85 percent ethanol) rather than hybrids; in the long run they
appear to be putting their research and development efforts (and spending)
into hydrogen fuel-cell technologies, which create electricity through an
electrochemical reaction between hydrogen and oxygen. Given the current
rudimentary state of development of fuel cell vehicles and hydrogen fueling
infrastructure required for their use, and given the many technological and
cost barriers to this development, however, it is unlikely that the tax credit for
fuel cell vehicles will stimulate much demand. However, if these problems
could be addressed, then tax credits that reduce the price of fuel cell vehicles
to the comparable gasoline vehicle price could stimulate demand for fuel cells
and reduce petroleum consumption. To the extent that the ATV credits accrue
to flexible fuel vehicles there is some concern that consumers will continue to
use gasoline in those vehicles rather than E85. Available data suggest that
very few such vehicles actually use E85, which is not only more expensive
than gasoline, but is scarce due to the lack of supply infrastructure. This
means that, in effect, the ATV tax credits are actually encouraging the
demand for conventionally powered domestic vehicles.

From an economic perspective, allowing special tax credits for selected
technologies (and not others) distorts the allocation of resources - it creates
economic inefficiencies and distortions. It encourages investments in high
cost technologies, ones that would not otherwise be economical at current and
expected prices and rates of return. For businesses this requires retooling and
the cost of commercialization. Some data indicate that the cost of hybrids is
greater than the retail selling price - that manufacturers are losing money on
hybrids. This cost premium is, in part, due to the higher cost of hybrid power
train components. Conversely, when motor fuel prices are high, many
motorists have sufficient financial incentives to purchase more fuel efficient
vehicles, such as hybrids, without tax credits. This results in a windfall for
many consumers - a financial reward for undertaking investments that
would have been undertaken even without the credits - at taxpayer's
expense. This may not be a good use of taxpayer revenues, particularly during
times of large federal budget deficits.

Some of the ATVs that qualify for the tax credits are not only imported but
are very expensive and would tend to be purchased by upper income
households or businesses, which raise questions of the distributional effects of
the credits: For example, such an imported vehicle may sell for $55,000 or
more. The credits might tend to favor middle and upper income households,
or businesses that have the income and wealth to invest in such expensive
ATVs. Such tax credits are often justified on the grounds of energy
conservation, if consumption of energy resulted in negative effects on society,
such as pollution. In general, however, it would be more efficient to directly
tax energy motor fuels or gas guzzlers than to subsidize a particular method of
achieving conservation measures.

Selected Bibliography

Bearden, David M. EPA's Tier 2 Emission Standards for New Motor
Vehicles: A Fact Sheet, U.S. Library of Congress. Congressional Research
Service. CRS Report RS20247. June 12, 2000.
European Commission. Urban Transport: Options for Propulsion Systems
and Instruments for Analysis. March 22, 2001. (Contract No. UR-97-SC-
2076), p. 64, 65.
Fisher, Anthony C., and Michael H. Rothkopf. "Market Failure and
Energy Policy: A Rationale for Selective Conservation," Energy Policy, v. 17.
August 1989, pp. 397-406.
Graham, R. Comparing the Benefits and Impact of Hybrid Electric
Vehicle Options. EPRI Report # 1000349. July 2001.
Hahn, Robert W. "Energy Conservation: An Economic Perspective."
American Enterprise Institute, October 2005.
Hassett, Kevin A., and Gilbert E. Metcalf. "Energy Conservation
Investment: Do Consumers Discount the Future Correctly?" Energy Policy,
v. 21. June 1993, pp. 710-716.
Lazzari, Salvatore. Energy Tax Policy: History and Current Issues.
Library of Congress, Congressional Research Service Report RL33578.
Washington, DC: July 28, 2006.
_. Energy Tax Policy: An Economic Analysis. Library of Congress,
Congressional Research Service Report RL 32265. Washington, DC: March
10, 2004.
_. Expired and Expiring Energy Tax Incentives. Library of Congress,
Congressional Research Service Report 94-525. Washington, DC: June 22,
1994.
Metcalf, Gilbert E. "Economics and Rational Conservation Policy."
Energy Policy, v. 22. October 1994, pp. 819-825.
Pimental, D. and A. Pleasant, et al. "U.S. Energy Conservation and
Efficiency." Energy, Development, and Sustainability. v. 6, September 2004.
pp. 279-306.
Sutherland, Ronald J. "Energy Efficiency or the Efficient Use of Energy
Resources." Energy Sources, v. 16, 1994. pp. 257-268.
Sutherland, Ronald J. "The Economics of Energy Conservation Policy."
Energy Policy, v. 24. April 1996, pp. 361-370.
U.S. Department of Energy. TAFV Alternative Fuels and Vehicle Choice
Model Documentation. Prepared for Oak Ridge National Laboratory
(ORNL/TM-2001/134), by David L. Greene. July, 2001.
U.S. Department of the Treasury. Internal Revenue Service. IRS News
Release: IR-2006-145. September 20, 2006.
U.S. Department of the Treasury. Internal Revenue Service. IRS Notice:
2006-78. Cumulative Bulletin 2006-41. October 10, 2006.
Yacobucci, Brent. Alternative Transportation Fuels and Vehicles: Energy,
Environment, and Developmental Issues. U.S. Library of Congress.
Congressional Research Service. CRS Report RL 30758, January 7, 2005.

Yacobucci, Brent D. Advanced Vehicle Technologies: Energy,
Environment, and Developmental Issues. U.S. Library of Congress:
Congressional Research Service. CRS Report RL 30484, December 17, 2004.
Yacobucci, Brent D. Tax Incentives for Alternative and Advanced
Technology Vehicles. U.S. Library of Congress: Congressional Research
Service. CRS Report RL 22351, December 19, 2005.

Energy

TAX CREDITS FOR CLEAN FUEL VEHICLE
REFUELING PROPERTY

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

(1)

2007

(1)

2008

(1)

2009

(1)

2010

(1)

(1)Less than $50 million.

Authorization

Section 30C.

Description

A 30 percent tax credit is provided for the cost of any qualified alternative
fuel vehicle refueling property installed in a business or at the taxpayer's
principal residence. The credit is limited to $30,000 for businesses at each
separate location, and $1,000 for residences. Clean fuel refueling property is
basically any tangible equipment (such as a pump) used to dispense a fuel
into a vehicle's tank. Qualifying property includes fuel storage and dispensing
units and electric vehicle recharging equipment. A clean fuel is defined as any
fuel at least 85 percent of the volume of which consists of ethanol (E85) or
methanol (M85), natural gas, compressed natural gas (CNG), liquefied
natural gas, liquefied petroleum gas, and hydrogen, or any mixture of
biodiesel and diesel fuel, determined without regard to any use of kerosene
and containing at least 20 percent biodiesel. The taxpayer's basis in the
property is reduced by the amount of the credit. No credit is available for
property used outside the United States.

Only the portion of the credit attributable to property subject to an
allowance for depreciation would be treated as a portion of the general
business credit; the remainder of the credit would be allowable to the extent
of the excess of the regular tax (reduced by certain other credits) over the
alternative minimum tax for the year. This credit is effective for property
placed in service after December 31, 2005, and in the case of property
relating to hydrogen, before January 1, 2015; and in the case of any other
property, before January 1, 2010.

Impact

Under current depreciation rules (the Modified Cost Recovery System) the
cost of most equipment used in retail gasoline and other fuel dispensing
stations is generally recovered over five years using the double-declining
balance method. However, some of the property might be classified
differently and have a longer recovery period. For example, concrete footings
and other "land improvements" have a recovery period of nine years.
Alternatively, under IRC section 179, a small business fuel retailer may elect
to expense up to $100,000 of such investments. Allowing a 30 percent
investment tax credit for alternative fuel dispensing equipment greatly
reduces the after-tax cost, raises the pre-tax return, and reduces the marginal
effective tax rates significantly. This should increase investment in alternative
fuel dispensing equipment and increase the supply of alternative fuels.

To the extent that the credits are effective in increasing the supply of
alternative fuels, and substitute for petroleum products (gasoline and diesel
fuel), there is a decline in petroleum use and importation. Fuel consumed in
conventional motor vehicles accounts for the largest fraction of total
petroleum consumption and is a leading source of dependence on foreign oil.
Alternative fuel vehicles are also generally less polluting, producing
significantly lower total fuel cycle emissions when compared to equivalently
sized conventional vehicles.

Rationale

Section 30C was enacted as part of the Energy Policy Act of 2005 (P.L.
109-58) to stimulate the supply of alternative motor fuels such as E85
(mixtures of 15 percent gasoline and 85 percent ethanol) and CNG. The
provision complements the two other major tax incentives for alternative
fuels: the tax credits for advanced technology vehicles, including alternative
fueled vehicles, under IRC section 30B, and the tax credits for the sale or use
of the alternative fuel under IRC section 6426 and 6427. The Congress
believed that further investments in alternative fuel infrastructure are
necessary to encourage consumers to invest in alternative fuel vehicles. This
investment, in turn, is necessary to transform the mode of transportation in the
United States toward more clean fuel efficient vehicles, relying less on
petroleum, particularly imported petroleum, which endangers U.S. energy and
economic security. The Energy Policy Act of 1992 (P.L. 102-486) introduced
a $100,000 tax deduction for business investment in clean fuel refueling
property. This tax deduction was set to expire on January 1, 2007, but the
Energy Policy Act of 2005 accelerated the expiration date by one year and
replaced the deduction with the 30% tax credit.

Assessment

Substantial economic research over the years suggests that lack of
investment in alternative fuel supply is due, at least in part, to lack of
consumer demand for the vehicles, which was in turn due to the lack of
alternative fuel infrastructure. The section 30C tax credit for clean fuel
refueling property was intended to address this market obstacle to alternative
fuel production and use. In the short run, domestic automobile companies
have favored production of flexible-fuel vehicles (particularly vehicles that
can use E85). To the extent that the ATV credits under IRC section 30B
accrue to flexible fuel vehicles, there is some concern that consumers will
continue to use gasoline in those vehicles rather than E85. Available data
suggest that very few such vehicles actually use E85, which is not only more
expensive than gasoline, but is scarce due to the lack of supply infrastructure.
This finding means that, in effect, the ATV tax credits may actually
encourage the demand for vehicles that end up running on conventional fuels.

Recent data show, for instance, that of the 120,000 fuel retailers in the
United States, only about 600 dispense E85. The 30 percent tax credit for
alternative fuel property at refueling stations could address this shortage and
market problem to the development of alternative fuels. Given the current
rudimentary state of development of E85 and other alternative fuel refueling
infrastructure required for their use, and given the many technological and
cost barriers to this development, the tax credit might stimulate additional
investment. Greater (and more convenient) supply of alternative fuels could
then reduce their price, stimulate demand for alternative fuels, and reduce
petroleum consumption and importation.

From an economic perspective, however, allowing special tax credits for
selected technologies (and not others) distorts the allocation of resources - it
creates distortions and economic inefficiencies. It encourages investments in
high cost technologies, ones that would not otherwise be economical at
current and expected prices and rates of return. Economic theory suggests
that taxes on conventional fuels and conventional fuels using vehicles, such as
the gas-guzzler tax of IRC section 4064, is more effective and efficient in
stimulating the development of the least cost alternatives to gasoline and
diesel fuel. When conventional motor fuel prices are sufficiently high, many
motorists have sufficient financial incentives to purchase more fuel efficient
vehicles, and vehicles fueled by alternative fuels, without tax credits.

Selected Bibliography

European Commission. Urban Transport: Options for Propulsion Systems
and Instruments for Analysis. March 22, 2001. (Contract No. UR-97-SC-
2076), p. 64, 65.
Boes, Richard F., and G. Michael Ransom. "Clean-Fuel Vehicles and
Refueling Property in the United States Tax Code." Logistics and
Transportation Review. March 1994.v.30. pp. 73-79.
Chirinko, Robert S., Steven M. Fazzarri, and Andrew P. Meyer. "How
Responsive is Business Capital Formation to its User Cost? An Exploration
with Micro Data." Journal of Public Economics vol. 74 (1999), pp. 53-80.
Cohen, Darryl, and Jason Cummins. A Retrospective Evaluation of the
Effects of Temporary Partial Expensing. Federal Reserve Board Staff
Working Paper 2006-19, April 2006.
Cordes, Joseph J. "Expensing," in the Encyclopedia of Taxation and Tax
Policy, Joseph J. Cordes, Robert D. Ebel, and Jane G. Gravelle, eds
(Washington: Urban Institute Press, 2005).
Cummins, Jason G., Kevin A. Hassett, and R. Glenn Hubbard, "A
Reconsideration of Investment Behavior Using Tax Reforms as Natural
Experiments." Brookings Papers on Economic Activity, 1994, no. 1, pp. 1-
72.
Guenther, Gary. Small Business Expensing Allowance: Current Status,
Legislative Proposals, and Economic Effects. CRS Report RL31852,
October 3, 2006.
Lazzari, Salvatore. Energy Tax Policy: History and Current Issues.
Library of Congress, Congressional Research Service Report RL33578.
Washington, DC: July 28, 2006.
_. Energy Tax Policy: An Economic Analysis. Library of Congress,
Congressional Research Service Report RL 32265. Washington, DC: March
10, 2004.
_. Expired and Expiring Energy Tax Incentives. Library of Congress,
Congressional Research Service Report 94-525. Washington, DC: June 22,
1994.
U.S. Department of Energy. TAFV Alternative Fuels and Vehicle Choice
Model Documentation. Prepared for Oak Ridge National Laboratory
(ORNL/TM-2001/134), by David L. Greene. July, 2001.
"Tax Briefing: A Look at the Energy Tax Incentives Act of 2005 and the
SAFE Transportation Equity Act of 2005." Taxes. September 2005. v. 83.
pp. 19-27.
Yacobucci, Brent. Alternative Transportation Fuels and Vehicles: Energy,
Environment, and Developmental Issues. U.S. Library of Congress.
Congressional Research Service. CRS Report RL 30758, January 7, 2005.

Energy

FIVE-YEAR CARRYBACK PERIOD FOR CERTAIN
NET OPERATING LOSSES OF
ELECTRIC UTILITY COMPANIES

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.1

2007

(1)

2008

(1)

2009

(2)

2010

(2)

(1) Tax expenditure of less than $50 million.
(2) Negative tax expenditure of less than $50 million.

Authorization

Section 172.

Description

Certain electric utility companies may elect to extend the Net Operating
Loss (NOL) carryback period to five years for a portion of NOLs arising in
2003, 2004 and 2005. The election applies to the 2006-2008 taxable years,
and is limited to 20 percent of the taxpayer's transmission and pollution
control investments during the prior taxable year. There are various other
limitations.

Impact

The net operating loss (NOL) of a business enterprise is generally the
amount by which tax deductions exceed gross revenue. In general, for most
businesses, NOLs may be carried back two years and forward 20 years.
However, special NOL carryback rules apply to (1) casualty and theft losses
of individual taxpayers, (2) NOLs in a farming or small business due to
(presidentially declared) disasters, (3) selected types of farm losses, (4) real
estate investment trusts, (5) special liability losses, (6) excess interest losses,
and (7) bad debt losses of commercial banks. For these 7 categories of NOLs,
the carryback period is three years instead of two.

A carryback is more valuable than a carry-forward, because there is no
delay in receiving the benefit of the loss deduction. For example, at a 10%
discount rate, a dollar received one year into the future is worth only 91 cents;
a dollar received five years into the future is worth 62 cents, and a dollar
received 20 years into the future is worth 15 cents. If the losses were
expected to never be used, the value of the loss deduction is zero.

The loss carryback not only provides some cash flow benefits to the firm,
but also, because it is limited to 20 percent of prior year investment in
qualified property, provides the equivalent of an investment credit. For
example, if the losses are expected to be delayed five years and the taxpayer's
tax rate is 35 percent, another dollar of qualified investment would yield an
NOL deduction valued at the equivalent of a 2.7 percent investment tax
credit, i.e., 2.7 cents [($1-0.62) times 0.2 times 0.35)]. The maximum
investment tax credit equivalent value for the NOL under this provision (for
losses that were expected to expire) is 7 percent, i.e., under the most favorable
assumptions, the five-year carryback of NOLs for electric utilities is
equivalent to an investment tax credit of 7 percent. The exact nature of the
investment subsidy is, however, difficult to determine, since the amount of
losses is limited and can be applied to different years. Which of the two
ceilings is reached first, therefore, determines the value of the investment
subsidy.

Rationale

The NOL deduction has been a part of the federal tax code for a long time.
In general, the rationale for allowing NOLs to be carried forward and back is
to try to achieve symmetry in tax treatment between businesses with stable
incomes and those whose incomes are more variable but average the same
over time. Without this deduction, there would be disparity in tax treatment
between these types of businesses. The five year carryback of electric utility
losses was enacted as part of the Energy Policy Act of 2005 (P.L. 109-58).

There is no explicit statement of rationale for this provision. The initial
provision, which was originally in the Senate bill and limited to all
investment, appeared in the Joint Tax Committee explanation to be viewed as
an extension of an earlier relief provision rather than an investment incentive.
This earlier provision in the Job Creation and Worker Assistance Act of 2002
(P.L. 107-147) provided for a temporary extension of the carryback period
from two to five years for all firms, for NOLs generated (or reported) in 2001
and 2002. In this case, the special treatment was apparently intended to
address the economic hardship of many electric utilities at a time of faltering
restructuring and deregulation.

Assessment

This provision is a combination of a relief provision for firms with tax
losses and an investment subsidy (due to the investment limit). Both the need
for utilities to handle restructuring costs and the desirability of an investment
incentive, as well as their inter-relationship, must be addressed. One could
make a case that some difficulties facing utilities were the result of changes in
government regulation, and some relief is warranted. Providing a loss
carryback is one way to target such relief.

A case may be made for a subsidy to investment in electric transmission
assets based on the under supply of transmission services by a natural
monopoly. However, in this regard, the juxtaposition of the carryback with a
limit based on investment is difficult to justify as the investment subsidy
applies only to firms with losses. Those utilities most in need of relief are
probably least likely to have significant current capital investment, if their
losses arose from an excess capacity arising from prior investment. Nor is
there a clear reason to restrict an investment subsidy, if one is desired, to
firms in loss positions. Also, economically efficient pollution control is
better achieved by a tax on pollution rather than an investment subsidy.

Selected Bibliography

Brumbaugh, David L. Federal Taxes, the Steel Industry, and Net
Operating Loss Carryforwards. Library of Congress. Congressional
Research Service Report 88-5 E. Washington, DC: December 18, 1987.
Abel, Amy. Energy Policy Act of 2005, P.L. 109-58: Electricity
Provisions. Congressional Research Service Report RL33248. Washington,
DC: January 24, 2006.
Joskow, Paul L. "Restructuring, Competition, and Regulatory Reform in
the U.S. Electricity Sector," Journal of Economic Perspectives. Summer
1997. pp. 119-138.

Mills, Lillian F., Kaye J. Newberry, and Garth F. Novack. "How Well Do
Compustat NOL Data Identify Firms With U.S. Tax Return Loss Carryovers?
The Journal of the American Taxation Association. v.25, Fall 2003. pp.1-17.
U.S. Congress, Joint Committee on Taxation. Federal Tax Issues Relating
to Restructuring of the Electric Power Industry. Hearing before the
Subcommittee on Long-Term Growth and Debt Reduction of the Senate
Finance Committee, October 15, 1999. JCX 72-99.

Natural Resources and Environment

EXCESS OF PERCENTAGE OVER COST DEPLETION:
NONFUEL MINERALS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.1

0.2

2007

0.1

0.2

2008

0.1

0.2

2009

0.1

0.2

2010

0.1

0.2

Authorization

Sections 611, 612, 613, and 291.

Description

Firms that extract minerals, ores, and metals from mines are permitted a
deduction to recover their capital investment, which depreciates due to the
physical and economic depletion of the reserve as the mineral is recovered
(section 611).

There are two methods of calculating this deduction: cost depletion, and
percentage depletion. Cost depletion allows for the recovery of the actual
capital investment - the costs of discovering, purchasing, and developing a
mineral reserve - over the period during which the reserve produces income.
Each year, the taxpayer deducts a portion of the adjusted basis (original
capital investment less previous deductions) equal to the fraction of the
estimated remaining recoverable reserves that have been extracted and sold.
Under this method, the total deductions cannot exceed the original capital
investment.

Under percentage depletion, the deduction for recovery of capital
investment is a fixed percentage of the "gross income" - i.e., sales revenue
- from the sale of the mineral. Under this method, total deductions typically
exceed the capital invested.

Section 613 states that mineral producers must claim the higher of cost or
percentage depletion. The percentage depletion allowance is available for
many types of minerals, at rates ranging from 5 percent (for clay, sand, gravel,
stone, etc.) to 22 percent (for sulphur, uranium, asbestos, lead, etc.).

Metal mines generally qualify for a 14 percent depletion, except for gold,
silver, copper, and iron ore, which qualify for a 15 percent depletion. The
percentage depletion rate for foreign mines is generally 14 percent.

Percentage depletion is limited to 50percent of the taxable income from the
property. For corporate taxpayers, section 291 reduces the percentage
depletion allowance for iron ore by 20 percent. Allowances in excess of cost
basis are treated as a preference item and taxed under the alternative
minimum tax.

Impact

Historically, generous depletion allowances and other tax benefits reduced
effective tax rates in the minerals industries significantly below tax rates on
other industries, providing incentives to increase investment, exploration, and
output, especially for oil and gas. It is possible for cumulative depletion
allowances to total many times the amount of the original investment. The
combination of this subsidy and the deduction of exploration and
development expenses represents a significant boon to mineral producers that
are eligible for both. In addition, the Mining Law of 1872 permits U.S.
citizens and businesses to freely prospect for hard rock minerals on federal
lands, and allows them to mine the land if an economically recoverable
deposit is found. No federal rents or royalties are imposed upon the sale of the
extracted minerals. A prospecting entity may establish a claim to an area that
it believes may contain a mineral deposit of value and preserve its right to that
claim by paying an annual holding fee of $100 per claim. Once a claimed
mineral deposit is determined to be economically recoverable, and at least
$500 of development work has been performed, the claim holder may apply
for a "patent" to obtain title to the surface and mineral rights. If approved, the
claimant can obtain full title to the land for $2.50 or $5.00 per acre.

Issues of principal concern are the extent to which percentage depletion:

(1) decreases the price of qualifying minerals, and therefore encourages
their consumption;

(2) bids up the price of exploration and mining rights; and

(3) encourages the development of new deposits and increases production.

Most analyses of percentage depletion have focused on the oil and gas
industry, which - before the 1975 repeal of percentage depletion for major
oil companies - accounted for the bulk of percentage depletion. There has
been relatively little analysis of the effect of percentage depletion on other
industries. The relative value of the percentage depletion allowance in
reducing the effective tax rate of mineral producers is dependent on a number
of factors, including the statutory percentage depletion rate, income tax rates,
and the effect of the net income limitation.

Rationale

Provisions for a depletion allowance based on the value of the mine were
made under a 1912 Treasury Department regulation (T.D. 1742), but this was
never effectuated.

A court case resulted in the enactment, as part of the Tariff Act of 1913, of
a "reasonable allowance for depletion" not to exceed five percent of the value
of output. This statute did not limit total deductions; Treasury regulation No.
33 limited total deductions to the original capital investment.

This system was in effect from 1913 to 1918, although in the Revenue Act
of 1916, depletion was restricted to no more than the total value of output,
and, in the aggregate, to no more than capital originally invested or fair
market value on March 1, 1913 (the latter so that appreciation occurring
before enactment of income taxes would not be taxed).

On the grounds that the newer mineral discoveries that contributed to the
war effort were treated less favorably, discovery value depletion was enacted
in 1918. Discovery depletion, which was in effect through 1926, allowed
deductions in excess of capital investment because it was based on the market
value of the deposit after discovery. In 1921, because of concern with the
size of the allowances, discovery depletion was limited to net income; it was
further limited to 50 percent of net income in 1924.

For oil and gas, discovery value depletion was replaced in 1926 by the
percentage depletion allowance, at the rate of 27.5percent. This was due to
the administrative complexity and arbitrariness, and due to its tendency to
establish high discovery values, which tended to overstate depletion
deductions.

For other minerals, discovery value depletion continued until 1932, at
which time it was replaced by percentage depletion at the following rates:
23percent for sulphur, 15percent for metal mines, and 5percent for coal.

From 1932 to 1950, percentage depletion was extended to most other
minerals. In 1950, President Truman recommended a reduction in the top
depletion rates to 15percent, but Congress disagreed. The Revenue Act of
1951 raised the allowance for coal to 10percent and granted it to more
minerals.

In 1954, still more minerals were granted the allowance, and foreign mines
were granted a lower rate. In 1969, the top depletion rates were reduced and
the allowance was made subject to the minimum tax. The Tax Equity and
Fiscal Responsibility Act of 1982 reduced the allowance for corporations that
mined coal and iron ore by 15percent. The Tax Reform Act of 1986 raised
the cutback in corporate allowances for coal and iron ore from 15percent to
20percent.

Assessment

Standard accounting and economic principles state that the appropriate
method of capital recovery in the mineral industry is cost depletion adjusted
for inflation. The percentage depletion allowance permits mineral producers
to continue to claim a deduction even after all the investment costs of
acquiring and developing the property have been recovered. Thus it is a
mineral production subsidy rather than an investment subsidy. In cases where
a taxpayer has obtained mining rights relatively inexpensively under the
provisions of the Mining Law of 1872, it can be argued that such taxpayers
should not be entitled to the additional benefits of the percentage depletion
provisions.

As a production subsidy, however, percentage depletion is economically
inefficient, encouraging excessive development of existing properties rather
than exploration of new ones. Although accelerated depreciation for non-
mineral assets may lower effective tax rates by speeding up tax benefits, these
assets cannot claim depreciation deductions in excess of investment.

However, arguments have been made to justify percentage depletion on
grounds of unusual risks, the distortions in the corporate income tax, and
national security, and to protect domestic producers. Mineral price volatility
alone does not necessarily justify percentage depletion.

Percentage depletion may not be the most efficient way to increase
mineral output. Percentage depletion may also have adverse environmental
consequences, encouraging the use of raw materials rather than recycled
substitutes.

Selected Bibliography

Andrews-Speed, Philip, and Christopher Rogers."Mining Taxation on
Issues for the Future," Resources Policy, v. 25. 1999, pp. 221-227.
Anderson, Robert D., Alan S. Miller, and Richard D. Spiegelman. "U.S.
Federal Tax Policy: The Evolution of Percentage Depletion for Minerals,"
Resources Policy, v. 3. September 1977, pp. 165-176.
Conrad, Robert F. "Mining Taxation: A Numerical Introduction,"
National Tax Journal, v. 33. December, 1980, pp. 443-449.
Crowson, Philip. Inside Mining: The Economics of the Supply and
Demand of Minerals and Metals. London: Mining Journal Books, 1998.
Davidson, Paul. "The Depletion Allowance Revisited," Natural Resources
Journal, v. 10. January 1970, pp. 1-9.
Dorsey, Christine. "Clinton Administration Revives Plan to Revoke
Mining Tax Break." Las Vegas Review - Journal. February 10, 2000. p. 4D.
Fenton, Edmund D. "Tax Reform Act of 1986: Changes in Hard Mineral
Taxation," Oil and Gas Tax Quarterly, v. 36. September, 1987, pp. 85-98.
Frazier, Jessica and Edmund D. Fenton. "The Interesting Beginnings of the
Percentage Depletion Allowance," Oil and Gas Tax Quarterly, v. 38. June
1990, pp. 697-712.
Lagos, Gustavo. "Mining Investment and Compensation - Mineral
Taxation and Investment." Natural Resources Forum. August 1993.v.17.
Lazzari, Salvatore. The Effects of the Administration's Tax Reform
Proposal on the Mining Industry. Library of Congress, Congressional
Research Service Report 85-WP. Washington, DC: July 29, 1985.
_. Energy Tax Policy: An Economic Analysis. Library of Congress,
Congressional Research Service Report RL 30406. Washington, DC: June
28, 2005.
-. The Federal Royalty and Tax Treatment of the Hard Rock Minerals
Industry: An Economic Analysis. Library of Congress, Congressional
Research Service Report 90-493 E. Washington, DC: October 15, 1990.
Muzondo, Timothy R. "Mineral Taxation, Market failure, and the
Environment." International Monetary Fund. Staff Papers - International
Monetary Fund. March 1993.v.40. Washington, pp. 152-178.
Randall, Gory. "Hard Mineral Taxation-Practical Problems," Idaho Law
Review, v. 19. Summer 1983, pp. 487-503.
Tripp, John D., Hugh D. Grove, and Michael McGrath. "Maximizing
Percentage Depletion in Solid Minerals," Oil and Gas Tax Quarterly, v. 30.
June 1982, pp. 631-646.
Updegraft, Kenneth E., and Joel D. Zychnick. "Transportation of Crude
Mineral Production by Mine Owners and its Effect on Hard Minerals
Depletion Allowance," Tax Lawyer, v. 35. Winter 1982, pp. 367-387.
U.S. General Accounting Office. Selected Tax Provisions Affecting the
Hard Minerals Mining and Timber Industry. GAO/GGD-87-77 FS. June
1987. Washington, DC: U.S. Government Printing Office, June 1987.

Ward, Frank A., and Joe Kerkvliet. "Quantifying Exhaustible Resource
Theory: An Application to Mineral Taxation Policy." Resource and Energy
Economics. June 1993.v.15. pp. 203-242.

Natural Resources and Environment

EXPENSING OF MULTIPERIOD TIMBER-GROWING
COSTS; AMORTIZATION AND EXPENSING OF
REFORESTATION EXPENSES

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.1

0.2

0.3

2007

0.1

0.2

0.3

2008

0.1

0.2

0.3

2009

0.1

0.2

0.3

2010

0.1

0.2

0.3

Authorization

Sections 194, 263A(c)(5).

Description

Taxpayers may deduct up to $10,000 of reforestation expenditures
incurred with respect to any qualified timber property in any tax year.
Expenditures exceeding the cap may be amortized over 84 months. In most
other industries, such indirect costs are capitalized under the uniform
capitalization rules.

Most of the production costs of maintaining a timber stand after it is
established are expensed (deducted when incurred), rather than capitalized
(reducing gain when the timber is sold). These costs include indirect carrying
costs, such as interest and property taxes, as well as costs of disease and pest
control and brush clearing.

Impact

By allowing the deduction of expenses when incurred, the effective tax
rate on investments in these indirect costs is zero. These provisions lower the
effective tax rate on timber growing in general. The extent of the effect of tax
provisions on the timber industry is in some dispute. Most of the benefit goes
to corporations, and thus is likely to benefit higher-income individuals (see
discussion in Introduction).

Rationale

The original ability to expense indirect costs of timber growing was
apparently part of a general perception that these costs were maintenance
costs, and thus deductible as ordinary costs of a trade or business. There were
a series of revenue rulings and court cases over the years distinguishing
between what expenses might be deductible and what expenses might be
capitalized (for example, I. T. 1610 in 1923, an income tax unit ruling), Mim.
6030 in 1946 (a mimeographed letter ruling), Revenue Ruling 55-412 in
1955, and Revenue Ruling 66-18 in 1966).

The Tax Reform Act of 1986 included uniform capitalization rules which
required indirect expenses of this nature to be capitalized in most cases.
Several exception were provided, including timber. There is no specific
reason given for exempting timber per se, but the general reason given for
exceptions to the uniform capitalization rules is that they are cases were
application "might be unduly burdensome."

The expensing of the first $10,000 of reforestation costs was added in
American Jobs Creation Act of 2004 (P.L. 108-357) and clarified in Gulf
Opportunity Zone Act of 2005 (P.L. 109-135). The provision replaced an
existing reforestation credit. The change was made to simplify the treatment
of reforestation costs, and the basic purpose of the incentive was to encourage
reforestation. The act also included timber growing in the manufacturing
activities eligible for the new manufacturing deduction under Sec. 199 of the
Code.

Assessment

The tax benefit provides a forgiveness of tax on the return to part of the
investment in timber growing. While tax subsidy often lead to misallocation
of resources and a welfare loss, this provision might be different. Timber
growing might provide benefits to society in general (called externalities in
economics), such as improved environment, recreational opportunities, or
aesthetics. In general, private investors cannot capture most of these benefits,
therefore they would tend to invest less than may be socially desirable in
reforestation and timber growing. Tax subsidy may help alleviate this
problem. Still, some argue that the tax benefit design make it a rather weak
incentive. In addition, the tax approach must be weighed against other
alternatives, such as direct subsidies or direct ownership of timber lands by
the government.

Selected Bibliography

Society of American Foresters, Study Group on Forest Taxation. "Forest
Taxation." Journal of Forestry, v. 78. July 1980, pp. 1-7.
U.S. Congress, Joint Economic Committee. "The Federal Tax Subsidy of
the Timber Industry," by Emil Sunley, in The Economics of Federal Subsidy
Programs. 92nd Congress, 2nd session. July 15, 1972.
-, Joint Committee on Taxation. General Explanation of the Tax Reform
Act of 1986. May 4, 1987, pp. 508-509.
U.S. Department of Agriculture, Forest Service. A Forest Owner's Guide
to the Federal Income Tax, Agriculture Handbook No. 708. Washington,
DC: U.S. Government Printing Office, October 1995.
U.S. Department of Treasury. Special Expensing and Amortization Rules
in Tax Reform for Fairness, Simplicity, and Economic Growth, v. 2, Nov.
1984, pp. 299-313.
U.S. General Accounting Office. Selected Tax Provisions Affecting the
Hard Minerals Mining and Timber Industries, Fact Sheet for the Honorable
John Melcher, United States Senate. June 1987.
-. Forest Service: Timber Harvesting, Planting, Assistance Programs and
Tax Provisions, Briefing Report to the Honorable Sander M. Levin, House of
Representatives. April 1990.

Natural Resources and Environment

EXPENSING OF EXPLORATION AND DEVELOPMENT COSTS:
NONFUEL MINERALS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

(1)

0.1

(1)

2007

(1)

0.1

(1)

2008

(1)

0.1

(1)

2009

(1)

0.1

(1)

2010

(1)

0.1

(1)

(1) Less than $50 million.

Authorization

Sections 263, 291, 616-617, 56, 1254.

Description

Firms engaged in mining are permitted to expense (to deduct in the year
paid or incurred) rather than capitalize (i.e., recover such costs through
depletion or depreciation) certain exploration and development (E&D) costs.
This provision is an exception to general tax rules.

In general, mining exploration costs are those (non-equipment) costs
incurred to ascertain the existence, location, extent, or quality of any
potentially commercial deposit of ore or other depletable mineral prior to the
development stage of the mine or deposit.

Development costs generally are those incurred for the development of a
mine or other natural deposits after the existence of ores in commercially
marketable quantities has been determined. Development expenditures
generally include those for construction of shafts and tunnels, and in some
cases drilling and testing to obtain additional information for planning
operations. There are no limits on the current deductibility of such costs.
Expensing of mine E&D costs may be taken in addition to percentage
depletion, but it subsequently reduces percentage depletion deductions (i.e., is
recaptured). The costs of tangible equipment must be depreciated.

Expensing of E&D costs applies only to domestic properties; E&D costs
on foreign properties must be depreciated. The excess of expensing over the
capitalized value (amortized over 10 years) is a tax preference item that is
subject to the alternative minimum tax.

Impact

E&D costs for non-fuels minerals are not as large a portion of the costs of
finding and developing a mineral reserve as is the case for oil and gas, where
they typically account for over two-thirds of the costs of creating a mineral
asset. Expensing of such costs is also less of a benefit than percentage
depletion allowances. The Joint Committee on Taxation estimates total tax
expenditures from expensing E&D costs at $500 million over the period
2006-2010.

Nevertheless they are a capital expense which otherwise would be depleted
over the income-producing life of the mineral reserve. Combined with other
tax subsidies, such as percentage depletion, expensing reduces effective tax
rates in the mineral industry below tax rates on other industries, thereby
providing incentives to increase investment, exploration, and output. This cost
reduction increases the supply of the mineral and reduces its price.

This tax expenditure is largely claimed by corporate producers. The at-risk,
recapture, and minimum tax restrictions that have since been placed on the
use of the provision have primarily limited the ability of high-income
taxpayers to shelter their income from taxation through investment in mineral
exploration.

Rationale

Expensing of mine development expenditures was enacted in 1951 to
encourage mining and reduce ambiguity in its tax treatment. The provision for
mine exploration was added in 1966.

Prior to the Tax Reform Act of 1969, a taxpayer could elect either to
deduct without dollar limitation exploration expenditures in the United States
(which subsequently reduced percentage depletion benefits), or to deduct up
to $100,000 a year with a total not to exceed $400,000 of foreign and
domestic exploration expenditures without recapture.

The 1969 act subjected all post-1969 exploration expenditures to
recapture. The Tax Equity and Fiscal Responsibility Act of 1982 added
mineral exploration and development costs as tax preference items subject to
the alternative minimum tax, and limited expensing for corporations to 85
percent. The Tax Reform Act of 1986 required that all exploration and
development expenditures on foreign properties be capitalized.

Assessment

E&D costs are generally recognized to be capital costs, which, according
to standard accounting and economic principles, should be recovered through
depletion (cost depletion adjusted for inflation).

Lease bonuses and other exploratory costs (survey costs, geological and
geophysical costs) are properly treated as capital costs, although they may be
recovered through percentage rather than cost depletion. Immediate
expensing of E&D costs provides a tax subsidy for capital invested in the
mineral industry with a relatively large subsidy for corporate producers.

By expensing rather than capitalizing these costs, the tax code effectively
sets taxes on the return to such expenditures at zero. As a capital subsidy,
however, expensing is inefficient because it makes investment decisions
based on tax considerations rather than inherent economic considerations.

Arguments have been made over the years to justify expensing on the basis
of unusual investment risks, the distortions in the corporate income tax,
strategic materials and national security, and protection of domestic
producers (especially small independents).

Expensing is a costly and inefficient way to increase mineral output and
enhance energy security. Expensing may also have adverse environmental
consequences by encouraging the development of raw materials as opposed to
recycled substitutes.

Selected Bibliography

Andrews-Speed, Philip, and Christopher Rogers. "Mining Taxation Issues
for the Future," Resources Policy, v. 25 (1999), pp. 221-227.
Congressional Budget Office. Budget Options. Section 28: Repeal the
Expensing of Exploration and Development Costs for Extractive Industries.
February 2005.
Conrad, Robert F. "Mining Taxation: A Numerical Introduction."
National Tax Journal, v. 33, December, 1980, pp. 443-449.
Crowson, Philip. Inside Mining: The Economics of the Supply and
Demand of Minerals and Metals. London: Mining Journal Books, 1998.

Dorsey, Christine. "Clinton Administration Revives Plan to Revoke
Mining Tax Break." Las Vegas Review - Journal. February 10, 2000. p. 4D.
Lagos, Gustavo. "Mining Investment and Compensation - Mineral
Taxation and Investment." Natural Resources Forum. August 1993. v.17.
Lazzari, Salvatore. Energy Tax Policy: An Economic Analysis. Library of
Congress, Congressional Research Service Report RL30406. Washington,
DC: June 28, 2006.
-. The Federal Royalty and Tax Treatment of the Hard Rock Minerals
Industry: An Economic Analysis. Library of Congress, Congressional
Research Service Report 90-493E. Washington, DC: October 15, 1990.
Muzondo, Timothy R. "Mineral Taxation, Market Failure, and the
Environment." International Monetary Fund. Staff Papers. International
Monetary Fund. March 1993.v.40. Washington, pp. 152-178.
U.S. General Accounting Office. Selected Tax Provisions Affecting the
Hard Minerals Mining and Timber Industry. GAO/GGD-87-77 FS,
Washington, D.C., Government Printing Office, June 1987.
U.S. General Accounting Office. Selected Tax Provisions Affecting the
Hard Minerals Mining and Timber Industry. GAO/GGD-87-77 FS. June
1987. Washington, DC: U.S. Government Printing Office, June 1987.
Ward, Frank A., and Joe Kerkvliet. "Quantifying Exhaustible Resource
Theory: An Application to Mineral Taxation Policy." Resource and Energy
Economics. June 1993.v.15. pp. 203-242.
Wilburn, D.R. "Exploration." Mining Engineering. May 2003. v.55. pp.
30-43.

Natural Resources and Environment

EXCLUSION OF INTEREST ON STATE AND LOCAL
GOVERNMENT SEWAGE, WATER, AND
HAZARDOUS WASTE FACILITIES BONDS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.4

0.2

0.6

2007

0.4

0.2

0.6

2008

0.5

0.2

0.7

2009

0.5

0.2

0.7

2010

0.5

0.2

0.7

Authorization

Sections 103, 141, 142, and 146.

Description

Interest income from State and local bonds used to finance the construction
of sewage facilities, facilities for the furnishing of water, and facilities for the
disposal of hazardous waste is tax exempt.

Some of these bonds are classified as private-activity bonds rather than as
governmental bonds because a substantial portion of their benefits accrues to
individuals or business rather than to the general public. For more discussion
of the distinction between governmental bonds and private-activity bonds, see
the entry under General Purpose Public Assistance: Exclusion of Interest on
Public Purpose State and Local Debt.

The bonds classified as private activity for these facilities are subject to the
State private-activity bond annual volume cap.

Impact

Some of the benefits of the tax exemption also flow to bondholders. For a
discussion of the factors that determine the shares of benefits going to
bondholders and users of the sewage, water, and hazardous waste facilities,
and estimates of the distribution of tax-exempt interest income by income
class, see the "Impact" discussion under General Purpose Public Assistance:
Exclusion of Interest on Public Purpose State and Local Debt.

Rationale

Prior to 1968, no restriction was placed on the ability of State and local
governments to issue tax-exempt bonds to finance sewage, water, and
hazardous waste facilities. Although the Revenue and Expenditure Control
Act of 1968 imposed tests that would have restricted issuance of these bonds,
it provided a specific exception for sewage and water (allowing continued
unrestricted issuance).

Water-furnishing facilities must be made available to the general public
(including electric utility and other businesses), and must be either operated
by a governmental unit or have their rates approved or established by a
governmental unit. The hazardous waste exception was adopted by the Tax
Reform Act of 1986. The portion of a hazardous waste facility that can be
financed with tax-exempt bonds cannot exceed the portion of the facility to be
used by entities other than the owner or operator of the facility. In other
words, a hazardous waste producer cannot use tax-exempt bonds to finance a
facility to treat its own wastes.

Assessment

Many observers suggest that sewage, water, and hazardous waste treatment
facilities will be under-provided by state and local governments because the
benefit of the facilities extends beyond State and local government
boundaries. In addition, there are significant costs, real and perceived,
associated with siting an unwanted hazardous waste facility. The federal
subsidy through this tax expenditure may encourage increased investment as
well as spread the cost to more potential beneficiaries, federal taxpayers.

Alternatively, subsidizing hazardous waste treatment facilities reduces the
cost of producing waste if the subsidy is passed through to waste producers.
When the cost of producing waste declines, then waste emitters may in turn
increase their waste output. Thus, subsidizing waste treatment facilities may
actually increase waste production. Recognizing the potential effect of
subsidizing private investment in waste treatment, Congress eliminated a
general subsidy for private investment in waste and pollution control
equipment in the Tax Reform Act of 1986.

Even if a subsidy for sewage, water, and hazardous waste facilities is
considered appropriate, it is important to recognize the potential costs. As
one of many categories of tax-exempt private-activity bonds, bonds for these
facilities increase the financing cost of bonds issued for other public capital.
With a greater supply of public bonds, the interest cost on the bonds
necessarily increases to lure investors. In addition, expanding the availability
of tax-exempt bonds increases the range of assets available to individuals and
corporations to shelter their income from taxation.

Selected Bibliography

Fredriksson, Per G. "The Siting of Hazardous Waste Facilities in Federal
Systems: The Political Economy of NIMBY [Not In My Back Yard],"
Environmental and Resource Economics v. 15, no. 1 (January 2000), pp. 75-
87.
Maguire, Steven. Private Activity Bonds: An Introduction. Library of
Congress, Congressional Research Service Report RL31457. June 9, 2006.
-. Tax-Exempt Bonds: A Description of State and Local Government Debt.
Library of Congress, Congressional Research Service Report RL30638.
March 10, 2006.
U.S. Congress, Joint Committee on Taxation, Present Law and
Background Related to State and Local Government Bonds, Joint Committee
Print JCX-14-06, March 16, 2006.
U.S. Department of Treasury, Internal Revenue Service. Tax-Exempt
Private Activity Bonds, Publication 4078, June 2004.
Zimmerman, Dennis. Environmental Infrastructure and the State-Local
Sector: Should Tax-Exempt Bond Law Be Changed? Library of Congress,
Congressional Research Service Report 91-866 E. Washington, DC:
December 16, 1991.
-. The Private Use of Tax-Exempt Bonds: Controlling Public Subsidy of
Private Activities. Washington, DC: The Urban Institute Press, 1991.

Natural Resources and Environment

SPECIAL RULES FOR MINING RECLAMATION RESERVES

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

(1)

2007

(1)

2008

(1)

2009

(1)

2010

(1)

(1) Less than $50 million.

Authorization

Section 468.

Description

Firms are generally not allowed to deduct a future expense until "economic
performance" occurs--that is, until the service they pay for is performed and
the expense is actually paid. Electing taxpayers may, however, deduct the
current-value equivalent of certain estimated future reclamation and closing
costs for mining and solid waste disposal sites.

For Federal income tax purposes, the amounts deducted prior to economic
performance are deemed to earn interest at a specified interest rate. When the
reclamation has been completed, any excess of the amounts deducted plus
deemed accrued interest over the actual reclamation or closing costs is taxed
as ordinary income.

Impact

Section 468 permits reclamation and closing costs to be deducted at the
time of the mining or waste disposal activity that gives rise to the costs.
Absent this provision, the costs would not be deductible until the reclamation
or closing actually occurs and the costs are paid. Any excess amount
deducted in advance (plus deemed accrued interest) is taxed at the time of
reclamation or closing.

Rationale

This provision was adopted in 1984. Proponents argued that allowing
current deduction of mine reclamation and similar expenses is necessary to
encourage reclamation, and to prevent the adverse economic effect on mining
companies that might result from applying the general tax rules regarding
deduction of future costs.

Assessment

Reclamation and closing costs for mines and waste disposal sites that are
not incurred concurrently with production from the facilities are capital
expenditures. Unlike ordinary capital expenditures, however, these outlays
are made at the end of an investment project rather than at the beginning.

Despite this difference, writing off these capital costs over the project life
is appropriate from an economic perspective, paralleling depreciation of up-
front capital costs. The tax code does not provide systematic recognition of
such end-of-project capital costs. Hence they are treated under special
provisions that provide exceptions to the normal rule of denying deduction
until economic performance. Because the provisions align taxable income
and economic incomes closer together, it is debatable whether the exceptions
should be regarded as tax expenditures at all.

Selected Bibliography

Halperin, Daniel I. Interest in Disguise: Taxing the 'Time Value of
Money,' The Yale Law Journal. January 1986, pp. 506-552.
Kiefer, Donald W. The Tax Treatment of a 'Reverse Investment,' Tax
Notes. March 4, 1985, pp. 925-932.
U.S. Congress, Joint Committee on Taxation. General Explanation of the
Revenue Provisions of the Deficit Reduction Act of 1984. Committee Print,
98th Congress, 2nd session, December 31, 1984, pp. 273-276.
Wise, Spence and J. Ralph Byington. Mining and Solid Waste
Reclamation and Closing Costs, Oil, Gas & Energy Quarterly, vol. 50, pp.
47-55, September 2001.

Natural Resources and Environment

SPECIAL TAX RATE
FOR NUCLEAR DECOMMISSIONING RESERVE FUND

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.5

2007

0.6

2008

0.7

2009

0.8

2010

0.8

Authorization

Section 468A.

Description

Taxpayers who are responsible for the costs of decommissioning nuclear
power plants (e.g., utilities) can elect to create reserve funds to be used to pay
for decommissioning. The funds receive special tax treatment: amounts
contributed to a reserve fund are deductible in the year made and are not
included in the taxpayer's gross income until the year they are distributed,
thus effectively postponing tax on the contributed amounts. Amounts actually
spent on decommissioning are deductible in the year they are made. The
fund's investments, however, are subject to a 20% tax rate - a lower rate than
that which applies to most other corporate income. The amount that can be
contributed to an account is limited to the lesser of the "cost of service"
amount or an amount the Internal Revenue Service (IRS) determines would
provide funding for the actual decommissioning costs, when they occur. The
"cost of service" amount is the amount charged by utilities to customers as
representing decommissioning costs.

Impact

As noted above, amounts contributed to a qualified fund are deductible in
the year contributed but are taxed when withdrawn to pay for
decommissioning costs. By itself, such treatment would constitute a tax
deferral. However, full taxation of the investment earnings of the tax-
deferred funds (the treatment that applied before 1992) would offset any
benefit from the deferral. Accordingly, taken alone, only current law's
reduced tax rate poses a tax benefit.

But an additional issue is whether the favorable tax treatment accorded to
the funds simply compensates for other, unfavorable, tax treatment of
decommissioning costs. Under current law there is a tax penalty associated
with decommissioning because outlays for nuclear decommissioning are not
permitted to be deducted until they are actually made. To the extent a
taxpayer incurs a liability for those costs in advance of the outlays, this
treatment constitutes a tax penalty similar to a reverse tax deferral; accurate
treatment would require the costs to be deducted to reflect the loss in value of
the plant as the required outlay becomes closer in time.

The likely economic effect of the reduced rates is to encourage outlays on
nuclear decommissioning because the tax-saving funds are contingent on
making such outlays. At the same time, however, to the extent that
decommissioning costs are required by government regulations to be incurred
with or without the special tax treatment, the reduced rates pose an incentive
to invest in nuclear power plants. The benefit of the favorable tax treatment
likely accrues to owners of electric utilities that use nuclear power and to
consumers of the electricity they produce.

Rationale

The special decommissioning funds were first enacted by the Deficit
Reduction Act of 1984 (Public Law 98-369), but the funds' investment
earnings were initially subject to tax at the highest corporate tax rate (46%, at
the time). The funds were established because Congress believed that the
establishment of segregated reserve funds was a matter of "national
importance." At the same time, however, Congress "did not intend that this
deduction should lower the taxes paid by the owners...in present value terms,"
and thus imposed full corporate taxes on funds' investment earnings.

The reduced tax rate was enacted by the Energy Policy Act of 1992 (Public
Law 102-486). The rate was reduced to provide "a greater source of funds"
for decommissioning expenses. More recently, Congress in 2000 approved a
measure that would eliminate the "cost of service" limitation on contributions
to funds (leaving intact, however, the limit posed by the IRS determination.)
The Clinton Administration proposed a similar measure in its fiscal year 2001
budget, but the congressional bill was vetoed for reasons not related to
decommissioning costs.

Assessment

As noted above, the reduced tax rates may provide a tax benefit linked
with amounts contributed to qualified funds. The impact of the resulting tax
benefit on economic efficiency depends in part on the effect of non-tax
regulations governing decommissioning. Nuclear powerplants that are not
appropriately decommissioned might impose external pollution costs on the
economy that are not reflected in the market price of nuclear energy. To the
extent government regulations require plants to be shut down in a manner that
eliminates pollution, this "market failure" may already be corrected and any
tax benefit is redundant. To the extent regulations do not require effective
decommissioning, the tax benefit may abet economic efficiency by
encouraging decommissioning outlays. The equity effect of the tax benefit is
distinct from regulatory fixes of pollution. It is likely that decommissioning
costs required by regulation are borne by utility owners and consumers of
nuclear energy. The tax benefit probably shifts a part of this burden to
taxpayers in general. Note also, however, that the reduced rates may simply
compensate for the delayed deduction of decommissioning costs.

Selected Bibliography

Khurana, Inder K., Richard H. Pettway, and K.K. Raman. "The Liability
Equivalence of Unfunded Nuclear Decommissioning Costs." Journal of
Accounting and Public Policy, vol. 20, no. 2, Summer 2001.
Palmer, Stephen L. "A Suggestion for Federal Tax Treatment of Accrued
Nuclear Power Plant Decommissioning Expenses." Tax Lawyer 35 (Spring
1982), pp. 779-797.
U.S. Congress, Joint Committee on Taxation. Federal Tax Issues Relating
to Restructuring of the Electric Power Industry. Joint Committee Print, 106th
Congress, 1st session. Washington, DC: Government Printing Office, October
15, 1999, pp. 39-43.
-. General Explanation of the Revenue Provisions of the Deficit
Reduction Act of 1984. Joint Committee Print, 98th Congress, 2d Session.
Washington, DC: Government Printing Office, 1971, pp. 270-272.
U.S. Department of the Treasury. General Explanations of the
Administration's Fiscal Year 2001 Revenue Proposals. Washington, DC:
2000, pp. 117-118.
U.S. General Accounting Office, Nuclear Regulation: NRC Needs More
Effective Analysis to Ensure Accumulation of Funds to Decommission
Nuclear Power Plants. Report GAO-04-32, October 2003.

Zimmerman, Raymond A. and Jeri Farrow. "Decommissioning Funds:
Snagged on Tax Law?" Public Utilities Fortnightly 139 (April 1, 2001), pp.
34.

Natural Resources and Environment

EXCLUSION OF CONTRIBUTIONS IN AID OF CONSTRUCTION
FOR WATER AND SEWER UTILITIES

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

(1)

2007

(1)

2008

(1)

2009

(1)

2010

(1)

(1)Less than $50 million.

Authorization

Section 118(c),(d).

Description

Contributions in aid of construction are charges paid by utility customers,
usually builders or developers, to cover the cost of installing facilities to
service housing subdivisions, industrial parks, manufacturing plants, etc. In
some cases, the builder/developer transfers completed facilities to the utility
rather than paying cash to the utility to finance construction of the facilities.

Qualifying contributions in aid of construction received by regulated water
and sewage disposal utilities which provide services to the general public in
their service areas are not included in the utilities' gross income if the
contributions are spent for the construction of the facilities within 2 years
after receipt of the contributions. Service charges for starting or stopping
services do not qualify as nontaxable capital contributions. Assets purchased
with (or received as) qualifying contributions have no basis (hence, cannot be
depreciated by the utility) and may not be included in the utility's rate base for
rate-making purposes.

Impact

Before the Tax Reform Act of 1986 (TRA86), the special treatment
described above applied to contributions in aid of construction received by
regulated utilities that provide steam, electric energy, gas, water, or sewage
disposal services. This treatment effectively exempted from taxation the
services provided by facilities financed by contributions in aid of
construction. The treatment was repealed by TRA86 but reinstated by the
Small Business Job Protection Act of 1996 for water and sewage facilities
only.

Repeal of the special treatment resulted in increases in the amounts utilities
charge their customers as contributions in aid of construction. Before
TRA86, a utility would charge its customers an amount equal to the cost of
installing a facility. After TRA86, utilities had to charge an amount equal to
the cost of the facility plus an amount to cover the tax on the contribution in
aid of construction. This parallels the pricing of most other business services,
for which companies must charge customers the actual cost of providing the
service plus an amount to cover the tax on the income.

The higher cost associated with contributions in aid of construction as a
result of the change in the TRA86 led to complaints from utility customers
and proposals to reverse the change. The special treatment of contributions in
aid of construction was reinstated - but only for water and sewage utilities -
in the Small Business Job Protection Act of 1996. As a result of this
reinstatement, water and sewage utility charges for contributions in aid of
construction are lower than they would be if the contributions were still
taxable. The charge now covers only the cost of the financed facility; there is
no markup to cover taxes on the charge.

To the extent that the lower charges to builders and developers for
contributions in aid of construction are passed on to ultimate consumers
through lower prices, the benefit from this special tax treatment accrues to
consumers. If some of the subsidy is retained by the builders and developers
because competitive forces do not require it to be passed forward in lower
prices, then the special tax treatment also benefits the owners of these firms.

Rationale

The stated reason for reinstating the special treatment of contributions in
aid of construction for water and sewage utilities was concern that the
changes made by the Tax Reform Act of 1986 may have inhibited the
development of certain communities and the modernization of water and
sewage facilities.

Assessment

The contribution in aid of construction tax treatment allows the utility to
write off or expense the cost of the financed capital facility in the year it is put
in place rather than depreciating it over its useful life. This treatment, in
effect, exempts the services provided by the facility from taxation and thereby
provides a special subsidy. Absent a public policy justification, such
subsidies distort prices and undermine economic efficiency.

In repealing the special tax treatment of contributions in aid of construction
in TRA86, Congress determined that there was no public policy justification
for continuing the subsidy. In reinstating the special tax treatment for water
and sewage utilities in the Small Business Job Protection Act of 1996,
Congress determined that there was an adequate public policy justification for
providing the subsidy to these particular utilities.

Selected Bibliography

Committee on Finance, Small Business Job Protection Act of 1996, Report
104-281, U.S. Senate, 104th Congress, 2d Session, June 18, 1996, p. 136-
137.
Conference Report, Small Business Job Protection Act of 1996, Report
104-737, U.S. House of Representatives, 104th Congress, 2d Session, August
1, 1996, p. 158-160.
Joint Committee on Taxation, General Explanation of the Tax Reform Act
of 1986, Joint Committee Print, JCS-10-87, May 4, 1987, p. 544-547.

Energy

AMORTIZATION OF CERTIFIED POLLUTION
CONTROL FACILITIES

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

(1)

2007

(1)

2008

0.1

2009

0.1

2010

0.1

(1) Negative tax expenditure of less than $50 million.

Authorization

Section 169(d)(5).

Description

This provision makes the pre-1976 5 year option to amortize investments in
pollution control equipment for coal-fired electric generation plants available
to those plants placed in service on or after January 1, 1976. Before
enactment of IRC section 169(d)(5), 5-year amortization of pollution control
equipment applied only to older coal-fired power plants - those placed in
service before January 1, 1976. However, investments in pollution control
equipment made in connection with post-1975 power plants now qualify for
amortization over 7 years rather than 5 years. The 5-year amortization
incentive for pre-1976 plants applies only to pollution control equipment with
a useful life of 15 years or less. In that case 100% of the cost can be
amortized over five years. If the property or equipment has a useful life
greater than 15 years, then the proportion of the costs that can be amortized
over 5 years is less than 100%.

Qualifying pollution control equipment means any technology that is
installed in or on a qualifying facility to reduce air emissions of any pollutant
regulated by the Environmental Protection Agency (EPA) under the Clean Air
Act. This includes scrubber systems, particulate collectors and removal
equipment (such as electrostatic precipitators), thermal oxidizers, vapor
recovery systems, low nitric oxide burners, flare systems, bag houses,
cyclones, and continuous emission monitoring systems. The pollution control
equipment needs to have been placed in service after April 11, 2005.

Impact

In the federal tax code, amortization is a method of depreciation that
recovers the total cost basis evenly (i.e., straight line depreciation) over the
recovery period, in this case either 5 or 7 years depending on the age of the
power plant. In either case, however, because the two recovery periods are
substantially less than the economic life of the assets, such amortization
provides more accelerated depreciation deductions for pollution control
equipment than would otherwise be the case under the Modified Accelerated
Cost Recovery System ( MACRS ), in which the recovery period for the
conventional type of electric generating equipment is either 15 or 20 years,
depending on the type of equipment. The recovery period is 15 years for
generating equipment that uses internal combustion, jet, or diesel engines; 20
years for most types of conventional electric utility tangible property such as
steam or gas turbines, boilers, combustors, condensers, combustion turbines
operated in a combined cycle with a conventional steam unit, and related
assets. The shorter period for internal combustion engines is because this type
of equipment typically deteriorates faster than conventional coal-fired
equipment. Also the recovery method is one of the more accelerated types:
either the double-declining balance method or the 150% declining balance
method. Amortization in this way thus provides more accelerated
depreciation deductions for pollution control equipment than does MACRS.
Because of the time value of money, the earlier deduction is worth more in
present value terms, which reduces the cost of capital and the effective tax
rates on the investment returns. This should provide an incentive for power
plant companies (primarily the tax paying investor-owned utilities, or IOUs)
to invest in pollution control equipment.

This provision targets electric utilities, a major source of the
disproportionate amount of air pollution. And while older coal plants still
emit a disproportionate amount of pollution among all coal-fired plants, the
provision complements prior law by also targeting emissions from newer
plants. The incentive will facilitate utilities in meeting a new suite of EPA
mandates to reduce emissions of sulfur dioxide (SO2 ), nitrous oxide (NO2),
and mercury (Hg)

Rationale

This provision was part of the Energy Policy Act of 2005 (P.L. 109-58).
Before that investments in pollution control equipment for pre-1976 coal-fired
plants were amortizable over 5 years. Before the 2005 act, pollution control
equipment added to "newer" plants (those placed in service after 1975) was
depreciated using the same MACRS methods that apply to other electric
generating equipment on the date they are placed in service (15- or 20-year
recovery period using the 150% declining balance method, as discussed
below). The 5-year amortization of pollution control equipment was added by
the Tax Reform Act of 1969 to compensate for the loss of the investment tax
credit, which was repealed by the same act. Prior to 1987, pollution control
equipment could be financed by tax-exempt bonds. This benefitted all types
of electric utilities and not just public power companies, because although the
state or local government would issue the bonds, the facilities were leased
back to the IOUs or cooperatives. Billions of dollars of pollution control
equipment were financed in this way until the safe-harbor leasing tax rules
were repealed by the Tax Reform Act of 1986.

Assessment

Pollution control equipment used in connection with coal-fired power
plants is a significant fraction of a plant's cost. Thus, the tax treatment of this
type of equipment is important in determining the investment decisions of the
electric utility. The Clean Air Act's "New Source Review" provisions require
the installation of state-of-the-art pollution-control equipment whenever an
air-polluting plant is built or when a "major modification" is made on an
existing plant. By creating a more favorable (in some cases much more
favorable) regulatory environment for existing facilities than new ones,
grandfathering creates an incentive to keep old, grandfathered facilities up
and running.

The federal tax code has also provided an unintended incentive to retain -
a disincentive to scrap - equipment and other business assets. One of these
tax provisions is the 5-year amortization of pollution control equipment
connected with older (pre-1976) power plants. This, and other provisions
under prior law (such as accelerated depreciation and investment tax credits),
and current tax penalties for premature dispositions of capital equipment
under the recapture provisions and the alternative minimum tax) may have
provided a disincentive to invest in new equipment and other new assets.

Selected Bibliography

Abel, Amy. Energy Policy Act of 2005, P.L. 109-58: Electricity
Provisions. Congressional Research Service Report RL33248. Washington,
DC: January 24, 2006.
Hsu, Shi-Ling. "What's Old Is New: The Problem with New Source
Review." Regulation. Spring 2006. v. 29. Washington: pp. 36-43.
Joskow, Paul L. "Competitive Electricity Markets and Investment in New
Generating Capacity," MIT Research Paper. April, 28, 2006.
Joskow, Paul L. Transmission Policy in the United States. AEI-Brookings
Joint Center for Regulatory Studies. October 2004.
Joskow, Paul L. "Restructuring, Competition, and Regulatory Reform in
the U.S. Electricity Sector," Journal of Economic Perspectives. Summer
1997. pp. 119-138.
Lee, Amanda I., and James Alm. "The Clean Air Act Amendments and
Firm Investment in Pollution Abatement Equipment." Land Economics.
August 2004. v. 80. pp. 433.
McCarthy, James E., and Larry Parker. Costs and Benefits of Clear Skies:
EPA's Analysis of Multi-Pollutant Clean Air Bills. U.S. Library of Congress.
Congressional Research Service Report RL33165. November 23, 2005.
Parker, Larry, and John Blodgett. Air Quality and Electricity: Enforcing
New Source Review. U.S. Library of Congress. Congressional Research
Service Report RL30432. January 31, 2000.
Popp, David. "Pollution Control Innovations and the Clean Air Act of
1990." Journal of Policy Analysis and Management. Fall 2003. v. 22. pp.
641.
Sterner, Thomas. Policy Instruments for Environmental and Natural
Resource Management. Resources for the Future, Washington. 2003.
U.S. Congress, Joint Committee on Taxation. Federal Tax Issues Relating
to Restructuring of the Electric Power Industry. Hearing before the
Subcommittee on Long-Term Growth and Debt Reduction of the Senate
Finance Committee, October 15, 1999. JCX 72-99.

Agriculture

EXCLUSION OF COST-SHARING PAYMENTS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

(1)

2007

(1)

2008

(1)

2009

(1)

2010

(1)

(1)Less than $50 million

Authorization

Section 126.

Description

There are a number of programs under which both the Federal and State
Governments make payments to taxpayers which represent a share of the cost
of certain improvements made to the land. These programs generally relate to
improvements which further conservation, protect the environment, improve
forests, or provide habitats for wildlife. Under Section 126, the grants
received under certain of these programs are excluded from the recipient's
gross income.

To qualify for the exclusion, the payment must be made primarily for the
purpose of conserving soil and water resources or protecting the environment,
and the payment must not produce a substantial increase in the annual income
from the property with respect to which the payment was made.

Impact

The exclusion of these grants and payments from tax provides a general
incentive for various conservation and land improvement projects that might
not otherwise be undertaken.

Rationale

The income tax exclusion for certain cost-sharing payments was part of the
tax changes made under the Revenue Act of 1978. The rationale for this
change was that in the absence of an exclusion many of these conservation
projects would not be undertaken. In addition, since the grants are to be spent
by the taxpayer on conservation projects, the taxpayer would not necessarily
have the additional funds needed to pay the tax on the grants if they were not
excluded from taxable income.

Assessment

The partial exclusion of certain cost-sharing payments is based on the
premise that the improvements financed by these grants benefit both the
general public and the individual landowner. The portion of the value of the
improvement financed by grant payments attributable to public benefit should
be excluded from the recipient's gross income while that portion of the value
primarily benefitting the landowner (private benefit) is properly taxable to the
recipient of the payment.

The problem with this tax treatment is that there is no way to identify the
true value of the public benefit. In those cases where the exclusion of cost-
sharing payment is insufficient to cover the value of the public benefit, the
project probably would not be undertaken.

On the other hand, on those projects that are undertaken the exclusion of
the cost-sharing payment probably exceeds the value of the public benefit and
hence, the excess provides a subsidy primarily benefitting the landowner.

Selected Bibliography

U.S. Department of the Treasury, Internal Revenue Service, Farmer's Tax
Guide, Publication 225, 2005, pp. 11-12.
U.S. Congress. Joint Committee on Taxation. Study of the Overall State
of the Federal Tax System and Recommendations for Simplification,
Pursuant to Section 8022(3)(B) of the Internal Revenue Code of 1986,
Volume II. JCS-3-01, April 2001, pp. 460-462.

-, Present Law and Description of Proposals Relating to Federal Income
Tax Provisions That Impact Energy, Fuel, and Land Use Conservation and
Preservation. July 24, 2000.
-, Senate Committee on Finance. Technical Corrections Act of 1979, 96th
Congress, 1st session. December 13, 1979, pp. 79-81.
-, General Explanation of the Revenue Act of 1978.

Agriculture

EXCLUSION OF CANCELLATION
OF INDEBTEDNESS INCOME OF FARMERS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.1

2007

0.1

2008

0.1

2009

0.1

2010

0.1

Authorization

Sections 108 and 1017.

Description

This provision allows farmers who are solvent to treat the income arising
from the cancellation of certain indebtedness as if they were insolvent
taxpayers. Under this provision, income that would normally be subject to
tax, the cancellation of a debt, would be excluded from tax if the discharged
debt was "qualified farm debt" discharged or canceled by a "qualified
person."

To qualify, farm debt must meet two tests: it must be incurred directly from
the operation of a farming business, and at least 50 percent of the taxpayer's
previous three years of gross receipts must come from farming.

To qualify, those canceling the qualified farm debt must participate
regularly in the business of lending money, cannot be related to the taxpayer
who is excluding the debt, cannot be a person from whom the taxpayer
acquired property securing the debt, or cannot be a person who received any
fees or commissions associated with acquiring the property securing the debt.
Qualified persons include federal, state, and local governments.

The amount of canceled debt that can be excluded from tax cannot exceed
the sum of adjusted tax attributes and adjusted basis of qualified property.
Any canceled debt that exceeds this amount must be included in gross
income. Tax attributes include net operating losses, general business credit
carryovers, capital losses, minimum tax credits, passive activity loss and
credit carryovers, and foreign tax credit carryovers. Qualified property
includes business (depreciable) property and investment (including farmland)
property.

Taxpayers can elect to reduce the basis of their property before reducing
any other tax benefits.

Impact

This exclusion allows solvent farmers to defer the tax on the income
resulting from the cancellation of a debt. Generally, the exclusion of
cancellation of indebtedness is not available to other taxpayers unless they are
insolvent or unless they were living in the core disaster area or the Hurricane
Katrina disaster area on August 25, 2005, and suffered economic loss as the
result of the hurricane.

Rationale

The exclusion for the cancellation of qualified farm indebtedness was
enacted as part of the Tax Reform Act of 1986. At the time, the intended
purpose of the provision was to avoid tax problems that might arise from
other legislative initiatives designed to alleviate the credit crisis in the farm
sector.

For instance, Congress was concerned that pending legislation providing
Federal guarantees for lenders participating in farm-loan write-downs would
cause some farmers to recognize large amounts of income when farm loans
were canceled. As a result, these farmers might be forced to sell their
farmland to pay the taxes on the canceled debt. This tax provision was
adopted to mitigate that problem.

Assessment

The exclusion of cancellation of qualified farm income indebtedness does
not constitute a forgiveness of tax but rather a deferral of tax. By electing to
offset the canceled debt through reductions in the basis of property, a taxpayer
can postpone the tax that would have been owed on the canceled debt until
the basis reductions are recaptured when the property is sold or through
reduced depreciation in the future. Since money has a time value (a dollar
today is more valuable than a dollar in the future), however, the deferral of
tax provides a benefit in that it effectively lowers the tax rate on the income
realized from the discharge of indebtedness.

Selected Bibliography

U.S. Congress, Joint Committee on Taxation. General Explanation of the
Tax Reform Act of 1986.
-, House Committee on the Budget Conference Report. Omnibus Budget
Reconciliation Act of 1993. Washington, DC, 1993.
-, Joint Committee on Taxation. Technical Explanation of H.R. 3768, The
"Katrina Emergency Tax Relief Act of 2005" as passed by the House and the
Senate on September 21, 2005. JCX-69-05. September 22, 2005.
U.S. Treasury. Internal Revenue Service. Farmer's Tax Guide.
Publication 225, 2005. pp. 15-17.
-, Internal Revenue Service. Reduction of Tax Attributes Due to Discharge
of Indebtedness. Federal Register, Vol. 69, No. 91, Tuesday May 11, 2004.
pp. 26038-26040.

Agriculture

CASH ACCOUNTING FOR AGRICULTURE

Estimated Revenue Loss*

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

2007

2008

2009

2010

--
* Estimated to produce a negative tax expenditure over the forecast period.
Disaggregated estimates available from the Joint Committee on Taxation.

Authorization

Sections 162, 175, 180, 446, 447, 448, 461, 464, and 465.

Description

Most farm businesses (with the exception of certain farm corporations and
partnerships or any tax shelter operation) may use the cash method of tax
accounting to deduct costs attributable to goods held for sale and in inventory
at the end of the tax year. These businesses are also allowed to expense some
costs of developing assets that will produce income in future years. Both of
these rules thus allow deductions to be claimed before the income associated
with the deductions is realized.

Costs that may be deducted before income attributable to them is realized
include livestock feed and the expenses of planting crops for succeeding
year's harvest. Costs that otherwise would be considered capital expenditures
but that may be deducted immediately by farmers include certain soil and
water conservation expenses, costs associated with raising dairy and breeding
cattle, and fertilizer and soil conditioner costs.

Impact

For income tax purposes, the cash method of accounting is less
burdensome than the accrual method of accounting and also provides benefits
in that it allows taxes to be deferred into the future. Farmers who use the cash
method of accounting and the special expensing provisions receive tax
benefits not available to taxpayers required to use the accrual method of
accounting.

Rationale

The Revenue Act of 1916 established that a taxpayer may compute
personal income for tax purposes using the same accounting methods used to
compute income for business purposes. At the time, because accounting
methods were less sophisticated and the typical farming operation was small,
the regulations were apparently adopted to simplify record keeping for
farmers.

Specific regulations relating to soil and water conservation expenditures
were adopted in the Internal Revenue Code of 1954. Provisions governing
the treatment of fertilizer costs were added in 1960.

The Tax Reform Act of 1976 required that certain farm corporations and
some tax shelter operations use the accrual method of accounting rather than
cash accounting. The Tax Reform Act of 1986 further limited the use of cash
accounting by farm corporations and tax shelters and repealed the expensing
rules for certain land clearing operations. The Act also limited the use of cash
accounting for assets that had preproductive periods longer than two years.
These restrictions, however, were later repealed by the Technical and
Miscellaneous Revenue Act of 1988.

Assessment

The effect of deducting costs before the associated income is realized
understates income in the year of deduction and overstates income in the year
of realization. The net result is that tax liability is deferred which results in an
underassessment of tax. In addition, in certain instances when the income is
finally taxed, it may be taxed at preferential capital gains rates.

Selected Bibliography

U.S. Department of the Treasury. Internal Revenue Service. Farmer's Tax
Guide. Publication 225, 2005, pp. 5-6.
-, Internal Revenue Service. Accounting Periods and Methods.
Publication 538. 2004.

U.S. Congress, Joint Committee on Taxation. General Explanation of Tax
Legislation Enacted in the 107th Congress. JCS-1-03, January 2003, pp. 240-
242.
-, Joint Committee on Taxation. Overview of Present Law and Selected
Proposals Regarding the Federal Income Taxation of Small Business and
Agriculture. JCX-45-02, May 2002, pp. 37-39.
-, Joint Committee on Taxation. General Explanation of the Revenue Act
of 1978.
U.S. Senate, Committee on Finance. Technical Corrections Act of 1979.
96th Congress, 1st session, December 13, 1979, pp. 79-81.
U.S. Congress. Congressional Budget Office. Budget Options. February
2001, p. 439.

Agriculture

INCOME AVERAGING FOR FARMERS AND FISHERMEN

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

(1)

2007

(1)

2008

(1)

2009

(1)

2010

(1)

(1)Less than $50 million.

Authorization

Section 1301.

Description

For taxable years beginning after December 31, 1997, taxpayers have the
option to calculate their current year income tax by averaging over the prior 3-
year period, all or a portion of their income from farming or commercial
fishing. The taxpayer can designate all or a part of his current year income
from farming as "elected farm income" or from fishing as "fishing business"
income. The taxpayer then allocates 1/3 of the "elected farm income" or
"fishing business" income to each of the prior 3 taxable years.

The current year income tax for a taxpayer making this election is
calculated by taking the sum of his current year tax calculated without
including the "elected farm income" or "elected fishing business" income and
the extra tax in each of the three previous years that results from including 1/3
of the current year's "elected farm income" or "fishing business" income.

"Elected farm income" can include the gain on the sale of farm assets with
the exception of the gain on the sale of land.

The tax computed using income averaging for farmers and fisherman does
not apply for purposes of computing the regular income tax and subsequent
determination of alternative minimum tax liability.

Impact

This provision provides tax relief primarily to taxpayers whose main
source of income derives from agricultural production or commercial fishing.
It allows these taxpayers to exert some control over their taxable incomes and
hence, their tax liabilities in those years that they experience fluctuations in
their incomes.

Rationale

Income averaging for farmers was enacted as part of the Taxpayer Relief
Act of 1997. Congress believed that the income from farming can fluctuate
dramatically from year to year and that these fluctuations are outside the
control of the taxpayers. To address this problem, Congress felt that
taxpayers who derive their income from agriculture should be allowed an
election to average farm income and mitigate the adverse tax consequences
of fluctuating incomes under a progressive tax structure.

Assessment

Under an income tax system with progressive tax rates and an annual
assessment of tax, the total tax assessment on an income that fluctuates from
year to year will be greater than the tax levied on an equal amount of income
that is received in equal annual installments. Under pre-1986 income tax law,
income averaging provisions were designed to help avoid the over assessment
of tax that might occur under a progressive tax when a taxpayer's income
fluctuated from year to year. These pre-1986 tax provisions were especially
popular with farmers who, due to market or weather conditions, might
experience significant fluctuations in their annual incomes.

The Tax Reform Act of 1986 repealed income averaging. At the time, it
was argued that the reduction in the number of tax brackets and the level of
marginal tax rates reduced the need for income averaging. Farmers argued
that even though the tax brackets had been widened and tax rates reduced, the
fluctuations in their incomes could be so dramatic that without averaging they
would be subject to an inappropriately high level of income taxation.

As marginal income tax rates were increased in 1990 and 1993, Congress
became more receptive to the arguments for income averaging and reinstated
limited averaging in the Taxpayer Relief Act of 1997. Under this Act,
income averaging for farmers was a temporary provision and was to expire
after January 1, 2001. The Omnibus Consolidated and Emergency
Supplemental Appropriations Act of 1998 made income averaging for
farmers permanent.

The American Jobs Creation Act of 2004 expanded income averaging to
include commercial fisherman. It also coordinated income averaging with the
individual alternative minimum tax so that the use of income averaging would
not cause farmers or fishermen to incur alternative minimum tax liability.

It appears, however, that the current income averaging provisions fall short
of the economic ideal on several fronts. For instance, from an economic
perspective the source of income fluctuations should not matter when
deciding whether or not income averaging is needed. Hence, limiting
averaging to farm income or commercial fishing income may appear unfair to
other taxpayers such as artists and writers who also may have significant
fluctuations in their annual incomes.

A more significant theoretical problem is that these provisions only allow
for upward income averaging. Under a theoretically correct income tax,
income averaging would be available for downward fluctuations in income as
well as upward fluctuations. Downward income averaging would mean that
taxpayers who experienced major reductions in their annual incomes would
also qualify for income averaging. This would allow them to mitigate sharp
reductions in their current year incomes by reducing their current year taxes to
reflect taxes that had already been prepaid in previous years when their
incomes were higher.

Selected Bibliography

U.S. Congress, House of Representatives. American Jobs Creation Act of
2004. Conference Report to Accompany H.R. 4520. H. Rept. 108-755.
October 2004.
-,Joint Committee on Taxation. Overview of Present Law and Selected
Proposals Regarding the Federal Income Taxation of Small Business and
Agriculture. JCX-45-02, May 2002, pp. 44-45.
-, Joint Committee on Taxation. Technical Explanation of S.3152,
"Community Renewal and New Markets Act of 2000." JCX-105-00, October
2000, p. 54.
-, Joint Committee on Taxation. Conference Report on Tax and Trade
Provisions of the Omnibus Consolidated and Emergency Supplemental
Appropriations Act. (H.R. 4328). October 1998.

-, Joint Committee on Taxation. Taxpayer Relief Act of 1998. September
1998.
-, Joint Committee on Taxation. Taxpayer Relief Act of 1997. July 1997.
-, Joint Committee on Taxation. General Explanation of the Tax Reform
Act of 1986. May 1987.
U.S. Department of the Treasury. Internal Revenue Service. IRS Final
Regulations (T.D. 8972) on Averaging of Farm Income. January 8, 2002.
-, Internal Revenue Service. Farmer's Tax Guide. Publication 225. 2005.

Agriculture

FIVE-YEAR CARRYBACK PERIOD FOR
NET OPERATING LOSSES ATTRIBUTABLE TO FARMING

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

(1)

2007

(1)

2008

(1)

2009

(1)

2010

(1)

(1)Less than $50 million.

Authorization

Section 172.

Description

A net operating loss, the amount by which business and certain other
expenses exceed income for the year, may be carried forward and deducted
from other income for 20 years following the loss year. It may, at the
taxpayer's election, instead be carried back to earlier years in which there was
positive income. For most taxpayers, the carryback period is limited to the
previous 2 years, although small businesses in federally declared disaster
areas may carry losses back 3 years. (The Job Creation and Workers
Assistance Act of 2002 temporarily extended the net operating loss carryback
period to 5 years for losses arising in taxable years ending in 2001 and 2002
for businesses that normally have a 2 or 3 year loss carryback.) Current law
permits losses attributed to a farming business (as defined in section
263A(e)(4)) to be carried back 5 years. The Gulf Opportunity Zone Act of
2005 broadened the definition of farm income to include losses on qualified
timber property located in the Gulf or Rita Opportunity Zones.

Impact

For businesses that have paid taxes within the allowed carryback period,
making use of the carryback rather than the carryforward option for operating
losses means receiving an immediate refund rather than waiting for a future
tax reduction. Although the special 5-year carryback applies only to losses
incurred in a farming business, the losses may be used to offset taxes paid on
any type of income. Thus the beneficiaries of this provision are farmers who
have either been profitable in the past or who have had non-farm income on
which they paid taxes.

Rationale

Some provision for deducting net operation losses from income in other
years has been an integral part of the income tax system from its inception.
The current general rules (20-year carryforwards and 2-year carrybacks) date
from the "Taxpayer Relief Act of 1997," P.L. 105-34, which shortened the
carryback period from 3 to 2 years (except for farmers and small businessmen
in federally declared disaster areas, which remained at 3 years).

The 5-year carryback for farm losses was enacted as a part of the "Omnibus
Consolidated and Emergency Supplemental Appropriations Act," P.L. 105-
277. The committee reports state that a special provision for farmers was
considered appropriate because of the exceptional volatility of farm income.

The Gulf Opportunity Zone Act of 2005 broadened the definition of farm
income to include losses on qualified timber property located in the Gulf or
Rita Opportunity Zones. This change is effective for losses incurred on or
after August 28, 2005 (in the Gulf Opportunity Zone), on or after September
23, 2005 (in the Rita Zone), on or after October 23, 2005 (in the Wilma Zone)
and before January 1, 2007.

Assessment

In an ideal income tax system, the government would refund taxes in loss
years with the same alacrity that it collects them in profit years, and a
carryback of losses would not be considered a deviation from the normal tax
structure. Since the current system is less than ideal in many ways, however,
it is difficult to say whether the loss carryover rules bring it closer to or move
it further away from the ideal.

The special rule for farmers is intended to compensate for the excessive
fluctuations in income farmers are said to experience. This justification is
offered for many of the tax benefits farmers are allowed, but it is not actually
based on evidence that farmers experience annual income fluctuations greater
than other small businessmen. The farm losses may offset taxes on non-farm
income, so some of the benefit will accrue to persons whose income is not
primarily from farming.

Selected Bibliography

U.S. Treasury Department. Internal Revenue Service. Net Operating
Losses (NOLs) for Individuals, Estates, and Trusts. Publication 536. 2005.
U.S. Congress, Joint Committee on Taxation. General Explanation of Tax
Legislation Enacted in 1998, pp. 276-277.
-, Joint Committee on Taxation. Summary of P. L. 107-147, The "Job
Creation and Worker Assistance Act of 2002", JCX-22-02, March 2002, p. 2.
-, Joint Committee on Taxation. Technical Explanation of the Revenue
Provisions of H.R. 4440, "The Gulf Opportunity Zone Act of 2005" As
Passed By The House of Representatives and the Senate. JCX-88-05,
December 16, 2005, p. 22.
U.S. House, Committee on Ways and Means. Taxpayer Relief Act of 1998.
105th Congress, 2nd session, September 23, 1998, pp. 57-59.

Commerce and Housing:
Financial Institutions

EXEMPTION OF CREDIT UNION INCOME

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

1.7

2007

1.8

2008

1.9

2009

2.0

2010

2.1

Authorization

Section 501(c)(14) of the Internal Revenue Code of 1986 and section 122
of the Federal Credit Union Act, as amended (12 U.S.C. sec. 1768).

Description

Credit unions without capital stock and organized and operated for mutual
purposes and without profit are not subject to Federal income tax.

Impact

Credit unions are the only depository institutions exempt from Federal
income taxes. If this exemption were repealed, both federally chartered and
State chartered credit unions would become liable for payment of Federal
corporate income taxes on their retained earnings but not on earnings
distributed to depositors.

For a given addition to retained earnings, this tax exemption permits credit
unions to pay members higher dividends and charge members lower interest
rates on loans. Over the past 20 years, this tax exemption may have
contributed to the more rapid growth of credit unions compared to other
depository institutions.

Opponents of credit union taxation emphasize that credit unions provide
many services free or below cost in order to assist low-income members.
These services include small loans, financial counseling, and low-balance
share drafts. They argue that the taxation of credit unions would create
pressure to eliminate these subsidized services. But whether or not consumer
access to basic depository services is a significant problem is disputed.

Rationale

Credit unions have never been subject to the Federal income tax. Initially,
they were included in the provision that exempted domestic building and loan
associations - whose business was at one time confined to lending to
members - and nonprofit cooperative banks operated for mutual purposes.
The exemption for mutual banks and savings and loan institutions was
removed in 1951, but credit unions retained their exemption. No specific
reason was given for continuing the exemption of credit unions.

In 1978, the Carter Administration proposed that the taxation of credit
unions be phased in over a five-year period. In 1984, a report of the
Department of the Treasury to the President proposed that the tax exemption
of credit unions be repealed. In 1985, the Reagan Administration proposed
the taxation of credit unions with over $5 million in gross assets. In the
budget for fiscal year 1993, the Bush Administration proposed that the tax
exemption for credit unions with assets in excess of $50 million be repealed.
On March 16, 2004, Donald E. Powell, Chairman of the Federal Deposit
Insurance Corporation, stated that "credit unions ought to pay taxes."

Assessment

Supporters of the credit union exemption emphasize the uniqueness of
credit unions compared to other depository institutions. Credit unions are
nonprofit financial cooperatives organized by people with a common bond
which is a unifying characteristic among members that distinguishes them
from the general public.

Credit unions are directed by volunteers for the purpose of serving their
members. Consequently, the exemption's supporters maintain that credit
unions are member-driven while other depository institutions are profit-
driven. Furthermore, supporters argue that credit unions are subject to certain
regulatory constraints not required of other depository institutions and that
these constraints reduce the competitiveness of credit unions. For example,
credit unions may lend only to members.

Proponents of taxation argue that deregulation has caused extensive
competition among all depository institutions, including credit unions, and
that the tax exemption gives credit unions an unwarranted advantage.
Proponents of taxation argue that depository institutions should have a level
playing field in order for market forces to allocate resources efficiently.

Selected Bibliography

Bickley, James M. Should Credit Unions be Taxed? Library of Congress,
Congressional Research Service Report 97-548 E. Washington, DC: Updated
March 28, 2006.
Jolly, Robert W., Gary D. Koppenhaver, and Joshua D. Roe. Growth of
Large-Scale Credit Union in Iowa: Implications for Public Policy. Ames,
Iowa: Department of Economics, Iowa State University, Working Paper
#04031, November 2004.
U.S. Congress, Congressional Budget Office. Budget Options.
Washington, DC: U.S. Government Printing Office, February 2005, p. 301.
U.S. Government Accountability Office, Issues Regarding the Tax-Exempt
Status of Credit Unions, Testimony before the House Committee on Ways
and Means, November 3, 2005.
Tatom, John. Competitive Advantage: A Study of the Federal Tax
Exemption for Credit Unions. Washington, DC: Tax Foundation, 2005.

Commerce and Housing:
Insurance Companies

EXCLUSION OF INVESTMENT INCOME
ON LIFE INSURANCE AND ANNUITY CONTRACTS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

25.5

2.5

28.0

2007

26.1

2.5

28.6

2008

26.8

2.6

29.4

2009

27.5

2.7

30.2

2010

28.2

2.7

30.9

Authorization

Sections 72, 101, 7702, 7702A.

Description

Life insurance companies invest premiums they collect, and returns on
those investments help pay benefits. Amounts not paid as benefits may be
paid as policy dividends or given back to policyholders as cash surrender
values or loan values.

Policyholders are not generally taxed on this investment income,
commonly called "inside build-up," as it accumulates. Insurance companies
also usually pay no taxes on this investment income. Death benefits for most
policies are not taxed at all, and amounts paid as dividends or withdrawn as
cash values are taxed only when they exceed total premiums paid for the
policy, allowing tax-free investment income to pay part of the cost of the
insurance protection. Investment income that accumulates within annuity
policies is also free from tax, but annuities are taxed on their investment
component when paid.

Life insurance policies must meet tests designed to limit the tax-free
accumulation of income. If investment income accumulates very much faster
than is needed to fund the promised benefits, that income will be attributed to
the owner of the policy and taxed currently. If a corporation owns a life
insurance policy, investment income is included in alternative minimum
taxable income.

Impact

The interest exclusion on life insurance savings allows policyholders to
pay for a portion of their personal insurance with tax-free interest income.
Although the interest earned is not currently paid to the policyholder, it is
used to cover at least part of the cost of the insurance coverage, and it may be
received in cash if the policy is terminated. In spite of recent limitations on
the amount of income that can accumulate tax-free in a contract, the tax-free
interest income benefit can be substantial.

The tax deferral for interest credited to annuity contracts allows taxpayers
to save for retirement in a tax-deferred environment without restriction on the
amount that can be invested for these purposes. Although the amounts
invested in an annuity are not deductible by the taxpayer, as are contributions
to qualified pension plans or some IRAs, the tax deferral on the income
credited to such investments represents a significant tax benefit to the
taxpayer.

These provisions thus offer preferential treatment for the purchase of life
insurance coverage and for savings held in life insurance policies and annuity
contracts. Middle-income taxpayers, who make up the bulk of the life
insurance market, reap most of this provision's benefits. Higher-income
taxpayers, once their life insurance requirements are satisfied, generally
obtain better after-tax yields from tax-exempt State and local obligations or
tax-deferred capital gains.

Rationale

The exclusion of death benefits paid on life insurance dates back to the
1913 tax law. While no specific reason was given for exempting such
benefits, insurance proceeds may have been excluded because they were
believed to be comparable to bequests, which also were excluded from the tax
base.

The nontaxable status of the life insurance inside build-up and the tax
deferral on annuity investment income also dates from 1913. Floor
discussions of the bill made it clear that inside build-up was not taxable, and
that amounts received during the life of the insured would be taxed only when
they exceeded the investment in the contract (premiums paid), although these
provisions were not explicitly included in the law.

These rules were to some extent based on the general tax principle of
constructive receipt. The interest income was not viewed as actually
belonging to the policyholders because they would have to give up the
insurance protection or the annuity guarantees to obtain the interest.

The inside build-up in several kinds of insurance products was made
taxable to the policy owners in recent years. (Corporate-owned policies were
included under the minimum tax in the Tax Reform Act of 1986. The Deficit
Reduction Act of 1984 and the Technical and Miscellaneous Revenue Act of
1988 imposed taxes on inside build-up and distributions for policies with an
overly large investment component.) This change suggests that the Congress
finds the exclusion rationale based on the constructive receipt doctrine
unpersuasive in some cases. The President's Advisory Panel on Federal Tax
Reform, which issued its final report in November 2005, recommended
elimination of the exemption on life insurance investment earnings. Instead
the Advisory Panel favored savings incentives which would treat various
investment vehicles in a more neutral manner. Congress has enacted no
legislation which would implement recommendations of the Advisory Panel.

Assessment

The tax treatment of policy income combined with the tax treatment of life
insurance company reserves (see "Special Treatment of Life Insurance
Company Reserves," below) makes investments in life insurance policies
virtually tax-free. Cash value life insurance can operate as an investment
vehicle that combines life insurance protection with a financial instrument
that operates similarly to bank certificates of deposit and mutual fund
investments. This exemption of inside build-up distorts investors' decisions
by encouraging them to choose life insurance over competing savings
vehicles such as bank accounts, mutual funds, or bonds. The result could be
overinvestment in life insurance and excessive levels of life insurance
protection relative to what would occur if life insurance products competed on
a level playing field with other investment opportunities.

There is some evidence, however, that people underestimate the financial
loss their deaths could cause and so tend to be underinsured. If this is the
case, some encouragement of the purchase of life insurance might be
warranted. There is no evidence of the degree of encouragement required or
of the efficacy of providing that encouragement through tax exemption.

The practical difficulties of taxing inside build-up to the policy owners and
the desire not to add to the distress of heirs by taxing death benefits have
discouraged many tax reform proposals covering life insurance. Taxing at the
company level as a proxy for individual income taxation has been a suggested
alternative.

Inside build-up exclusion contributed to the surge in the number of
corporate-owned life insurance (COLI) policies in the 1980s. Many firms,
which had previously bought policies only for key personnel, began to buy
life insurance on large numbers of lower level employees. Several newspaper
articles focused COLI policies bought without employees' knowledge or
consent, which have been termed "dead peasant insurance" or "janitor
insurance." The IRS, arguing that such COLI policies serve as a tax shelter,
sued several major corporations, and these cases limited some of the tax
benefits of COLI policies. (See the 2006 Joint Tax Committee summary for
citations.) The Pension Protection Act of 2006 (P. L. 109-280) limited tax
benefits of COLI policies to key personnel and to benefits paid to survivors,
and requires firms to obtain employee's written consent. The Joint Tax
Committee estimated that these limits will have a negligible effect on
revenues.

Selected Bibliography

Brumbaugh, David L. Taxes and the "Inside Build-Up" of Life
Insurance: Recent Issues. Library of Congress, Congressional Research
Service Report RS20923, August 2, 2006.
Christensen, Burke A. "Life Insurance: the Under-Appreciated Tax
Shelter." Trusts and Estates 135 (November 1996), pp. 57-60.
Esperti, Robert A., et al. "Post-EGTRRA Life Insurance Planning: the
Economic Growth and Tax Relief Reconciliation Act of 2001 Promises
Repeal of the Estate Tax in 2010, But Will it Ever Come to Pass?" The Tax
Adviser 33 (August 2002), pp. 532-537.
Gallagher, Gregory W. and Charles L. Ratner, eds. Federal Income
Taxation of Life Insurance, 2nd edition. Chicago: American Bar Association,
1999.
Goode, Richard. "Policyholders' Interest Income from Life Insurance
Under the Income Tax," Vanderbilt Law Review 15 (December 1962), pp.
33-55.
Harman, William B., Jr. "Two Decades of Insurance Tax Reform." Tax
Notes 57 (November 12, 1992), pp. 901-914.
Kotlikoff, Lawrence J. The Impact of Annuity Insurance on Savings and
Inequality, Cambridge, Mass.: National Bureau of Economic Research, 1984.
McClure, Charles E. "The Income Tax Treatment of Interest Earned on
Savings in Life Insurance." In The Economics of Federal Subsidy Programs.
Part 3: Tax Subsidies. (U.S. Congress, Joint Economic Committee.)
Washington, DC: U.S. Government Printing Office, July 15, 1972.

Pike, Andrew D. Taxation of Life Insurance Products: Background and
Issues. Library of Congress, Congressional Research Service Report
RL32000, July 18, 2003.
President's Advisory Panel on Federal Tax Reform. Simple, Fair, and
Pro-Growth: Proposals to Fix America's Tax System: Report of the
President's Advisory Panel on Federal Tax Reform. Washington, DC:
November 2005.
Schultz Ellen E. and Theo Francis, "Companies Profit on Workers' Deaths
Through 'Dead Peasants' Insurance", Wall Street Journal, April 19, 2002
U.S. Congress, Committee on Ways and Means. Technical and
Miscellaneous Revenue Act of 1988. Report to accompany H.R. 4333. 100th
Congress, 2nd session. House Report 100-1104. Washington, DC:
Government Printing Office, October 21, 1988, pp. 96-108.
U.S. Congress, Joint Committee on Taxation. "Life Insurance Tax
Provisions." In General Explanation of the Revenue Provisions of the Deficit
Reduction Act of 1984. Joint Committee Print, 98th Congress, 2nd session.
Washington, DC: Government Printing Office, December 31, 1984.
-. Tax Reform Proposals: Taxation of Insurance Products and
Companies. Joint Committee Print, 99th Congress, 1st session. Washington:
Government Printing Office, September 20, 1985.
-. Present-Law Federal Tax Treatment, Proposals, and Issues Relating to
Company-Owned Life Insurance, Joint Committee Print JCX-91-03, 108th
Congress, 1st session. Washington: Government Printing Office, October 15,
2003
-. 'Technical Explanation of H.R. 4, The "Pension Protection Act
of 2006," As Passed by the House on July 28, 2006, and As
Considered by the Senate on August 3, 2006." Joint Committee Print
JCX-38-06, 109th Congress, 2nd session. Washington, DC: Government
Printing Office, August 3, 2006, pp.208-222.
-. 'Estimated Budget Effects of H.R. 4, The "Pension Protection
Act of 2006," As Introduced in The House of Representatives on July
28, 2006.' Joint Committee Print JCX-36-06 , 109th Congress, 2nd
session. Washington, DC: Government Printing Office, July 28, 2006,
p.4.
U.S. Congressional Budget Office. "Options to Increase Revenues:
Include Investment Income from Life Insurance and Annuities in Taxable
Income." In Budget Options. Washington, DC: 2005.
U.S. Department of the Treasury. Report to the Congress on the Taxation
of Life Insurance Company Products. Washington, DC: March 30, 1990.
Vickrey, William S. Agenda for Progressive Taxation. New York:
Ronald Press, 1947. Reprint, Clifton, NJ: Kelley, 1970.
-. "Insurance Under the Federal Income Tax," Yale Law Journal 52 (June
1943), pp. 554-585.
Webel, Baird. Corporate Owned Life Insurance (COLI): Insurance and
Tax Issues, Library of Congress, Congressional Research Service Report
RL33414, May 10, 2006.

Commerce and Housing:
Insurance Companies

SMALL LIFE INSURANCE COMPANY
TAXABLE INCOME ADJUSTMENT

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.1

2007

0.1

2008

0.1

2009

0.1

2010

0.1

Authorization

Section 806.

Description

Life insurance companies with gross assets of less than $500 million are
allowed a special "small life insurance company deduction." Generally,
consolidated group tests are used in applying the taxable income and gross
asset standards. The amount of the deduction is 60 percent of so much of
otherwise taxable income from insurance operations for a taxable year that
does not exceed $3 million, reduced by 15 percent of the excess of otherwise
taxable income over $3 million.

Thus, the deduction phases out as a company's taxable insurance income
increases from $3 million to $15 million, computed without this deduction. A
company with taxable insurance income over $15 million, computed without
this deduction, is not entitled to a small life insurance company deduction.

Impact

The small life insurance company deduction reduces the tax rate for
"small" life insurance companies. An insurer with assets of up to $500
million and taxable incomes of up to $15 million can still be considered small
relative to very large companies that comprise most of the industry. A
company eligible for the maximum small company deduction of $1.8 million
is, in effect, taxed at a rate of 13.6 percent instead of the regular 34 percent
corporate rate.

Because these companies may be either investor-owned stock companies
or policyholder-owned mutual companies, determining the distribution of
benefits is difficult. Competitive pressures may force companies to pass some
of these benefits on to life insurance policyholders.

Rationale

This provision was added in the massive revision of life insurance
company taxation included in the Deficit Reduction Act of 1984 (P.L. 98-
369). The justification given is that, although "the Congress believed that,
without this provision, the Act provided for the proper reflection of taxable
income," the Congress was also concerned about a sudden sharp increase in
the companies' taxes. A companion provision, reducing taxes by an arbitrary
amount for all life insurance companies, was repealed in the Tax Reform Act
of 1986, but the deduction for small companies was retained.

Assessment

The principle of basing taxes on the ability to pay, often put forth as a
requisite of an equitable and fair tax system, does not justify reducing taxes
on business income for firms below a certain size. Tax burdens are ultimately
borne by persons, such as business owners, customers, employees, or other
individuals, not by firms. The burden that a business's taxes places on a
person is not determined by the size of the business.

Imposing lower tax rates on smaller firms distorts the efficient allocation of
resources, since it offers a cost advantage based on size and not economic
performance. This tax reduction serves no simplification purpose, since it
requires an additional set of computations and some complex rules to prevent
abuses. It may serve to help newer companies to become established and
build up the reserves State laws require of insurance companies.

Selected Bibliography

U.S. Congress, Joint Committee on Taxation. "Tax Treatment of Life
Insurance Companies." In General Explanation of the Revenue Provisions
of the Deficit Reduction Act of 1984. Joint Committee Print, 98th Congress,
2d session. Washington, DC: Government Printing Office, December 31,
1984, pp. 582-593.
-. Tax Reform Proposals: Taxation of Insurance Products and
Companies. Joint Committee Print, 99th Congress, 1st session. Washington,
DC: Government Printing Office, September 20, 1985.

Commerce and Housing:
Insurance Companies

SPECIAL TREATMENT
OF LIFE INSURANCE COMPANY RESERVES

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

1.9

2007

2.0

2008

2.0

2009

2.1

2010

2.2

Authorization

Sections 803(a)(2), 805(a)(2), 807.

Description

Most businesses calculate taxable income by deducting expenses when the
business becomes liable for paying them. Life insurance companies,
however, are allowed to deduct additions to reserves for future liabilities
under insurance policies, offsetting current income with future expenses.

Impact

Reserves are accounts recorded in the liabilities section of balance sheets
to indicate a claim against assets for future expenses. When additions to the
reserve accounts are allowed as deductions in computing taxable income, it
allows an amount of tax-free (or tax-deferred) income to be used to purchase
assets. Amounts are added to reserves from both premium income and the
investment income earned by the invested assets, so reserve accounting
shelters both premium and investment income from tax.

A large part of the reserves of life insurance companies is credited to
individual policyholders, to whom the investment income is not taxed either
(see "Exclusion of Investment Income on Life Insurance and Annuity
Contracts," above).

The nature of the life insurance industry suggests that a reduction in its
corporate taxes would go primarily to policyholders. Thus the beneficiaries
of this tax expenditure are probably not the owners of capital in general (see
Introduction) but rather those who invest in life insurance products in
particular.

Rationale

The first modern corporate income tax enacted in 1909 provided that
insurance companies could deduct additions to reserves required by law, and
some form of reserve deduction has been allowed ever since.

Originally, the accounting rules of most regulated industries were adopted
for tax purposes, and reserve accounting was required by all State insurance
regulations. The many different methods of taxing insurance companies tried
since 1909 all allowed some form of reserve accounting.

Before the Deficit Reduction Act of 1984, which set the current rules for
taxing life insurance companies, reserves were those required by State law
and generally computed by State regulatory rules. The Congress, concluding
that the conservative regulatory rules allowed a significant overstatement of
deductions, set rules for tax reserves that specified what types of reserves
would be allowed and what discount rates would be used.

Assessment

Reserve accounting allows the deduction from current income of expenses
relating to the future. This is the standard method of accounting for insurance
regulatory purposes, where the primary goal is to assure that a company will
be able to pay its promised benefits and the understatement of current income
is regarded as simply being conservative.

Under the income tax, however, the understatement of current income
gives a tax advantage. Combined with virtual tax exemption of life insurance
product income at the individual level, this tax advantage makes life
insurance a far more attractive investment vehicle than it would otherwise be
and leads to the overpurchase of insurance and overinvestment in insurance
products.

One often-proposed solution would retain reserve accounting but limit the
deduction to amounts actually credited to the accounts of specific
policyholders, who would then be taxable on the additions to their accounts.
This would assure that all premium and investment income not used to pay
current expenses was taxed at either the company or individual level, more in
line with the tax treatment of banks, mutual funds, and other competitors of
the life insurance industry.

Selected Bibliography

Aaron, Henry J. The Peculiar Problem of Taxing Life Insurance
Companies. Washington, DC: The Brookings Institution, 1983.
Harman, William B., Jr. "Two Decades of Insurance Tax Reform." Tax
Notes 57 (November 12, 1992), pp. 901-914.
Kopcke, Richard W. "The Federal Income Taxation of Life Insurance
Companies." New England Economic Review. (March/April 1985), pp. 5-19.
Taylor, Jack. "Federal Taxation of the Insurance Industry." In The
Encyclopedia of Taxation and Tax Policy (2nd ed.), eds. Joseph J. Cordes,
Robert O. Ebel, and Jane G. Gravelle. Washington DC: Urban Institute
Press, 2005.
U.S. Congress, Joint Committee on Taxation. "Life Insurance Tax
Provisions." In General Explanation of the Revenue Provisions of the Deficit
Reduction Act of 1984. Joint Committee Print, 98th Congress, 2d session.
Washington, DC: Government Printing Office, December 31, 1984.
-. Tax Reform Proposals: Taxation of Insurance Products and
Companies. Joint Committee Print, 99th Congress, 1st session. Washington,
DC: Government Printing Office, September 20, 1985.
-. Taxation of Life Insurance Companies. Joint Committee Print, 101st
Congress, 1st session. Washington, DC: Government Printing Office, October
16, 1989, pp. 8-11.
U.S. Department of the Treasury. Final Report to the Congress on Life
Insurance Company Taxation. Washington, DC, 1989.
-. Tax Reform for Fairness, Simplicity, and Economic Growth, Volume 2,
General Explanation of the Treasury Department Proposals. Washington,
DC, November 1984, pp. 268-269.

Commerce and Housing:
Insurance Companies

DEDUCTION OF UNPAID PROPERTY LOSS RESERVES
FOR PROPERTY AND CASUALTY INSURANCE COMPANIES

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

3.4

2007

3.4

2008

3.5

2009

3.6

2010

3.6

Authorization

Sections 832(b)(5), 846.

Description

Most businesses calculate taxable income by deducting expenses when the
business becomes liable for paying them. Property and casualty insurance
companies, however, are allowed to deduct the discounted value of estimated
losses they will be required to pay in the future under insurance policies
currently in force, including claims in dispute. This allows them to deduct
future expenses from current income and thereby defer tax liability.

Impact

The allowance of a deduction for unpaid losses of a property or casualty
insurer differs from the treatment of other taxpayers in two important
respects. First, insurers may estimate not only the amount of liabilities they
have incurred but also the existence of the liability itself. Second, the
company may deduct an unpaid loss even though it is contesting the liability.
An ordinary accrual-method taxpayer generally may not deduct the amount of
a contested liability.

The net effect of these differences is to permit insurers to accelerate the
deduction of losses claimed relative to the timing of those deductions under
the generally applicable rules.

Competition in the property and casualty insurance industry would cause
most of this reduction in corporate taxes to go to the benefit of the purchasers
of insurance, including other businesses, homeowners, and private property
owners.

Rationale

The first modern corporate income tax enacted in 1909 provided that
insurance companies could deduct additions to reserves required by law, and
some form of loss-reserve deduction has been allowed ever since. Originally,
the accounting rules of most regulated industries were adopted for tax
purposes, and reserve accounting was required by all State insurance
regulations.

Before the Tax Reform Act of 1986, property and casualty insurance
company reserves for unpaid losses were simply the undiscounted amount
expected to be paid eventually, as generally required or allowed by State law.
The Congress, concluding that the conservative regulatory rules allowed an
overstatement of loss reserve deductions, required that loss reserves be
discounted for tax purposes.

Assessment

Reserve accounting allows the deduction from current income of expenses
relating to the future. This is the standard method of accounting for insurance
regulatory purposes, where the primary goal is assuring that a company will
be able to pay its policyholders and the possible understatement of current
income is not regarded as a problem.

But the understatement of current income gives an income tax advantage,
which is the basis for calling this item a tax expenditure.

An argument can be made, however, that deducting additions to a properly
discounted reserve for losses that have already occurred and that can be
estimated with reasonable certainty does not distort economic income. Since
the insurance industry is based on being able to estimate its future payments
from current policies, measuring current income could appropriately take into
account the known future payments. From this perspective, only those
additions to reserves that exceed expected losses (as perhaps those for
contested liabilities) would properly be considered a tax expenditure.

Selected Bibliography

Harman, William B., Jr. "Two Decades of Insurance Tax Reform." Tax
Notes 57 (November 12, 1992), pp. 901-914.
Shepard, Lee A. "Normal Tax Accounting for Property and Casualty
Insurance." Tax Notes 71 (April 15, 1996), pp. 395-398.
Taylor, Jack. "Federal Taxation of the Insurance Industry." In The
Encyclopedia of Taxation and Tax Policy (2nd ed.), eds. Joseph J. Cordes,
Robert O. Ebel, and Jane G. Gravelle. Washington DC: Urban Institute
Press, 2005.
U.S. Congress, Joint Committee on Taxation. "Loss Reserves." In
General Explanation of the Tax Reform Act of 1986. Joint Committee Print,
100th Congress, 1st session. Washington, DC: Government Printing Office,
May 4, 1987, pp. 600-618.
-.. Tax Reform Proposals: Taxation of Insurance Products and
Companies. Joint Committee Print, 99th Congress, 1st session. Washington,
DC: Government Printing Office, September 20, 1985, pp. 32-49.
U.S. Department of the Treasury. "Limit Property and Casualty Insurance
Company Reserve Deduction." In Tax Reform for Fairness, Simplicity, and
Economic Growth. General Explanation of the Treasury Department
Proposals. Washington, DC: November 1984, pp. 273-277.
U.S. General Accounting Office. Congress Should Consider Changing
Federal Income Taxation of the Property/Casualty Insurance Industry.
GAO/GGD-85-10. Washington, DC, March 25, 1985.

Commerce and Housing:
Insurance Companies

SPECIAL DEDUCTION FOR
BLUE CROSS AND BLUE SHIELD COMPANIES

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.9

2007

1.0

2008

1.0

2009

1.0

2010

1.0

Authorization

Section 833.

Description

Blue Cross and Blue Shield and a number of smaller health insurance
providers in existence on August 16, 1986, and other nonprofit health insurers
that meet strict community-service standards, are subject to tax as property
and casualty insurance companies, but are allowed a special deduction (for
regular tax purposes only) of up to 25 percent of the excess of the year's
health-related claims and expenses over their accumulated surplus at the
beginning of the year. The deduction is limited to net taxable income for the
year and is not allowed in computing the alternative minimum tax. These
organizations are also allowed a full deduction for unearned premiums, unlike
other property and casualty insurance companies.

Impact

The special deduction exempts from the regular corporate tax of up to 35
percent enough taxable income each year to maintain reserves equal to 25
percent of the year's health-related payouts (three months' worth). Since the
deduction is not allowed for the alternative minimum tax, however, the
income is subject to tax at the minimum tax rate of 20 percent. The Blue
Cross/Blue Shield organizations are not investor owned, so the reduced taxes
benefit either their subscribers or all health insurance purchasers (in reduced
premiums), their managers and employees (in increased wages and/or
discretionary funds), or affiliated hospitals and physicians (in increased fees).

Rationale

The Blue Cross/Blue Shield plans were first subjected to tax in the Tax
Reform Act of 1986, which also provided for the special deduction described
above. The "Blues" had been ruled tax-exempt by Internal Revenue
regulations since their inception in the 1930s, apparently because they were
regarded as community service organizations. The special tax deduction was
given them in 1986 partly in recognition of their continuing (but much more
limited) role in providing community-rated health insurance.

Assessment

Most of the health insurance written by Blue Cross and Blue Shield plans
is in the form of group policies indistinguishable in price and coverage from
those offered by commercial insurers. Some of the plans have accumulated
enough surplus to purchase unrelated businesses, many receive a substantial
part of their income from administering Medicare or self-insurance plans of
other companies, and some have argued that their tax preferences have
benefitted their managers and their affiliated hospitals and physicians more
than their communities.

They do, however, retain in their charters a commitment to offer individual
policies not available elsewhere. Some continue to offer policies with
premiums based on community payout experience ("community rated").
Their former tax exemption and their current reduced tax rates presumably
serve to subsidize these community activities.

Selected Bibliography

Embry-Thompson, Leah D. and Robert K. Kolbe. "Federal Tax
Exemption of Prepaid Health Care Plans after IRC 501(m)." Exempt
Organizations 1992 Continuing Professional Education Text. Available at
[www.irs.gov/pub/irs-tege/eotopicl92.pdf].
Law, Sylvia A. Blue Cross: What Went Wrong? New Haven: Yale
University Press, 1974.
McGovern, James J. "Federal Tax Exemption of Prepaid Health Care
Plans." The Tax Adviser 7 (February 1976), pp. 76-81.
McNurty, Walter. "Big Questions for the Blues: Where to from Here?"
Inquiry 33 (Summer 1996), pp. 110-117.
Starr, Paul. The Social Transformation of American Medicine. New
York: Basic Books, 1983, pp.290-310.
Taylor, Jack. Blue Cross/Blue Shield and Tax Reform. Library of
Congress, Congressional Research Service Report 86-651 E. Washington,
DC: April 9, 1986.
-. Income Tax Treatment of Health Care Insurers. Library of Congress,
Congressional Research Service Report 94-772 E. Washington, DC: October
5, 1994.
U.S. Congress, Joint Committee on Taxation. "Tax Exempt Organizations
Engaged in Insurance Activities." In General Explanation of the Tax Reform
Act of 1986. Joint Committee Print, 100th Congress, 1st session. Washington,
DC: Government Printing Office, May 4, 1987, pp. 583-592.
-. Description and Analysis of Title VII of H.R. 3600, S. 1757, and S.
1775 ("Health Security Act"), Joint Committee Print, 103rd Congress, 1st
session. Washington, DC: Government Printing Office, December 20, 1993,
pp. 82-96.
Wasley, Terree P. "Health Care in the Twentieth Century: A History of
Government Interference and Protection." Business Economics 28 (April
1993), pp. 11-17.
Weiner, Janet Ochs. "The Rebirth of the Blues." Medicine and Health
Supplement (February 18, 1991).

Commerce and Housing:
Housing

DEDUCTION FOR MORTGAGE INTEREST
ON OWNER-OCCUPIED RESIDENCES

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

69.4

2007

75.6

2008

80.7

2009

85.9

2010

91.1

H.R. 6111 (December 2006) increased the cost by $0.1 billion in FY2008.

Authorization

Section 163(h).

Description

A taxpayer may claim an itemized deduction for "qualified residence
interest," which includes interest paid on a mortgage secured by a principal
residence and a second residence. The underlying mortgage loans can
represent acquisition indebtedness of up to $1 million, plus home equity
indebtedness of up to $100,000. In 2007, premiums for mortgage insurance
are deductible as interest, but are phased out as 10 percent for each $1,000
over $100,000.

Impact

The deduction is considered a tax expenditure because homeowners are
allowed to deduct their mortgage interest even though the implicit rental
income from the home (comparable to the income they could earn if the home
were rented to someone else) is not subject to tax.

Renters and the owners of rental property do not receive a comparable
benefit. Renters may not deduct any portion of their rent under the Federal
income tax. Landlords may deduct mortgage interest paid for rental property,
but they are subject to tax on the rental income.

For taxpayers who can itemize, the home mortgage interest deduction
encourages home ownership by reducing the cost of owning compared with
renting. It also encourages them to spend more on housing (measured before
the income tax offset), and to borrow more than they would in the absence of
the deduction.

The mortgage interest deduction primarily benefits middle- and upper-
income households. Higher-income taxpayers are more likely to itemize
deductions. As with any deduction, a dollar of mortgage interest deduction is
worth more the higher the taxpayer's marginal tax rate.

Higher-income households also tend to have larger mortgage interest
deductions because they can afford to spend more on housing and can qualify
to borrow more. The home equity loan provision favors taxpayers who have
been able to pay down their acquisition indebtedness and whose homes have
appreciated in value.

Distribution by Income Class of the Tax
Expenditure for Mortgage Interest, 2005

Income Class
(in thousands of $)

Percentage
Distribution

Below $10

0.0%

$10 to $20

0.1%

$20 to $30

0.7%

$30 to $40

1.6%

$40 to $50

3.1%

$50 to $75

12.2%

$75 to $100

13.8%

$100 to $200

40.4%

$200 and over

28.1%

Rationale

The income tax code instituted in 1913 contained a deduction for all
interest paid, with no distinction between interest payments made for
business, personal, living, or family expenses. There is no evidence in the
legislative history that the interest deduction was intended to encourage home
ownership or to stimulate the housing industry at that time. In 1913 most
interest payments represented business expenses. Home mortgages and other
consumer borrowing were much less prevalent than in later years.

Before the Tax Reform Act of 1986 (TRA86), there were no restrictions
on either the dollar amount of mortgage interest deduction or the number of
homes on which the deduction could be claimed. The limits placed on the
mortgage interest deduction in 1986 and 1987 were part of the effort to limit
the deduction for personal interest.

Under the provisions of TRA86, for home mortgage loans settled on or
after August 16, 1986, mortgage interest could be deducted only on a loan
amount up to the purchase price of the home, plus any improvements, and on
debt secured by the home but used for qualified medical and educational
expense. This was an effort to restrict tax-deductible borrowing of home
equity in excess of the original purchase price of the home. The interest
deduction was also restricted to mortgage debt on a first and second home.

The Omnibus Budget Reconciliation Act of 1987 placed new dollar limits
on mortgage debt incurred after October 13, 1987, upon which interest
payments could be deducted. An upper limit of $1 million ($500,000 for
married filing separately) was placed on the combined "acquisition
indebtedness" for a principal and second residence. Acquisition indebtedness
includes any debt incurred to buy, build, or substantially improve the
residence(s). The ceiling on acquisition indebtedness for any residence is
reduced down to zero as the mortgage balance is paid down, and can only be
increased if the amount borrowed is used for improvements.

The TRA86 exception for qualified medical and educational expenses was
replaced by the explicit provision for home equity indebtedness: in addition to
interest on acquisition indebtedness, interest can be deducted on loan amounts
up to $100,000 ($50,000 for married filing separately) for other debt secured
by a principal or second residence, such as a home equity loan, line of credit,
or second mortgage. The sum of the acquisition indebtedness and home
equity debt cannot exceed the fair market value of the home(s). There is no
restriction on the purposes for which home equity indebtedness can be used.

Mortgage interest is one of several deductions subject to the phaseout on
itemized deductions for taxpayers whose AGI exceeds the applicable
threshold amount--$150,500 for single taxpayers in 2006, indexed for
inflation. (This phaseout was instituted for tax years 1991 through 1995 by
the Omnibus Budget Reconciliation Act of 1990 and made permanent by the
Omnibus Budget Reconciliation Act of 1993.)

The temporary deductibility of mortgage insurance was added by H.R.
6111 (December 2006).

Assessment

Major justifications for the mortgage interest deduction have been the
desire to encourage homeownership and to stimulate residential construction.
Homeownership is alleged to encourage neighborhood stability, promote
civic responsibility, and improve the maintenance of residential buildings.
Homeownership is also viewed as a mechanism to encourage families to save
and invest in what for many will be their major financial asset.

A major criticism of the mortgage interest deduction has been its
distribution of tax benefits in favor of higher-income taxpayers. It is unlikely
that a housing subsidy program that gave far larger amounts to high income
compared with low income households would be enacted if it were proposed
as a direct expenditure program.

The preferential tax treatment of owner-occupied housing relative to other
assets is also criticized for encouraging households to invest more in housing
and less in other assets that might contribute more to increasing the Nation's
productivity and output.

Efforts to limit the deduction of some forms of interest more than others
must address the ability of taxpayers to substitute one form of borrowing for
another. For those who can make use of it, the home equity interest deduction
can substitute for the deductions phased out by TRA86 for consumer interest
and investment interest in excess of investment income. This alternative is
not available to renters or to homeowners with little equity buildup.

Analysts have pointed out that the rate of homeownership in the United
States is not significantly higher than in countries such as Canada that do not
provide a mortgage interest deduction under their income tax. The value of
the U.S. deduction may be at least partly capitalized into higher prices at the
middle and upper end of the housing market.

Selected Bibliography

Bourassa, Steven C. and Grigsby, William G. "Income Tax Concessions
for Owner-Occupied Housing," Housing Policy Debate, vol. 11, iss. 3, 2000,
pp. 521-546.
Brady, Peter, Cronin, Julie-Anne, and Houser, Scott. "Regional
Differences in the Utilization of the Mortgage Interest Deduction," Public
Finance Review, vol. 31, (July 2003), pp. 327-366.

Capozza, Dennis R., Richard K. Green, and Patric H. Hendershott.
"Taxes, Mortgage Borrowing and Residential Land Prices," in Economic
Effects of Fundamental Tax Reform, eds. Henry H. Aaron and William G.
Gale. Washington, DC: Brookings Institution Press, 1996, pp. 171-210.
Cecchetti, Stephen G. and Peter Rupert. "Mortgage Interest Deductibility
and Housing Prices," Economic Commentary. Federal Reserve Bank of
Cleveland, February 1, 1996.
Chatterjee, Satyjit. "Taxes, Homeownership, and the Allocation of
Residential Real Estate Risk," Business Review, Federal Reserve Bank of
Philadelphia, September-October 1996, pp. 3-10.
Engen, Eric M. and William G. Gale. "Tax-Preferred Assets and Debt,
and the Tax Reform Act of 1986: Some Implications for Fundamental Tax
Reform," National Tax Journal, vol. 49, (September 1996), pp. 331-339.
Follain, James R., and David C. Ling. "The Federal Tax Subsidy to
Housing and the Reduced Value of the Mortgage Interest Deduction,"
National Tax Journal, vol. 44, (June 1991), pp. 147-168.
Follain, James R., and Robert M. Dunsley. "The Demand for Mortgage
Debt and the Income Tax," Journal of Housing Research, vol. 8, no. 2, 1997,
pp. 155-191.
Glaeser, Edward L. and Jesse M. Shapiro. "The Benefits of the Home
Mortgage Interest Deduction," NBER Working Paper Series 9284, National
Bureau of Economic Research, October 2002.
Green, Richard K. and Kerry D. Vandell. "Giving Households Credit:
How Changes in the U.S. Tax Code Could Promote Homeownership,"
Regional Science and Urban Economics, vol. 29, no. 4, July 1999, pp.
419-444.
Gyourko, Joseph and Sinai, Todd. "The Spatial Distribution of
Housing-Related Ordinary Income Tax Benefits," Real Estate Economics,
vol. 31, (Winter 2003), pp. 529-531.
Howard, Christopher. The Hidden Welfare State: Tax Expenditures and
Social Policy in the United States. Princeton: Princeton Univ. Press, 1997.
Jackson, Pamela J. Fundamental Tax Reform: Options for the Mortgage
Interest Deduction, Library of Congress, Congressional Research Service
Report RL33025, April 26, 2006.
Maki, Dean M. "Portfolio Shuffling and Tax Reform," National Tax
Journal , vol. 49, ( September 1996), pp. 317-329.
Nakagami, Yasuhiro and Alfred M. Pereira. "Budgetary and Efficiency
Effects of Housing Taxation in the United States," Journal of Urban
Economics, vol. 39, (January 1996), pp. 68-86.
Rose, Clarence C. "The Investment Value of Home Ownership," Journal
of Financial Service Professionals, vol. 60, (January 2006), pp. 57-66.
Rosen, Harvey S. "Housing Subsidies: Effects on Housing Decisions,
Efficiency, and Equity," Handbook of Public Economics, vol. I, eds. Alan J.
Auerbach and Martin Feldstein. The Netherlands, Elsevier Science
Publishers B.V. (North-Holland), 1985, pp. 375-420.
Reschovsky, Andrew and Richard K. Green. Tax Credits and Tenure
Choice, Proceedings, 91st Annual Conference on Taxation, 1998.
Washington, DC: National Tax Association, 1999, pp. 401-410.

Sinai, Todd, and Joseph Gyourko. "The (Un)Changing Geographical
Distribution of Housing Tax Benefits: 1980 to 2000," in Tax Policy and the
Economy, 2003 Conference Report, ed. James Poterba. National Bureau of
Economic Research, November 4, 2003.
U.S. Department of Treasury, Internal Revenue Service, Publication 936,
Home Mortgage Interest Deduction.

Commerce and Housing:
Housing

DEDUCTION FOR PROPERTY TAXES
ON OWNER-OCCUPIED RESIDENCES

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

19.9

2007

13.8

2008

13.5

2009

13.4

2010

13.2

Authorization

Section 164.

Description

Taxpayers may claim an itemized deduction for property taxes paid on
owner-occupied residences.

Impact

The deductibility of property taxes on owner-occupied residences provides
a subsidy both to home ownership and to the financing of State and local
governments. Like the deduction for home mortgage interest, the Federal de-
duction for real property (real estate) taxes reduces the cost of home
ownership relative to renting.

Renters may not deduct any portion of their rent under the Federal income
tax. Landlords may deduct the property tax they pay on a rental property but
are taxed on the rental income.

Homeowners may deduct the property taxes but are not subject to income
tax on the imputed rental value of the dwelling. For itemizing homeowners,
the deduction lowers the net price of State and local public services financed
by the property tax and raises their after-Federal-tax income.

Like all personal deductions, the property tax deduction provides uneven
tax savings per dollar of deduction. The tax savings are higher for those with
higher marginal tax rates, and those homeowners who do not itemize
deductions receive no direct tax savings.

Higher-income groups are more likely to itemize property taxes and to
receive larger average benefits per itemizing return. Consequently, the tax
expenditure benefits of the property tax deduction are concentrated in the
upper-income groups.

Distribution by Income Class of the Tax Expenditure
for Property Taxes, 2005

Income Class
(in thousands of $)

Percentage
Distribution

Below $10

0.0

$10 to $20

2.1

$20 to $30

4.0

$30 to $40

5.9

$40 to $50

8.2

$50 to $75

20.9

$75 to $100

18.8

$100 to $200

30.2

$200 and over

9.0

Rationale

Under the original 1913 Federal income tax law all Federal, State, and
local taxes were deductible, except those assessed against local benefits (for
improvements which tend to increase the value of the property), for
individuals as well as businesses.

A major rationale was that tax payments reduce disposable income in a
mandatory way and thus should be deducted when determining a taxpayer's
ability to pay the Federal income tax.

Over the years, the Congress has gradually eliminated the deductibility of
certain taxes under the individual income tax, unless they are business-
related. Deductions were eliminated for Federal income taxes in 1917, for
estate and gift taxes in 1934, for excise and import taxes in 1943, for State
and local excise taxes on cigarettes and alcohol and fees such as drivers' and
motor vehicle licenses in 1964, for excise taxes on gasoline and other motor
fuels in 1978, and for sales taxes in 1986.

In 2004, sales tax deductibility was reinstated for the 2004 and 2005 tax
years by the "American Jobs Creation Act of 2004," (P.L. 108-357). In
contrast to pre-1986 law, State sales and use taxes can only be deducted in
lieu of State income taxes, not in addition to. Taxpayers who itemize and live
in States without a personal income tax benefitted the most from the new law.
As of October 2006, the sales tax deductibility option had not been extended.

State and local taxes are among several deductions subject to the phaseout
on itemized deductions for taxpayers whose AGI exceeds the applicable
threshold amount--$150,500 for 2006, indexed for inflation. (The phaseout is
scheduled to gradually phase-out beginning in the 2006 tax year and be
completely eliminated beginning with the 2010 tax year.)

Assessment

Proponents argue that the deduction for State and local taxes is a way of
promoting fiscal federalism by helping State and local governments to raise
revenues from their own taxpayers. Itemizers receive an offset for their
deductible State and local taxes in the form of lower Federal income taxes.
Deductibility thus helps to equalize total Federal-State-local tax burdens
across the country: itemizers in high-tax States and local jurisdictions pay
somewhat lower Federal taxes as a result of their higher deductions, and vice
versa.

By allowing property taxes to be deducted in the same way as State and
local income, sales, and personal property taxes, the Federal Government
avoids interfering in State and local decisions about which of these taxes to
rely on. The property tax is particularly important as a source of revenue for
local governments and school districts.

Nevertheless, the property tax deduction is not an economically efficient
way to provide Federal aid to State and local governments in general, or to
target aid on particular needs, compared with direct aid. The deduction works
indirectly to increase taxpayers' willingness to support higher State and local
taxes by reducing the net price of those taxes and increasing their income
after Federal taxes.

The same tax expenditure subsidy is available to property taxpayers,
regardless of whether the money is spent on quasi-private benefits enjoyed by
the taxpayers or redistributive public services, or whether they live in
exclusive high-income jurisdictions or heterogeneous cities encompassing a
low-income population. The property-tax-limitation movements of the 1970s
and 1980s, and State and local governments' increased reliance on non-
deductible sales and excise taxes and user fees during the 1980s and 1990s,
suggest that other forces can outweigh the advantage of the property tax
deduction.

Two separate lines of argument are offered by critics to support the case
that the deduction for real property taxes should be restricted. One is that a
large portion of local property taxes may be paying for services and facilities
that are essentially private benefits being provided through the public sector.
Similar services often are financed by non-deductible fees and user charges
paid to local government authorities or to private community associations
(e.g., for water and sewer services or trash removal).

Another argument is that if imputed income from owner-occupied housing
is not subject to tax, then associated expenses, such as mortgage interest and
property taxes, should not be deductible.

Like the mortgage interest deduction, the value of the property tax
deduction may be capitalized to some degree into higher prices for the type of
housing bought by taxpayers who can itemize. Consequently, restricting the
deduction for property taxes could lower the price of housing purchased by
middle- and upper-income taxpayers, at least in the short run.

Selected Bibliography

Aaron, Henry. Who Pays the Property Tax? Washington, DC: The
Brookings Institution, 1975.
Birch, John W., Mark A. Sunderman, and Brent C. Smith. "Vertical
Inequity in Property Taxation: A Neighborhood Based Analysis," Journal of
Real Estate Finance and Economics, v. 29, n. 1, July 2004, pp. 71-78.
Carroll, Robert J., and John Yinger. "Is the Property Tax a Benefit Tax?
The Case of Rental Housing," National Tax Journal, v. 47, no. 2, June 1994,
pp. 295-316.
Kenyon, Daphne A. "Federal Income Tax Deductibility of State and Local
Taxes," Intergovernmental Perspective, Fall 1984, v. 10, no. 4, pp. 19-22.
Maguire, Steven. Federal Deductibility of State and Local Taxes. Library
of Congress, Congressional Research Service Report RL32781. Washington,
D.C.: September 28, 2006.

Netzer, Dick. "Local Government Finance and the Economics of Property
Tax Exemption," State Tax Notes, June 23, 2003, pp. 1053-1069.
Rosen, Harvey S. "Housing Decisions and the U.S. Income Tax: An
Economic Analysis," Journal of Public Economics, v. 11, no. 1. February
1979, pp. 1-23.
Tannenwald, Robert. "The Subsidy from State and Local Tax
Deductibility: Trends, Methodological Issues and its Value After Federal Tax
Reform," Federal Reserve Bank of Boston, Working Paper 97/08, December
1997.
U.S. Congress, Senate Committee on Governmental Affairs,
Subcommittee on Intergovernmental Relations. Limiting State-Local Tax
Deductibility in Exchange for Increased General Revenue Sharing: An
Analysis of the Economic Effects, 98th Congress, 1st session, Committee
Print S. Prt. 98-77, August 1983. A condensed version was published in
Nonna A. Noto and Dennis Zimmerman, "Limiting State-Local Tax
Deductibility: Effects Among the States," National Tax Journal, v. 37, no. 4,
December 1984, pp. 539-549.
U.S. Department of the Treasury, Office of State and Local Finance.
Federal-State-Local Fiscal Relations, Report to the President and the
Congress. Washington, DC: U.S. Government Printing Office, September
1985, pp. 251-283. Also Technical Papers, September 1986, v. 1, pp. 349-
552.

Commerce and Housing:
Housing

EXCLUSION OF CAPITAL GAINS
ON SALES OF PRINCIPAL RESIDENCES

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

24.1

2007

25.2

2008

25.7

2009

26.3

2010

27.1

Authorization

Section 121.

Description

A taxpayer may exclude from federal income tax up to $250,000 of capital
gain ($500,000 in the case of married taxpayers filing joint returns) from the
sale or exchange of their principal residence. To qualify the taxpayer must
have owned and occupied the residence for at least two of the previous five
years. The exclusion is limited to one sale every two years. Special rules
apply in the case of sales necessitated by changes in employment, health, and
other circumstances.

Impact

Excluding the capital gains on the sale of principal residences from tax
primarily benefits middle- and upper-income taxpayers. At the same time,
however, this provision avoids putting an additional tax burden on taxpayers,
regardless of their income levels, who have to sell their homes because of
changes in family status, employment, or health. It also provides tax benefits
to elderly taxpayers who sell their homes and move to less expensive housing
during their retirement years. This provision simplifies income tax
administration and record keeping.

Rationale

Capital gains arising from the sale of a taxpayer's principal residence have
long received preferential tax treatment. The Revenue Act of 1951
introduced the concept of deferring the tax on the capital gain from the sale of
a principal residence if the proceeds of the sale were used to buy another
residence of equal or greater value. This deferral principal was supplemented
in 1964 by the introduction of the tax provision that allowed elderly taxpayers
a one-time exclusion from tax for some of the capital gain derived from the
sale of their principal residence. Over time, the one-time exclusion provision
was modified such that all taxpayers aged 55 and older were allowed a one-
time exclusion for up to $125,000 gain from the sale of their principal
residence.

By 1997, Congress had concluded that these two provisions, tax free
rollovers and the one-time exclusion of $125,000 in gain for elderly
taxpayers, had created significant complexities for the average taxpayer with
regard to the sale of their principal residence. To comply with tax
regulations, taxpayers had to keep detailed records of the financial
expenditures associated with their home ownership. Taxpayers had to
differentiate between those expenditures that affected the basis of the property
and those that were merely for maintenance or repairs. In many instances
these records had to be kept for decades.

In addition to record keeping problems, Congress believed that the prior
law rules promoted an inefficient use of taxpayers' resources. Because
deferral of tax required the purchase of a new residence of equal or greater
value, prior law may have encouraged taxpayers to purchase more expensive
homes than they otherwise would have.

Finally, Congress believed that prior law may have discouraged some
elderly taxpayers from selling their homes to avoid possible tax consequences.
Elderly taxpayers who had already used their one-time exclusion and those
who might have realized a gain in excess of $125,000, may have held on to
their homes longer than they otherwise would have.

As a result of these concerns, Congress repealed the rollover provisions
and the one-time exclusion of $125,000 of gain in the Taxpayer Relief Act of
1997. In their place, Congress enacted the current tax rules which allow a
taxpayer to exclude from federal income tax up to $250,000 of capital gain
($500,000 in the case of married taxpayers filing joint returns) from the sale
or exchange of their principal residence.

Assessment

This exclusion from income taxation gives homeownership a competitive
advantage over other types of investments, since the capital gains from
investments in other assets are generally taxed when the assets are sold.
Moreover, when combined with other provisions in the tax code such as the
deductibility of home mortgage interest, homeownership is an especially
attractive investment. As a result, savings are diverted out of other forms of
investment and into housing.

Viewed from another perspective, many see the exclusion on the sale of a
principal residence as justifiable because the tax law does not allow the
deduction of personal capital losses, because much of the profit from the sale
of a personal residence can represent only inflationary gains, and because the
purchase of a principal residence is less of a profit-motivated decision than
other types of investments. Taxing the gain on the sale of a principal
residence might also interfere with labor mobility.

Selected Bibliography

Gravelle, Jane and Jackson, Pamela J. The Exclusion of Capital Gains for
Owner Occupied Housing. Library of Congress, Congressional Research
Service Report RL32978. Washington DC: 2006.
Esenwein, Gregg A. Individual Capital Gains Income: Legislative
History. Library of Congress, Congressional Research Service Report 98-
473E. Washington DC: 2006.
Fox, John O., If Americans Really Understood the Income Tax. Boulder,
Colorado: Westview Press, 2001, pp. 177- 200.
Burman, Leonard E., Sally Wallace, and David Weiner, "How Capital
Gains Taxes Distort Homeowners' Decisions," Proceedings of the 89th
Annual Conference, 1996, Washington, DC: National Tax Association, 1997.
U.S. Department of the Treasury, Internal Revenue Service, Selling Your
Home, Publication 523, 2005.
U.S. Congress, Joint Committee on Taxation. Description of Revenue
Provisions Contained in the President's Fiscal Year 2001 Budget Proposal.
March 6, 2000.
-. General Explanation of Tax Legislation Enacted in 1997. December
17, 1997.
U.S. Congress, Congressional Budget Office. Perspectives on the
Ownership of Capital Assets and the Realization of Capital Gains. May
1997.

Commerce and Housing:
Housing

EXCLUSION OF INTEREST ON STATE AND LOCAL
GOVERNMENT BONDS FOR OWNER-OCCUPIED HOUSING

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.9

0.3

1.2

2007

1.0

0.4

1.4

2008

1.0

0.4

1.4

2009

1.1

0.4

1.5

2010

1.1

0.4

1.5

Authorization

Sections 103, 141, 143, and 146 of the Internal Revenue Code of 1986.

Description

Interest income on State and local bonds issued to provide mortgages at
below-market interest rates on owner-occupied principal residences of first-
time homebuyers is tax exempt. The issuer of mortgage bonds typically uses
bond proceeds to purchase mortgages made by a private lender. The
homeowners make their monthly payments to the private lender, which passes
them through as payments to the bondholders. The first time homebuyer's
requirement is waived on a one time basis for veterans from the enactment of
H.R. 6111 (December 2006) through 2008.

These mortgage revenue bonds (MRBs) are classified as private-activity
bonds rather than governmental bonds because a substantial portion of their
benefits accrues to individuals or business rather than to the general public.
For more discussion of the distinction between governmental bonds and
private-activity bonds, see the entry under General Purpose Public
Assistance: Exclusion of Interest on Public Purpose State and Local Debt.

Numerous limitations have been imposed on State and local MRB
programs, among them restrictions on the purchase prices of the houses that
can be financed, on the income of the homebuyers, and on the portion of the
bond proceeds that must be expended for mortgages in targeted (lower
income) areas.

A portion of capital gains on an MRB-financed home sold within ten years
must be rebated to the Treasury. Housing agencies may trade in bond
authority for authority to issue equivalent amounts of mortgage credit
certificates (MCCs). MCCs take the form of nonrefundable tax credits for
interest paid on qualifying home mortgages.

MRBs are subject to the private-activity bond annual volume cap that is
equal to the greater of $80 per State resident or $246.6 million in 2006. The
cap has been adjusted for inflation since 2003. Housing agencies must
compete for cap allocations with bond proposals for all other private-activities
subject to the volume cap.

Impact

Some of the benefits of the tax exemption also flow to bondholders. For a
discussion of the factors that determine the shares of benefits going to
bondholders and homeowners, and estimates of the distribution of tax-exempt
interest income by income class, see the "Impact" discussion under General
Purpose Public Assistance: Exclusion of Interest on Public Purpose State
and Local Debt.

Rationale

The first MRBs were issued without any Federal restrictions during the
high-interest-rate period of the late 1970s. State and local officials expected
reduced mortgage interest rates to increase the incidence of homeownership.
The Mortgage Subsidy Bond Tax Act of 1980 imposed several targeting
requirements, most importantly restricting the use of MRBs to lower-income
first-time purchasers. The annual volume of bonds issued by governmental
units within a State was capped, and the amount of arbitrage profits (the
difference between the interest rate on the bonds and the higher mortgage rate
charged to the home purchaser) was limited to one percentage point.

Depending upon the state of the housing market, targeting restrictions have
been relaxed and tightened over the decade of the 1980s. MRBs were
included under the unified volume cap on private-activity bonds by the Tax
Reform Act of 1986.

MRBs had long been an "expiring tax provision" with a sunset date.
MRBs first were scheduled to sunset on December 31, 1983, by the Mortgage
Subsidy Bond Tax Act of 1980. Additional sunset dates have been adopted
five times when Congress has decided to extend MRB eligibility for a
temporary period. The Omnibus Budget Reconciliation Act of 1993 made
MRBs a permanent provision.

The most recent change to the program was enacted by the Tax Increase
Prevention and Reconciliation Act (TIPRA; P.L. 109-222), which required
that payors of state and municipal bond tax-exempt interest begin to report
those payments to the Internal Revenue Service after December 31, 2005.
The manner of reporting is similar to reporting requirements for interest paid
on taxable obligations. Additionally in the 109th Congress, the program was
expanded temporarily to assist in the rebuilding efforts after the Gulf Region
hurricanes of the Fall of 2005.

Assessment

Income, tenure status, and house-price-targeting provisions imposed on
MRBs make them more likely to achieve the goal of increased
homeownership than many other housing tax subsidies that make no targeting
effort, such as is the case for the mortgage-interest deduction. Nonetheless, it
has been suggested that most of the mortgage revenue bond subsidy goes to
families that would have been homeowners even if the subsidy were not
available.

Even if a case can be made for this federal subsidy for homeownership, it
is important to recognize the potential costs. As one of many categories of
tax-exempt private-activity bonds, MRBs increase the financing cost of bonds
issued for other public capital. With a greater supply of public bonds, the
interest rate on the bonds necessarily increases to lure investors. In addition,
expanding the availability of tax-exempt bonds increases the assets available
to individuals and corporations to shelter their income from taxation.

Selected Bibliography

-. "The Economics of Mortgage Revenue Bonds: A Still Small Voice."
In Mortgage Revenue Bonds: Housing Markets, Home Buyers and Public
Policy, edited by Danny W. Durning, Boston, MA: Kluwer Academic
Publishers, 1992.
MacRae, Duncan, David Rosenbaum, and John Tuccillo. Mortgage
Revenue Bonds and Metropolitan Housing Markets. Washington, DC: The
Urban Institute, May 1980.
Maguire, Steven. Private Activity Bonds: An Introduction. Library of
Congress, Congressional Research Service Report RL31457. June 90, 2006.
-. Tax-Exempt Bonds: A Description of State and Local Government
Debt. Library of Congress, Congressional Research Service Report
RL30638. March 10, 2006.
Temple, Judy. "Limitations on State and Local Government Borrowing for
Private Purposes," National Tax Journal, v. 46, March 1993, pp. 41-52.
U.S. General Accounting Office. Home Ownership: Mortgage Bonds Are
Costly and Provide Little Assistance to Those in Need. GAO/RCED-88-111.
1988.
Wrightson, Margaret T. Who Benefits from Single-Family Housing
Bonds? History, Development and Current Experience of State-Administered
Mortgage Revenue Bond Programs. Washington, DC: Georgetown
University, Public Policy Program, April 1988.
Zimmerman, Dennis. The Private Use of Tax-Exempt Bonds: Controlling
Public Subsidy of Private Activity. Washington, DC: The Urban Institute
Press, 1991.

Commerce and Housing:
Housing

EXCLUSION OF INTEREST ON STATE AND LOCAL
GOVERNMENT BONDS FOR RENTAL HOUSING

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.5

0.2

0.7

2007

0.5

0.2

0.7

2008

0.5

0.2

0.7

2009

0.6

0.2

0.8

2010

0.6

0.2

0.8

Authorization

Sections 103, 141, 142, and 146 of the Internal Revenue Code of 1986.

Description

Interest income on State and local bonds used to finance the construction
of multifamily residential rental housing units for low- and moderate-income
families is tax exempt. These rental housing bonds are classified as private-
activity bonds rather than as governmental bonds because a substantial
portion of their benefits accrues to individuals or business, rather than to the
general public. For more discussion of the distinction between governmental
bonds and private-activity bonds, see the entry under General Purpose Public
Assistance: Exclusion of Interest on Public Purpose State and Local Debt.

These residential rental housing bonds are subject to the State private-
activity bond annual volume cap that is equal to the greater of $80 per State
resident or $246.6 million in 2006. The cap has been adjusted for inflation
since 2003. Several additional requirements have been imposed on these
projects, primarily on the share of the rental units that must be occupied by
low-income families and the length of time over which the income restriction
must be satisfied.

Impact

Since interest on the bonds is tax exempt, purchasers are willing to accept
lower before-tax rates of interest than on taxable securities. These low
interest rates enable issuers to offer residential rental housing units at reduced
rates. Some of the benefits of the tax exemption also flow to bondholders.
For a discussion of the factors that determine the shares of benefits going to
bondholders and renters, and for estimates of the distribution of tax-exempt
interest income by income class, see the "Impact" discussion under General
Purpose Public Assistance: Exclusion of Interest on Public Purpose State
and Local Debt.

Rationale

Before 1968, State and local governments were allowed to issue tax-
exempt bonds to finance multifamily rental housing without restriction. The
Revenue and Expenditure Control Act of 1968 (RECA 1968) imposed tests
that restricted the issuance of these bonds. However, the Act also provided a
specific exception which allowed unrestricted issuance for multifamily rental
housing.

Most States issue these bonds in conjunction with the Leased Housing
Program under Section 8 of the United States Housing Act of 1937. The Tax
Reform Act of 1986 restricted eligibility for tax-exempt financing to projects
satisfying one of two income-targeting requirements: 40 percent or more of
the units must be occupied by tenants whose incomes are 60 percent or less of
the area median gross income, or 20 percent or more of the units are occupied
by tenants whose incomes are 50 percent or less of the area median gross
income. The Tax Reform Act of 1986 subjected these bonds to the State
volume cap on private-activity bonds.

Assessment

This exception was provided because it was believed that subsidized
housing for low- and moderate-income families provided benefits to the
Nation, and provided equitable treatment for families unable to take
advantage of the substantial tax incentives available to those able to invest in
owner-occupied housing.

Even if a case can be made for a federal subsidy for multifamily rental
housing due to underinvestment at the State and local level, it is important to
recognize the potential costs. As one of many categories of tax-exempt
private-activity bonds, those issued for multifamily rental housing increase the
financing cost of bonds issued for other public capital. With a greater supply
of public bonds, the interest rate on the bonds necessarily increases to lure
investors. In addition, expanding the availability of tax-exempt bonds
increases the assets available to individuals and corporations to shelter their
income from taxation.

Selected Bibliography

Maguire, Steven. Private Activity Bonds: An Introduction. Library of
Congress, Congressional Research Service Report RL31457. June 9, 2006.
-. Tax-Exempt Bonds: A Description of State and Local Government
Debt. Library of Congress, Congressional Research Service Report
RL30638. March 10, 2006.
U.S. General Accounting Office. Information on Selected Capital
Facilities Related to the Essential Governmental Function Test. GAO-06-
1082. 2006.
U.S. Congress, Congressional Budget Office. Tax-Exempt Bonds for
Multi-Family Residential Rental Property, 99th Congress, 1st session. June
21, 1985.
-, Joint Committee on Taxation. General Explanation of the Revenue
Provisions of the Tax Reform Act of 1986. May 4, 1987: 1171-1175.
Zimmerman, Dennis. The Private Use of Tax-Exempt Bonds: Controlling
Public Subsidy of Private Activity. Washington, DC: The Urban Institute
Press, 1991.

Commerce and Housing:
Housing

TAX CREDIT FOR FIRST-TIME HOMEBUYERS
IN THE DISTRICT OF COLUMBIA

Estimated Revenue Loss*

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

(1)

2007

(1)

2008

(1)

2009

(1)

2010

(1)

*This provision expired on December 31st, 2005. H. R. 6111
(December 2006) extended it through 2007 but there is no separate
revenue estimate.
(1)Less than $50 million.

Authorization

Section 1400C.

Description

The Tax Credit for First-Time District of Columbia Homebuyers (TCDCH)
allows a non-refundable credit against federal taxes of up to $5,000 for the
first-time purchase of a principal residence in the District of Columbia. The
credit applies to both individuals and married couples filing jointly. The
credit is phased out for individuals earning from $70,000 to $90,000 and for
joint filers earning from $110,000 to $130,000. The credit is available only
once for homebuyers who acquired title to a qualifying principal residence
after August 4, 1997 and before December 31, 2005.

Impact

The TCDCH transfers federal revenue to qualified first-time homebuyers in
the District of Columbia (DC) and indirectly to those selling homes to tax
credit recipients. Assuming individuals who receive the tax credit are
relatively well-off - they have the resources to purchase a home in a relatively
expensive market - the primary beneficiaries of this credit are most likely
better off financially than the average federal taxpayer.

Rationale

Some analysts suggest that a high rate of owner-occupied housing creates
significant positive spillovers or externalities for a community or city and
should be encouraged. Owners, it is argued, maintain their homes and
property better than do renters, and thus, the value of their property as well as
neighboring properties increases. Created by the Taxpayer Relief Act of 1997
(P.L. 105-34), the TCDCH provides an incentive to purchase a home in DC
which should then increase the rate of home ownership. Compared to
neighboring Maryland (71.2%) and Virginia (71.2%), the homeownership
rate was significantly lower in the District of Columbia (45.8%).

Assessment

The TCDCH is intended to encourage the first-time purchase of a home in
DC. In effect, the federal government is offering individuals and married
couples up to $5,000 to do something they may or may not do otherwise: buy
their first home in the District of Columbia. The effectiveness of the tax
credit thus depends upon how many marginal or additional homebuyers are
induced into buying homes in DC. There are actually two choices that may
be influenced by the tax credit: 1) whether or not to buy a first home, and 2)
whether or not to buy the home in DC.

As an investment, the decision to buy a home is very similar to the decision
to buy any long-term asset. From a financial perspective, the decision
depends on the rate of return of the asset over the holding period. The one-
time tax credit will not increase the long-term rate of return appreciably and
thus is unlikely to attract many more first-time homebuyers. Some of the
advantage offered by the credit is counterbalanced by the fact that the
existence of the credit may induce sellers to raise their selling price.
However, the one-time tax credit may not increase demand (and thus price)
enough to lure many existing property owners in DC to convert their property
into owner-occupied housing.

The tax credit is may or may not be very effective in influencing the
location of a first-time home purchase in the Washington, D.C. metropolitan
area. DC is distinctly different from the two alternative home locations,
Maryland and Virginia. In theory, the lack of comparable substitute locations
implies that homebuyers are not going to switch preferences based upon the
small tax credit (relative to the 2005 median home price in the DC
metropolitan area of $404,900). For example, a first-time home-buyer will
most likely choose a location based on the array of public (and private)
services to be consumed in the jurisdiction rather than the one-time tax credit.

Currently, little significant empirical evidence exists concerning the use of
the TCDCH or its effectiveness in promoting home-ownership in DC.
However, a 2005 study suggests that the credit has been successful because of
several factors occurring after implementation of the credit, including an
increase in the rate of first-time homebuyers, an increase in the rate of
growth in homeownership in the District of Columbia (as compared to
neighboring regions in Maryland and Virginia), and an increase in the rate of
house price appreciation in the District of Columbia (relative to its
neighbors). According to Bureau of the Census data, from 1996 (the year
before the program was implemented) to 2005 the rate of home-ownership in
DC has increased slightly faster (from 40.4% to 45.8%) than the rate in the
greater Washington Metropolitan area (from 63.4% to 68.4%). Of course the
growth in DC home-ownership rates may have been the same without the
TCDCH.

Selected Bibliography

The data on home-ownership rates are available on the internet from the
United States Bureau of Census, Housing Vacancy and Homeownership
Annual Statistics: 2005, Table 13: Homeownership Rates by State: 1984 to
2005,
http://www.census.gov/hhes/www/housing/hvs/annual05/ ann05t13. html
Poterba, James M. "Tax Subsidies to Owner-Occupied Housing: An Asset-
Market Approach," Quarterly Journal of Economics, v. 99 (November 1984),
p. 729.
Strauss, Robert P. "The Income of Central City Suburban Migrants: A
Case Study of the Washington, D.C. Metropolitan Area," National Tax
Journal, v. 51, no. 3 (September 1998).
Tong, Zhong Yi, "Washington DC's First-Time Home-Buyer Tax Credit:
An Assessment of the Program," Fannie Mae Foundation Special Report,
2005;
http://www.fanniemaefoundation.org/programs/pdf/dctaxcredit_rpt.pdf.
U.S Congress, Joint Committee on Taxation. General Explanation of Tax
Legislation Enacted in 1997, committee print, 105th cong., 1st session
Washington,DC: Government Printing Office, 1997, p. 104.

Commerce and Housing:
Housing

ADDITIONAL EXEMPTION FOR HOUSING PROVIDED
TO INDIVIDUALS DISPLACED BY HURRICANE KATRINA

Estimated Revenue Loss

[in billions of dollars]

Fiscal Year

Individuals

Corporations

Total

2006

0.1

2007

(1)

2008

2009

2010

(1) Less than $50 million in revenue loss.

Authorization

Section 151.

Description

Taxable income is reduced by $500 for each Hurricane Katrina displaced
individual to whom a taxpayer provides housing. The total for each taxpayer
is capped at $2,000 and is reduced by any exemptions claimed under the
provision for prior years. The exemption is available in 2005 and 2006,
although a taxpayer may claim a person only once. No deduction is allowed
if the taxpayer receives any rent or other amount (from any source) in
connection with the provision of housing.

The taxpayer must include on his or her return the displaced person's
taxpayer identification number. The displaced individual may not be the
spouse or dependent of the taxpayer.

In order to qualify, the displaced person must have had a principal place of
abode on August 28, 2005, in the Hurricane Katrina disaster area. If the home
was not in the core disaster area, then either the home had to have been
damaged by the Hurricane or the person was evacuated due to it.

Impact

The additional exemption generally results in additional tax savings for
taxpayers who chose to provide free housing to displaced persons. The
additional exemption is not subject to the income-based phaseouts applicable
to personal exemptions and is allowed as a deduction in computing alternative
minimum taxable income.

Rationale

The exemption was enacted by the Katrina Emergency Tax Relief Act of
2005 (KETRA; P.L. 109-73) in September 2005, after the extensive damage
caused by hurricanes in the Gulf Region. The law contained temporary tax
relief intended to directly and indirectly assist individuals in recovering from
Hurricane Katrina. The exemption, which was included among several other
charitable giving incentives, is itself a charitable giving incentive that
subsidizes the provision of housing assistance by one individual on behalf of
another.

Assessment

The provision provides relief to taxpayers who have assisted individuals
adversely affected by Hurricane Katrina by reducing the amount of income
subject to tax.

While the provision was aimed at taxpayers who assisted individuals
suffering losses, some questions might be raised as to why relief provisions
were allowed for a major disaster, such as a large scale hurricane, but not for
smaller scale disasters (e.g., tornadoes) or losses proceeding from other
sources.

Selected Bibliography

Gravelle, Jane, Tax Policy Options After Hurricane Katrina, Library of
Congress, Congressional Research Service Report RL33088, October 23,
2006.
Internal Revenue Service, Information for Taxpayers Affected by
Hurricanes Katrina, Wilma and Rita, Publication 4492, January 1, 2006.
Lunder, Erika.. The Gulf Opportunity Zone Act of 2005, Library of
Congress, Congressional Research Service Report RS22344, February 14,
2006.
U.S. Congress, Joint Committee on Taxation, Technical Explanation of the
Revenue Provisions of H.R. 3768, The Katrina Emergency Relief Act of
2005, As Passed by the House of Representatives and the Senate, JCX-69-05,
Washington, DC, September 21, 2005.

Commerce and Housing:
Housing

EMPLOYER HOUSING FOR INDIVIDUALS AFFECTED
BY HURRICANE KATRINA

EXCLUSION OF EMPLOYER PROVIDED HOUSING;
EMPLOYER CREDIT FOR HOUSING EMPLOYEES

Estimated Revenue Loss

[in billions of dollars]

Fiscal Year

Individuals

Corporations

Total

2006

0.1

2007

(1)

2008

2009

2010

(1) Less than $50 million in revenue loss.

Authorization

Section 1400P.

Description

A temporary income exclusion is available for the value of in-kind lodging
provided to a qualified employee (and the employee's spouse or dependents)
by, or on behalf of, a qualified employer. The amount of the exclusion for
any month for which lodging is furnished cannot exceed $600. The exclusion
does not apply for purposes of Social Security and Medicare taxes or
unemployment tax. Qualified employers providing in-kind lodging to
qualified employees may claim a credit equal to 30 percent of the amount of
the expense. The remainder of the cost may be deducted.

In order to be eligible, the employee must have had a principal residence in
the Gulf Opportunity (GO) Zone on August 28, 2005, and must perform
substantially all employment services for the qualified employer in the GO
Zone. The employer must have a trade or business in the GO Zone, and the
lodging must have been provided during the first six months after the act's
enactment. The GO Zone is the core disaster area designated by the Federal
Emergency Management Agency (FEMA) as eligible for individual assistance
and includes the southern parts of Louisiana and Mississippi, and
southwestern counties in Alabama.

Impact

Prior to the enactment of the temporary provisions for Katrina victims,
employer-provided housing was included in income as compensation (and
deducted by the employer) and was considered wages for purposes of social
security and Medicare taxes and unemployment tax. For employees, the
exclusion reduces income subject to tax. For employers, the credit is
equivalent to a direct cost reduction. For example, for a firm in the 35
percent tax bracket, the credit reduces the cost of providing housing by 19.5
percent, the difference between a credit and a deduction (100 -35 or 65
percent ) on 30 percent of the cost.

As a result of the special exclusion, taxpayers receiving housing assistance
pay less tax than other taxpayers with the same or smaller economic incomes.
At the same time, however, they may be willing to accept lower wages so
that part of the benefit is passed back to the employer as a reduction in
employment costs. The individual exclusion also provides a reduction in the
cost of hiring workers in that case: if the worker is in the 15 percent tax
bracket, the employer could provide compensation only 85 percent as large as
needed compared to the case where such compensation is taxable.

The benefit of the credit is larger for smaller firms with lower tax rates,
while the benefit of the housing exclusion is greater for higher paid
employees who have higher marginal tax rates. As a fraction of wages,
however, the benefit for higher income individuals is limited because of the
dollar ceiling.

Rationale

The provisions were enacted by the Gulf Opportunity Zone Act of 2005
(GOZone; P.L. 109-135) in December 2005 as part of the congressional
response to the hurricane that struck the Gulf Region. This legislation,
adopted within a few months of Hurricane Katrina, was largely directed at
creating incentives for rebuilding and recovery, and one objective of the
provision may be to encourage employers to hire workers in an area where
substantial amounts of housing were destroyed.

Assessment

There is relatively little evidence to determine the effectiveness of the
housing exclusion and credit in increasing employment and business activity
in the GO Zone. The evidence based on previous studies of enterprise zone
provisions targeted at poor areas does not indicate that tax incentives are very
successful. However, experience in a low income area, usually of a city, may
not provide sufficient evidence to gauge the effects on a much larger
geographic area composed of both higher and lower income affected by a
major disaster.

To the extent that employers would have provided lodging in the absence
of the incentive, the tax provision provides a benefit to either the employee or
the employer, resulting in some inequity in the tax system.

Selected Bibliography

Gravelle, Jane G. "Tax Incentives in the Aftermath of Hurricane Katrina,"
Municipal Finance Journal, v. 26, Fall 2005, pp. 1-13.
Gravelle, Jane, Tax Policy Options After Hurricane Katrina, Library of
Congress, Congressional Research Service Report RL33088, October 23,
2006.
Lunder, Erika. The Gulf Opportunity Zone Act of 2005, Library of
Congress, Congressional Research Service, Report RS22344, February 14,
2006.
Stoker, Robert P. And Michael J. Rich. "Lessons and Limits: Tax
Incentives and Rebuilding the Gulf Coast After Katrina," The Brookings
Institution, Survey Series, August 2006.
U.S. Congress, Joint Committee on Taxation, Technical Explanation of the
Revenue Provisions of H.R. 4440, The "Gulf Opportunity Zone Act of 2005,"
as Passed by The House Of Representatives And The Senate, JCX-88-05,
December 16, 2005.

Commerce and Housing:
Housing

DEPRECIATION OF RENTAL HOUSING IN EXCESS
OF ALTERNATIVE DEPRECIATION SYSTEM

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

4.0

0.4

4.4

2007

4.6

0.5

5.1

2008

5.3

0.6

5.9

2009

6.1

0.7

6.8

2010

7.0

0.8

7.8

Authorization

Sections 167 and 168.

Description

The tax expenditure measures the revenue loss from current depreciation
deductions in excess of the deductions that would have been allowed under
this longer 40-year period. The current revenue effects also reflect different
write-off methods and lives prior to the 1986 revisions, since many buildings
pre-dating that time are still being depreciated.

Prior to 1981, taxpayers were generally offered the choice of using the
straight-line method or accelerated methods of depreciation, such as double-
declining balance and sum-of-years digits, in which greater amounts are
deducted in the early years. (Used buildings with a life of twenty years or
more were restricted to 125-percent declining balance methods.) The period
of time over which deductions were taken varied with the taxpayer's
circumstances.

Beginning in 1981, the tax law prescribed specific write-offs which
amounted to accelerated depreciation over periods varying from 15 to 19
years. Since 1986, all depreciation on residential buildings has been on a
straight-line basis over 27.5 years.

Example: Suppose a building with a basis of $10,000 was subject to
depreciation over 27.5 years. Depreciation allowances would be constant at
1/27.5 x $10,000 = $364. For a 40-year life the write-off would be $250 per
year. The tax expenditure in the first year would be measured as the
difference between the tax savings of deducting $364 or $250, or $114.

Impact

Because depreciation methods faster than straight-line allow for larger
deductions in the early years of the asset's life and smaller depreciation deduc-
tions in the later years, and because shorter useful lives allow quicker
recovery, accelerated depreciation results in a deferral of tax liability.

It is a tax expenditure to the extent it is faster than economic (i.e., actual)
depreciation, and evidence indicates that the economic decline rate for
residential buildings is much slower than that reflected in tax depreciation
methods.

The direct benefits of accelerated depreciation accrue to owners of rental
housing. Benefits to capital income tend to concentrate in the higher-income
classes (see discussion in the Introduction).

Rationale

Prior to 1954, depreciation policy had developed through administrative
practices and rulings. The straight-line method was favored by IRS and
generally used. Tax lives were recommended for assets through "Bulletin F,"
but taxpayers were also able to use a facts-and-circumstances justification.

A ruling issued in 1946 authorized the use of the 150-percent declining
balance method. Authorization for it and other accelerated depreciation
methods first appeared in legislation in 1954 when the double declining
balance and other methods were enacted. The discussion at that time focused
primarily on whether the value of machinery and equipment declined faster in
their earlier years. However, when the accelerated methods were adopted,
real property was included as well.

By the 1960s, most commentators agreed that accelerated depreciation
resulted in excessive allowances for buildings. The first restriction on
depreciation was to curtail the benefits that arose from combining accelerated
depreciation with lower capital gains taxes when the building was sold. That
is, while taking large deductions reduced the basis of the asset for measuring
capital gains, these gains were taxed at the lower capital gains rate rather than
the ordinary tax rate.

In 1964, 1969, and 1976 various provisions to "recapture" accelerated
depreciation as ordinary income in varying amounts when a building was sold
were enacted.

In 1969, depreciation on used rental housing was restricted to 125 percent
declining balance depreciation. Low-income housing was exempt from these
restrictions.

In the Economic Recovery Tax Act of 1981, residential buildings were
assigned specific write-off periods that were roughly equivalent to 175-
percent declining balance methods (200 percent for low-income housing) over
a 15-year period under the Accelerated Cost Recovery System (ACRS).

These changes were intended as a general stimulus to investment.
Taxpayers could elect to use the straight-line method over 15 years, 35 years,
or 45 years. (The Deficit Reduction Act of 1984 increased the 15-year life to
18 years; in 1985, it was increased to 19 years.) The recapture provisions
would not apply if straight-line methods were originally chosen. The
acceleration of depreciation that results from using the shorter recovery period
under ACRS was not subject to recapture as accelerated depreciation.

The current treatment was adopted as part of the Tax Reform Act of 1986,
which lowered tax rates and broadened the base of the income tax.

Assessment

Evidence suggests that the rate of economic decline of residential structures
is much slower than the rates allowed under current law, and this provision
causes a lower effective tax rate on such investments than would otherwise be
the case. This treatment in turn tends to increase investment in rental housing
relative to other assets, although there is considerable debate about how
responsive these investments are to tax subsidies.

At the same time, the more rapid depreciation roughly offsets the
understatement of depreciation due to the use of historical cost-basis
depreciation, assuming inflation is at a rate of two percent or so. Moreover,
many other assets are eligible for accelerated depreciation as well, and the
allocation of capital depends on relative treatment.

Much of the previous concern about the role of accelerated depreciation in
encouraging tax shelters in rental housing has faded because the current
depreciation provisions are less rapid than those previously in place, and
because there is a restriction on the deduction of passive losses. (However,
the restrictions were eased somewhat in 1993.)

Selected Bibliography

Auerbach, Alan, and Kevin Hassett. "Investment, Tax Policy, and the Tax
Reform Act of 1986," Do Taxes Matter: The Impact of the Tax Reform Act of
1986, ed. Joel Slemrod. Cambridge, Mass.: MIT Press, 1990, pp. 13-49.
Board of Governors of the Federal Reserve System. Public Policy and
Capital Formation. April 1981.
Brannon, Gerard M. "The Effects of Tax Incentives for Business
Investment: A Survey of the Economic Evidence," The Economics of Federal
Subsidy Programs, Part 3: Tax Subsidies, U.S. Congress, Joint Economic
Committee, July 15, 1972, pp. 245-268.
Brazell, David W. and James B. Mackie III. "Depreciation Lives and
Methods: Current Issues in the U.S. Capital Cost Recovery System," National
Tax Journal, v. 53 (September 2000), pp. 531-562.
Break, George F. "The Incidence and Economic Effects of Taxation," The
Economics of Public Finance. Washington, DC: The Brookings Institution,
1974.
Bruesseman, William B., Jeffrey D. Fisher and Jerrold J. Stern. "Rental
Housing and the Economic Recovery Tax Act of 1981," Public Finance
Quarterly, v. 10. April 1982, pp. 222-241.
Burman, Leonard E., Thomas S. Neubig, and D. Gordon Wilson. "The Use
and Abuse of Rental Project Models," Compendium of Tax Research 1987,
Office of Tax Analysis, Department of The Treasury. Washington, DC: U.S.
Government Printing Office, 1987, pp. 307-349.
DeLeeuw, Frank, and Larry Ozanne. "Housing," In How Taxes Affect
Economic Behavior, eds. Henry J. Aaron and Joseph A. Pechman.
Washington, DC: The Brookings Institution, 1981, pp. 283-326.
Deloitte and Touche. Analysis of the Economic Depreciation of Structure,
Washington, DC: June 2000.
Feldstein, Martin. "Adjusting Depreciation in an Inflationary Economy:
Indexing Versus Acceleration." National Tax Journal, v. 34. March 1981, pp.
29-43.
Follain, James R., Patric H. Hendershott, and David C. Ling. "Real Estate
Markets Since 1980: What Role Have Tax Changes Played?", National Tax
Journal, v. 45, September 1992, pp. 253-266.

Fromm, Gary, ed. Tax Incentives and Capital Spending. Washington, DC:
The Brookings Institution, 1971.
Fullerton, Don, Robert Gillette, and James Mackie. "Investment Incentives
Under the Tax Reform Act of 1986," Compendium of Tax Research 1987,
Office of Tax Analysis, Department of The Treasury. Washington, DC: U.S.
Government Printing Office, 1987, pp. 131-172.
Fullerton, Don, Yolanda K. Henderson, and James Mackie. "Investment
Allocation and Growth Under the Tax Reform Act of 1986," Compendium of
Tax Research 1987, Office of Tax Analysis, Department of The Treasury.
Washington, DC: U.S. Government Printing Office, 1987, pp. 173-202.
Gravelle, Jane G. "Differential Taxation of Capital Income: Another Look
at the Tax Reform Act of 1986," National Tax Journal, v. 63. December
1989, pp. 441-464.
-. Depreciation and the Tax Treatment of Real Estate. Library of
Congress, Congressional Research Service Report RL30163. Washington,
DC: October 25, 2000.
-. Economic Effects of Taxing Capital Income, Chapters 3 and 5.
Cambridge, MA: MIT Press, 1994.
-. "Whither Tax Depreciation?" National Tax Journal, vol. 54,
September, 2001, pp. 513-526.
Harberger, Arnold. "Tax Neutrality in Investment Incentives," The
Economics of Taxation, eds. Henry J. Aaron and Michael J. Boskin.
Washington, DC: The Brookings Institution, 1980, pp. 299-313.
Hulten, Charles, ed. Depreciation, Inflation, and the Taxation of Income
From Capital. Washington, DC: The Urban Institute, 1981.
Hulten, Charles R., and Frank C. Wykoff. "Issues in Depreciation
Measurement." Economic Inquiry, v. 34, January 1996, pp. 10-23.
Jorgenson, Dale W. "Empirical Studies of Depreciaton." Economic
Inquiry, v. 34, January 1996, pp. 24-42.
Mackie, James. "Capital Cost Recovery," in The Encyclopedia of Taxation
and Tax Policy, eds. Joseph J. Cordes, Robert O. Ebel, and Jane G. Gravelle.
Washington, DC: Urban Institute Press, 2005.
Nadiri, M. Ishaq, and Ingmar R. Prucha. "Depreciation Rate Estimation of
Physical and R&D Capital." Economic Inquiry, v. 34, January 1996, pp. 43-
56.
Poterba, James M. "Taxation and Housing Markets: Preliminary Evidence
on the Effects of Recent Tax Reforms," Do Taxes Matter: The Impact of the
Tax Reform Act of 1986, ed. Joel Slemrod. Cambridge, Mass: The MIT
Press, 1990, pp. 13-49.
Surrey, Stanley S. Pathways to Tax Reform. Chapter VII: "Three Special
Tax Expenditure Items: Support to State and Local Governments, to
Philanthropy, and to Housing." Cambridge, Mass: Harvard University Press,
1973.
Taubman, Paul and Robert Rasche. "Subsidies, Tax Law, and Real Estate
Investment," The Economics of Federal Subsidy Programs, Part 3: "Tax
Subsidies." U.S. Congress, Joint Economic Committee, July 15, 1972, pp.
343-369.

U.S. Congress, Congressional Budget Office. Real Estate Tax Shelter
Subsidies and Direct Subsidy Alternatives. May 1977.
-, Joint Committee on Taxation. General Explanation of the Tax Reform
Act of 1986. May 4, 1987, pp. 89-110.
U.S. Department of Treasury. Report to the Congress on Depreciation
Recovery Periods and Methods. Washington, DC: June 2000.

Commerce and Housing:
Housing

TAX CREDIT FOR LOW-INCOME HOUSING

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

1.4

3.4

4.8

2007

1.5

3.6

5.1

2008

1.6

3.8

5.4

2009

1.7

4.1

5.8

2010

1.9

4.4

6.3

Authorization

Section 42.

Description

The Low Income Housing Tax Credit (LIHTC) was created by the Tax
Reform Act of 1986 (P.L. 99-514), providing a tax credit for a portion of the
costs of low-income rental housing. The credit is claimed over a period of 10
years. The credit rate is set so that the present value of the tax credit is equal
to 70 percent for new construction and 30 percent for projects receiving other
Federal benefits (such as tax exempt bond financing), or for substantially
rehabilitated existing housing.

The credit is allowed only for the fraction of units serving low-income
tenants, which are subject to a maximum rent. To qualify, at least 40 percent
of the units in a rental project must be occupied by families with incomes less
than 60 percent of the area median or at least 20 percent of the units in a
rental project must be occupied by families with incomes less than 50 percent
of the area median . (In practice, data show the vast majority of tax credit
projects are composed almost entirely of low-income units). Rents in low-
income units are restricted to 30 percent of the 60 percent (or 50 percent) of
area median income. An owner's required commitment to keep units
available for low-income use was originally 15 years, but the Omnibus
Budget Reconciliation Act of 1989 extended this period to 30 years for
projects begun after 1989.

The credits are allocated in a competitive process by State housing
agencies to developers, most of whom then sell their 10-year stream of tax
credits to investors to raise capital for the project. The original law established
an annual per-resident limit of $1.25 for the State's total credit authority.
Under the Community Renewal Tax Relief Act of 2000 (P.L 106-554), this
limit was increased to $1.50 in 2001, $1.75 in 2002, and thereafter, adjusted
for inflation ($1.90 for 2006). There is a minimum annual credit amount for
small States, also indexed for inflation, currently about $2.1 million for States
where the $1.90 per capita formula would yield less. The housing authority
must require an enforceable 30-year low-income use (through restrictive
covenants), although after the initial 15-year period, an owner may sell the
project (at a controlled price) or convert it to market-rate housing if the
housing authority is unable to find a buyer, often a nonprofit group, willing to
maintain the project as low-income use for the remainder of the 30 year
period.

The amount of the credit that can be offset against unrelated income is
limited to the equivalent of $25,000 in deductions, under the passive loss
restriction rules.

Impact

This provision substantially reduces the cost of investing in qualified units.
The competitive sale of tax credits by developers to investors and the
oversight requirements by housing agencies should prevent excess profits
from occurring, and direct much of the benefit to qualified tenants of the
housing units.

Most tax credits are now purchased by corporations, including banks who
are satisfying their requirements under the Community Reinvestment Act, and
by the government-sponsored enterprises, Fannie Mae and Freddie Mac, also
satisfying their affordable housing lending goals. Freddie Mac reported that
its low-income housing tax credit portfolio now exceeds $3 billion (200,000
units in more than 2,800 projects).

Rationale

The tax credit for low-income housing was adopted in the Tax Reform Act
of 1986 to provide a subsidy directly linked to the addition of rental housing
with limited rents for low-income households. It replaced less targeted
subsidies in the law, including accelerated depreciation, five-year
amortization of rehabilitation expenditures, expensing of construction-period
interest and taxes, and general availability of tax-exempt bond financing. The
credit was scheduled to expire at the end of 1989, but was temporarily
extended a number of times until made permanent by the Omnibus Budget
Reconciliation Act of 1993 (P.L. 103-66).

The Omnibus Budget Reconciliation Act of 1989 (P.L. 101-239) required
States to regulate tax-credit projects more carefully to insure that investors
were not earning excessive rates of return and introduced the requirement
that new projects have a long-term plan for providing low-income housing.
Legislation in 1988, (the Technical and Miscellaneous Revenue Act of 1988,
P.L. 100-647), in 1989 (noted above), and in 1990 (the Omnibus Budget
Reconciliation Act of 1990, P.L. 101-508) made technical and substantive
changes to the provision. As noted above, the Community Renewal Tax
Relief Act of 2000 increased the annual tax credit allocation limit, indexed it
to inflation, and made minor amendments to the program.

Assessment

The low-income housing credit, now giving States the equivalent of nearly
$5.5 billion of annual budget authority, is more targeted to benefitting lower-
income individuals than the more general tax provisions it replaced.
Moreover, by allowing State authorities to direct its use, the credit can be
used as part of a general neighborhood revitalization program. The most
comprehensive data base of tax credit units, compiled by the Department of
Housing and Urban Development (HUD), revised as of March 31, 2006,
shows nearly 24,500 projects and nearly 1,257,000 housing units placed in
service between 1987 and 2003. With about 100,000 units now being added
each year, the current total is likely in excess of 1.5 million units. The HUD
data base of units built from 1995 through 2003 shows nearly two-thirds were
newly constructed (although only one-third in the Northeast were new
construction), about one-third of the projects had a nonprofit sponsor, nearly
one-half of units are located in central cities and about 40 percent are in metro
area suburbs. It is estimated that about 35 percent of LIHTC properties have
tenant-based rental assistance (HUD's Section 8 program, now called the
Housing Choice Voucher program). Data also show that LIHTC units are
more likely to be located in largely minority- or renter-occupied census tracts
or tracts with large proportions of female-headed households, compared to
households in general or rental units in general.

Much less is known about the financial aspects of tax credit projects and
how much it actually costs to provide an affordable rental unit under this
program when all things are considered. Many tax credit projects receive
other Federal subsidies, and as noted, more than one-third of tax credit renters
receive additional Federal rental assistance. HUD's Federal Housing
Administration (FHA) program is insuring an increasing number of tax credit
projects. There are reports that some neighborhoods are saturated with tax
credit projects and projects targeted to households with 60 percent of area
median income frequently have as high a vacancy rate as the surrounding
unsubsidized market.

There are a number of criticisms that can be made of the credit (see the
Congressional Budget Office study in the bibliography below for a more
detailed discussion). The credit is unlikely to have a substantial effect on the
total supply of low-income housing, based on both micro-economic analysis
and some empirical evidence. There are significant overhead and
administrative costs, especially if there are attempts to insure that investors do
not earn excess profits. Direct funding by the Federal government to State
housing agencies would avoid the cost of the syndication process (the sale of
tax credits to investors as "tax shelters.") And, in general, many economists
would argue that housing vouchers, or direct-income supplements to the low-
income, are more direct and fairer methods of providing assistance to lower-
income individuals. However, others argue that because of landlord
discrimination against low income people, minorities, and those with young
children (and sometimes an unwillingness to get involved in a government
program, particularly in tight rental markets), a mix of vouchers and project-
based assistance like the tax credit might be necessary.

A study by the Chicago Rehab Network of 1998 audits of Chicago tax
credit projects containing 8,704 units found that 73 percent had no operating
reserves and 44 percent had no replacement reserves, with a significant
number of projects likely to face "a future of deferred maintenance, rising
vacancies and ever deepening budget shortfalls." A HUD-commissioned
study (report dated August 2000) of 39 projects found that 50 percent of tax
credit renters pay more than 30 percent of their income for rent, 13 percent
paying more than 50 percent of income.

A looming issue has to do with the projects completed from 1987
through1989 that have 15-year affordability restrictions that began expiring in
2002. There may be as many as 70,000 of these units whose owners could
decide to opt out of the low-income rental operations with relative ease.
There has been almost no information yet reported on this potential. A report
by the Joint Center for Housing Studies at Harvard University and the
Neighborhood Reinvestment Corporation on the expiring affordability issue
concluded that : "Lack of monitoring or insufficient funds for property repair
or purchase will place even properties for which there is an interest in
preserving affordability at risk of market conversion, reduced income-
targeting, or disinvestment and decline." An increasing amount of tax credits
have been and are likely to be used for the preservation of existing affordable
housing in the future rather than for new units that add to the overall supply
of affordable units.

Selected Bibliography

Burman, Leonard. "Low Income Housing Credit," in The Encyclopedia of
Taxation and Tax Policy, eds. Joseph J. Cordes, Robert O. Ebel, and Jane G.
Gravelle. Washington, DC: Urban Institute Press, 2005.
Collignon, Kate. Expiring Affordability of Low-Income Housing Tax
Credit Properties: The Next Era in Preservation. Cambridge, MA:
Neighborhood Reinvestment Corporation and Joint Center for Housing
Studies of Harvard University, October 1999.
Cummings, Jean L, and Denise DiPasquale. "The Low-Income Housing
Tax Credit: An Analysis of the First Ten Years," Housing Policy Debate, v.
10, no. 2, 1999. pp. 251-307.
Freeman, Lance. Siting Affordable Housing: Location and Neighborhood
Trends of Low Income Housing Tax Credit Developments in the 1990s. The
Brookings Institution. March 2004.
Green, Richard K., Stephen Malpezzi, and Kiat-Ying Seah. Low Income
Housing Tax Credit Housing Developments And Property Values. The
Center for Urban Land Economics Research. June 12, 2002.
Herman, Kim, Walter Clare, Susan Herd, Dana Jones, Erica Stewart, and
Barbara Burnham. "Tax Credits and Rural Housing," Voices from the
Housing Assistance Council , Winter 2003-2004.
Jackson, Pamela J. An Introduction to the Design of the Low-Income
Housing Tax Credit, Library of Congress, Congressional Research Service
Report RS22389, March 21, 2006.
Khadduri, Jill, Larry Buron, and Carissa Climaco. "Are States Using the
Low Income Housing Tax Credit to Enable Families with Children to Live in
Low poverty and Racially Integrated Neighborhoods?" a report prepared for
the Poverty and Race Research Action Council and the National Fair
Housing Alliance, July 2006.
Olsen, Edgar O. "The Low-Income Housing Tax Credit: An Assessment,"
working paper from the University of Virginia, December 2004.
Olsen, Edgar O. "Fundamental Housing Policy Reform," working paper
from the University of Virginia, January 2006.
Present Realities, Future Prospects: Chicago's Low Income Housing Tax
Credit Portfolio. Summary Report 2002. Chicago Rehab Network.
Understanding the Dynamics: A Comprehensive Look at Affordable
Housing Tax Credit Properties. Ernst & Young's Affordable Housing
Services, July, 2002.
United States General Accounting Office. Costs and Characteristics of
Federal Housing Assistance. GAO-01-901R. July 2001.
House Committee on Ways and Means. Tax Provisions Related to
Housing. 2004 Green Book. 108th Congress, 2nd session, March 2004, pp. 13-
56 to 13-58.
Joint Committee on Taxation. General Explanation of the Tax Reform Act
of 1986. May 4, 1987, pp. 152-177.
U.S. Department of Housing and Urban Development. Making the Best
Use of Your LIHTC Dollars: A Planning Paper for State Policy Makers.
Washington, D. C. July 2004.

-, Assessment of the Economic and Social Characteristics of LIHTC
Residents and Neighborhoods. Washington, D. C. August 2000.
-, Updating the Low Income Housing Tax Credit Database: Projects
Placed in Service Through 2003. Washington, D.C. March 2006.

Commerce and Housing:
Housing

TAX CREDIT FOR REHABILITATION OF
HISTORIC STRUCTURES

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.1

0.3

0.4

2007

0.1

0.3

0.4

2008

0.1

0.3

0.4

2009

0.1

0.3

0.4

2010

0.1

0.3

0.4

Authorization

Section 47.

Description

Expenditures on certified structures qualify for a 20 percent tax credit if
used to substantially rehabilitate historic structures for use as residential rental
or commercial property. The basis (cost for purposes of depreciation) of the
building is reduced by the amount of the rehabilitation credit. The costs of
acquiring a building or an interest in such a building, such as a leasehold
interest, are not considered as qualifying expenditures. The costs of facilities
related to an existing building, such as a parking lot, also are not considered
as qualifying expenditures. Expenditures incurred by a lessee do not qualify
for the credit unless the remaining lease term on the date the rehabilitation is
completed is at least as long as the applicable recovery period under the
general depreciation rules (generally, 27.5 years for residential property and
39 years for nonresidential property). Straight-line depreciation must be used
to qualify for the rehabilitation credit.

The amount of the credit that can be offset against unrelated income is
limited to the equivalent of $25,000 in deductions under the passive loss
restriction rules. The ordering rules for the phaseout are provided in Section
469 of the Internal Revenue Code.

Certified historic structures are either individually registered in the
National Register of Historic Places or are structures certified by the Secretary
of the Interior as having historic significance and located in a registered
historic district. The State Historic Preservation Office reviews applications
and forwards recommendations for designation to the U.S. Department of
Interior.

Impact

The credit reduces the taxpayer's cost of preservation projects. Prior to the
Tax Reform Act of 1986 (P.L. 99-514), historic preservation projects had
become a popular tax shelter with rapid growth. The limits on credits under
the passive loss restrictions limit the use of this investment as a tax shelter.

Rationale

Rapid depreciation (amortized over a 60-month period) for capital
expenditures incurred in rehabilitation of certified historic structures was
adopted as part of the Tax Reform Act of 1976 (P.L. 94-455). In addition, the
act provided that in case of a substantially altered or demolished certified
historic structure, the amount expended for demolition or any loss sustained
on account of the demolition is to be charged to the capital account with
respect to the land and not includible in the depreciable basis of a replacement
structure. Further, accelerated depreciation methods are prohibited for the
replacement structure. These actions were taken because Congress believed
the preservation of historic structures and neighborhoods is an important
national goal dependent upon the enlistment of private funds in the
preservation movement. It was argued that prior law encouraged the
demolition and replacement of old buildings instead of their rehabilitation.

Partly in a move toward simplification and partly to add counterbalance to
new provisions for accelerated cost recovery, the tax incentives were changed
to a tax credit in 1981 and made part of a set of credits for rehabilitating older
buildings (varying by type or age).

The credit amount was reduced in 1986 because the rate was deemed too
high when compared with the new lower tax rates, and a reduction from a
three- to a two-tiered rehabilitation rate credit was adopted. A higher credit
rate was allowed for preservation of historic structures than for rehabilitations
of older qualified buildings first placed in service prior to 1936.

In response to tax simplification proposals which noted the numerous
limitations and qualifications of the loss limitation rules, ordering rules in the
Internal Revenue Code (Section 469) were clarified with the passage of the
Job Creation and Worker Assistance Act of 2002 (P.L. 107-147).

Temporary expansion of the tax credit amount was enacted with the Gulf
Opportunity Zone Act (GO Zone; P.L. 109-135). The expansion, which
became effective for expenditures made after August 28, 2005 and before
January 1, 2009, applies to certified historic structures located in specific
areas of the Gulf Region that were adversely affected by hurricanes in the fall
of 2005.

Assessment

Owners of historic buildings are encouraged to renovate them through the
use of the 20 percent tax credit available for substantial rehabilitation
expenditures approved by the Department of the Interior. Opponents of the
credit note that investments are allocated to historic buildings that would not
be profitable projects without the credit, resulting in economic inefficiency.
Proponents argue that investors fail to consider external benefits (preservation
of social and aesthetic values) which are desirable for society at large.

Selected Bibliography

Alperin, Kenneth A. "What You Should Know About The Historic
Rehabilitation Tax Credit," The Practical Tax Lawyer, vol. 19, iss. 2, pp. 31-
39.
Escherich, Susan M., Stephen J. Farneth, and Bruce D. Judd; with a
preface by Katherine H. Stevenson. "Affordable Housing Through Historic
Preservation: Tax Credits and the Secretary of the Interior's Standards for
Historic Rehabilitation." Washington, DC: U.S. Dept. of the Interior,
National Park Service, Cultural Resources, Preservation Assistance. For sale
by the U.S. Government Printing Office, Superintendent of Documents
[1995].
Fogleman, Valerie M. "A Capital Tax System to Preserve America's
Heritage: A Proposal Based on the British National Heritage Capital Tax
System," Vanderbilt Journal of Transnational Law, vol. 23, 1990, pp. 1-63.
Foong, Keat. "Historic Tax Credit Use Continues to Rise: Use of Federal
Program Can Be Extremely Lucrative, Although Requirements Can Deter
Developers," Multi-Housing News, vol. 37 (July 2002), pp. 1-4.
Kamerick, Megan. "Framers get a History Lesson: Historic Tax Credits
Can Help Framers Secure the Shops of Their Dreams," Art Business News,
vol. 31, April 2003, p. S1.
Linn, Charles. "PSFS Adaptive Reuse Illustrates Preservation Tax Credits
at Work," Architectural Record, vol. 188, October 2000, p. 63.

Listokin, David, Barbara Listokin, and Micahel Lahr. "The Contributions
of Historic Preservation to Housing and Economic Development," Housing
Policy Debate, vol. 9, Issue 3, 1998, pp. 431-478.
Mann, Roberta F. "Tax Incentives for Historic Preservation: An Antidote
for Sprawl?" Widner Law Symposium Journal, vol. 8, 2002, pp. 207-236.
National Park Service. Federal Historic Preservation Tax Incentives.
World Wide Web http://www2.cr.nps.gov/tps/tax/.
Novogradac, Michael J. and Eric J. Fortenbach. "Financing Rehab Projects
with the Rehabilitation Tax Credit," Journal of Property Management, vol.
54, September-October 1989, pp. 72-73.
Preservation Tax Incentives for Historic Buildings. Washington, DC: U.S.
National Park Service, 1990.
Oliver-Remshefski, Rebecca N. "Washington Slept Here: Protection and
Preservation of Our Architectural Heritage," Rutgers Law Review, vol. 55,
Winter 2003, pp. 611-640.
Smith, Neil. "Comment on David Listokin, Barbara Listokin, and Michael
Lahr's The Contributions of Historic Preservation to Housing and Economic
Development: Historic Preservation in a Neoliberal Age," Housing Policy
Debate, vol. 9, 1998, pp. 479-485.
Swaim, Richard. "Politics and Policymaking: Tax Credits and Historic
Preservation," Journal of Arts Management, Law, and Society, vol. 33, Issue
1, Spring 2003, pp. 32-40.
U.S. Congress, Congressional Budget Office. Budget Options. "Reduce
Tax Credits for Rehabilitating Buildings and Repeal the Credit for
Nonhistoric Structures." Washington, DC: February 2001, p. 427.
U.S. General Accounting Office. Historic Preservation Tax Incentives.
August 1, 1986. Washington, DC: GAO, August 1, 1986.
U.S. Congress, Joint Committee on Taxation. General Explanation of the
Revenue Act of 1978 (H.R. 13511, 95th Congress; Public Law 95-600).
Washington, DC: U.S. Government Printing Office, March 12, 197, pp. 155-
158.
-. General Explanation of the Economic Recovery Tax Act of 1981 (H.R.
4242, 97th Congress; Public Law 97-34). Washington, DC: U.S.
Government Printing Office, December 31, 1981, pp. 111-116.
-. General Explanation of the Tax Reform Act of 1986 (H.R. 3838, 99th
Congress; Public Law 99-514). Washington, DC: U.S. Government Printing
Office, May 4, 1987, pp.

Commerce and Housing:
Housing

INVESTMENT CREDIT FOR REHABILITATION
OF STRUCTURES, OTHER THAN HISTORIC STRUCTURES

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.1

(1)

0.1

2007

0.1

(1)

0.1

2008

0.1

(1)

0.1

2009

0.1

(1)

0.1

2010

0.1

(1)

0.1

(1)Less than $50 million.

Authorization

Section 47.

Description

Qualified expenditures made to substantially rehabilitate a nonresidential
building receive a 10-percent tax credit. Only expenditures on buildings
placed in service before 1936 are eligible. Expenditures made during any 24-
month period must exceed the greater of $5,000 or the adjusted basis (cost
less depreciation taken) of the building. The basis must be reduced by the full
amount of the rehabilitation credit.

For buildings to be eligible, at least 50 percent of the external walls must
be retained as external walls, at least 75 percent of the exterior walls must be
retained as internal or external walls, and at least 75 percent of the internal
structural framework of the building must be retained. The building must not
have been moved since 1936.

Impact

This provision encourages business firms to renovate property rather than
relocate. The credit reduces the cost of rehabilitation and thereby can turn
unprofitable rehabilitation projects into profitable rehabilitation projects, and
can make rehabilitation of a building more profitable than new construction.

Rationale

The Revenue Act of 1978 (P.L. 95-600) provided an investment tax credit
for rehabilitation expenditures made for nonresidential buildings in use for at
least 20 years, in response to concerns over the declining usefulness of older
buildings (especially those in older neighborhoods and central cities). The
purpose was to promote stability and restore economic vitality to deteriorating
areas.

Larger rehabilitation tax credits were enacted in the Economic Recovery
Tax Act of 1981(P.L. 97-34); the purpose was to counteract any tendency to
encourage firms to relocate and build new plants in response to significantly
shortened recovery periods. Concerns were expressed that investment in new
structures in new locations does not promote economic recovery if it displaces
older structures, and that relocation can cause hardship to workers and their
families.

The credit was retained in the Tax Reform Act of 1986 (P.L. 99-514),
because investors were viewed as failing to consider social and aesthetic
values of restoring older structures. The credit amount was reduced, because
the rate would have been too high when compared with the new lower tax
rates, also changed by the 1986 act.

Temporary expansion of the tax credit amount was enacted with the Gulf
Opportunity Zone Act (GO Zone; P.L. 109-135). The expansion, which
became effective for expenditures made after August 28, 2005 and before
January 1, 2009, applies to qualified structures located in specific areas of the
Gulf Region that were adversely affected by hurricanes in the fall of 2005.

Assessment

The main criticism of the tax credit is that it allocates investments to
restoring older buildings that would not otherwise be profitable, causing
economic inefficiency. This allocation may be desirable if there are external
benefits to society (e.g., aesthetic benefits or the promotion of using the
existing building stock rather than the promotion of destruction and
rebuilding at a greater cost) that the firm would not take into account.
Proponents of the credit note that if buildings at least 50 years old are worth
saving, then a rolling qualification period should be provided rather than the
fixed 1936 date, which was set in 1976 for buildings of that age. More
recently, the Joint Committee on Taxation recommended the elimination of
the 10 percent credit based on simplification arguments.

Selected Bibliography

Everett, John O. "Rehabilitation Tax Credit Not Always Advantageous,"
Journal of Taxation. August 1989, pp. 96-102.
Kamerick, Megan. "Framers get a History Lesson: Historic Tax Credits
Can Help Framers Secure the Shops of Their Dreams," Art Business News, v.
31, April 2003, p. S1.
Mann, Roberta F. "Tax Incentives for Historic Preservation: An Antidote
for Sprawl?" Widner Law Symposium Journal, v. 8, 2002, pp. 207-236.
National Park Service. Federal Historic Preservation Tax Incentives.
World Wide Web page http://www2.cr.nps.gov/tps/tax/.
Oliver-Remshefski, Rebecca N. "Washington Slept Here: Protection and
Preservation of Our Architectural Heritage," Rutgers Law Review, v. 55,
Winter 2003, pp. 611-640.
Taylor, Jack. Income Tax Treatment of Rental Housing and Real Estate
Investment After the Tax Reform Act of 1986, Library of Congress,
Congressional Research Service Report 87-603 E. Washington, DC: July 2,
1987.
U.S. Congress, Congressional Budget Office. Budget Options. "Reduce
Tax Credits for Rehabilitating Buildings and Repeal the Credit for
Nonhistoric Structures." Washington, DC: February 2001, p. 427.
U.S. Congress, Joint Committee on Taxation. General Explanation of the
Revenue Act of 1978, H.R. 13511, 95th Congress, Public Law 95-600.
Washington, DC: U.S. Government Printing Office, March 12, 1979, pp.
155-158.
-. General Explanation of the Economic Recovery Tax Act of 1981, H.R.
4242, 97th Congress, Public Law 97-34. Washington, DC: U.S.
Government Printing Office, December 31, 1981, pp. 111-116.
-. General Explanation of the Tax Reform Act of 1986, H.R. 3838, 99th
Congress, Public Law 99-514. Washington, DC: U.S. Government Printing
Office, May 4, 1987, pp. 148-152.
U.S. General Accounting Office. Historic Preservation Tax Incentives.
Washington, DC: August 1, 1986.

Commerce and Housing:
Other Business and Commerce

REDUCED RATES OF TAX*
ON DIVIDENDS AND LONG-TERM CAPITAL GAINS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

92.2

2007

94.5

2008

101.7

2009

99.6

2010

50.2

* The Tax Increase Prevention and Reconciliation Act of 2006 extended
the reduced rates, with a projected additional revenue cost of $5.3 billion in
FY2008, $12.8 billion in FY2009 and $5.3 billion in FY2010.

Authorization

Sections 1(h), 631, 1201-1256.

Description

Dividends on corporate stock and gains on the sale of capital assets held for
more than a year are subject to lower tax rates under the individual income
tax. Individuals subject to the 10- or 15-percent rate pay a 5-percent rate and
individuals in higher rates pay a 15-percent rate. The 5-percent rate will be
zero in 2008. After 2010 the rates will revert to their levels prior to changes
in 2003 (see rationale). Gain arising from prior depreciation deductions is
taxed at ordinary rates but with a maximum of 28 percent. Also, gain on the
sale of property used in a trade or business is treated as a long-term capital
gain if all gains for the year on such property exceed all losses for the year on
such property. Qualifying property used in a trade or business generally is
depreciable property or real estate that is held more than a year, but not
inventory.

The tax expenditure is the difference between taxing gains and dividends at
the lower rates and taxing them at the rates that apply to other income.

Several special categories of income that are treated as capital gains have
been listed separately in previous tax expenditure compendiums: energy
(capital gains treatment of coal royalties), natural resources (capital gains
treatment of iron ore royalties and timber), and agriculture (gains on farm
property including livestock). These items have become smaller, with only a
small subsidy, limited to individuals.

To be eligible for the lower dividend rate, stock must be held for 60 days
out of 120 days that begin 60 days before the ex dividend day. Only stock
paid by domestic corporations is eligible. For passthrough entities RICs
(regulated investment companies, commonly known as mutual funds) and real
estate investment trusts (REITs), payments to shareholders are eligible only to
the extent they were qualified dividends to the passthrough entities.

Impact

Since higher-income individuals receive most capital gains, benefits accrue
to high-income taxpayers. Dividends are also concentrated among higher
income individuals, although not to as great a degree as capital gains.
Estimates of the benefit in the table below are based on data provided by the
Joint Committee on Taxation.

Estimated Distribution of Tax Expenditure, 2005

[In billions of dollars]

Income Class

Capital Gains

Dividends

Less than $50,000

1.5

5.8

$50,000-$100,000

3.9

13.6

$100,000-$200,000

7.1

17.5

$200,000-$1,000,000

21.9

31.1

Over $1,000,000

65.6

32.0

The primary assets that typically yield capital gains are corporate stock, and
business and rental real estate. Corporate stock accounts for 20 percent to 50
percent of total realized gains, depending on the state of the economy and the
stock market. There are also gains from assets such as bonds, partnership
interests, owner-occupied housing, timber, and collectibles, but all of these
are relatively small as a share of total capital gains.

Rationale

Although the original 1913 Act taxed capital gains at ordinary rates, the
1921 law provided for an alternative flat-rate tax for individuals of 12.5
percent for gain on property acquired for profit or investment. This treatment
was to minimize the influence of the high progressive rates on market
transactions. The Committee Report noted that these gains are earned over a
period of years, but are nevertheless taxed as a lump sum.

Over the years, many revisions in this treatment have been made. In 1934,
a sliding scale treatment was adopted (where lower rates applied the longer
the asset was held). This system was revised in 1938.

In 1942, the sliding scale approach was replaced by a 50-percent exclusion
for all but short-term gains (held for less than six months), with an elective
alternative tax rate of 25 percent. The alternative tax affected only
individuals in tax brackets above 50 percent.

The 1942 act also extended special capital gains treatment to property used
in the trade or business, and introduced the alternative tax for corporations at
a 25-percent rate, the alternative tax rate then in effect for individuals. This
tax relief was premised on the belief that many wartime sales were
involuntary conversions which could not be replaced during wartime, and that
resulting gains should not be taxed at the greatly escalated wartime rates.

Treatment of gain from cutting timber was adopted in 1943, in part to
equalize the treatment of those who sold timber as a stand (where income
would automatically be considered a capital gain) and those who cut timber.
Capital gains treatment for coal royalties was added in 1951 to make the
treatment of coal lessors the same as that of timber lessors and to encourage
coal production. Similar treatment of iron ore was enacted in 1964 to make
the treatment consistent with coal and to encourage production. The 1951 act
also specified that livestock was eligible for capital gains, an issue that had
been in dispute since 1942.

The alternative tax for individuals was repealed in 1969, and the
alternative rate for corporations was reduced to 30 percent. The minimum tax
on preference income and the maximum tax offset, enacted in 1969, raised
the capital gains rate for some taxpayers.

In 1976 the minimum tax was strengthened, and the holding period
lengthened to one year. The effect of these provisions was largely eliminated
in 1978, which also saw introduced a 60-percent exclusion for individuals and
a lowering of the alternative rate for corporations to 28 percent. The
alternative corporate tax rate was chosen to apply the same maximum
marginal rate to capital gains of corporations as applied to individuals (since
the top rate was 70 percent, and the capital gains tax was 40 percent of that
rate due to the exclusion).

The Tax Reform Act of 1986, which lowered overall tax rates and provided
for only two rate brackets (15 percent and 28 percent), provided that capital
gains would be taxed at the same rates as ordinary income. This rate structure
included a "bubble" due to phase-out provisions that caused effective
marginal tax rates to go from 28 percent to 33 percent and back to 28 percent.

In 1990, this bubble was eliminated, and a 31-percent rate was added to the
rate structure. There had, however, been considerable debate over proposals
to reduce capital gains taxes. Since the new rate structure would have
increased capital gains tax rates for many taxpayers from 28 percent to 31
percent, the separate capital gains rate cap was introduced. The 28- percent
rate cap was retained when the 1993 Omnibus Budget Reconciliation Act
added a top rate of 36 percent and a 10-percent surcharge on very high
incomes, producing a maximum rate of 39.6 percent.

The Taxpayer Relief Act of 1997 provided the lower rates; its objective
was to increase saving and risk-taking, and to reduce lock-in. Individuals
subject to the 15-percent rate paid a 10-percent rate and individuals in the 28-,
31-, 36-, and 39.6-percent rate brackets paid a 20-percent rate. Gain arising
from prior depreciation deductions was taxed at ordinary rates but with a
maximum of 28 percent. Eventually, property held for five years or more
would be taxed at 8 percent and 18 percent, rather than 10 percent and 20
percent. The 8-percent rate applied to sales after 2000; the 18-percent rate
applied to property acquired after 2000 (and, thus, to such property sold after
2005). The holding period was increased to 18 months, but cut back to one
year in 1998.

The Jobs and Growth Tax Relief Reconciliation Act of 2003 provided for
the current lower rates, with a sunset after 2008 (extended to 2010 by the Tax
Increase Prevention and Reconciliation Act of 2006). The stated rationale
was to encourage investment and growth, and to reduce the distortions due to
higher taxes on dividends, which also encouraged use of debt finance and
retention of earnings.

Assessment

The original rationale for allowing a capital gains exclusion or alternative
tax benefit-the problem of bunching of income under a progressive tax-is
relatively unimportant under the current flatter rate structure.

A primary rationale for reducing the tax on capital gains is to mitigate the
lock-in effect. Since the tax is paid only on a realization basis, an individual
is discouraged from selling an asset. This effect causes individuals to hold a
less desirable mix of assets, causing an efficiency loss. This loss could be
quite large relative to revenue raised if the realizations response is large.

Some have argued, based on certain statistical studies, that the lock-in
effect is, in fact, so large that a tax cut could actually raise revenue. Others
have argued that the historical record and other statistical studies do not
support this view and that capital gains tax cuts will cause considerable
revenue loss. This debate about the realizations response has been a highly
controversial issue.

Although there are efficiency gains from reducing lock-in, capital gains
taxes can also affect efficiency through other means, primarily through the
reallocation of resources between types of investments. Lower capital gains
taxes may disproportionately benefit real estate investments, and may cause
corporations to retain more earnings than would otherwise be the case,
causing efficiency losses. At the same time lower capital gains taxes reduce
the distortion that favors corporate debt over equity, which produces an
efficiency gain.

Another argument in favor of capital gains relief is that much of gain
realized is due to inflation. On the other hand, capital gains benefit from
deferral of tax in general, and this deferral can become an exclusion if gains
are held until death. Moreover, many other types of capital income (e.g.,
interest income) are not corrected for inflation.

The particular form of this capital gains tax relief also results in more of a
concentration towards higher-income individuals than would be the case with
an overall exclusion.

The extension of lower rates to dividends in 2003 significantly reduced the
pre-existing incentives to corporations to retain earnings and finance with
debt, and reduced the distortion that favors corporate over non-corporate
investment. It is not at all clear, however, that the lower tax rates will induce
increased saving, another stated objective of the 2003 dividend relief, if the
tax cuts are financed with deficits.

Selected Bibliography

Amromin, Gene, Paul Harrison, Nellie Liang, and Steven Sharpe, How Did
the 2003 Dividend Tax Cut Affect Stock Prices and Corporate Payout Policy?
Board of Governors of the Federal Reserve System, Finance and Economic
Discussion Series 2005-57, 2005.
Amromin, Gene, Paul Harrison, and Steven Sharpe, How Did the 2003
Dividend Tax Cut Affect Stock Prices? Board of Governors of the Federal
Reserve System, Finance and Economic Discussion Series 2005-61, 2005.
Auerbach, Alan J. "Capital Gains Taxation and Tax Reform," National
Tax Journal, v. 42. September 1989, pp. 391-401.
Auerbach, Alan J., Leonard E. Burman, and Jonathan Siegel. "Capital
Gains Taxation and Tax Avoidance," in Does Atlas Shrug? The Economic
Consequences of Taxing the Rich, ed. Joel B. Slemrod. New York: Russell
Sage, 2000.
Auten, Gerald. "Capital Gains Taxation," in The Encyclopedia of Taxation
and Tax Policy, eds. Joseph J. Cordes, Robert O. Ebel, and Jane G. Gravelle.
Washington, DC: Urban Institute Press, 2005.
Auten, Gerald E., Leonard E. Burman, and William C. Randolph.
"Estimation and Interpretation of Capital Gains Realization Behavior:
Evidence from Panel Data," National Tax Journal, v. 42. September 1989,
pp. 353-374.
Auten, Gerald E., and Joseph J. Cordes. "Cutting Capital Gains Taxes,"
Journal of Economic Perspectives, v. 5. Winter 1991, pp. 181-192.
Bailey, Martin J. "Capital Gains and Income Taxation," Taxation of
Income From Capital, ed. Arnold C. Harberger. Washington, DC: The
Brookings Institution, 1969, pp. 11-49.
Blouin, Jennifer L. ; Raedy, Jana Smith ; Shackelford, Douglas A. "Did
Dividends Increase Immediately After the 2003 Reduction in Tax Rates?"
NBER Working Paper 10301, Cambridge, MA: National Bureau of
Economic Research, February, 2004.
Bogart, W.T. and W.M. Gentry. "Capital Gains Taxes and Realizations:
Evidence from Interstate Comparisons," Review of Economics and Statistics,
v. 71, May 1995, pp. 267-282.
Burman, Leonard E. The Labyrinth of Capital Gains Tax Policy.
Washington, DC: The Brookings Institution, 1999.
-. "Why Capital Gains Tax Cuts (Probably) Don't Pay for Themselves,"
Tax Notes. April 2, 1990, pp. 109-110.
-, and Peter D. Ricoy. "Capital Gains and the People Who Realize Them,"
National Tax Journal, v. 50, September 1997, pp.427-451.
-, and William C. Randolph. "Measuring Permanent Responses to Capital
Gains Tax Changes In Panel Data," American Economic Review, v. 84,
September, 1994.
-. "Theoretical Determinants of Aggregate Capital Gains Realizations."
Manuscript, 1992.
-, Kimberly Clark and John O'Hare. "Tax Reform and Realization of
Capital Gains in 1986," National Tax Journal, v. 41, March 1994, pp. 63-87.

Carroll, Robert; Hassett, Kevin A.; Mackie, James B., III. "The Effect of
Dividend Tax Relief on Investment Incentives," National Tax Journal v56,
September 2003: 629-51
Cook. Eric W., and John F. O'Hare, "Capital Gains Redux: Why Holding
Periods Matter," National Tax Journal, v. 45. March 1992, pp. 53-76.
Chetty, Raj and Emmanuel Saez, Dividend Taxes and Corporate Behavior:
Evidence from the 2003 Dividend Tax Cut, National Bureau of Economic
Research Working Paper 10841, Cambridge, MA, 2004.
David, Martin. Alternative Approaches to Capital Gains Taxation.
Washington DC: The Brookings Institution, 1968.
Davis, Albert J., "Measuring the Distributional Effects of Tax Changes for
the Congress," National Tax Journal, v. 44. September, 1991, pp. 257-268.
Desai, Mihir, "Taxing Corporation Capital Gains," Tax Notes, March 6,
2006, pp. 1079-1092.
Esenwein, Gregg, and Jane G. Gravelle, The Taxation of Dividend Income:
An Overview and Economic Analysis of the Issues, Library of Congress,
Congressional Research Service, Report RL31597, Washington, DC: June 2,
2006.
Fox, John O., "The Great Capital Gains Debate," Chapter 12, If Americans
Really Understood the Income Tax, Boulder, Colorado: Westview Press,
2001.
Gillingham, Robert, and John S. Greenlees, "The Effect of Marginal Tax
Rates on Capital Gains Revenue: Another Look at the Evidence," National
Tax Journal, v. 45. June 1992, pp. 167-178.
Gordon, Roger, and Martin Dietz, Dividends and Taxes, National Bureau
of Economic Research Working Paper 12292, Cambridge, MA, 2005.
Gravelle, Jane G. Can a Capital Gains Tax Cut Pay for Itself? Library of
Congress, Congressional Research Service Report 90-161 RCO. Washington,
DC: March 23, 1990.
-. Capital Gains Taxes: An Overview. Library of Congress, Congressional
Research Service Report 96-769 E. Washington, DC: Updated July 15, 2003.
-. Capital Gains Taxes, Innovation and Growth. Library of Congress,
Congressional Research Service Report RL30040, July 14, 1999.
-. Economic Effects of Taxing Capital Income, Chapters 4 and 6.
Cambridge, MA: MIT Press, 1994.
-. "Effects of Dividend Relief on Economic Growth, The Stock Market,
and Corporate Tax Preferences," National Tax Journal, v. 56, September
2003, 653-668.
-. Limits to Capital Gains Feedback Effects. Library of Congress,
Congressional Research Service Report 91-250. Washington, DC: March 15,
1991.
Hoerner, J. Andrew, ed. The Capital Gains Controversy: A Tax Analyst's
Reader. Arlington, VA: Tax Analysts, 1992.
Holt, Charles C., and John P. Shelton, "The Lock-In Effect of the Capital
Gains Tax," National Tax Journal, v. 15. December 1962, pp. 357-352.

Kiefer, Donald W. "Lock-In Effect Within a Simple Model of Corporate
Stock Trading," National Tax Journal, v. 43. March 1990, pp. 75-95.
Lang, Mark H. and Douglas A. Shackleford. "Capitalization of Capital
Gains Taxes: Evidence from Stock Price Reactions to the 1997 Rate
Reduction." Journal of Public Economics, v. 76 (April 2000), pp. 69-85.
Minarik, Joseph. "Capital Gains," How Taxes Affect Economic Behavior,
eds. Henry J. Aaron and Joseph A. Pechman. Washington, DC: The
Brookings Institution, 1983, pp. 241-277.
Plancich, Stephanie. "Mutual Fund Capital Gain Distributions and the Tax
Reform Act of 1997," National Tax Journal v.56,March 2003 (Part 2), pp.
271-96.
Poterba, James, "Venture Capital and Capital Gains Taxation," Tax Policy
and the Economy, v. 3, ed. Lawrence H. Summers, National Bureau of
Economic Research. Cambridge, Mass.: MIT Press, 1989, pp. 47-67.
Slemrod, Joel, and William Shobe. "The Tax Elasticity of Capital Gains
Realizations: Evidence from a Panel of Taxpayers," National Bureau of
Economic Research Working Paper 3737. January 1990.
U.S. Congress, Congressional Budget Office. How Capital Gains Tax
Rates Affect Revenues: The Historical Evidence. Washington, DC: U.S.
Government Printing Office, March 1988.
-. An Analysis of the Potential Macroeconomic Effects of the Economic
Growth Act of 1998. Prepared by John Sturrock. Washington, DC: August 1,
1998.
-. Indexing Capital Gains, prepared by Leonard Burman and Larry
Ozanne. Washington, DC: U.S. Government Printing Office, August 1990.
-. Perspectives on the Ownership of Capital Assets and the Realization of
Gains. Prepared by Leonard Burman and Peter Ricoy. Washington, DC:
May 1997.
U.S. Congress, Joint Committee on Taxation. General Explanation of Tax
Legislation Enacted in 1997. 105th Congress, 1st Session. Washington, DC:
U.S. Government Printing Office, December 17,1997, pp. 48-56.
U.S. Department of the Treasury, Office of Tax Analysis. Report to the
Congress on the Capital Gains Tax Reductions of 1978. Washington, DC:
U.S. Government Printing Office, September 1985.
Wetzler, James W. "Capital Gains and Losses," Comprehensive Income
Taxation, ed. Joseph Pechman. Washington, DC: The Brookings Institution,
1977, pp. 115-162.
Zodrow, George R. "Economic Analysis of Capital Gains Taxation:
Realizations, Revenues, Efficiency and Equity," Tax Law Review, v. 48, no.
3, pp. 419-527.

Commerce and Housing:
Other Business and Commerce

EXCLUSION OF CAPITAL GAINS AT DEATH
CARRYOVER BASIS OF CAPITAL GAINS ON GIFTS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

56.3

2007

57.4

2008

58.9

2009

77.3

2010

121.5

Authorization

Sections 1001, 1002, 1014, 1015, 1023, 1040, 1221, and 1222.

Description

A capital gains tax generally is imposed on the increased value of a capital
asset (the difference between sales price and original cost of the asset) when
the asset is sold or exchanged. This tax is not, however, imposed on the
appreciation in value when ownership of the property is transferred as a result
of the death of the owner or as a gift during the lifetime of the owner.

In the case of assets transferred at death, the heir's cost basis in the asset
(the amount that he subtracts from sales price to determine gain if the asset is
sold in the future) generally is the fair market value as of the date of
decedent's death. Thus no income tax is imposed on appreciation occurring
before the decedent's death, since the cost basis is increased by the amount of
appreciation that has already occurred. In the case of gift transfers, the
donee's basis in the property is the same as the donor's (usually the original
cost of the asset). Thus, if the donee disposes of the property in a sale or
exchange, the capital gains tax will apply to the pre-transfer appreciation.
Tax on the gain is deferred, however, and may be forgiven entirely if the
donee in turn passes on the property at death.

Assets transferred at death or by inter vivos gifts (gifts between living
persons) may be subject to the Federal estate and gift taxes, respectively,
based upon their value at the time of transfer. In 2010, when the estate tax is
scheduled to expire, some gain will be taxed at death, but this provision will
sunset after 2010.

Impact

The exclusion of capital gains at death is most advantageous to individuals
who need not dispose of their assets to achieve financial liquidity. Generally
speaking, these individuals tend to be wealthier. The deferral of tax on the
appreciation involved combined with the exemption for the appreciation
before death is a significant benefit for these investors and their heirs.

Failure to tax capital gains at death encourages lock-in of assets, which in
turn means less current turnover of funds available for investment. In
deciding whether to change his portfolio, an investor, in theory, takes into
account the higher pre-tax rate of return he might obtain from the new
investment, the capital gains tax he might have to pay if he changes his
portfolio, and the capital gains tax his heirs might have to pay if he decides
not to change his portfolio.

Often an investor in this position decides that, since his heirs will incur no
capital gains tax on appreciationprior to the investor's death, he should
transfer his portfolio unchanged to the next generation. The failure to tax
capital gains at death and the deferral of tax tend to benefit high-income
individuals (and their heirs) who have assets that yield capital gains.

Some insight into the distributional effects of this tax expenditure may be
found by considering the distribution of current payments of capital gains tax,
based on data provided by the Joint Committee on Taxation. These taxes are
heavily concentrated among high-income individuals. Of course, the
distribution of capital gains taxes could be different from the distribution of
taxes not paid because they are passed on at death, but the provision would
always accrue largely to higher-income individuals who tend to hold most of
the wealth in the country.

Estimated Distribution of Capital Gains Taxes, 2005

Income Class

Percentage

Less than $50,000

1.2

$50,000-$100,000

3.7

$100,000-$1,000,000

30.7

Over $1,000,000

64.4

The primary assets that typically yield capital gains are corporate stock, real
estate, and owner-occupied housing.

Rationale

The original rationale for nonrecognition of capital gains on inter vivos
gifts or transfers at death is not indicated in the legislative history of any of
the several interrelated applicable provisions. However, one current
justification given for the treatment is that death and inter vivos gifts are
considered as inappropriate events to result in the recognition of income.

The Tax Reform Act of 1976 provided that the heir's basis in property
transferred at death would be determined by reference to the decedent's basis.
This carryover basis provision was not permitted to take effect and was
repealed in 1980. The primary stated rationale for repeal was the concern that
carryover basis created substantial administrative burdens for estates, heirs,
and the Treasury Department.

Assessment

Failure to tax gains transferred at death is probably a primary cause of lock-
in and its attendant efficiency costs; indeed, without the possibility of passing
on gains at death without taxation, the lock-in effect would be greatly
reduced.

The lower capital gains taxes that occur because of failure to tax capital
gains at death can also affect efficiency through other means, primarily
through the reallocation of resources between types of investments. Lower
capital gains taxes may disproportionally benefit real estate investments and
may cause corporations to retain more earnings than would otherwise be the
case, causing efficiency losses. At the same time, lower capital gains taxes
reduce the distortion that favors corporate debt over equity, which produces
an efficiency gain.

There are several problems with taxing capital gains at death. There are
administrative problems, particularly for assets held for a very long time when
heirs do not know the basis. In addition, taxation of capital gains at death
would cause liquidity problems for some taxpayers, such as owners of small
farms and businesses. Therefore most proposals for taxing capital gains at
death would combine substantial averaging provisions, deferred tax payment
schedules, and a substantial deductible floor in determining the amount of
gain to be taxed.

Selected Bibliography

Auerbach, Alan J. "Capital Gains Taxation and Tax Reform," National
Tax Journal, v. 42. September, 1989, pp. 391-401.
Auerbach, Alan J., Leonard E. Burman, and Jonathan Siegel. "Capital
Gains Taxation and Tax Avoidance," in Does Atlas Shrug? The Economic
Consequences of Taxing the Rich, ed. Joel B. Slemrod. New York: Russell
Sage, 2000.
Auten, Gerald. "Capital Gains Taxation," in The Encyclopedia of Taxation
and Tax Policy, eds. Joseph J. Cordes, Robert O. Ebel, and Jane G. Gravelle.
Washington, DC: Urban Institute Press, 2005.
Bailey, Martin J. "Capital Gains and Income Taxation," Taxation of
Income From Capital, ed. Arnold C. Harberger. Washington, DC: The
Brookings Institution, 1969, pp. 11-49.
Bogart, W.T. and W.M. Gentry. "Capital Gains Taxes and Realizations:
Evidence from Interstate Comparisons," Review of Economics and Statistics,
v. 71, May 1995, pp. 267-282.
Burman, Leonard E. The Labyrinth of Capital Gains Tax Policy.
Washington, DC: The Brookings Institution, 1999.
Burman, Leonard E., and Peter D. Ricoy. "Capital Gains and the People
Who Realize Them," National Tax Journal, v. 50, September 1997, pp.427-
451.
Burman, Leonard E., and William C. Randolph. "Measuring Permanent
Responses to Capital Gains Tax Changes In Panel Data," American
Economic Review, v. 84, September, 1994.
-. "Theoretical Determinants of Aggregate Capital Gains Realizations,"
Manuscript, 1992.
David, Martin. Alternative Approaches to Capital Gains Taxation.
Washington, DC: The Brookings Institution, 1968.
Fox, John O., "The Great Capital Gains Debate," Chapter 12, If Americans
Really Understood the Income Tax, Boulder, Colorado: Westview Press,
2001.
Gravelle, Jane G. Can a Capital Gains Tax Cut Pay for Itself? Library of
Congress, Congressional Research Service Report 90-161 RCO, March 23,
1990.

-. Capital Gains Tax Issues and Proposals: An Overview. Library of
Congress, Congressional Research Service Report 96-769 E. Washington,
DC: Updated August 30, 1999.
-. Capital Gains Taxes, Innovation and Growth. Library of Congress,
Congressional Research Service Report RL30040, July 14, 1999.
-. Economic Effects of Taxing Capital Income, Chapter 6. Cambridge,
MA: MIT Press, 1994.
-. Limits to Capital Gains Feedback Effects. Library of Congress,
Congressional Research Service Report 91-250, March 15, 1991.
Hoerner, J. Andrew, ed. The Capital Gains Controversy: A Tax Analyst's
Reader. Arlington, VA: Tax Analysts, 1992.
Holt, Charles C., and John P. Shelton. "The Lock-In Effect of the Capital
Gains Tax," National Tax Journal, v. 15. December 1962, pp. 357-352.
Kiefer, Donald W. "Lock-In Effect Within a Simple Model of Corporate
Stock Trading," National Tax Journal, v. 43. March, 1990, pp. 75-95.
Minarik, Joseph. "Capital Gains." How Taxes Affect Economic Behavior,
eds. Henry J. Aaron and Joseph A. Pechman. Washington, DC: The
Brookings Institution, 1983, pp. 241-277.
Surrey, Stanley S., et al., eds. "Taxing Capital Gains at the Time of a
Transfer at Death or by Gift," Federal Tax Reform for 1976. Washington,
DC: Fund for Public Policy Research, 1976, pp. 107-114.
U.S. Congress, Congressional Budget Office. Perspectives on the
Ownership of Capital Assets and the Realization of Gains. Prepared by
Leonard Burman and Peter Ricoy. Washington, DC: May 1997.
-. An Analysis of the Potential Macroeconomic Effects of the Economic
Growth Act of 1998. Prepared by John Sturrock. Washington, DC: August 1,
1998.
U.S. Congress, Senate Committee on Finance hearing. Estate and Gift
Taxes: Problems Arising from the Tax Reform Act of 1976. 95th Congress,
1st session, July 25, 1977.
U.S. Department of the Treasury, Office of Tax Analysis. Report to the
Congress on the Capital Gains Tax Reductions of 1978. Washington, DC:
U.S. Government Printing Office, September, 1985.
Wagner, Richard E. Inheritance and the State. Washington, DC:
American Enterprise Institute for Public Policy Research, 1977.
Wetzler, James W. "Capital Gains and Losses," Comprehensive Income
Taxation, ed. Joseph Pechman. Washington, DC: The Brookings Institution,
1977, pp. 115-162.
Zodrow, George R. "Economic Analysis of Capital Gains Taxation:
Realizations, Revenues, Efficiency and Equity," Tax Law Review, v. 48, no.
3, pp. 419-527.

Commerce and Housing:
Other Business and Commerce

DEFERRAL OF GAIN ON NON-DEALER
INSTALLMENT SALES

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.5

0.6

1.1

2007

0.5

0.7

1.2

2008

0.5

0.7

1.2

2009

0.6

0.7

1.3

2010

0.6

0.8

1.4

Authorization

Sections 453 and 453A(b).

Description

An installment sale is a sale of property in which at least one payment will
be received in a tax year later than the year in which the sale took place.
Some taxpayers are allowed to report some sales of this kind for tax purposes
under a special method of accounting, called the installment method, in which
the gross profit from the sale is prorated over the years during which the
payments are received.

This conveys a tax advantage compared to being taxed in full in the year of
the sale, because the taxes that are deferred to future years have a time value
(the amount of interest they could earn).

Use of the installment method was once widespread, but it has been
severely curtailed in recent years. Under current law, it can be used only by
persons who do not regularly deal in the property being sold (except for the
sellers of farm property, timeshares, and residential building lots who may use
the installment method but must pay interest on the deferred taxes). The
latest legislative change in 2004 was a provision of the American Jobs
Creation Act denying the installment sale treatment to readily tradeable debt.

For sales by non-dealers, interest must be paid to the government on the
deferred taxes attributable to the portion of the installment sales that arise
during and remain outstanding at the end of the tax year of more than
$5,000,000. Transactions where the sales price is less than $150,000 do not
count towards the $5,000,000 limit. Interest payments offset the value of tax
deferral, so this tax expenditure represents only the revenue loss from those
transactions that give rise to interest-free deferrals.

Impact

Installment sale treatment constitutes a departure from the normal rule that
gain is recognized when the sale of property occurs. The deferral of taxation
permitted under the installment sale rules essentially furnishes the taxpayer an
interest-free loan equal to the amount of tax on the gain that is deferred.

The benefits of deferral are currently restricted to those transactions by
non-dealers in which the sales price is no more than $150,000 and to the first
$5,000,000 of installment sales arising during the year, to sales of personal-
use property by individuals, and to sales of farm property. (There are other
restrictions on many types of transactions, such as in corporate
reorganizations and sales of depreciable assets.)

Thus the primary benefit probably flows to sellers of farms, small
businesses, and small real estate investments.

Rationale

The rationale for permitting installment sale treatment of income from
disposition of property is to match the time of payment of tax liability with the
cash flow generated by the disposition. It has usually been considered unfair,
or at least impractical, to attempt to collect the tax when the cash flow is not
available, and some form of installment sale reporting has been permitted
since at least the Revenue Act of 1921. It has frequently been a source of
complexity and controversy, however, and has sometimes been used in tax
shelter and tax avoidance schemes.

Installment sale accounting was greatly liberalized and simplified in the
Installment Sales Revision Act of 1980 (P.L. 96-471). It was significantly
restricted by a complex method of removing some of its tax advantages in the
Tax Reform Act of 1986, and it was repealed except for the limited uses in
the Omnibus Budget Reconciliation Act of 1987. Further restrictions
applicable to accrual method taxpayers were enacted in the Work Incentives
Improvement Act of 1999 (P.L. 106-170). The 1999 Act prohibited most
accrual basis taxpayers from using the installment method of accounting.
Concern, however, in the small business community over these changes led to
the passage, in December 2000, of the Installment Tax Correction Act of
2000 (P.L. 106-573). The 2000 Act repealed the restrictions on the
installment method of accounting imposed by the 1999 Act. The repeal was
made retroactive to the date of enactment of the 1999 change.

Assessment

The installment sales rules have always been pulled between two opposing
goals: taxes should not be avoidable by the way a deal is structured, but they
should not be imposed when the money to pay them is not available.
Allowing people to postpone taxes simply by taking a note instead of cash in
a sale leaves obvious room for tax avoidance.

Trying to collect taxes from taxpayers who do not have the cash to pay is
administratively difficult and strikes many as unfair. After having tried many
different ways of balancing these goals, lawmakers have settled on a
compromise that denies the advantage of the method to taxpayers who would
seldom have trouble raising the cash to pay their taxes (retailers, dealers in
property, investors with large amounts of sales) and permits its use to small,
non-dealer transactions (with "small" rather generously defined).

Present law results in modest revenue losses and probably has little effect
on economic incentives.

Selected Bibliography

Esenwein, Gregg. Recent Tax Changes Affecting Installment Sales.
Library of Congress, Congressional Research Service Report RS20432.
Washington, DC: January 2002.
U.S. Congress, Joint Committee on Taxation. Overview of the Issues
Relating to the Modification of the Installment Sales Rules by the Ticket to
Work Incentives Improvement Act of 1999, Report JCX-15-00, February
2000.
-. General Explanation of Tax Legislation Enacted in the 106th Congress.
JCS-2-01. April 2001. p. 176.
U.S. Congress, House. Omnibus Budget Reconciliation Act of 1987,
Conference Report to Accompany H.R. 3545. 100th Congress, 1st session,
Report 100-495, pp. 926-931.
-. Committee on Ways and Means. Installment Sales Revision Act of
1980, Report to Accompany H.R. 6883. 98th Congress, 2nd session, Report
96-1042.

Internal Revenue Service. Installment Sales. Publication 537, for use in
preparing 2005 returns.
U.S. Congress, Joint Committee on Taxation. Comparison Of Certain
Provisions Of H.R. 4520 As Passed By The House Of Representatives And As
Amended By The Senate: Revenue Provisions, Report JCX-64-04, September
2004, p. 57.

Commerce and Housing:
Other Business and Commerce

DEFERRAL OF GAIN ON LIKE-KIND EXCHANGES

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.8

2.0

2.8

2007

0.8

2.1

2.9

2008

0.9

2.2

3.1

2009

0.8

2.4

3.2

2010

1.0

2.5

3.5

Authorization

Section 1031.

Description

When business or investment property is exchanged for property of a "like-
kind," no gain or loss is recognized on the exchange and therefore no tax is
paid at the time of the exchange on any appreciation. This is in contrast to the
general rule that any sale or exchange for money or property is a taxable
event.

It is also an exception to the rules allowing tax-free exchanges when the
property is "similar or related in service or use," the much stricter standard
applied in other areas, such as replacing condemned property (section 1033).
The latter is not considered a tax expenditure, but the postponed tax on
appreciated property exchanged for "like-kind" property is.

Impact

The like-kind exchange rules have been liberally interpreted by the courts
to allow tax-free exchanges of property of the same general type but of very
different quality and use. All real estate, in particular, is considered "like-
kind," allowing a retiring farmer from the Midwest to swap farm land for a
Florida apartment building or a right to pump water tax-free.

The provision is very popular with real estate interests, some of whom
specialize in arranging property exchanges. It is useful primarily to persons
who wish to alter their real estate holdings without paying tax on their
appreciated gain. Stocks and financial instruments are not eligible for this
provision, so it is not useful for rearranging financial portfolios.

Rationale

A provision allowing tax-free exchanges of like-kind property was
included in the first statutory tax rules for capital gains in the Revenue Act of
1921 and has continued in some form until today. Various restrictions over
the years took many kinds of property and exchanges out of its scope, but the
rules for real estate, in particular, were broadened over the years by court
decisions.

In moves to reduce some of the more egregious uses of the rules, the
Deficit Reduction Act of 1984 set time limits on completing exchanges and
the Omnibus Budget Reconciliation Act of 1989 outlawed tax-free exchanges
between related parties. The general rationale for allowing tax-free
exchanges is that the investment in the new property is merely a continuation
of the investment in the old.

A tax-policy rationale for going beyond this, to allowing tax-free
adjustments of investment holdings to more advantageous positions, does not
seem to have been offered. It may be that this was an accidental outgrowth of
the original rule.

The most recent legislative change was a provision of the American Jobs
Creation Act of 2004, as amended in Gulf Opportunity Zone Act of 2005,
affecting the recognition of a gain on a principal residence acquired in a like-
kind exchange. The exclusion for gain on the sale of a principal residence no
longer applies if the principal residence was acquired in a like-kind exchange
within the past five years. In effect, this requires the taxpayer to hold the
exchanged property for a full five years before it would qualify as a principal
residence.

Assessment

From an economic perspective, the failure to tax appreciation in property
values as it occurs defers tax liability and thus offers a tax benefit. (Likewise,
the failure to deduct declines in value is a tax penalty.) Continuing the
"nonrecognition" of gain, and thus the tax deferral, for a longer period by an
exchange of properties adds to the tax benefit.

This treatment does, however, both simplify transactions and make it less
costly for businesses and investors to replace property. Taxpayers gain
further benefit from the loose definition of "like-kind" because they can also
switch their property holdings to types they prefer without tax consequences.
This might be justified as reducing the inevitable bias a tax on capital gains
causes against selling property, but it is difficult to argue for restricting the
relief primarily to those taxpayers engaged in sophisticated real estate
transactions.

Selected Bibliography

Carnes, Gregory A., and Ted D. Englebrecht. "Like-kind Exchanges -
Recent Developments, Restrictions, and Planning Opportunities," CPA
Journal. January 1991, pp. 26-33.
U.S. Congress, Congressional Budget Office. Budget Options. February
2001, p. 423.
U.S. Congress, House Committee on Ways and Means. Omnibus Budget
Reconciliation Act of 1989. Conference Report to Accompany H.R. 3299,
Report 101-386, November 21, 1989, pp. 613-614.
U.S. Congress, Joint Committee on Taxation. Study of the Overall State of
the Federal Tax System and Recommendations for Simplification, Pursuant
to Section 8022(3)(B) of the Internal Revenue Code of 1986, Volume II, JCS-
3-01, pp. 300-305, April 2001.
-, Description of Revenue Provisions to Be Considered in Connection With
the Markup of the Miscellaneous Trade and Technical Corrections Act of
1999, JCS-2-00, p. 494, March 2000.
-, Description of Possible Options to Increase Revenues Prepared for the
Committee On Ways and Means. JCS-17-87, June 25, 1987, pp. 240-241.
-, General Explanation of the Revenue Provisions of the Deficit Reduction
Act of 1984. JCS-41-84, December 31, 1984, pp. 243-247.
Woodrum, William L., Jr. "Structuring an Exchange of Property to Defer
Recognition of Gain," Taxation for Accountants. November 1986, pp.
334-339.
Internal Revenue Service. Sales and Other Dispositions of Assets.
Publication 544, for use in preparing 2005 returns.
U.S. Congress, Joint Committee on Taxation. Comparison Of Certain
Provisions Of H.R. 4520 As Passed By The House Of Representatives And As
Amended By The Senate: Revenue Provisions, Report JCX-64-04, September
2004, p. 25.

Esenwein, Gregg A. The Sale of a Principal Residence Acquired Through
a Like-Kind Exchange. Library of Congress, Congressional Research Service
Report RS22113. Washington DC: 2005.

Commerce and Housing:
Other Business and Commerce

DEPRECIATION OF BUILDINGS OTHER
THAN RENTAL HOUSING IN EXCESS OF
ALTERNATIVE DEPRECIATION SYSTEM

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.4

0.8

2007

0.5

0.6

1.1

2008

0.7

0.8

1.5

2009

1.0

1.1

2.1

2010

1.3

1.4

2.7

H.R. 6111 (December 2006) increases the cost from FY2007-FY2010 by
$0.4, $0.5, $0.6, and $0.6 respectively.

Authorization

Section 167 and 168.

Description

Taxpayers are allowed to deduct the costs of acquiring depreciable assets
(assets that wear out or become obsolete over a period of years) as
depreciation deductions. The tax code currently allows new buildings other
than rental housing to be written off over 39 years, using a "straight line"
method where equal amounts are deducted in each period. There is also a
prescribed 40 year write-off period for these buildings under the alternative
minimum tax (also based on a straight-line method). Improvements required
for a new leasehold for a non-residential structure and certain restaurant
improvements made at least three years after original construction may be
depreciated over 15 years. This provision applies through 2007.

The tax expenditure measures the revenue loss from current depreciation
deductions in excess of the deductions that would have been allowed under
this longer 40-year period. The current revenue effects also reflect different
write-off methods and lives prior to the 1993 revisions, which set the 39-year
life, since many buildings pre-dating that time are still being depreciated.

Prior to 1981, taxpayers were generally offered the choice of using the
straight-line method or accelerated methods of depreciation, such as double-
declining balance and sum-of-years digits, in which greater amounts are
deducted in the early years. Non-residential buildings were restricted in 1969
to 150-percent declining balance (used buildings were restricted to straight-
line). The period of time over which deductions were taken varied with the
taxpayer's circumstances.

Beginning in 1981, the tax law prescribed specific write-offs which
amounted to accelerated depreciation over periods varying from 15 to 19
years. In 1986, all depreciation on nonresidential buildings was calculated on
a straight-line basis over 31.5 years, and that period was increased to 39 years
in 1993.

Example: Suppose a building with a basis of $10,000 was subject to
depreciation over 39 years. Depreciation allowances would be constant at
1/39 x $10,000 = $257. For a 40-year life the write-off would be $250 per
year. The tax expenditure in the first year would be measured as the
difference between the tax savings of deducting $250, instead of $257, or $7.

Impact

Because depreciation methods that are faster than straight-line allow for
larger deductions in the early years of the asset's life and smaller depreciation
deductions in the later years, and because shorter useful lives allow quicker
recovery, accelerated depreciation results in a deferral of tax liability.

It is a tax expenditure to the extent it is faster than economic (i.e., actual)
depreciation, and evidence indicates that the economic decline rate for non-
residential buildings is much slower than that reflected in tax depreciation
methods.

The direct benefits of accelerated depreciation accrue to owners of
buildings, and particularly to corporations. The benefit is estimated as the tax
saving resulting from the depreciation deductions in excess of straight-line
depreciation. Benefits to capital income tend to concentrate in the higher-
income classes (see discussion in the Introduction).

Rationale

In 1964, 1969, and 1976 various provisions to "recapture" accelerated
depreciation as ordinary income in varying amounts when a building was sold
were enacted. In 1969, depreciation for nonresidential structures was
restricted to 150-percent declining balance methods (straight-line for used
buildings).

In the Economic Recovery Tax Act of 1981, buildings were assigned
specific write-off periods that were roughly equivalent to 175-percent
declining balance methods (200 percent for low-income housing) over a 15-
year period under the Accelerated Cost Recovery System (ACRS). These
changes were intended as a general stimulus to investment.

Taxpayers could elect to use the straight-line method over 15 years, 35
years, or 45 years. (The Deficit Reduction Act of 1984 increased the 15-year
life to 18 years; in 1985, it was increased to 19 years.) The recapture provi-
sions would not apply if straight-line methods were originally chosen. The
acceleration of depreciation that results from using the shorter recovery period
under ACRS was not subject to recapture as accelerated depreciation.

The current straight-line treatment was adopted as part of the Tax Reform
Act of 1986, which lowered tax rates and broadened the base of the income
tax. A 31.5-year life was adopted at that time; it was increased to 39 years by
the Omnibus Budget Reconciliation Act of 1993.

In 2002, certain qualified leasehold improvements in non-residential
buildings were made eligible for a temporary bonus depreciation (expiring
after 2004) allowing 30 percent of the cost to be deducted when incurred.
The percentage was increased to 50 percent in 2003.

The provision allowing a 15-year recovery period for qualified leasehold
improvements and restaurant improvements was adopted in 2004 but
suspended after 2005. H.R. 6111 (December 2006) extended the provision
through 2007.

Assessment

Evidence suggests that the rate of economic decline of rental structures is
much slower than the rates allowed under current law, and this provision
causes a lower effective tax rate on such investments than would otherwise be
the case. This treatment in turn tends to increase investment in nonresidential
structures relative to other assets, although there is considerable debate about
how responsive these investments are to tax subsidies.

At the same time, the more rapid depreciation roughly offsets the
understatement of depreciation due to the use of historical cost basis
depreciation, assuming inflation is at a rate of two percent or so. Moreover,
many other assets are eligible for accelerated depreciation as well, and the
allocation of capital depends on the relative treatment.

Much of the previous concern about the role of accelerated depreciation in
encouraging tax shelters in commercial buildings has faded because the
current depreciation provisions are less rapid than those previously in place
and because there is a restriction on the deduction of passive losses.

Selected Bibliography

Break, George F. "The Incidence and Economic Effects of Taxation," The
Economics of Public Finance. Washington, DC: The Brookings Institution,
1974.
Burman, Leonard E., Thomas S. Neubig, and D. Gordon Wilson. "The
Use and Abuse of Rental Project Models," Compendium of Tax Research
1987, Office of Tax Analysis, Department of The Treasury. Washington,
DC: U.S. Government Printing Office, 1987, pp. 307-349.
Cummins, Jason G., Kevin Hassett and R. Glenn Hubbard. "Have Tax
Reforms Affected Investment?" in James M. Poterba, Tax Policy and The
Economy, v. 9, Cambridge: MIT Press, 1994.
-. A Reconsideration of Investment Behavior Using Tax Reforms as
Natural Experiments, Brookings Papers on Economic Activity no. 2, 1994,
pp. 1-74.
Deloitte and Touche. Analysis of the Economic Depreciation of Structure,
Washington, DC: June 2000.
Feldstein, Martin. "Adjusting Depreciation in an Inflationary Economy:
Indexing Versus Acceleration," National Tax Journal, v. 34. March 1981,
pp. 29-43.
Follain, James R., Patric H. Hendershott, and David C. Ling, "Real Estate
Markets Since 1980: What Role Have Tax Changes Played?" National Tax
Journal, vol. 45, September 1992, pp. 253-266.
Fromm, Gary, ed. Tax Incentives and Capital Spending. Washington, DC:
The Brookings Institution, 1971.
Fullerton, Don, Robert Gillette, and James Mackie, "Investment Incentives
Under the Tax Reform Act of 1986," Compendium of Tax Research 1987,
Office of Tax Analysis, Department of The Treasury. Washington, DC: U.S.
Government Printing Office, 1987, pp. 131-172.
Fullerton, Don, Yolanda K. Henderson, and James Mackie, "Investment
Allocation and Growth Under the Tax Reform Act of 1986," Compendium of
Tax Research 1987, Office of Tax Analysis, Department of The Treasury.
Washington, DC: U.S. Government Printing Office, 1987, pp. 173-202.
Gravelle, Jane G. "Differential Taxation of Capital Income: Another Look
at the Tax Reform Act of 1986," National Tax Journal, v. 63. December
1989, pp. 441-464.
-. Depreciation and the Tax Treatment of Real Estate. Library of
Congress, Congressional Research Service Report RL30163. Washington,
DC: October 25, 2000.
-. Economic Effects of Taxing Capital Income, Chapter 6. Cambridge,
MA: MIT Press, 1994.
-. "Whither Tax Depreciation?" National Tax Journal, vol. 54,
September, 2001, pp. 513-526.
Harberger, Arnold. "Tax Neutrality in Investment Incentives," The
Economics of Taxation, eds. Henry J. Aaron and Michael J. Boskin.
Washington, DC: The Brookings Institution, 1980.
Hulten, Charles, ed. Depreciation, Inflation, and the Taxation of Income
From Capital. Washington, DC: The Urban Institute, 1981.
Hulten, Charles R., and Frank C. Wykoff. "Issues in Depreciation
Measurement." Economic Inquiry, v. 34, January 1996, pp. 10-23.

Jorgenson, Dale W. "Empirical Studies of Depreciation." Economic
Inquiry, v. 34, January 1996, pp. 24-42.
Mackie, James. "Capital Cost Recovery," in The Encyclopedia of Taxation
and Tax Policy, eds. Joseph J. Cordes, Robert O. Ebel, and Jane G. Gravelle.
Washington, DC: Urban Institute Press, 2005.
Nadiri, M. Ishaq, and Ingmar R. Prucha. "Depreciation Rate Estimation of
Physical and R&D Capital." Economic Inquiry, v. 34, January 1996, pp. 43-
56.
Taubman, Paul and Robert Rasche. "Subsidies, Tax Law, and Real Estate
Investment," U.S. Congress, Joint Economic Committee, The Economics of
Federal Subsidy Program," Part 3: "Tax Subsidies." July 15, 1972, pp.
343-369.
U.S. Congress, Congressional Budget Office. Real Estate Tax Shelter
Subsidies and Direct Subsidy Alternatives. May 1977.
-. Joint Committee on Taxation. General Explanation of the Tax Reform
Act of 1986. May 4, 1987, pp. 89-110.
U.S. Department of the Treasury. Report to the Congress on Depreciation
Recovery Periods and Methods. Washington, DC: June 2000.

Commerce and Housing:
Other Business and Commerce

DEPRECIATION ON EQUIPMENT IN EXCESS OF
ALTERNATIVE DEPRECIATION SYSTEM

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

-2.2

5.7

3.5

2007

0.1

11.0

11.1

2008

2.2

17.7

19.9

2009

4.3

23.4

27.7

2010

6.1

27.7

33.8

Authorization

Section 167 and 168.

Description

Taxpayers are allowed to deduct the cost of acquiring depreciable assets
(assets that wear out or become obsolete over a period of years) as
depreciation deductions. How quickly the deductions are taken depends on
the period of years over which recovery occurs and the method used.
Straight-line methods allow equal deductions in each year; accelerated
methods, such as declining balance methods, allow larger deductions in the
earlier years.

Equipment is currently divided into six categories to be depreciated over 3,
5, 7, 10, 15, and 20 years. Double declining balance depreciation is allowed
for all but the last two classes, which are restricted to 150 percent declining
balance. A double declining balance method allows twice the straight-line
rate to be applied in each year to the remaining undepreciated balance; a 150-
percent declining balance rate allows 1.5 times the straight-line rate to be
applied in each year to the remaining undepreciated balance. At some point,
the taxpayer can switch to straight-line-write off the remaining
undepreciated cost in equal amounts over the remaining life.

The 1986 law also prescribed a depreciation system for the alternative
minimum tax, which applies to a broader base. The alternative depreciation
system requires recovery over the midpoint of the Asset Depreciation Range,
using straight-line depreciation. The Asset Depreciation Range was the set of
tax lives specified before 1981 and these lives are longer than the lives
allowed under the regular tax system.

This tax expenditure measures the difference between regular tax
depreciation and the alternative depreciation system. The tax expenditure
also reflects different write-off periods and lives for assets acquired prior to
the 1986 provisions. For most of these older assets, regular tax depreciation
has been completed, so that the effects of these earlier vintages of equipment
would be to enter them as a revenue gain rather than as a loss.

In the past, taxpayers were generally offered the choice of using the
straight-line method or accelerated methods of depreciation such as double-
declining balance and sum-of-years digits, in which greater amounts are
deducted in the early years. Tax lives varied across different types of
equipment under the Asset Depreciation Range System, which prescribed a
range of tax lives. Equipment was restricted to 150-percent declining balance
by the 1981 Act, which shortened tax lives to five years.

Example: Consider a $10,000 piece of equipment that falls in the five-year
class (with double declining balance depreciation) with an eight-year
midpoint life. In the first year, depreciation deductions would be 2/5 times
$10,000, or $4,000. In the second year, the basis of depreciation is reduced
by the previous year's deduction to $6,000, and depreciation would be $2400
(2/5 times $6,000).

Depreciation under the alternative system would be 1/8th in each year, or
$1,250. Thus, the tax expenditure in year one would be the difference
between $4,000 and $1,250, multiplied by the tax rate. The tax expenditure
in year two would be the difference between $2,400 and $1,250 multiplied by
the tax rate.

Fifty percent of investment in advanced mine safety equipment may be
expensed from the date of enactment of H.R. 6111 (December2006 through
20082006

Impact

Because depreciation methods that are faster than straight-line allow for
larger depreciation deductions in the early years of the asset's life and smaller
deductions in the later years, and because shorter useful lives allow quicker
recovery, accelerated depreciation results in a deferral of tax liability. It is a
tax expenditure to the extent it is faster than economic (i.e., actual)
depreciation, and evidence indicates that the economic decline rate for
equipment is much slower than that reflected in tax depreciation methods.

The direct benefits of accelerated depreciation accrue to owners of assets
and particularly to corporations. The benefit is estimated as the tax saving
resulting from the depreciation deductions in excess of straight-line
depreciation under the alternative minimum tax. Benefits to capital income
tend to concentrate in the higher-income classes (see discussion in the
Introduction).

Rationale

A ruling issued in 1946 authorized the use of the 150-percent declining
balance method. Authorization for it and other accelerated depreciation
methods first appeared in legislation in 1954 when the double-declining
balance and other methods were enacted. The discussion at that time focused
primarily on whether the value of machinery and equipment declined faster in
their earlier years.

In 1962, new tax lives for equipment assets were prescribed that were
shorter than the lives existing at that time. In 1971, the Asset Depreciation
Range System was introduced by regulation and confirmed through
legislation. This system allowed taxpayers to use lives up to twenty percent
shorter or longer than those prescribed by regulation.

In the Economic Recovery Tax Act of 1981, equipment assets were
assigned fixed write-off periods which corresponded to 150-percent declining
balance over five years (certain assets were assigned three-year lives). These
changes were intended as a general stimulus to investment and to simplify the
tax law by providing for a single write-off period. The method was
eventually to be phased into a 200-percent declining balance method, but the
150-percent method was made permanent by the Tax Equity and Fiscal
Responsibility Act of 1982. The current treatment was adopted as part of the
Tax Reform Act of 1986, which lowered tax rates and broadened the base of
the income tax.

A temporary provision allowed a write-off of 30% of the cost in the first
year (for 36 months beginning September 10th, 2001), adopted in 2002 as an
economic stimulus. The percentage was increased to 50% in 2003 and
expired in 2004.

Assessment

Evidence suggests that the rate of economic decline of equipment is much
slower than the rates allowed under current law, and this provision causes a
lower effective tax rate on such investments than would otherwise be the case.
The effect of these benefits on investment in equipment is uncertain,
although more studies find equipment somewhat responsive to tax changes
than they do structures. Equipment did not, however, appear to be very
responsive to the temporary expensing provisions adopted in 2003 and
expanded in 2003.

The more rapid depreciation more than offsets the understatement of
depreciation due to the use of historical cost basis depreciation, if inflation is
at a rate of about two percent or so for most assets. Under these
circumstances the effective tax rate on equipment is below the statutory tax
rate and the tax rates of most assets are relatively close to the statutory rate.
Thus, equipment tends to be favored relative to other assets and the tax
system causes a misallocation of capital.

Some arguments are made that investment in equipment should be
subsidized because it is more "high tech"; conventional economic theory
suggests, however, that tax neutrality is more likely to ensure that investment
is allocated to its most productive use.

Selected Bibliography

Clark, Peter K. Tax Incentives and Equipment Investment, Brookings
Papers on Economic Activity no. 1, 1994, pp. 317-339.
Cohen, Darryl and Jason Cummins. A Retrospective Evaluation of the
Effects of Temporary Partial Expensing, Federal Reserve Board Staff
Working Paper 2006-19, Washington, D.C., April, 2006.
Cummins, Jason G., Kevin Hasset and R. Glenn Hubbard. "Have Tax
Reforms Affected Investment?" in James M. Poterba, Tax Policy and The
Economy, v. 9, Cambridge: MIT Press, 1994.
-. A Reconsideration of Investment Behavior Using Tax Reforms as
Natural Experiments, Brookings Papers on Economic Activity, no. 2, 1994,
pp. 1-74.
Dunn, Wendy E., Mark E. Doms, Stephen D. Oliner, and Daniel E.
Sichel. "How Fast Do Personal Computers Depreciate? Concepts and
New Estimates," National Bureau of Economic Research Working Paper
No. 10521, Cambridge, MA., May 2004.
Feldstein, Martin. "Adjusting Depreciation in an Inflationary Economy:
Indexing Versus Acceleration," National Tax Journal, v. 34. March 1981,
pp. 29-43.
Fullerton, Don, Robert Gillette, and James Mackie. "Investment Incentives
Under the Tax Reform Act of 1986," Compendium of Tax Research 1987,
Office of Tax Analysis, Department of The Treasury. Washington, DC: U.S.
Government Printing Office, 1987, pp. 131-172.
Fullerton, Don, Yolanda K. Henderson, and James Mackie. "Investment
Allocation and Growth Under the Tax Reform Act of 1986," Compendium of
Tax Research 1987, Office of Tax Analysis, Department of The Treasury.
Washington, DC: U.S. Government Printing Office, 1987, pp. 173-202.
Gravelle, Jane G. "Differential Taxation of Capital Income: Another Look
at the Tax Reform Act of 1986," National Tax Journal, v. 63. December
1989, pp. 441-464.
-. Depreciation and the Tax Treatment of Real Estate. Library of
Congress, Congressional Research Service Report RL30163. Washington,
DC: October 25, 2000.
-. Economic Effects of Taxing Capital Income, Chapters 3 and 5.
Cambridge, MA: MIT Press, 1994.
-. "Whither Tax Depreciation?" National Tax Journal, vol. 54,
September, 2001, pp. 513-526.
Harberger, Arnold, "Tax Neutrality in Investment Incentives," The
Economics of Taxation, eds. Henry J. Aaron and Michael J. Boskin.
Washington, DC: The Brookings Institution, 1980, pp. 299-313.
Hendershott, Patric and Sheng-Cheng Hu, "Investment in Producers'
Durable Equipment," How Taxes Affect Economic Behavior, eds. Henry J.
Aaron and Joseph A. Pechman. Washington, DC: The Brookings Institution,
1981, pp. 85-129.
Hulten, Charles, ed. Depreciation, Inflation, and the Taxation of Income
From Capital. Washington, DC: The Urban Institute, 1981.
Hulten, Charles R., and Frank C. Wykoff. "Issues in Depreciation
Measurement." Economic Inquiry, v. 34, January 1996, pp. 10-23.

Jorgenson, Dale W. "Empirical Studies of Depreciaton." Economic
Inquiry, v. 34, January 1996, pp. 24-42.
Mackie, James. "Capital Cost Recovery," in The Encyclopedia of Taxation
and Tax Policy, eds. Joseph J. Cordes, Robert O. Ebel, and Jane G. Gravelle.
Washington, DC: Urban Institute Press, 2005.
Nadiri, M. Ishaq, and Ingmar R. Prucha. "Depreciation Rate Estimation of
Physical and R&D Capital." Economic Inquiry, v. 34, January 1996, pp. 43-
56.
Oliner, Stephen D. "New Evidence on the Retirement and Depreciation of
Machine Tools." Economic Inquiry, v. 34, January 1996, pp.57-77.
U.S. Congress, Joint Committee on Taxation. General Explanation of the
Tax Reform Act of 1986. May 4, 1987, pp. 89-110.
U.S. Department of the Treasury. Report to the Congress on Depreciation
Recovery Periods and Methods. Washington, DC: June 2000.

Commerce and Housing:
Other Business and Commerce

EXPENSING OF DEPRECIABLE
BUSINESS PROPERTY

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

2.8

0.6

3.4

2007

2.6

0.6

3.2

2008

0.1

-0.1

0.0

2009

-0.8

-0.4

-1.2

2010

-0.4

-0.2

-0.6

These figures do not reflect the revenue effects of the changes in the
section 179 expensing allowance made by the Tax Increase Prevention and
Reconciliation Act of 2005, which increased the total revenue loss by $2.8
billion in 2008, $4.5 billion in 2009, and $0.2 billion in 2010.

Authorization

Section 179.

Description

A business taxpayer (other than a trust or estate) may deduct (or expense)
no less than $100,000 of the cost of qualifying depreciable property in the tax
year when it is placed in service. In 2006, the maximum expensing allowance
for most firms able to claim it is $108,000. (The allowance is higher for firms
located in so-called Enterprise and Empowerment Zones, Renewal
Communities, the areas affected by Hurricane Katrina, and the portion of
Manhattan directly affected by the terrorist attacks of September 11, 2001.)
Under current federal tax law, this treatment is available from May 2003
through the end of 2009. The alternative to expensing is to recover the cost
over a longer period according to current depreciation schedules. Beginning
in 2010 and beyond, the maximum expensing allowance will drop to $25,000.

For the most part, qualifying property is new and used machinery,
equipment, and computer software purchased for use in a trade or business.
Software is eligible for expensing only from 2003 through 2009.

The amount that may be expensed is subject to two important limitations: a
dollar limitation and an income limitation. Under the former, the maximum
expensing allowance is reduced, dollar for dollar, by the amount by which the
total cost of qualifying property placed in service in a tax year from 2003
through 2009 exceeds a threshold of not less than $400,000 (an amount that is
also known as the phase-out threshold). In 2006, this threshold is $430,000
for most firms able to claim the allowance. (The threshold is higher for firms
located in Empowerment and Enterprise Zones, Renewal Communities, the
areas affected by Hurricane Katrina, and the portion of Manhattan affected by
the terrorist attacks of September 11, 2001.) Beginning in 2010 and beyond,
the threshold will drop to $200,000. As a result of the dollar limitation, none
of the cost of qualifying property may be expensed once the total cost reaches
$538,000 in 2006. Under the income limitation, the expensing allowance
may not exceed the taxable income a business taxpayer earns from the active
conduct of the trade or business in which the qualifying property is used.
Business taxpayers may not carry forward expensing allowances lost because
of the dollar limitation, but they may carry forward those denied because of
the income limitation.

Impact

In the absence of section 179, the cost of depreciable business property
would have to be recovered over longer periods. Thus, the provision greatly
accelerates the depreciation of relatively small purchases of qualified business
assets. This effect has important implications for the cash flow of firms, since
the present value of the taxes owed on the stream of income earned by a
depreciable asset decreases as the rate of depreciation rises. In theory,
expensing has the potential to stimulate increased business investment, as it is
equivalent to taxing the income earned from eligible business assets at a
marginal effective tax rate of zero.

The allowance offers another benefit to firms able to take advantage of it:
it simplifies their tax accounting.

Because the allowance has a phase-out threshold, most of the firms that
take advantage of it are relatively small in asset, employment, or revenue size.

Benefits to capital income tend to concentrate in the higher income classes
(see discussion in the Introduction).

Rationale

The expensing allowance originated as a special first-year depreciation
deduction that was enacted as part of the Small Business Tax Revision Act of
1958. The deduction was equal to 20 percent of the first $10,000 of spending
($20,000 in the case of a joint return) on new and used business equipment
and machinery with a tax life of six or more years. It was intended to provide
tax relief and an investment incentive for small firms, and to simplify their tax
accounting.

The deduction remained intact until the Economic Recovery Tax Act of
1981 (ERTA) replaced it with a maximum expensing allowance of $5,000.
ERTA also established a timetable for increasing the allowance to $10,000 by
1986 and an investment tax credit. Business taxpayers were not permitted to
claim both the allowance and the credit for acquisitions of the same assets.
As a result, relatively few firms took advantage of the allowance until the
investment tax credit was repealed by the Tax Reform Act of 1986.

A provision of the Deficit Reduction Act of 1984, postponed the scheduled
increase in the maximum allowance to $10,000 from 1986 to 1990. The
allowance did reach $10,000 in 1990, as scheduled.

It remained at that amount until 1993, when President Clinton proposed a
temporary investment credit for equipment for large firms and a permanent
one for small firms. The credits were not adopted, but the Omnibus Budget
Reconciliation Act of 1993 increased the expensing allowance to $17,500, as
of January 1, 1993.

With the enactment of the Small Business Job Protection Act of 1996, the
size of the allowance embarked on an accelerated upward path: it rose to
$18,000 in 1997, $18,500 in 1998, $19,000 in 1999, $20,000 in 2000,
$24,000 in 2001 and 2002, and $25,000 in 2003 and thereafter.

The maximum allowance would still be $25,000, were it not for the
enactment of the Jobs and Growth Tax Relief Reconciliation Act of 2003
(JGTRRA). The act made three important changes in the allowance. First, it
raised the maximum amount that can be expensed to $100,000 and the phase-
out threshold to $400,000, for 2003 through 2005. Second, JGTRRA
indexed both amounts for inflation in 2004 and 2005. Finally, it added
purchases of off-the-shelf computer software for business use to the list of
depreciable assets eligible for expensing in 2003 through 2005.

Under the American Jobs Creation Act of 2004, all the changes in the
allowance made by JGTRRA are extended through 2007.

The Tax Increase Prevention and Reconciliation Act of 2005 extended
these changes through 2009.

Assessment

The expensing allowance under section 179 has important implications for
tax administration and economic efficiency. With regard to the former, it
simplifies tax accounting for firms able to take advantage of the allowance.
With regard to the latter, the provision encourages increased investment by
smaller firms in a way that might divert financial capital away from more
productive uses. Nonetheless, its overall influence on tax administration and
the allocation of economic resources is limited because most large firms are
unable to take advantage of the allowance.

Although some argue that investment in and by smaller firms should be
fostered because they tend to create more jobs and generate more
technological innovation than larger firms, evidence on this issue is mixed. In
addition, conventional economic analysis offers no support for investment tax
subsidies targeted at such firms. In theory, taxing the returns to all
investments at the same rate does less harm to social welfare than does
making the tax rate on those returns dependent on a firm's size.

Some question the efficacy of expensing as a policy tool for encouraging
higher levels of business investment in plant and equipment. A better
approach, in the view of these skeptics, would be to enact permanent
reductions in corporate and individual tax rates.

The economic effects of expensing may receive greater congressional
consideration in coming months. In November 2005, an advisory panel on
federal tax reform created by President George W. Bush the previous January
issued its final report. After evaluating a number of reform proposals, the
panel recommended two reform plans: the "Simplified Income Tax Plan" and
the Growth and Investment Tax Plan." While plans would modify the current
rules governing the tax treatment of depreciation, only the Growth and
Investment Plan would allow all new investments by firms of all sizes to be
expensed.

Selected Bibliography

Armington, Catherine, and Marjorie Odle. "Small Business--How Many
Jobs?" The Brookings Review, v. 1, no. 2. Winter 1982, pp. 14-17.

Cahlin, Richard A. "Current Deduction Available for Many Costs That
Are Capital in Nature," Taxation for Accountants, v. 29. November 1982, pp.
292-295.
Cash, Stephen L. and Thomas L. Dickens, "Depreciation After the 2003
Tax Act - Part 1: Taxes," Strategic Finance, October 1, 2003, p. 17.
Cordes, Joseph J., "Expensing," in The Encyclopedia of Taxation and Tax
Policy, Joseph J. Cordes, Robert D. Ebel, and Jane G. Gravelle, eds.,
Washington, DC: Urban Institute Press,1999, p. 114.
Gaffney, Dennis J., Maureen H. Smith-Gaffney, and Bonnie M. Moe,
"JGTRRA Increases in Accelerated Capital Recovery Provisions Are
Generally Taxpayer Friendly," Journal of Taxation, July, 2003, p. 20.
Gravelle, Jane G. Small Business Tax Subsidy Proposals, Library of
Congress, Congressional Research Service Report 93-316. Washington, DC:
March 15, 1994.
Guenther, Gary. Small Business Expensing Allowance: Current Status,
Legislative Proposals, and Economic Effects, Library of Congress,
Congressional Research Service, Report RL31852, Washington, DC: October
3, 2006.
Holtz-Eakin, Doug. "Should Small Business be Tax-Favored?" National
Tax Journal, v. 48, September 1995, pp. 447-462.
Neubig, Tom. "Where's the Applause? Why Most Corporations Prefer a
Lower Rate." Tax Notes, April 24, 2006. pp. 483-486.
President's Advisory Panel on Federal Tax Reform. Simple, Fair, and
Pro-Growth: Proposals to Fix America's Tax System. Washington, DC:
November 2005.
U.S. Congress, Senate Committee on Finance hearing 104-69. Small
Business Tax Incentives. Washington, DC: U.S. Government Printing
Office, June 7, 1995.

Commerce and Housing:
Other Business and Commerce

AMORTIZATION OF BUSINESS START-UP COSTS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.7

(1)

0.7

2007

0.7

(1)

0.7

2008

0.8

(1)

0.8

2009

0.8

(1)

0.8

2010

0.9

(1)

0.9

(1)Less than $50 million.

Authorization

Section 195.

Description

In general, business taxpayers are allowed to deduct all normal and
reasonable expenses they incur in conducting their trade or business. This
rule implies that costs incurred before the start of a business should not be
considered deductible because they were not incurred in connection with
carrying on an active trade or business. Instead, start-up costs should be
capitalized and added to a taxpayer's basis in the business. Yet under section
195, a business taxpayer may deduct up to $5,000 in qualified start-up
expenditures and amortize any remaining amount over 15 years. In the
absence of such an option, no deduction would be allowed for start-up
expenditures.

Start-up expenditures must satisfy two requirements to qualify for this
preferential treatment. First, they must be related to one or more of the
following activities: looking into the creation or acquisition of an active trade
or business; creating an active trade or business; or engaging in what the
Internal Revenue Service sees as "a profit-seeking or income-producing
activity" before an active trade or business commences. Second, the
expenditures must be tied to costs that would be deductible if they were paid
or incurred in connection with an existing trade or business. Excluded from
qualifying start-up expenditures are interest payments on debt, tax payments,
and spending on research and development that is deductible under section
174.

Impact

The election to deduct and amortize business start-up costs removes an
impediment to the formation of new businesses by permitting the immediate
deduction of expenses that otherwise could not be recovered until the owner
sold his or her interest in the business.

Benefits to capital income tend to concentrate in the higher income classes
(see discussion in the Introduction).

Rationale

Before the enactment of section 195 in 1980, the question of whether an
expense incurred in connection with starting a new trade or business was
currently deductible or should be capitalized was a source of controversy and
costly litigation between business taxpayers and the Internal Revenue Service
(IRS). Business taxpayers had the option of treating certain organizational
expenditures for the formation of a corporation or partnership as deferred
expenses on an elective basis and amortizing them over a period of not less
than 60 months (Code sections 248 and 709).

Section 195 first entered the federal tax code through the Miscellaneous
Revenue Act of 1980. The original provision allowed business taxpayers to
amortize start-up expenditures over a period of not less than 60 months. It
defined start-up expenditures as any expense "paid or incurred in connection
with investigating the creation or acquisition of an active trade or business, or
creating an active trade or business." In addition, the expense had to be one
that would have been immediately deductible if it were paid or incurred in
connection with the expansion of an existing trade or business. Congress
added section 195 to facilitate the creation of new businesses and reduce the
likelihood of protracted legal disputes over the tax treatment of start-up
expenditures.

Nevertheless, in spite of the changes enacted in 1980, numerous disputes
continued to arise over whether certain business start-up costs should be
expensed under section 162, capitalized under section 263, or amortized
under section 195. In an attempt to diminish the controversy and litigation
surrounding the interpretation of section 195, Congress added a provision to
the Deficit Reduction Act of 1984 clarifying the definition of start-up
expenditures. Specifically, the provision required taxpayers to treat start-up
expenditures as deferred expenses, which meant that they were to be
capitalized unless a taxpayer elected to amortize them over a period of not
less than 60 months. It also broadened the definition of start-up expenditures
to include any expenses incurred in connection with activities aimed at
earning a profit or producing income before the day when the active conduct
of a trade of business commenced; the expenses had to be incurred in
anticipation of entering the trade or business.

No changes were made in section 195 until the enactment of the American
Jobs Creation Act of 2004. The act included a provision limiting the scope of
the amortization of business start-up costs under prior law. Specifically, the
provision permitted business taxpayers to deduct up to $5,000 in eligible
start-up costs in the tax year when their trade or business began. This amount
must be reduced (but not below zero) by the amount by which these costs
exceed $50,000. Any remaining amount must be amortized over 15 years,
beginning with the month in which the active conduct of the trade or business
commenced. The definition of start-up costs was left unchanged. In making
these modifications to section 195, Congress seemed to have two aims. One
was to encourage the formation of new firms that do not require substantial
start-up costs by allowing a large share of those costs to be deductible in the
tax year when the firms begin to operate. The second aim was to make the
amortization period for start-up costs consistent with that for intangible assets
under section 197, which was (and is) 15 years.

Assessment

In theory, business start-up costs should be written off over the life of the
business on the grounds that they are a capital expense. Such a view,
however, does raise the thorny problem of determining the useful life of a
business at its outset.

Section 195 has two distinct advantages. First, it substantially lowers the
likelihood of costly and drawn-out legal disputes involving business taxpayers
and the IRS over the tax treatment of start-up costs. Second, the provision
does so at a relatively small revenue cost.

Selected Bibliography

Davis, Jon E., "Amortization of Start-Up Costs," Tax Adviser, April 1999,
p. 222.
Fiore, Nicholas J., "IRS Issues Guidance on Amortizable Start-Up Cost,"
Tax Adviser, July 1999, pp. 527-532.
Garris, Henry A., "Update and Review of Start-Up Expenditures," CPA
Journal, March 1991, p. 60.
Guenther, Gary. Small Business Tax Benefits: Overview and Economic
Analysis, Library of Congress, Congressional Research Service Report
RL32254, Washington, DC: March 3, 2004.
Internal Revenue Service, Starting a Business and Keeping Records,
publication 583, Washington, D.C.: March 2006.
Kalinka, Susan, "When Will Business Investigatory Expenditures Be
Amortizable Start-Up Costs?," Taxes, September 1998, pp. 5-9.
Kline, Robin, "Disallowed Start-Up Expenses," Tax Adviser, October
1998, pp. 666-667.
Paul, Michael S., "Elect to Amortize Nondeductible Start-Up Expenses,"
Taxation for Accountants, August 1995, pp. 68-73.
Persellin, Mark B. and Shawn E. Novak, "Start-Up Expenditures:
Compliance and Planning Issues," Journal of Corporate Taxation, Summer
1995, p. 141.
Schnee, Edward J., "Speed Up the Deduction of Business Expansion
Costs," Practical Tax Strategies, July 1999, pp. 4-12.
Thornton, David A., "IRS Clarifies the Applicability of Section 195 to
Business Acquisitions," Tax Adviser, September 1999, pp. 625-626.
U.S. Congress, House Committee on Ways and Means. Miscellaneous
Revenue Act of 1980. Report 96-1278, pp. 9-13.
-, Senate Committee on Finance. Jumpstart Our Business Strength (Jobs)
Act. Report 108-192, pp. 196-197.
-, Joint Committee on Taxation. General Explanation of the Revenue
Provisions of the Deficit Reduction Act of 1984. Committee Print, 98th
Congress, 2nd Session, December 31, 1984, pp. 295-297.
Wilcox, Gary B. "Start-Up Cost Treatment Under Section 195: Tax
Disparity in Disguise," Oklahoma Law Review, v. 36. Spring 1983, pp.
449-466.

Commerce and Housing Credit:
Other Business and Commerce

REDUCED RATES ON FIRST $10,000,000
OF CORPORATE TAXABLE INCOME

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

4.3

2007

4.3

2008

4.3

2009

4.3

2010

4.3

Authorization

Section 11.

Description

Corporations with less than $10 million in taxable income are taxed
according to a complicated graduated rate structure. Under the existing
structure, the tax rate is 15 percent on the first $50,000 of income, 25 percent
on the next $25,000, and an average of 34 percent thereafter. To offset the
benefit from the lower rates, a tax rate of 39 percent is imposed on corporate
taxable income between $100,000 and $335,000. As a result, the benefit of
the lower rates vanishes for corporations with taxable income in excess of
$335,000: they pay a flat average rate of 34 percent. The tax rate on taxable
income between $335,000 and $10 million is 34 percent. It rises to 35
percent for taxable income from $10 million to $15 million. When taxable
income falls between $15 million and $18,333,333, the rate jumps to 38
percent. And a flat rate of 35 percent applies to taxable income above
$18,333,333. Thus, the benefit of the 34 percent rate is phased out when
income reaches $18,333,333.

The graduated rates do not apply to the taxable income of personal-service
corporations; instead, it is taxed at a flat rate of 35 percent. In addition, there
are restrictions on eligibility for the lower rates to prevent abuse by related
corporations.

The tax expenditure for section 11 lies in the difference between taxes paid
and the taxes that would be owed if all corporate income were taxed at a flat
35 percent rate.

Impact

The reduced rates mainly affect smaller corporations. This is because the
graduated rate structure limits the benefits of the rates under 35 percent to
corporations with taxable incomes below $335,000.

The graduated rates encourage firms to use the corporate form of legal
organization and allow some small corporations that might otherwise operate
as passthrough entities (e.g., sole proprietorships or partnerships) to provide
fringe benefits. They also encourage the splitting of operations between sole
proprietorships, partnerships, S corporations and regular C corporations.
Most businesses are not incorporated; so only a small fraction of firms are
affected by this provision.

This provision is likely to benefit higher-income individuals who are the
primary owners of capital (see Introduction for a discussion).

Rationale

In the early years of the corporate income tax, exemptions from the tax
were allowed in some years. A graduated rate structure was first adopted in
1936. From 1950 to 1974, corporate income was subject to a "normal tax"
and a surtax, and the first $25,000 of income was exempt from the surtax.
The exemption was intended to provide tax relief for small businesses.

Not surprisingly, this dual structure led many large firms to reorganize their
operations into numerous smaller corporations in order to avoid paying the
surtax. Some steps to remedy this loophole were taken in 1963. But the most
important correction came in 1969, when legislation was enacted that limited
clusters of corporations controlled by the same interest to a single exemption.

In 1975, a graduated rate structure with three brackets was adopted. In
1984, a law was enacted which included a provision phasing out the
exemption for taxable incomes between $1 million and $1.405 million. The
act also lowered the rates that applied to incomes up to $100,000.

The present graduated rate structure for corporate taxable income below
$10 million came into being with the passage of the Tax Reform Act of 1986.
More specifically, the act lowered the ceilings on the rates and accelerated
the phase-out of the reduced rates so that their benefits gradually disappeared
between $100,000 and $335,000. In taking these steps, Congress was
attempting to target the benefits of the graduated rate structure more precisely
at smaller firms. Motivated by a desire to reduce a large and growing budget
deficit by raising revenue, Congress added the 35-percent corporate tax rate
through the Omnibus Budget Reconciliation Act of 1993.

Assessment

A principal justification for the graduated rates is that they provide needed
assistance to small businesses. The rates do so by lowering their cost of
capital for new investments and increasing their cash flow during periods
when many of them struggle to survive. But can the graduated rates be
justified on economic grounds?

Unlike the graduated rates of the individual tax, the corporate graduated
rate structure cannot be justified on the basis of a firm's ability to pay. The
reason is two-fold: individuals and not corporations end up paying corporate
taxes, and owners of small corporations are likely to be very well off. In
addition, graduated rates can serve as a means of reducing the tax burden of
small business owners. Such a reduction is possible when the individual
income of owners of small corporations is taxed at a higher rate than the
income of their corporations. These considerations suggest that tax relief for
small firms cannot be justified on the grounds of equity.

Can such tax relief be justified on the basis of economic efficiency? Once
again, the case seems weak or less than persuasive. Although some argue that
government policy should support investment in and by small firms because
they tend to create more jobs and generate more technological innovations
than larger firms, evidence on this issue is decidedly mixed. Conventional
economic analysis implies that maximum output is likely to be produced
when the returns to all investments are taxed at the same rate. A graduated
rate structure discourages investments in and by firms subject to the higher
marginal tax rates of the phase-out range. Such an incentive effect can distort
the allocation of economic resources by diverting the flow of financial capital
from its most productive uses. Graduated rates also give large corporations
an incentive to operate for tax purposes as multiple smaller units, where
economies of scale have less of an impact on the returns to investment.

Graduated rates do, however, make it possible for owners of businesses in
the lower income brackets to operate as corporations. Generally, business
owners are free to operate their firms as a regular C corporation or some kind
of passthrough entity (i.e., sole proprietorship, partnership, limited liability
company, or S corporation) for legal purposes. Income earned by
passthrough entities is attributed to the owners (whether or not it is
distributed) and taxed at individual income tax rates. Depending on the
amount, it is possible for income earned by corporations to be taxed at lower
rates than income earned by passthrough entities. Differences between the
two rates create opportunities for the sheltering of income in corporations.
There may be some circumstances, however, where operating as a
passthrough entity is not feasible. For instance, corporate status may be
indispensable if more than one class of stock or favorable tax treatment of
employee fringe benefits is desired.

Selected Bibliography

Armington, Catherine, and Marjorie Odle. "Small Business--How Many
Jobs?" Brookings Review, v. 1, no. 2. Winter 1982, pp. 14-17.
Brumbaugh, David. Federal Business Taxation: The Current System, Its
Effects, and Options for Reform. Library of Congress, Congressional
Research Service Report RL33171. Washington, DC: September 21, 2006.
Gravelle, Jane G. Small Business Tax Subsidy Proposals. Library of
Congress, Congressional Research Service Report 93-316. Washington, DC:
March 15, 1994.
-. "The Corporate Income Tax: Where Has It Been and Where Is It
Going?." National Tax Journal, vol. 57, December 2004. pp. 903-923.
Guenther, Gary. Small Business Tax Benefits: Overview and Economic
Analysis. Library of Congress, Congressional Research Service Report
RL32254. Washington, DC: March 3, 2004.
Pechman, Joseph A. Federal Tax Policy. Washington, DC: The
Brookings Institution, 1987, pp. 302-305.
Plesko, George A. "`Gimme Shelter?' Closely Held Corporations Since
Tax Reform," National Tax Journal, v. 48. September 1995, pp. 409-416.
Holtz-Eakin, Douglas. "Should Small Business be Tax-Favored?"
National Tax Journal, v. 48, September 1995, pp. 447-462.
Schnee, Edward J. "Refining the Definition of a Personal Service
Corporation." Journal of Accountancy, vol. 202, no. 3, September 1, 2006.
p. 74
U.S. Congress, Congressional Budget Office. Reducing the Deficit:
Spending and Revenue Options,. Washington, DC: U.S. Government
Printing Office, March 1997, p. 337.
-, Joint Committee on Taxation. General Explanation of the Tax Reform
Act of 1986, 99th Congress, 2nd session. May 4, 1987: pp. 271-273.
-, Senate Committee on Finance hearing 104-69. Small Business Tax
Incentives. Washington, DC: U.S. Government Printing Office, June 7, 1995.
U.S. Department of the Treasury. Tax Reform for Fairness, Simplicity,
and Economic Growth, v. 2, General Explanation of the Treasury
Department Proposals. November, 1974, pp. 128-129.

Commerce and Housing:
Other Business and Commerce

PERMANENT EXEMPTION
FROM IMPUTED INTEREST RULES

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.4

(1)

0.4

2007

0.4

(1)

0.4

2008

0.4

(1)

0.4

2009

0.4

(1)

0.4

2010

0.5

(1)

0.5

(1)less than $50 million

Authorization

Sections 163(e), 483, 1274, and 1274A.

Description

The failure to report interest as it accrues can allow the deferral of taxes.
The tax code generally requires that debt instruments bear a market rate of
interest at least equal to the average rate on outstanding Treasury securities of
comparable maturity. If an instrument does not, the Internal Revenue Service
imputes a market rate to it. The imputed interest must be included as income
to the recipient and is deducted by the payer.

There are several exceptions to the general rules for imputing interest on
debt instruments. Debt associated with the sale of property when the total
sales price is no more than $250,000, the sale of farms or small businesses by
individuals when the sales price is no more than $1 million, and the sale of a
personal residence, is not subject to the imputation rules at all. Debt
instruments for amounts not exceeding an inflation-adjusted maximum (about
$4.6 million or $3.3 million, depending on the kind of the debt instrument),
given in exchange for real property, may not have imputed to them an interest
rate greater than 9 percent.

This tax expenditure is the revenue loss in the current year from the
deferral of taxes caused by these exceptions.

Impact

The exceptions to the imputed interest rules are generally directed at "seller
take-back" financing, in which the seller of the property receives a debt
instrument (note, mortgage) in return for the property. This is a financing
technique often used in selling personal residences or small businesses or
farms, especially in periods of tight money and high interest rates, both to
facilitate the sales and to provide the sellers with continuing income.

This financing mechanism can also be used, however, to shift taxable
income between tax years and thus delay the payment of taxes. When interest
is fully taxable but the gain on the sale of the property is taxed at reduced
capital gains rates, as in current law, taxes can be eliminated, not just
deferred, by characterizing more of a transaction as gain and less as interest
(that is, the sales price could be increased and the interest rate decreased).

With only restricted exceptions to the imputation rules, and other recent tax
reforms, the provisions now cause only modest revenue losses and have
relatively little economic impact.

Rationale

Restrictions were placed on the debt instruments arising from seller-
financed transactions beginning with the Revenue Act of 1964, to assure that
taxes were not reduced by manipulating the purchase price and stated interest
charges. These restrictions still allowed considerable creativity on the part of
taxpayers, however, leading ultimately to the much stricter and more
comprehensive rules included in the Deficit Reduction Act of 1984.

The 1984 rules were regarded as very detrimental to real estate sales and
they were modified almost immediately (temporarily in 1985 [P.L. 98-612]
and permanently in 1986 [P.L. 99-121]). The exceptions to the imputed
interest rules described above were introduced in 1984 and 1986 (P.L. 99-
121) to allow more flexibility in structuring sales of personal residences,
small businesses, and farms by the owners, and to avoid the administrative
problems that might arise in applying the rules to other smaller sales.

Assessment

The imputed interest and related rules dealing with property-for-debt
exchanges were important in restricting unwarranted tax benefits before the
Tax Reform Act of 1986 eliminated the capital gains exclusion and
lengthened the depreciable lives of buildings.

Under pre-1986 law, the seller of commercial property would prefer a
higher sales price with a smaller interest rate on the associated debt, because
the gain on the sale was taxed at lower capital gains tax rates. The buyer
would at least not object to, and might prefer, the same allocation because it
increased the cost of property and the amount of depreciation deductions
(i.e., the purchaser could deduct the principal, through depreciation
deductions, as well as the interest). It was possible to structure a sale so that
both seller and purchaser had more income at the expense of the government.

Under current depreciation rules and low interest rates, this allocation is
much less important. In addition, the 9-percent cap on imputed interest for
some real estate sales has no effect when market interest rates are below that
figure.

Selected Bibliography

U.S. Congress, Joint Committee on Taxation. Description of the Tax
Treatment of Imputed Interest on Deferred Payment Sales of Property, JCS-
15-85. May 17, 1985.
-. General Explanation of the Revenue Provisions of the Deficit Reduction
Act of 1984, JCS-41-84. December 31, 1984, pp.108-127.
Internal Revenue Service. Installment Sales. Publication 537, for use in
preparing 2005 returns, p. 9.

Commerce and Housing:
Other Business and Commerce

EXPENSING OF MAGAZINE CIRCULATION EXPENDITURES

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

(1)

(2)

2007

(1)

(2)

2008

(1)

(2)

2009

(1)

(2)

2010

(1)

(2)

(1)Less than $50 million.
(2)Less than $100 million

Authorization

Section 173.

Description

In general, publishers of newspapers, magazines, and other periodicals are
allowed to deduct their expenditures to maintain, establish, or increase
circulation in the year when the expenditures are made.

Current deductions of these expenditures are permitted even though
expenditures to establish or increase circulation would otherwise be treated as
capital expenditures under section 263. Expenditures eligible for this
preferential treatment do not include purchases of land and depreciable
property or the expansion of circulation through the purchase of another
publisher or its list of subscribers.

The tax expenditure in section 173 lies in the difference between the
current deduction of costs and the present value of the depreciation
deductions that would be taken if these costs were capitalized.

Impact

Publishers are permitted a current deduction for circulation costs, including
some that otherwise should be treated as capital in nature. Such preferential
treatment speeds up the recovery of those costs, increasing cash flow and
reducing the cost of capital for publishers. Investment in maintaining and
expanding circulation is a critical element of the competitive strategies for
publishers of newspapers and magazines. The number of readers is an
important source of revenue in and of itself, and the advertising rates
publishers can charge typically are based on the volume of sales and
readership.

Like many other business tax expenditures, the benefit tends to accrue to
high-income individuals (see Introduction for a discussion).

Rationale

Section 173 was added to the federal tax code through the Revenue Act of
1950. In taking this step, Congress was hoping to eliminate some of the
problems associated with distinguishing between expenditures to maintain
circulation, which had been treated as currently deductible, and those to
establish or develop new circulation, which had to be capitalized. Numerous
legal disputes between publishers and the Internal Revenue Service over the
application and interpretation of such a distinction had arisen as far back as
the late 1920s.

Section 173 remained unchanged until the passage of the Tax Equity and
Fiscal Responsibility Act of 1982. Among other things, the act made the
expensing of circulation expenditures a preference item under the alternative
minimum tax (AMT) for individuals and required affected individuals to
amortize any such expenditures over 10 years. Congress lowered the recovery
period to three years in the Deficit Reduction Act of 1984, where it now
stands. The Tax Reform Act of 1986 further clarified the treatment of
circulation expenditures under the individual AMT: specifically, the act
allowed taxpayers who recorded a loss on the disposition of property related
to such expenditures (e.g., a newspaper) to claim as a deduction against the
AMT all remaining circulation expenditures that have yet to be deducted for
the purpose of the minimum tax.

Assessment

Although section 173 provides a significant tax benefit for publishers in
that it allows them to expense the acquisition of an asset (i.e., lists of
subscribers) that yield returns in future tax years, it simplifies tax compliance
and accounting for them and tax administration for the IRS. Without such
treatment, it would be necessary for IRS or Congress to clarify how to
distinguish between expenditures for establishing or expanding circulation
and expenditures for maintaining circulation.

Selected Bibliography

Commerce Clearing House. "'50 Act Clarified Tax Treatment of
Circulation Expenses of Publishers," Federal Tax Guide Reports, v. 48.
September 9, 1966, p. 2.
Davidson, James H. "A Publisher's Guide to Tax Reform - Part 2," Folio:
The Magazine for Magazine Management, February 1987.
U.S. Congress, Joint Committee on Internal Revenue Taxation. Summary
of H.R. 8920, "The Revenue Act of 1950," as agreed to by the Conferees.
September 1950, p. 12.
Joint Committee on Taxation. General Explanation of the Revenue
Provisions of the Deficit Reduction Act of 1984, Committee Print, 98th
Congress, 2nd session. December 31, 1984, p. 986
-, General Explanation of the Tax Reform Act of 1986, Committee Print,
99th Congress, 2nd Session, May 4, 1987, p. 445.
Washburn, David. "Newspapers Hope Online Readers Will Keep Them
Profitable." Copley News Service. December 4, 2005. Available at
www.copleynews.com.

Commerce and Housing:
Other Business and Commerce

SPECIAL RULES FOR MAGAZINE,
PAPERBACK BOOK, AND RECORD RETURNS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

(1)

2007

(1)

2008

(1)

2009

(1)

2010

(1)

(1)Less than $50 million.

Authorization

Section 458.

Description

In general, if a buyer returns goods to the seller, the seller's income is
reduced in the year in which the items are returned. If the goods are returned
after the tax year in which the goods were sold, the seller's income for the
previous year is not affected.

An exception to the general rule has been granted to publishers and
distributors of magazines, paperbacks, and records, who may elect to exclude
from gross income for a tax year the income from the sale of goods that are
returned after the close of the tax year. The exclusion applies to magazines
that are returned within two months and fifteen days after the close of the tax
year, and to paperbacks and records that are returned within four months and
fifteen days after the close of the tax year.

To be eligible for the special election, a publisher or distributor must be
under a legal obligation, at the time of initial sale, to provide a refund or
credit for unsold copies.

Impact

Publishers and distributors of magazines, paperbacks, and records who
make the special election are not taxed on income from goods that are
returned after the close of the tax year. The special election mainly benefits
large publishers and distributors.

Rationale

The purpose of the special election for publishers and distributors of
magazines, paperbacks, and records is to avoid imposing a tax on accrued
income when goods that are sold in one tax year are returned after the close of
the year.

The special rule for publishers and distributors of magazines, paperbacks,
and records was enacted by the Revenue Act of 1978.

Assessment

For goods returned after the close of a tax year in which they were sold, the
special exception allows publishers and distributors to reduce income for the
previous year. Therefore, the special election is inconsistent with the general
principles of accrual accounting.

The special tax treatment granted to publishers and distributors of
magazines, paperbacks, and records is not available to producers and
distributors of other goods. On the other hand, publishers and distributors of
magazines, paperbacks, and records often sell more copies to wholesalers and
retailers than they expect will be sold to consumers.

One reason for the overstocking of inventory is that it is difficult to predict
consumer demand for particular titles. Overstocking is also used as a
marketing strategy that relies on the conspicuous display of selected titles.
Knowing that unsold copies can be returned, wholesalers and retailers are
more likely to stock a larger number of titles and to carry more copies of
individual titles.

For business purposes, publishers generally set up a reserve account in the
amount of estimated returns. Additions to the account reduce business
income for the year in which the goods are sold. For tax purposes, the special
election for returns of magazines, paperbacks, and records is similar, but not
identical, to the reserve account used for business purposes.

Selected Bibliography

U.S. Congress, Joint Committee on Taxation. General Explanation of the
Revenue Act of 1978, 95th Congress, 2nd session. March 12, 1979, pp. 235-
41.
-, Tax Reform Proposals: Accounting Issues, Committee Print, 99th
Congress, 1st session. September 13, 1985.
U.S. Department of the Treasury, Internal Revenue Service. "Certain
Returned Magazines, Paperbacks or Records," Federal Register, v. 57,
August 26, 1992, pp. 38595-38600.

Commerce and Housing:
Other Business and Commerce

COMPLETED CONTRACT RULES

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

(1)

0.3

2007

(1)

0.3

2008

(1)

0.4

2009

(1)

0.4

2010

(1)

0.5

(1)Less than $50 million

Authorization

Section 460.

Description

Some taxpayers with construction or manufacturing contracts extending for
more than one tax year are allowed to report some or all of the profit on the
contracts under special accounting rules rather than the normal rules of tax
accounting. Many such taxpayers use the "completed contract" method.

A taxpayer using the completed contract method of accounting reports
income on a long-term contract only when the contract has been completed.
All costs properly allocable to the contract are also deducted when the
contract is completed and the income reported, but many indirect costs may
be deducted in the year paid or incurred. This mismatching of income and
expenses allows a deferral of tax payments that creates a tax advantage in this
type of reporting.

Most taxpayers with long-term contracts are not allowed to use the
completed contract method and must capitalize indirect costs and deduct them
only when the income from the contract is reported. There are exceptions,
however. Home construction contracts may be reported according to the
taxpayer's "normal" method of accounting and allow current deductions for
costs that others are required to capitalize.

Other real estate construction contracts may also be subject to these more
liberal rules if they are of less than two years duration and the contractor's
gross receipts for the past three years have averaged $10 million or less.
Contracts entered into before March 1, 1986, if still ongoing, may be reported
on a completed contract basis, but with full capitalization of costs.

Contracts entered into between February 28, 1986, and July 11, 1989, and
residential construction contracts other than home construction may be
reported in part on a completed contract basis, but may require full cost
capitalization. This tax expenditure is the revenue loss from deferring the tax
on those contracts still allowed to be reported under the more liberal
completed contract rules.

Impact

Use of the completed contract rules allows the deferral of taxes through
mismatching income and deductions because they allow some costs to be
deducted from other income in the year incurred, even though the costs
actually relate to the income that will not be reported until the contract's
completion, and because economic income accrues to the contractor each year
he works on the contract but is not taxed until the year the contract is
completed. Tax deferral is the equivalent of an interest-free loan from the
Government of the amount of the deferred taxes. Because of the restrictions
now placed on the use of the completed contract rules, most of the current tax
expenditure relate to real estate construction, especially housing.

Rationale

The completed contract method of accounting for long-term construction
contracts has been permitted by Internal Revenue regulations since 1918, on
the grounds that such contracts involved so many uncertainties that profit or
loss was undeterminable until the contract was completed.

In regulations first proposed in 1972 and finally adopted in 1976, the
Internal Revenue Service extended the method to certain manufacturing
contracts (mostly defense contracts), at the same time tightening the rules as
to which costs must be capitalized. Perceived abuses, particularly by defense
contractors, led the Congress to question the original rationale for the
provision and eventually led to a series of ever more restrictive rules. The
Tax Equity and Fiscal Responsibility Act of 1982 (P.L. 97-248) further
tightened the rules for cost capitalization.

The Tax Reform Act of 1986 (P.L. 99-514) for the first time codified the
rules for long-term contracts and also placed restrictions on the use of the
completed contract method. Under this Act, the completed contract method
could be used for reporting only 60 percent of the gross income and
capitalized costs of a contract, with the other 40 percent reported on the
"percentage of completion" method, except that the completed contract
method could continue to be used by contractors with average gross receipts
of $10 million or less to account for real estate construction contracts of no
more than two years duration. It also required more costs to be capitalized,
including interest.

The Omnibus Budget Reconciliation Act of 1987 (P.L. 100-203) reduced
the share of a taxpayer's long-term contracts that could be reported on a
completed contract basis from 60 percent to 30 percent. The Technical and
Miscellaneous Revenue Act of 1988 (P.L. 100-647) further reduced the
percentage from 30 to 10, (except for residential construction contracts, which
could continue to use the 30 percent rule) and also provided the exception for
home construction contracts.

The Omnibus Budget Reconciliation Act of 1989 (P.L. 101-239) repealed
the provision allowing 10 percent to be reported by other than the percentage
of completion method, thus repealing the completed contract method, except
as noted above.

The most recent legislative change was a provision of the American Jobs
Creation Act of 2004, later amended in the Gulf Opportunity Zone Act of
2005, permitting naval shipbuilders to use the completed contract method.

Assessment

Use of the completed contract method of accounting for long-term
contracts was once the standard for the construction industry. Extension of
the method to defense contractors, however, created a perception of wide-
spread abuse of a tax advantage. The Secretary of the Treasury testified
before the Senate Finance Committee in 1982 that "virtually all" defense and
aerospace contractors used the method to "substantially reduce" the taxes they
would otherwise owe.

The principal justification for the method had always been the uncertainty
of the outcome of long-term contracts, an argument that lost a lot of its force
when applied to contracts in which the Government bore most of the risk. It
was also noted that even large construction companies, who used the method
for tax reporting, were seldom so uncertain of the outcome of their contracts
that they used it for their own books; their financial statements were almost
always presented on a strict accrual accounting basis comparable to other
businesses.

Since the use of the completed contract rules is now restricted to a very
small segment of the construction industry, it produces only small revenue
losses for the Government and probably has little economic impact in most
areas. One area where it is still permitted, however, is in the construction of
single-family homes, where it adds some tax advantage to an already heavily
tax-favored sector.

Selected Bibliography

Knight, Ray A., and Lee G. Knight. Recent Developments Concerning the
Completed Contract Method of Accounting, The Tax Executive, v. 41, Fall
1988, pp. 73-86.
U.S. Congress, House of Representatives Committee on the Budget.
Omnibus Budget Reconciliation Act of 1989. September 1989, p. 1347.
-, Joint Committee on Taxation. General Explanation of the Revenue
Provisions of the Tax Equity and Fiscal Responsibility Act of 1982. JCS-38-
82, December 31, 1982, pp. 148-154.
-. General Explanation of the Tax Reform Act of 1986. JCS-10-87, May
4, 1987, pp. 524-530.
-. Tax Reform Proposals: Accounting Issues. JCS-39-85, September 13,
1985, pp. 45-49.
U.S. General Accounting Office, Congress Should Further Restrict Use of
the Completed Contract Method. Report GAO/GGD-86-34, January 1986.

Commerce and Housing:
Other Business and Commerce

CASH ACCOUNTING,
OTHER THAN AGRICULTURE

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.8

(1)

0.8

2007

0.8

(1)

0.8

2008

0.8

(1)

0.8

2009

0.9

(1)

0.9

2010

0.9

(1)

0.9

(1)Less than $50 million.

Authorization

Sections 446 and 448.

Description

Under the cash method of accounting, income is reported in the year in
which it is received and deductions are taken in the year in which expenses
are paid. Under the accrual method of accounting, income is generally
recognized when it is earned, whether or not it has actually been received.
Deductions for expenses are generally allowed in the year in which the costs
are actually incurred.

All taxpayers (except some farmers) must use the accrual method of
accounting for inventories and for some income and expenses that span tax
years (e.g., depreciation and prepaid expenses). Tax shelters, C corporations,
partnerships that have C corporations as partners, and certain trusts must use
the accrual method of accounting. Individuals and many businesses may use
the cash method of accounting, however. The cash method may be used by
small businesses, qualified personal service corporations, and certain farm
and timber interests (discussed under "Agriculture" above).

A small business is a business with average annual gross receipts of $10
million or less for the three preceding tax years. Qualified personal service
corporations are employee-owned service businesses in the fields of health,
law, accounting, engineering, architecture, actuarial science, performing arts,
or consulting.

Impact

For tax purposes, most individuals and many businesses use the cash
method of accounting because it is less burdensome than the accrual method
of accounting. The revenue losses mainly benefit the owners of smaller
businesses and professional service corporations of all sizes.

Rationale

Individuals and many businesses are allowed to use the cash method of
accounting because it generally requires less record-keeping than other
methods of accounting.

According to the Revenue Act of 1916, a taxpayer may compute income
for tax purposes using the same accounting method used to compute income
for business purposes. The Internal Revenue Code of 1954 allowed taxpayers
to use a combination of accounting methods for tax purposes. The Tax
Reform Act of 1986 prohibited tax shelters, C corporations, partnerships that
have C corporations as partners, and certain trusts from using the cash method
of accounting.

Assessment

The choice of accounting methods may affect the amount and timing of a
taxpayer's Federal income tax payments. Under the accrual method, income
for a given period is more clearly matched with the expenses associated with
producing that income. Therefore, the accrual method more clearly reflects a
taxpayer's net income for a given period. For business purposes, the accrual
method also provides a better indication of a firm's economic performance for
a given period.

Under the cash method of accounting, taxpayers have greater control over
the timing of receipts and payments. By shifting income or deductions from
one tax year to another, taxpayers can defer the payment of income taxes or
take advantage of lower tax rates. On the other hand, because of its relative
simplicity, the cash method of accounting involves lower costs of compliance.
The cash method is also the method most familiar to the individuals and
businesses to whom its use is largely confined.

Selected Bibliography

Tinsey, Frederick C. "Many Accounting Practices Will Have to be
Changed as a Result of the Tax Reform Act," Taxation for Accountants, v.
38. January 1987, pp. 48-52.
U.S. Congress, Joint Committee on Taxation. Tax Reform Proposals:
Accounting Issues, Committee Print, 99th Congress, 1st session. September
13, 1985.
-. Technical Explanation of S.3152, The "Community Renewal and New
Markets Act of 2000." JCX-105-00, October 2000, p. 77.
-. Technical Explanation of the "Economic Security and Worker
Assistance Act of 2002." JCX-6-02, February 13, 2002, p. 62.
-, General Explanation of Tax Legislation Enacted in the 107th Congress.
JCS-1-03, January 2003, pp. 240-242.
U.S. Department of the Treasury. Announcement 2002-45. Revenue
Procedure 2002-14. April 12, 2002.
U.S. Department of the Treasury. Internal Revenue Service. Accounting
Periods and Methods. Publication 538. 2004.

Commerce and Housing:
Other Business and Commerce

EXCLUSION OF INTEREST ON
STATE AND LOCAL GOVERNMENT SMALL-ISSUE
QUALIFIED PRIVATE ACTIVITY BONDS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.3

0.1

0.4

2007

0.3

0.1

0.4

2008

0.3

0.1

0.4

2009

0.4

0.1

0.5

2010

0.4

0.1

0.5

Authorization

Sections 103, 141, 144, and 146.

Description

Interest income on State and local bonds used to finance business loans of
$1 million or less for construction of private manufacturing facilities is tax
exempt. These small-issue industrial development bonds (IDBs) are
classified as private-activity bonds rather than governmental bonds because a
substantial portion of their benefits accrues to individuals or business rather
than to the general public. For more discussion of the distinction between
governmental bonds and private-activity bonds, see the entry under General
Purpose Public Assistance: Exclusion of Interest on Public Purpose State
and Local Debt.

The $1 million loan limit may be raised to $10 million ($20 million in
certain economically distressed areas) if the aggregate amount of related
capital expenditures (including those financed with tax-exempt bond
proceeds) made over a six-year period is not expected to exceed $20 million.
The bonds are subject to the State private-activity bond annual volume cap.

Impact

Some of the benefits of the tax exemption also flow to bondholders. For a
discussion of the factors that determine the shares of benefits going to
bondholders and business borrowers, and estimates of the distribution of tax-
exempt interest income by income class, see the "Impact" discussion under
General Purpose Public Assistance: Exclusion of Interest on Public Purpose
State and Local Debt.

Rationale

The first bonds for economic development were issued without any Federal
restrictions. State and local officials expected that reduced interest rates on
business loans would increase investment and jobs in their communities. The
Revenue and Expenditure Control Act of 1968 imposed several targeting
requirements, limiting the tax exempt bond issue to $1 million and the
amount of capital spending on the project to $5 million over a six-year period.
The Revenue Act of 1978 increased the $5 million limit on capital
expenditures to $10 million, and to $20 million for projects in certain
economically distressed areas. The American Jobs Creation Act of 2004
(P.L. 108-357) increased the related expenditures limit to $20 million for all
qualified projects.

Several tax acts in the 1970s and early 1980s denied use of the bonds for
specific types of business activities. The Deficit Reduction Act of 1984
restricted use of the bonds to manufacturing facilities, and limited any one
beneficiary's use to $40 million of outstanding bonds. The annual volume of
bonds issued by governmental units within a State first was capped in 1984,
and then included by the Tax Reform Act of 1986 under the unified volume
cap on private-activity bonds. This cap is equal to the greater of $80 per
capita or $246.6 million in 2006. The cap has been adjusted for inflation
since 2003.

Small-issue IDBs long had been an "expiring tax provision" with a sunset
date. IDBs first were scheduled to sunset on December 31, 1986 by the Tax
Equity and Fiscal Responsibility Act of 1982. Additional sunset dates have
been adopted three times when Congress has decided to extend small-issue
IDB eligibility for a temporary period. The Omnibus Budget Reconciliation
Act of 1993 made IDBs permanent. The American Jobs Creation Act of
2004 increased the total capital expenditure limitation from $10 million to
$20 million for small-issue IDBs. Congress, at the time, thought it was
appropriate because the $10 million limit had not been changed for many
years.

Assessment

It is not clear that the Nation benefits from these bonds. Any increase in
investment, jobs, and tax base obtained by communities from their use of
these bonds probably is offset by the loss of jobs and tax base elsewhere in
the economy. National benefit would have to come from valuing the
relocation of jobs and tax base from one location to another, but the use of the
bonds is not targeted to a subset of geographic areas that satisfy explicit
Federal criteria such as income level or unemployment rate. Any jurisdiction
is eligible to utilize the bonds.

As one of many categories of tax-exempt private-activity bonds, small-
issue IDBs have increased the financing costs of bonds issued for public
capital. With a greater supply of public bonds, the interest rate on bonds
necessarily increases to lure investors. In addition, expanding the availability
of tax-exempt bonds also increases the assets available to individuals and
corporations to shelter their income from taxation.

Bibliography

Anderson, John E., and Robert W. Wassmer. Bidding for Business: The
Efficacy of Local Economic Development Incentives in a Metropolitan Area.
Kalamazoo, MI: W.E. Upjohn Institute for Employment Research, 2000, pp.
1-24.
Maguire, Steven. Private Activity Bonds: An Introduction. Library of
Congress, Congressional Research Service Report RL31457. June 9, 2006.
-. Tax-Exempt Bonds: A Description of State and Local Government
Debt. Library of Congress, Congressional Research Service Report
RL30638. March 10, 2006.
Stutzer, Michael J. "The Statewide Economic Impact of Small-Issue
Industrial Development Bonds," Federal Reserve Bank of Minneapolis
Quarterly Review, v. 9. Spring 1985, pp. 2-13.
Temple, Judy. "Limitations on State and Local Government Borrowing for
Private Purposes." National Tax Journal, vol 46, March 1993, pp. 41-53.
U.S. Congress, Congressional Budget Office. Statement of Donald B.
Marron before the Subcommittee on Select Revenue Measures Committee on
Ways and Means U.S. House of Representatives. "Economic Issues in the
Use of Tax-Preferred Bond Financing," March 16, 2006.
U.S. Congress, Congressional Budget Office. The Federal Role in State
Industrial Development Programs, 1984.

-. Small Issue Industrial Revenue Bonds, April 1981.
U.S. Congress, Joint Committee on Taxation, Present Law and
Background Related to State and Local Government Bonds, Joint Committee
Print JCX-14-06, March 16, 2006.
Zimmerman, Dennis. The Private Use of Tax-Exempt Bonds: Controlling
Public Subsidy of Private Activity. Washington, DC: The Urban Institute
Press, 1991.
-. "Federal Tax Policy, IDBs and the Market for State and Local Bonds,"
National Tax Association--Tax Institute of America Symposium: Agendas for
Dealing with the Deficit, National Tax Journal, v. 37. September 1984, pp.
411-420.

Commerce and Housing:
Other Business and Commerce

EXCEPTION FROM NET OPERATING LOSS LIMITATIONS
FOR CORPORATIONS IN BANKRUPTCY PROCEEDINGS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.6

2007

0.6

2008

0.6

2009

0.6

2010

0.6

Authorization

Section 382(l)(5).

Description

In general, net operating losses of corporations may be carried back three
years or carried forward fifteen years to offset taxable income in those years.
If one corporation acquires another, the tax code has rules to determine
whether the acquiring corporation inherits the tax attributes of the acquired
corporation, including its net operating loss carryforwards, or whether the tax
attributes of the acquired corporation disappear.

The acquiring corporation will inherit the tax attributes of the acquired
corporation if the transaction qualifies as a tax-free reorganization. To qualify
as a reorganization, the acquired corporation must essentially (or largely)
continue in operation but in a different form. The owners of the acquired
corporation must become owners of the acquiring corporation, and the
business of the acquired corporation must be continued. An example is a
merger of one corporation into another by exchanging stock of the acquiring
corporation for stock of the acquired corporation.

While net operating loss carryforwards from an acquired corporation may
be used to offset taxable income of the acquiring corporation after a
reorganization, limitations are imposed. In general, the amount of income of
the acquiring corporation that may be offset each year is determined by
multiplying the value of the stock of the acquired corporation immediately
before the ownership change by a specified long-term interest rate.

The purpose of the limitation is to prevent reorganized corporations from
being able to absorb net operating loss carryforwards more rapidly than an
approximation of the pace at which the acquired corporation would have
absorbed them had it continued in existence.

If certain conditions are met, subsection 382(l)(5) provides an exception to
the general limitation on net operating loss carryforwards for cases in which
the acquired corporation was in bankruptcy proceedings at the time of the
acquisition. In this case (unless the corporation elects otherwise), the
limitation on net operating loss carryforwards does not apply. In some cases,
however, certain adjustments are made to the amount of loss carryforwards of
the acquired corporation that may be used by the successor corporation.

Impact

Section 382(l)(5) allows the use of pre-acquisition net operating loss
carryforwards in circumstances in which they could not be used, in most
cases, under the general rule.

The general rule determines the amount of the carryforwards which may be
used to offset income based on the equity value of the acquired corporation at
the time of acquisition. But most corporations in bankruptcy have zero or
negative equity value. Hence, absent this exception, their successor
corporations would be denied use of any of the carryovers.

Rationale

The rationale for the bankruptcy exception to the limitation on net
operating loss carryovers is that the creditors of the acquired corporation who
become shareholders in the bankruptcy reorganization may have, in effect,
become the owners before the reorganization and borne some of the losses of
the bankrupt corporation. In this case, the effective owners of the acquired
corporation become owners of the acquiring corporation even though an
ownership change appears to have occurred. Limitations are imposed to
prevent abusive transactions.

Assessment

While the rationale for the provision is reasonable, the exception is not
structured to be fully consistent with the rationale. There is no test to
determine what portion, if any, of the preacquisition net operating loss
carryforwards was borne by creditors who became shareholders.

Selected Bibliography

Peaslee, James M., and Lisa A. Levy. "Section 382 and Separate
Tracking," Tax Notes. September 28, 1992, pp. 1779-1790.
U.S. Congress, Joint Committee on Taxation. General Explanation of the
Tax Reform Act of 1986. 100th Congress, 1st session, May 4, 1987, pp.
288-327.
U.S. Senate, Committee on Finance. The Subchapter C Revision Act of
1985. 99th Congress, 1st session, May 1985.

Commerce and Housing
Other Business and Commerce

TAX CREDIT FOR EMPLOYER-PAID
FICA TAXES ON TIPS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.3

0.2

0.5

2007

0.4

0.2

0.6

2008

0.4

0.2

0.6

2009

0.4

0.2

0.6

2010

0.5

0.3

0.8

Authorization

Section 45B.

Description

All employee tip income is treated as employer-provided wages for
purposes of the Federal Unemployment Tax Act (FUTA) and the Federal
Insurance Contributions Act (FICA). For purposes of the minimum wage
provisions, the reported tips are treated as employer-provided wages to the
extent they do not exceed one-half of the minimum wage rate.

A general business tax credit (Section 38) is provided for food or beverage
establishments in an amount equal to the employer's FICA tax obligation
attributable to reported tips in excess of those treated as wages for purposes of
satisfying the minimum wage provisions of the Fair Labor Standards Act.
Tips taken into account are those received from customers in connection with
the providing, delivering, or serving of food or beverages for consumption if
the tipping of employees delivering or serving food or beverages by
customers is customary. A deduction is not permitted for any amount taken
into account in determining the credit. Unused FICA credits may not be
carried back to any taxable year which ended before the date of enactment.

The U.S. Supreme Court held on June 17, 2002, that the Internal Revenue
Service (IRS) may use the aggregate estimation method to calculate a
restaurant's FICA tax liability for unreported tip income. The Supreme
Courts' decision rested on whether the law authorized the IRS to base the
FICA assessment upon its aggregate estimate of all tips paid to its employees,
or whether the law required IRS to determine total tip income by determining
each individual employee's tip income separately, then adding those
determinations together. The Supreme Court found that IRS could use an
estimate as long as the method used was reasonable.

Impact

The provision lessens the cost to business firms that serve food and
beverages for a portion of the employer's portion of their employee's Social
Security taxes. The tax credit operates to reduce tax liability, but not to less
than zero because the credit is non-refundable as a general business credit.
However, the credit may be carried back to tax years ending after August 10,
1993 and forward for 15 years.

The direct beneficiaries of this provision are food and beverage operators.
Some believe that prior law had the unintended effect of employers
discouraging the reporting of all tip income by their employees so as to reduce
the employer's Social Security tax payments. To the extent that tip income is
not reported, both income and Social Security tax revenues are reduced.
Current law poses no additional tax burdens on food and beverage operators
for complete reporting of tip income. To the extent that tips are reported and
Social Security taxes paid, employees may be eligible for larger payments
from the Social Security system when they retire.

Rationale

The credit for employer-paid FICA taxes on tips was first provided by the
Omnibus Budget Reconciliation Act of 1993 (P.L. 101-508). The provision
was not included in the House bill nor in the Senate's amendment. The
provision appeared and was included in the Conference Committee report
without a rationale being offered. Popular press reports indicated that the
purpose was to soften the impact on the restaurant industry for the reduction
of the deductible amount of business meals from 80 to 50 percent also
included in that act.

A provision included in the Small Business Job Protection Act of 1996
(P.L. 104-188) made modifications to the effective date and extended the
provision to employees delivering food or beverages. (Prior law provided the
credit only for tips earned on the premises of an establishment.) The
legislative history of these changes indicates an intent to change the effective
date and that the Treasury's interpretation was not consistent with the
provision as adopted. The Ways and Means committee report stated that it
was appropriate "to apply the credit to all persons who provide food and
beverages, whether for consumption on or off the premises."

Assessment

It is generally argued that tip income is earnings and should be treated the
same as other forms of compensation. Waiters and waitresses as well as
delivery persons are not self-employed individuals and their tip income is part
of their total compensation. Thus, tips are seen as a surrogate wage that
employers might have to pay in their absence. It is argued that all employers
should share equally in the costs of future benefits their employees will
receive under the Social Security program.

Because Social Security taxes are determined with respect to the entire
amount of earnings (including tip income), current law in effect provides a
benefit only to food and beverage employers whose employees receive part of
their compensation in the form of tips. Even other businesses whose
employees receive a portion of their compensation in the form of tip income
(such as cab drivers, hairdressers, etc.) are barred from use of this tax credit.
Thus, the provision violates the principle of horizontal equity. Since all other
employers pay Social Security taxes on the entire earnings of their employees,
it may place them at a competitive disadvantage. For example, a carry-out
food concern where tipping is not usual pays the full costs of Social Security
taxes while a sit-down diner does not. In effect, a portion of the Social
Security taxes paid by food and beverage employers reduces business income
taxes. To the extent business taxes are reduced, funds are taken from federal
tax receipts to fund future Social Security benefits. Thus, taxpayers at large
are paying a portion of the Social Security taxes of those firms using the
employer tip tax credit.

The restaurant industry maintains that tip income is not a wage but a gift
between their employees and the customers that they serve. They also
contend that if the tip income is seen as compensation, then they should be
able to count all tip income in determining the minimum wage (current law
allows only one-half the minimum wage to be counted from tip income). The
industry argues that having to report the tip income of their employees places
large administrative costs upon their operations and has shifted the burdens of
reporting and collection from the individual to the restaurant.

Selected Bibliography

Allen, Robin Lee. "FICA Troubles are Back: Operators Arm for Fight"
Nation's Restaurant News, vol. 28, January 31, 1994, pp. 1, 52.
Bennett, Alison. "IRS to Resume Employer-Only Tip Audits; Agency
Expanding Tip Reporting Program," Daily Tax Report, Bureau of National
Affairs, Inc., No. 82, April 27, 2000, pp. GG-1-GG-2.
Crowson, Christopher. "Service with a Chagrin: The Problem of Aggregate
Estimates of Unreported Tips in the United States v. Fior D'Italia, Inc.," The
Campbell Law Review, vol. 25, no. 93, Fall 2002, pp. 93-114.
Donovan, Jeremiah S. "Tax-Exempt Organizations and Claiming the Tip
Credit," Tax Adviser, vol. 30, August 1999, pp. 552-553.
Erickson, Jennifer M. "Fior D'Italia: The "Taxing" Problem of Unreported
Tip Income," Iowa Law Review, vol. 88, no. 655, March 2003, pp. 655-679.
Fesler, Dan R. and Larry Maples. "Fior D'Italia: Supreme Court Approves
Aggregate Method on Tips," Taxes, vol. 80, no. 11, November 2002, pp. 53-
59.
McInnes, John T. "Internal Revenue - IRS Aggregate Estimates of
Unreported Employee Tip Income to Determine Employer FICA Liability
Now Constitutional - United States v. Fior D'Italia, Inc.," Suffolk Journal of
Trail and Appellate Advocacy, vol. 8, 2003, pp. 179-188.
Myers, Robert J. "Social Security in the Pork Barrel: The Restaurateurs
Try To Raid the Treasury," Tax Notes, v 59, April 19, 1993. p. 427-428.
Peckron, Harold S. "The Tip Police: Aftermath of the Fior D'Italia Rule,"
Catholic University Law Review, vol. 52, no. 1, Fall 2002, pp. 1-36.
Raby, Burgess J.W. and William L. Raby. "The War on Unreported Cash
Tips," Tax Notes, vol. 81, November 2, 1998, pp. 605-609.
Rosenthal, Ellin. "IRS, Restaurateurs Clash Over FICA Credit on Tip
Income," Tax Notes, vol. 63, April 4, 1994. Pp. 16-17.
Sher, David Lupi. "Forces are Mounting Against IRS's Tip Income
Policies," Tax Notes, vol. 84, August 2, 1999, pp. 675-680.
Simpson, Glenn R. "Special Delivery; Pizza Makers' Success On Tax
Break Reveals a Slice of Political Life; Bet Before 1994 Elections Paid Off
Big After GOP Took Control of Congress; Roots in Health-Care Debate,"
Wall Street Journal, September 9, 1996, pp. A1, A7.
Suelzer, Ray. "IRS Hopes to Get Employee TIP Reporting on `TRAC',"
Taxes, vol. 73, August 1995, pp. 463-467.
U.S. Congress, Congressional Budget Office. Budget Options. "Replace
the Income Tax Credit with a Business Deduction for Employer FICA on
Certain Tip Income." Washington, DC: February 2001, p. 436.
U.S. Congress, Joint Committee on Taxation. "Present Law and
Background Relating to the Tax Treatment of Tip Income." Washington,
DC: July 13, 2004, pp. 1-7.
Wolf, Kelley. "IRS May Collect Employment Taxes on Aggregated
Amount of Unreported Tip Income," Taxes, vol. 78, June 2000, pp. 35-38.

Commerce and Housing:
Other Business and Commerce

PRODUCTION ACTIVITY DEDUCTION

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.9

2.7

3.6

2007

1.3

3.9

5.2

2008

1.8

5.5

7.3

2009

2.0

5.9

7.9

2010

2.6

7.4

10.0

H.R. 6111 (December 2006) increased the cost by $0.1 billion in
FY2007 and FY 2006.

Authorization

Section 199.

Description

Qualified production activities income is allowed a deduction from taxable
income of 3% in 2005-2006, 6% in 2007-2009, and 9% thereafter. The
deduction cannot exceed total taxable income of the firm and is limited to
50% of wages related to the qualified activity.

Production property is property manufactured, produced, grown or
extracted within the United States. Eligible property also includes domestic
film, energy, and construction, and engineering and architectural services.
For the latter, the services must be produced in the United States for
construction projects located in the United States. The law specifically
excludes the sale of food and beverages prepared at a retail establishment,
transmission and distribution of electricity, gas, and water, and receipts from
property leased, licensed, or rented to a related party. The benefits are also
allowed for Puerto Rico for 2007 and 2008.

There are rules that allow the allocation of the deduction to pass through
entities and cooperatives. The provision also allows the revocation without
penalty of a prior election to treat timber cutting as the sale of a capital asset.
The deduction is also allowed under the alternative minimum tax. The tax
expenditure is the tax savings due to the deduction.

Impact

This provision lowers the effective tax rate on the favored property, in most
cases when fully phased in, from the top corporate tax rate of 35% to 31.85%.
The deduction is available to both corporations and unincorporated
businesses, but primarily benefits corporations. For the many proprietorships
that have few or no employees, the benefit will be limited or absent because
of the wage requirement unless the firm incorporates.

In a letter dated September 22, 2004 to Mark Prator and Patrick Heck,
responding to a query about the similar (although slightly different) Senate
version of the provision, the Joint Tax Committee indicated that three quarters
of the benefit would have gone to corporations, 12 percent would have gone
to Subchapter S firms (smaller incorporated firms that elect to be treated as
partnerships) and cooperatives, 9 percent would have gone to partnerships,
and 4 percent to sole proprietorships. Based on the revenue estimates ($3
billion for 2006) and projected corporate tax receipts of $249 billion for that
year, the implication is that around a third of corporate activity qualifies.

The beneficial treatment given to income from these activities will
encourage more investment in manufacturing and other production activities
and less in sales and services. It will also encourage more equity investment
in the affected sectors.

Rationale

This provision was enacted as part of the American Jobs Creation Act of
2004 (P.L. 108-357), a bill that repealed the Extraterritorial Income provision
that was found to be an unacceptable export subsidy by the World Trade
Organization. The stated purpose was to enhance the ability of firms to
compete internationally and to create and preserve manufacturing jobs.

The Tax Increase Prevention Act of 2006 modified the provision by
clarifying that wages for purposes of the deduction limit were those relating to
domestic production activities. H.R. 6111 (December 2006) added the
benefit for Puerto Rico.

Assessment

The provision should somewhat expand the sector qualifying for the
benefit and contract other sectors. It will introduce some inefficiency into the
economy by diverting investment into this area, although it will also primarily
lower the burden on corporate equity investment which is more heavily taxed
than other forms of investment and among qualifying firms reduce the
incentive for debt finance. This latter effect would product an efficiency gain.

Economists in general do not expect that there is a need to use tax
incentives to create jobs in the long run because job creation occurs naturally
in the economy. Nor can tax provisions permanently affect the balance of
trade, since exchange rates would adjust.

There has been concern about the difficulty in administering a tax
provision that provides special benefits for a particular economic activity.
Firms will have an incentive to characterize their activities as eligible and to
allocate as much profit as possible into the eligible categories. A number of
articles written by tax practitioners and letters written to the Treasury indicate
that many issues of interpretation have arisen relating to the definition of
qualified activity, treatment of related firms, and specific products such as
computer software and films and recording. Canada had adopted a similar
provision several years ago and repealed it because of the administrative
complications.

Selected Bibliography

Deloitte Tax LLP. "Producing Results: An Analysis of the New Production
Activities Deduction," Tax Notes, February 21, 2005, pp. 961-984.
Dilley, Steven C. and Fred Jacobs, "The Qualified Production Activities
Deduction: Some Planning Tools," Tax Notes, July 4, 2005, pp. 87-98.
Gravelle, Jane G. Comparison of Tax Incentives for Domestic
Manufacturing in Current Legislative Proposals. Library of Congress,
Congressional Research Service Report RL32103, Washington, DC: October
1, 2004.
Jenks, Carl M. "Domestic Production Deduction: FAQs and a Few
Answers," Tax Notes, August 28, 2006, pp. 751-757.
Rojas, Warren. "New Manufacturing Deduction Presents Many Open
Questions." Tax Notes, October 18, 2004, pp. 279-280.
U.S. Congress, House, Conference Report on the American Jobs Creation
Act, Report 108-77, Washington, DC: U.S. Government Printing Office,
2004.

Commerce and Housing:
Other Business and Commerce

DEDUCTION OF CERTAIN FILM AND TELEVISION
PRODUCTION COSTS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

(1)

0.1

2007

(1)

0.1

2008

(1)

0.1

2009

(1)

2010

(1)

(1) Less than $50 million.

Authorization

Section 181.

Description

The cost of producing films and television programs must be depreciated
over a period of time using the income forecast method (which allows
deductions based on the pattern of expected earnings). This provision allows
production costs for qualified film and television shows to be deducted when
incurred. Eligible productions are restricted to those with a cost of $15
million or less ($20 million if produced in certain designated low income
areas) and in which at least 75 percent of the compensation is for services
performed in the United States. The provision expires after 2008. Only the
first 44 episodes of a television series qualify, and sexually explicit
productions are not eligible.

Impact

Expensing provides a benefit because deductions can be taken earlier. For
example, at a seven percent interest rate, the value of taking a deduction
currently is 40 percent greater than taking a deduction five years from now
(1+.07)5. The benefit is greatest per dollar of investment for those
productions whose expected income is spread out over a long period of time
and whose production period is lengthy. This provision encourages film and
television producers to locate in the United States and counters the growth in
so-called "runaway" production.

The dollar ceiling targets the benefit to smaller productions. The average
cost of producing a movie for theatrical release in 2003 (by members of the
Motion Picture Association of America) was $63.8 million, so that many of
these movie productions would not qualify. One study found that made-for-
television movies and mini-series, in particular, have experienced relocation
abroad, and that most of this business has gone to Canada. Many countries,
including Canada, provide subsidies for production.

Rationale

This provision was enacted as part of the American Jobs Creation Act of
2004 (P.L. 108-357). The purpose was to discourage the "runaway"
production of film and television production to other countries, where tax and
other incentives are often offered.

Assessment

This provision will provide an incentive to remain in the United States, at
least for firms that are profitable enough to have tax liability. The magnitude
of the benefit depends on the average lag time from production to earning
income. If that lag is five years and the discount rate is seven percent, for
example, the value of the deduction is increased by 40 percent, and with a 35-
percent tax rate, the reduction in cost would be about 14 percent. If the
average lag is only a year, the reduction is slightly over two percent.

In general, special subsidies to industries and activities tend to lead to
inefficient allocation of resources. Moreover, in the long run, providing
subsidies to counter those provided by other countries will not necessarily
improve circumstances, unless they induce both parties to reduce or eliminate
their subsidies. At the same time, individuals who have specialized in film
and television production are harmed when production shifts to other
countries, and the disruption can be significant when caused through
provision of large subsidies or tax incentives.

Because tax subsidies cannot benefit firms that do not have tax liability, the
scope of this provision may be narrower than would be the case with a direct
subsidy.

Selected Bibliography

Beer, Steen C. and Maria Miles, "Relief Effort," Filmmaker Magazine,
Winter 2005, http://www.filmmakermagazine.com/winter2005/
line_items/relief_effort.php
Monitor Corporation, U.S. Runaway Film and Television Production Study
Report, Prepared for the Screen Actors Guild and Directors Guild of America,
Cambridge MA, 1999.
Moore, Schuyler M. "Film-Related Provisions of the American Jobs
Creation Act," Tax Notes, December 20, 2204, pp. 1667-1671.
Motion Picture Association of America. Worldwide Market Research, U.S.
Entertainment Industry: 2003 MPA Market Statistics, 2004.
U.S. Congress, House, Conference Report on the American Jobs Creation
Act, Report 108-77, Washington, DC: U.S. Government Printing Office,
2004.
U.S. Department of Commerce. The Migration of U.S. Film and Television
Production: Impact of "Runaways" on Workers and Small Business in the
U.S. Film Industry, January 18,2001.

Commerce and Housing:
Other Business and Commerce

TAX CREDIT FOR THE COST OF CARRYING TAX-PAID
DISTILLED SPIRITS IN WHOLESALE INVENTORIES

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

(1)

2007

(1)

2008

(1)

2009

(1)

2010

(1)

(1)Less than $50 million.

Authorization

Section 5011.

Description

This credit applies to domestically bottled distilled spirits purchased
directly from the bottler (distilled spirits that are imported in bulk and then
bottled domestically also qualify for the credit) . The credit is calculated by
multiplying the number of cases of bottled distilled spirits by the average tax
financing cost per case for the most recent calender year ending before the
beginning of the taxable year. A case is 12, 80-proof 750-milliliter bottles.
The average tax-financing cost per case is the amount of interest that would
accrue at corporate overpayment rates during an assumed 60-day holding
period on an assumed tax rate of $25.68 per case.

Impact

The excise tax on distilled spirits is imposed when distilled spirits are
removed from the plant where they are produced. In the case of imported
distilled spirits that are bottled, the excise tax is imposed when they are
removed from a U.S. customs bonded warehouse. For distilled spirits
imported in bulk containers for bottling in the United States, the excise tax is
imposed in the same way as for domestically produced distilled spirits, when
the bottled distilled spirits are removed from the bottling plant.

The current federal excise tax rate on distilled spirits is $13.50 per proof
gallon.

Assuming an interest rate in the range of 5 to 6 percent, the tax credit will
save wholesalers approximately $0.25 a case or $0.02 per bottle of distilled
spirit.

Rationale

The tax credit is intended to help equalize the differential costs associated
with wholesaling domestically produced distilled spirits and imported distilled
spirits. Under current law, wholesalers are not required to pay the federal
excise tax on bottled imported spirits until the spirits are removed from a
bonded warehouse and sold to a retailer. The federal tax on domestically
produced distilled spirits, however, is passed forward as part of the purchase
price when the distiller transfers the product to the wholesaler. It is argued
that this raises the cost of domestically distilled spirits to wholesalers relative
to the cost of bottled imported spirits. The credit is designed to compensate
the wholesaler for the foregone interest that could have been earned on the
funds that were used to pay the excise taxes on the domestically produced
distilled spirits being held in inventory.

Assessment

Under current law, tax credits are not allowed for the costs of carrying
products in inventory on which an excise tax has been levied. Normally, the
excise tax that is included in the purchase price of an item is deductible as a
cost when the item is sold.

Allowing wholesalers a tax credit for the interest costs (or float) of holding
excise tax-paid distilled confers a tax benefit to the wholesalers of distilled
spirits that is not available to other businesses that also carry tax-paid
products in inventory. For instance, wholesalers of beer and wine also hold
excise tax-paid products in their inventories and are engaged in similar
income producing activities as wholesalers of distilled spirits, but beer and
wine wholesalers are not eligible for this tax credit.

In addition, given the relatively small size of the credit, the credit is
unlikely to have much effect on price differentials between domestically
produced distilled spirits and imported distilled spirits. The credit is also
unlikely to produce much tax savings for small wholesalers. It is likely that
most of the tax benefits of this credit will accrue to large volume wholesalers
of distilled spirits.

Selected Bibliography

U.S. Congress, Joint Committee on Taxation. Summary Description of the
"Highway Reauthorization and Excise Tax Simplification Act of 2005," Title
V of H.R. 3, as Passed by the Senate on May 17, 2005. JCX-41-05, June 13,
2005, pp. 9-10.
-, Committee of Conference. Safe, Accountable, Flexible, Efficient
Transportation Equity Act: A Legacy for Users. Report 109-203, July 28,
2005, pp. 1132-1133.

Commerce and Housing:
Other Business and Commerce

TAX BENEFITS RELATED TO 2005 HURRICANE DISASTER
COSTS: EXPENSING OF CLEAN-UP COSTS, ADDITIONAL
FIRST YEAR DEPRECIATION, CARRYBACK OF LOSSES; TAX
CREDIT FOR EMPLOYEE RETENTION

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

(1)

0.1

2007

(1)

0.1

2008

(1)

0.1

2009

(1)

2010

(1)

(1) Less than $50 million.

H.R. 6111 (December 2006) increased the cost by $0.2 billion in
FY2009 and FY2010.

Authorization

Section 1400N.

Description

Several provisions provide special allowances for deducting costs relating
to businesses in the Gulf Opportunity Zone (GO Zone), an area of the
Hurricane Katrina official disaster area (which caused significant damage to
the Gulf Coast, including New Orleans, in August of 2005). An employee
retention tax credit is provided for areas affected by subsequent Hurricanes
Wilma and Rita, affecting the Gulf Coast and Florida, as well as Katrina. The
GO Zone is also the core disaster area designated by the Federal Emergency
Management Authority (FEMA) and covers the southern part of Louisiana
and Mississippi, and southwestern counties in Alabama.

The cost of demolition of buildings and the removal of some debris is
normally added to the basis of land which is not depreciable; 50% of the
costs of this nature incurred in the GO Zone after August 28, 2005 and
through 2007 may be deducted. Taxpayers are also allowed to deduct 50%
of the cost of investment in depreciable property (machinery, equipment, and
buildings), with the remaining property depreciated under normal rules.
Property qualifying must commence original use in the GO Zone (used
property qualifies if not previously used in the GO Zone) and must be related
to an active trade or business in the Zone. Property must be placed in service
after August 28, 2005, and before the end of 2007 for equipment and before
the end of 2010 for buildings.

Several provisions increase loss carryback allowances. Generally firms
with losses can carry back losses two years to offset against prior year income,
and forward for 20 years. Certain losses attributable to a disaster can be
treated as if they occurred in the previous taxable year. A three year
carryback is provided for individual casualty losses and for farming
businesses or small businesses in a disaster area. Farming losses can be
carried back five years. For the GO Zone, casualty losses for public utilities,
up to the amount of any net operating loss, may be carried back 10 years, and
public utility casualty losses in general may be treated as if they occurred in
the fifth previous year (effectively a five-year carryback position). For all
businesses, losses attributable to casualty, moving expense for employees,
temporary housing for employees, depreciation and repairs, up to the current
net operating loss can be carried back five years.

Employers are allowed a credit of 40% of up to $6,000 of qualified wages
for employees retained in the Katrina, Rita, and Wilma zone areas, during the
period a business is inoperable.

Impact

The expensing, bonus depreciation, and carryback provisions allow
taxpayers to obtain the tax benefit earlier than would otherwise be the case.
For example, at a seven percent interest rate, the value of taking a deduction
currently is 40 percent greater than taking a deduction five years from now
(1+.07)5. The benefit is greatest per dollar of cost or investment the more
delayed the benefit. For taxpayers who hold property for a long period of
time, for example, the deduction for the clean-up costs will not occur until far
in the future when the property is sold. Bonus depreciation is more valuable
for long-lived assets, such as buildings. The loss carryback provisions are
particularly important for local business in the disaster area where businesses
are less likely to be currently profitable. These provisions encourage
employers to make investments and restore property in the disaster area, as
well as providing financial relief for businesses with losses due to the
Hurricane.

The wage credit encourages and aids employers in keeping employees on
the payroll who cannot perform their jobs because the business is not
operating.

Rationale

The wage retention credit was initially enacted in the Katrina Emergency
Tax Relief Act of 2005, passed in September shortly after the Katrina
disaster. Most of the objective of this initial legislation was to provide tax
relief for victims of the disaster. The wage credit was limited to employers
with fewer than 200 employees. The Gulf Opportunity Zone Act of 2005
extended the wage credit to areas affected by Hurricanes Rita and Wilma, and
eliminated the employee cap. This latter action, in December 2005, also
provided the expensing, bonus depreciation, and carry-back provisions. This
act was more specifically directed at rebuilding the disaster area by providing
targeted subsidies to business. H.R. 6111 (December 2006) extended the
placed in service date for buildings, originally through 2008, through 2010.

Assessment

These provisions will provide some incentive to clean up property and
invest in the targeted area. It will also afford relief for employers who retain
workers as well as an incentive to do so. The evidence based on previous
studies of enterprise zone provisions targeted at poor areas does not indicate
that tax incentives are very successful. However, experience in a low-income
area, usually of a city, may not provide sufficient evidence on the effects in a
much larger geographic area composed of higher and lower income areas that
is affected by a major disaster. It is difficult to determine how effective these
provisions are or may be.

The extended loss provisions are likely to be important to providing any
other tax subsidies since many firms are likely to be unprofitable in the short
run. Applying bonus depreciation to buildings yields a much larger cost
reduction than for equipment, since depreciation for buildings occurs over 39
years for commercial structures and 27.5 for residential structure.
Depreciation for equipment is typically five to seven years. The inclusion of
buildings may be particularly important for New Orleans and to a disaster
area where buildings were destroyed.

In general, special subsidies to industries and activities tend to lead to
inefficient allocation of resources and the argument can be made that market
forces should be relied upon to determine what rebuilding should take place.
At the same time, one can make the case that all taxpayers should assist in
recovery of an area affected by such a large scale disaster, as a part of national
risk-spreading.

Selected Bibliography

Gravelle, Jane G. "Tax Incentives in the Aftermath of Hurricane Katrina,"
Municipal Finance Journal, v. 26, Fall 2005, pp. 1-13.
Gravelle, Jane, Tax Policy Options After Hurricane Katrina, Library of
Congress, Congressional Research Service Report RL33088, October 23,
2006.
Internal Revenue Service, Information for Taxpayers Affected by
Hurricanes Katrina, Wilma and Rita, Publication 4492, January 1, 2006.
Richardson, James A. "Katrina/Rita: The Ultimate Test for Tax Policy?"
National Tax Journal, v. 59, September 2006, pp.551-560.
Stoker, Robert P. and Michael J. Rich. Lessons and Limits: Tax
Incentives and Rebuilding the Gulf Coast After Katrina, Metropolitan Policy
Program, Washington, DC: The Brookings Institution, August 2006.
U.S. Congress, Joint Committee on Taxation, Technical Explanation of the
Revenue Provisions of H.R. 4400, The Gulf Opportunity Zone Act of 2005, As
Passed by the House of Representatives and the Senate, JC88-05,
Washington, DC, December 16, 2005.

Transportation

EXCLUSION OF INTEREST ON STATE AND LOCAL
GOVERNMENT BONDS FOR HIGHWAY PROJECTS AND
RAIL-TRUCK TRANSFER FACILITIES

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

(1)

2007

(1)

2008

(1)

2009

(1)

2010

(1)

(1) Less than $50 million.

Authorization

Sections 103, 141, 142, and 146.

Description

The Safe, Accountable, Flexible, Efficient Transportation Equity Act: A
Legacy for Users, P.L. 109-59, enacted on August 10, 2005, created a new
class of tax-exempt, qualified private activity bonds for the financing of
qualified highway or surface freight transfer facilities. Qualified facilities
include: (1) any surface transportation project which receives federal
assistance under title 23; (2) any project for an international bridge or tunnel
for which an international entity authorized under federal or State law is
responsible and which receives federal assistance under title 23; and (3) any
facility for the transfer of freight from truck to rail or rail to truck (including
any temporary storage facilities directly related to such transfers) which
receives federal assistance under title 23 or title 49. The bonds used to
finance these facilities are classified as private-activity bonds rather than
governmental bonds because a substantial portion of the benefits generated by
the project(s) accrue to individuals or business rather than to the government.
For more discussion of the distinction between governmental bonds and
private-activity bonds, see the entry under General Purpose Public
Assistance: Exclusion of Interest on Public Purpose State and Local Debt.

Bonds issued for qualified highway or surface freight transfer facilities are
not subject to the federally imposed annual State volume cap on private-
activity bonds. The bonds are capped, however, by a national limitation of
$15 billion to be allocated at the discretion of Secretary of Transportation.

Impact

Since interest on the bonds is tax exempt, purchasers are willing to accept
lower before-tax rates of interest than on taxable securities. These low-
interest rates allow issuers to construct highway or surface freight transfer
facilities at lower cost. Some of the benefits of the tax exemption and federal
subsidy also flow to bondholders. For a discussion of the factors that
determine the shares of benefits going to bondholders and users of the
highway or surface freight transfer facilities, and estimates of the distribution
of tax-exempt interest income by income class, see the "Impact" discussion
under General Purpose Public Assistance: Exclusion of Interest on Public
Purpose State and Local Debt.

Rationale

Before 1968, State and local governments were allowed to act as conduits
for the issuance of tax-exempt bonds to finance privately owned and operated
facilities. The Revenue and Expenditure Control Act of 1968 (RECA 1968),
however, imposed tests that restricted the issuance of these bonds. The Act
provided a specific exception which allowed issuance for specific projects
such as non-government-owned docks and wharves. Intermodal facilities are
similar in function to docks and wharves, yet were not included in the original
list of qualified facilities. The addition of truck-to-rail and rail-to-truck
intermodal projects to the list of qualified private activities in 2005 is
intended enhance the efficiency of the nation's long distance freight transport
infrastructure. With more efficient intermodal facilities, proponents suggest
that long distance truck traffic will shift from government financed interstate
highways to privately owned long distance rail transport.

Assessment

State and local governments tend to view these facilities as potential
economic development tools. The desirability of allowing these bonds to be
eligible for tax-exempt status hinges on one's view of whether the users of
such facilities should pay the full cost, or whether sufficient social benefits
exist to justify federal taxpayer subsidy. Economic theory suggests that to the
extent these facilities provide social benefits that extend beyond the
boundaries of the State or local government, the facilities might be
underprovided due to the reluctance of State and local taxpayers to finance
benefits for nonresidents.

Even if a case can be made for a federal subsidy arising from
underinvesting at the State and local level, it is important to recognize the
potential costs. As one of many categories of tax-exempt private-activity
bonds, those issued for transfer facilities increase the financing cost of bonds
issued for other public capital. With a greater supply of public bonds, the
interest rate on the bonds necessarily increases to lure investors. In addition,
expanding the availability of tax-exempt bonds increases the assets available
to individuals and corporations to shelter their income from taxation.

Selected Bibliography

Frittelli, John. Intermodal Connectors: A Method for Improving
Transportation Efficiency? Library of Congress, Congressional Research
Service Report RL31887. May 3, 2003.
Frittelli, John. Intermodal Rail Freight: A Role for Federal Funding?
Library of Congress, Congressional Research Service Report RL31834.
August 18, 2004.
Maguire, Steven. Private Activity Bonds: An Introduction. Library of
Congress, Congressional Research Service Report RL31457. June 9, 2006.
-. Tax-Exempt Bonds: A Description of State and Local Government
Debt. Library of Congress, Congressional Research Service Report
RL30638. March 10, 2006.
Zimmerman, Dennis. The Private Use of Tax-Exempt Bonds: Controlling
Public Subsidy of Private Activity. Washington, DC: The Urban Institute
Press, 1991.

Transportation

TAX CREDIT FOR
CERTAIN RAILROAD TRACK MAINTENANCE

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.1

2007

0.1

2008

0.1

2009

0.1

2010

(1)

(1) Less than $50 million.

Authorization

Section 45G.

Description

Qualified railroad track maintenance expenditures paid or incurred in a
taxable year by eligible taxpayers are eligible for a 50-percent business tax
credit. The credit is limited to $3,500 times the number of miles of railroad
track owned or leased by an eligible taxpayer. Railroad track maintenance
expenditures are amounts, which may be either repairs or capitalized costs,
spent to maintain railroad track (including roadbed, bridges, and related track
structures) owned or leased as of January 1, 2005, by a Class II or Class III
railroad. Eligible taxpayers are smaller (Class II or Class III) railroads and any
person who transports property using these rail facilities or furnishes property
or services to such a person.

The taxpayer's basis in railroad track is reduced by the amount of the credit
allowed (so that any deduction of cost or depreciation is only on the cost net
of the credit). The credit cannot be carried back to years before 2005. The
credit covers expenditures from 2005-2007.

For 2005-2008 the amount eligible is the gross expenditures not taking into
account reductions such as discounts or loan forgiveness.

Impact

This provision substantially lowers the cost of track maintenance for the
qualifying short line (regional) railroads, with tax credits covering half the
costs for those firms and individuals with sufficient tax liability. According
to the Federal Railroad Administration, as of the last survey in 1993, these
railroads accounted for 25% of the nation's rail miles. These regional
railroads are particularly important in providing transportation of agricultural
products.

Rationale

This provision was enacted as part of the American Jobs Creation Act of
2004 (P.L. 108-357). While no official rationale was provided in the bill,
sponsors of earlier free-standing legislation and industry advocates indicated
that the purpose was to encourage the rehabilitation, rather than the
abandonment, of short line railroads, which were spun off in the deregulation
of railroads in the early 1980s. Advocates also indicated that this service is
threatened by heavier 286,000-pound cars that must travel on these lines
because of inter-connectivity. They also suggested that preserving these local
lines will reduce local truck traffic. These is also some indication that a tax
credit was thought to be more likely to be achieved than grants.

The temporary provision relating to discounts was added by H.R. 6111
(December 2006).

Assessment

The arguments stated by the industry advocates and sponsors of the
legislation are also echoed in assessments by the Federal Railroad
Administration (FRA), which indicated the need for rehabilitation and
improvement, especially to deal with heavier cars. The FRA also suggested
that these firms have particular difficulty with access to bank loans.

In general, special subsidies to industries and activities tend to lead to
inefficient investment allocation since in a competitive economy businesses
should earn enough to maintain their capital. Nevertheless it may be judged
or considered desirable to subsidize rail transportation in order to reduce the
congestion and pollution of highway traffic. At the same time, a tax credit
may be less suited to remedy the problem than a direct grant since firms
without sufficient tax liability cannot use the credit.

Selected Bibliography

Prater, Marvin, The Long Term Viability of Short Line and Regional
Railroads. U.S. Department of Agriculture, Agricultural Marketing Services,
Washington, DC, July 1998.
U.S. Congress, House, Conference Report on the American Jobs Creation
Act, Report 108-77, Washington, DC: U.S. Government Printing Office,
2004.
U.S. Department of Transportation, Federal Railroad Administration.
Need for Railroad Rehabilitation and Improvement Financing. Available
http://www.fra.dot.gov/us/home.

Transportation

DEFERRAL OF TAX ON CAPITAL CONSTRUCTION
FUNDS OF SHIPPING COMPANIES

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.1

2007

0.1

2008

0.1

2009

0.1

2010

(1)

(1)Less than $50 million.

Authorization

Section 7518.

Description

U.S. operators of vessels in foreign, Great Lakes, or noncontiguous
domestic trade, or in U.S. fisheries, may establish a capital construction fund
(CCF) into which they may make certain deposits. Such deposits are
deductible from taxable income, and income tax on the earnings of the
deposits in the CCF is deferred.

When tax-deferred deposits and their earnings are withdrawn from a CCF,
no tax is paid if the withdrawal is used for qualifying purposes, such as to
construct, acquire, lease, or pay off the indebtedness on a qualifying vessel.
A qualifying vessel must be constructed or reconstructed in the United States,
and any lease period must be at least five years.

The tax basis of the vessel (usually its cost to the owner), with respect to
which the operator's depreciation deductions are computed, is reduced by the
amount of such withdrawal. Thus, over the life of the vessel tax depreciation
will be reduced, and taxable income will be increased by the amount of such
withdrawal, thereby reversing the effect of the deposit. However, since gain
on the sale of the vessel and income from the operation of the replacement
vessel may be deposited into the CCF, the tax deferral may be extended.

Withdrawals for other purposes are taxed at the top tax rate. This rule
prevents firms from withdrawing funds in loss years and escaping tax entirely.
Funds cannot be left in the account for more than 25 years.

Impact

The allowance of tax deductions for deposits can, if funds are continually
rolled over, amount to a complete forgiveness of tax. Even when funds are
eventually withdrawn and taxed, there is a substantial deferral of tax that
leads to a very low effective tax burden. The provision makes investment in
U.S.-constructed ships and registry under the U.S. flag more attractive than it
would otherwise be. Despite these benefits, however, there is very little (in
some years, no) U.S. participation in the worldwide market supplying large
commercial vessels.

The incentive for construction is perhaps less than it would otherwise be,
because firms engaged in international shipping have the benefits of deferral
of tax through other provisions of the tax law, regardless of where the ship is
constructed. This provision is likely to benefit higher-income individuals
who are the primary owners of capital (see Introduction for a discussion).

Rationale

The special tax treatment originated to ensure an adequate supply of
shipping in the event of war. Although tax subsidies of various types have
been in existence since 1936, the coverage of the subsidies was expanded
substantially by the Merchant Marine Act of 1970.

Before the Tax Reform Act of 1976 it was unclear whether any investment
tax credit was available for eligible vessels financed in whole or in part out of
funds withdrawn from a CCF. The 1976 Act specifically provided (as part of
the Internal Revenue Code) that a minimum investment credit equal to 50
percent of an amount withdrawn which was to purchase, construct, or
reconstruct qualified vessels was available in 1976 and subsequent years.

The Tax Reform Act of 1986 incorporated the deferral provisions directly
into the Internal Revenue Code. It also extended benefits to leasing, provided
for the minimum 25-year period in the fund, and required payment of the tax
at the top rate.

Assessment

The failure to tax income from the services of shipping normally
misallocates resources into less efficient uses, although it appears that the
effects on U.S. large commercial shipbuilding are relatively small.

There are two possible arguments that could be advanced for maintaining
this tax benefit. The first is the national defense argument - that it is
important to maintain a shipping and shipbuilding capability in time of war.
This justification may be in doubt today, since U.S. firms control many
vessels registered under a foreign flag and many U.S. allies control a
substantial shipping fleet and have substantial ship-building capability that
might be available to the U.S.

There is also an argument that subsidizing domestic ship-building and
flagging offsets some other subsidies - both shipbuilding subsidies that are
granted by other countries, and the deferral provisions of the U.S. tax code
that encourage foreign flagging of U.S.-owned vessels. Economic theory
suggests, however, that efficiency is not necessarily enhanced by introducing
further distortions to counteract existing ones.

Selected Bibliography

Jantscher, Gerald R. Chapter VI- "Tax Subsidies to the Maritime
Industries," Bread Upon The Waters: Federal Aids to the Maritime
Industries. Washington, DC: The Brookings Institution, 1975.
Madigan, Richard E. Taxation of the Shipping Industry. Centreville, MD:
Cornell Maritime Press, 1982.
U.S. Congress, Joint Committee on Taxation. General Explanation of the
Tax Reform Act of 1986, Committee Print, 99th Congress, 2nd session. May
4, 1987, pp. 174-176.
U.S. Department of Treasury. Tax Reform for Fairness, Simplicity, and
Economic Growth, Volume 2, General Explanation of the Treasury
Department Proposals. November, 1974, pp. 128-129.

Transportation

EXCLUSION OF EMPLOYER-PAID
TRANSPORTATION BENEFITS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

4.2

4.0

2007

4.3

4.2

2008

4.4

4.3

2009

4.5

4.4

2010

4.7

4.5

Authorization

Section 132(f).

Description

The value of transit passes provided directly by the employer can be
excluded from employees' income, subject to a monthly limit. This limit was
set at $100 per month for 2001. Each year the limit is adjusted for inflation,
and the adjustment is rounded to the nearest $5. In 2006, the limit was $105
per month. A similar exclusion applies to van pools. The limit applies to the
total of van pool costs and transit passes.

The value of employer-provided parking facilities can be excluded from
employee's income, subject to a monthly limit. This limit was set to $175 per
month in 1998, and the limit is adjusted for inflation each year. The limit was
increased to $205 in 2006.

The employers may choose to provide these benefits in cash, subject to a
compensation reduction arrangement.

Impact

Exclusion from taxation of transportation fringe benefits provides a subsidy
to employment in those businesses and industries in which such fringe
benefits are common and feasible. The subsidy provides benefits both to the
employees (more are employed and they receive higher compensation) and to
their employers (who have lower wage costs). To the extent that this
exemption induces employees to use mass transportation and to the extent that
mass transportation reduces traffic congestion, this exemption lowers
commuting costs.

The parking exclusion is more likely to benefit higher income individuals
than the mass transit and van pool subsidies. For those individuals receiving
benefits, the savings rise with marginal tax rate. The value of the benefit also
depends on the location of the employer: the provision is targeted towards the
taxpayers working in the urbanized areas or other places where transit is
available or parking space is limited.

Rationale

A statutory exclusion for the value of parking was introduced in 1984,
along with exclusions for a number of other fringe benefits. In many cases,
these practices had been long established and generally had been treated by
employers, employees, and the Internal Revenue Service as not giving rise to
taxable income.

Employees clearly receive a benefit from the availability of free or
discounted goods or services, but the benefit may not be as great as the full
amount of the discount. In enacting these provisions, Congress also wanted
to establish limits on the use of tax-free fringe benefits. Prior to enactment of
the provisions, the Treasury Department had been under a congressionally
imposed moratorium on issuance of regulations defining the treatment of
these fringes. There was a concern that without clear boundaries on use of
these fringe benefits, new approaches could emerge that would further erode
the tax base and increase inequities among employees in different businesses
and industries.

The Comprehensive Energy Policy Act of 1992 placed a dollar ceiling on
the exclusion of parking facilities and introduced the exclusions for mass
transit facilities and van pools in order to encourage mass commuting, which
would in turn reduce traffic congestion and pollution.

In 1998 the Transportation Equity Act for the 21st Century increased the
benefits' limits to their current levels and modified their phase-in periods and
inflation adjustment rules. It also allowed employees to elect cash in lieu of
transit benefits.

Assessment

The exclusion subsidizes employment in those businesses and industries in
which transportation fringe benefits are feasible and commonly used.
Because the exclusion applies to practices which are common and may be
feasible only in some businesses and locations, it creates inequities in tax
treatment among different employees and employers. One problem with
taxing directly supplied fringe benefits, such as free or reduced price parking,
is the administrative difficulty in determining fair market value.

Subsidies for mass transit and van pools, and for parking when provided
primarily for car pools, encourage use of mass transportation and may reduce
congestion and pollution. Reductions in commuting costs due to congestion
benefit commuters generally. If these subsidies induce commuters to use
modes of transportation which impose fewer external costs on others, such as
through traffic congestion, then economic efficiency is enhanced. If these
subsidies induce employees to make trips they otherwise would not make, the
overall economic benefit depends on how the increase in personal gain
compares to the external costs generated by such trips.

Selected Bibliography

Hevener, Mary B. "Energy Act Changes to Transportation Benefits, Travel
Expenses, and Backup Withholding." The Tax Executive, November-
December 1992, pp. 463-466.
Kies, Kenneth J. "Analysis of the New Rules Governing the Taxation of
Fringe Benefits," Tax Notes, v. 38. September 3, 1984, pp. 981-988.
McKinney, James E. "Certainty Provided as to the Treatment of Most
Fringe Benefits by Deficit Reduction Act," Journal of Taxation. September
1984, pp. 134-137.
Sunley, Emil M., Jr. "Employee Benefits and Transfer Payments,"
Comprehensive Income Taxation, ed. Joseph A. Pechman. Washington, DC:
The Brookings Institution, 1977, pp. 90-92.
Turner, Robert W. "Fringe Benefits," in The Encyclopedia of Taxation
and Tax Policy (2nd ed.), eds. Joseph J. Cordes, Robert O. Ebel, and Jane G.
Gravelle. Washington, DC: Urban Institute Press, 2005.
U.S. Congress, House. Comprehensive National Energy Policy Act,
Report 102-474, 102d Congress, 2d Session, May 5, 1992.
-, Joint Committee on Taxation. General Explanation of the Revenue
Provisions of the Deficit Reduction Act of 1984. Committee Print, 98th
Congress, 2nd session. December 31, 1984, pp. 838-866.
-, Joint Committee on Taxation. Estimated Budget Effects of the
Conference Agreement Relating to the Transportation Revenue and Trust
Fund Provisions of H.R. 2400 (Title IX). JCX-43-98. May 22, 1998.
-, Senate Committee on Finance. Fringe Benefits, Hearings, 98th
Congress, 2nd session. July 26, 27, 30, 1984.

Internal Revenue Service. Employer's Tax Guide to Fringe Benefits For
Benefits Provided in 2006. Publication 15-B, revised December 2005.
-, Revenue Procedure 2003-85, December 8, 2003.
-, Final Regulation (T.D. 8933) on Qualified Transportation Fringe
Benefits, January 11, 2001.
Hevener, Mary B. "Energy Act Changes to Transportation Benefits, Travel
Expenses, and Backup Withholding." The Tax Executive, November-
December 1992, pp. 463-466.
Kies, Kenneth J. "Analysis of the New Rules Governing the Taxation of
Fringe Benefits," Tax Notes, v. 38. September 3, 1984, pp. 981-988.
McKinney, James E. "Certainty Provided as to the Treatment of Most
Fringe Benefits by Deficit Reduction Act," Journal of Taxation. September
1984, pp. 134-137.
Sunley, Emil M., Jr. "Employee Benefits and Transfer Payments,"
Comprehensive Income Taxation, ed. Joseph A. Pechman. Washington, DC:
The Brookings Institution, 1977, pp. 90-92.
Turner, Robert. "Fringe Benefits," in The Encyclopedia of Taxation and
Tax Policy, eds. Joseph J. Cordes, Robert O. Ebel, and Jane G. Gravelle.
Washington, DC: Urban Institute Press, 1999.
U.S. Congress, House. Comprehensive National Energy Policy Act,
Report 102-474, 102d Congress, 2d Session, May 5, 1992.
-, Joint Committee on Taxation. General Explanation of the Revenue
Provisions of the Deficit Reduction Act of 1984. Committee Print, 98th
Congress, 2nd session. December 31, 1984, pp. 838-866.
-, Joint Committee on Taxation. Estimated Budget Effects of the
Conference Agreement Relating to the Transportation Revenue and Trust
Fund Provisions of H.R. 2400 (Title IX). JCX-43-98. May 22, 1998.
-, Senate Committee on Finance. Fringe Benefits, Hearings, 98th
Congress, 2nd session. July 26, 27, 30, 1984.
Internal Revenue Service. Employer's Tax Guide to Fringe Benefits For
Benefits Provided in 2004. Publication 15-B, revised January 2004.
-, Revenue Procedure 2003-85, December 8, 2003.
-, Final Regulation (T.D. 8933) on Qualified Transportation Fringe
Benefits, January 11, 2001.

Community and Regional Development

NEW YORK CITY LIBERTY ZONE TAX INCENTIVES

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

-0.1

0.4

0.3

2007

0.2

0.4

2008

0.1

0.2

2009

0.2

(1)

0.1

2010

0.1

-0.1

0.0

(1) Negative tax expenditure of less than $50 million.

Authorization

Section 1400L.

Description

The "Liberty Zone" (the Zone) is generally defined as the area in lower
Manhattan in New York City that was directly affected by the September 11,
2001 terrorist attacks. Specifically, the Zone "...is the area located on or
south of Canal Street, East Broadway (east of its intersection with Canal
Street), or Grand Street (east of its intersection with East Broadway) in the
Borough of Manhattan in the City of New York, New York." The tax
incentives include expansion of the Work Opportunity Tax Credit (WOTC)
for small employers in the Zone, accelerated depreciation for Zone
businesses, increased private-purpose tax-exempt bond capacity for New
York (Liberty bonds and special one-time advance refunding); and more
favorable tax treatment of gains realized from the replacement of property in
the Zone. In 2004, P.L. 108-311 extended the Liberty bond program through
January 1, 2010 and extended the additional advance refunding allowance for
bonds financing property in the Zone through January 1, 2006.

Impact

The tax benefits will likely reduce the tax burden on businesses in the
Zone, and some of these benefits will be passed from the business owners in
the Zone to their customers and investors. The impact on the Zone itself will
be positive as business investment shifts to liberty zone businesses, their
workers, and customers. The impact across metropolitan New York region
will probably be less noticeable as most investment in the Zone is likely to be
shifted from planned investment in neighboring areas. Some investment in
the Zone, however, may represent new investment.

Rationale

The "New York City Liberty Zone Tax Incentives" were created by the
"Job Creation and Worker Assistance Act of 2002" (P.L. 107-147). After the
September 11, 2001 terrorist attacks, the livelihood of businesses and workers
in lower Manhattan was severely tested. The Federal Reserve Bank of New
York (FRBNY) estimated the total cost of the September 11th attack to be
between $33 billion and $36 billion through June 2002. The same FRBNY
study estimated that, as a result of the September 11 attacks, the number of
people working in New York City's private sector fell by 51,000 in October
2001 and fell another 41,000 in the period between November 2001 and
March 2002. The Liberty Zone tax incentives are designed to address the
relatively severe economic shock that affected the lower Manhattan region.
Congressional leaders hope that these benefits will help lure investors into
lower Manhattan as well as retain businesses and workers that may otherwise
emigrate away from lower Manhattan.

Assessment

The benefit of expanding the WOTC eases the tax burden on employers in
the Zone who hire qualified new workers. The effectiveness of WOTC,
however, may be limited by the relative cost and complexity of administrative
compliance. For more on the WOTC, see the entry in this volume titled:
"Work Opportunity Tax Credit." The accelerated depreciation provision for
Zone businesses will lower the cost of capital but only through deferral of the
tax that would have been due under the normal depreciation schedule.
Businesses that use the bonus depreciation will pay less taxes today, but the
tax burden in the future will be slightly higher as depreciation expenses are
smaller than they would have otherwise been (note the negative tax
expenditure in 2009 and 2010). The tax benefit, therefore, is the present
value of the tax deferred. The accelerated depreciation may induce some
firms in the Zone to invest in new capital, however, the magnitude of the
impact of the incentive is uncertain. For more on accelerated depreciation for
business property, see the entry in this volume titled: "Expensing of
Depreciable Business Property."

Increased tax-exempt bond capacity for projects in New York City will
lower the cost of capital for qualified projects. The additional public
infrastructure spending induced by the increased capacity will likely benefit
businesses and workers in the Zone. Many economists, however, would
argue that the new public investment would replace new private investment.
Nevertheless, the subsidy responds to the relatively unique characteristics of
the disruption caused by the September 11 attacks. For more on the subsidy
for tax-exempt bonds, see the entry in this volume titled: "Exclusion of
Interest on State and Local Small-Issue Industrial Development Bonds." The
favorable tax treatment of gains realized from the replacement of property in
the Zone will benefit property owners that replace property damaged in the
Liberty Zone. Generally, only property owners can benefit from this
provision because renters are not eligible. For more on this provision, see the
entry in this volume titled: "Deferral of Gain on Involuntary Conversions
Resulting from Presidentially-Declared Disaster."

Generally, these geographic benefits induce investors to shift investment
spending rather than generate new investment spending. Thus, the localized
tax incentives redistribute tax revenue and investment from all federal
taxpayers to taxpayers in the Zone. From a national perspective, the
economic benefit of geographically based incentives is not clear. However,
taxpayers in the Zone are likely better off with the incentives.

Selected Bibliography

Bram, Jason, "New York City's Economy Before and After September
11," Federal Reserve Bank of New York: Current Issues in Economics and
Finance, February 2003.
Bram, Jason, James Orr and Carol Rappaport. "Measuring the Effects of
the September 11 Attack on New York City." Federal Reserve Bank of New
York Economic Policy Review, November 2002.
Chernick, Howard, and Andrew F. Haughwout, "Tax Policy and the Fiscal
Cost of Disasters: NY and 9/11," National Tax Journal, v. 59, September
2006, pp.561-578.
Glaeser, Edward L. and Jesse M. Shapiro. "Cities and Warfare: The
Impact of Terrorism on Urban Form." NBER Working Paper Series 8696,
National Bureau of Economic Research, December 2001.
Maguire, Steven. Private Activity Bonds: An Introduction. Library of
Congress, Congressional Research Service Report RL31457. November 10,
2004.
New York City Independent Budget Office, "Despite Economic Upturn,
City Still Faces Budget Shortfalls," Fiscal Outlook, Dec. 2003.
Thompson, William C., "NYC Outperforms the Nation in 1Q04 - First
Time Since 4Q99,"Economic Notes, v. 12, no. 2, June 2004.
U.S. Congress, Joint Committee on Taxation. Technical Explanation of
the Job Creation and Worker Assistance Act of 2002, (JCX 12-02), March 6,
2002.

U.S. General Accounting Office, Tax Administration: Information is Not
Available to Determine Whether $5 Billion in Liberty Zone Tax Benefits Will
be Realized. Report GAO-03-1102, October 2003.
Wildasin, David. "Local Public Finance in the Aftermath of September
11." Journal of Urban Economics, v. 51 (March 2002), pp. 225-237.

Community and Regional Development

EMPOWERMENT ZONE TAX INCENTIVES,
DISTRICT OF COLUMBIA TAX INCENTIVES,
AND INDIAN RESERVATION TAX INCENTIVES

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.3

0.7

1.0

2007

0.4

0.7

1.1

2008

0.4

0.5

0.9

2009

0.4

0.5

0.9

2010

0.2

0.3

0.5

Source: U.S. Congress, Joint Committee on Taxation, Estimated Revenue
Effects Of H.R. 4297, The "Tax Relief Extension Reconciliation Act Of 2005,"
As Reported By The Committee On Ways And Means, JCX-81-05, November
18, 2005. H.R. 6111 (December 2006) increased the cost for Fiscal Years
2007-2009 by $0.6, $0.4, and $0.1, and reduced it by $0.1 in
FY2010.

Authorization

Sections 38(b), 39(d),45A, 168(j), 280C(a), 1391-1397D, 1400-1400B.

Description

Empowerment Zone (EZ) and Enterprise Community (EC) tax incentives
were originally created by the Omnibus Budget Reconciliation Act of 1993
and expanded by the Taxpayer Relief Act of 1997 (TRA). The EZ/EC
program was expanded again by the Community Renewal Act of 2000. That
act also harmonized the eligibility rules for EZs/ECs and created a new
geography-based tax incentive program for so-called Renewal Communities
(RC). There are currently authorized 40 EZs (30 urban and 10 rural), 95 ECs
(65 urban and 30 rural), and 40 RCs (28 urban and 12 rural). The District of
Columbia EZ was also authorized in the TRA and is afforded the same tax
incentives as the other EZs. The DC Enterprise Zone incentives were
extended through December 31, 2005 by P.L. 108-311 and through 2007 by
H.R. 6111 (December 2006).

Designated areas must satisfy eligibility criteria including poverty rates and
population and geographic size limits; they will be eligible for benefits
through December 31, 2009.

For empowerment zones, the tax incentives include a 20 percent employer
wage credit for the first $15,000 of wages for zone residents who work in the
zone, $35,000 in expensing of equipment in investment (in addition to the
amount allowed generally) in qualified zone businesses, and expanded tax
exempt financing for certain zone facilities, primarily qualified zone
businesses.

In addition, qualified public schools in enterprise communities and
empowerment zones are allowed access to qualified zone academy bonds
(QZABs). QZABs are bonds designated for school modernization and
renovation where the federal government offers annual tax credits to the
bondholders in lieu of interest payments from the issuer. The Federal
Government is effectively paying the interest on the bonds for the state or
local governments. For more on QZABs, see the tax expenditure entry "Tax
Credit for Holders of Qualified Zone Academy Bonds" under the Education,
Training, Employment, and Social Services heading.

Businesses in RC are allowed a 15 percent wage credit on the first $10,000
of wages for qualified workers and an additional $35,000 in capital
equipment expensing. These qualified businesses are also allowed partial
deductibility of qualified buildings placed in service. Renewal community
tax benefits are available through December 31, 2009.

Enterprise communities receive only the tax exempt financing benefits.
Tax exempt bonds for any one community cannot exceed $3 million and
bonds for any one user cannot exceed $20 million for all zones or
communities. Businesses eligible for this financing are subject to limits that
target businesses operating primarily within the zones or communities.

Businesses on Indian reservations are eligible for accelerated depreciation
and for a credit for 20 percent of the cost of the first $20,000 of wages (and
health benefits) paid by the employer to tribal members and their spouses, in
excess of eligible qualified wages and health insurance cost payments made in
1993. These benefits are available for wages paid, and for property placed in
service before December 31, 2007.

In 1997 several tax incentives for the District of Columbia were adopted: a
wage tax credit of $3,000 per employee for wages paid to a District resident,
tax-exempt bond financing, and additional first-year expensing of equipment.
These apply to areas with poverty rates of 20 percent or more. There is also a
zero capital gains rate for business sales in areas with 10 percent poverty
rates. Those provisions were available through December 31, 2007. (A
credit for first-time home buyers adopted at that time is discussed under the
Commerce and Housing heading.)

Impact

Both businesses and employees within the designated areas may benefit
from these provisions. Wage credits given to employers can increase the
wages of individuals if not constrained by the minimum wage, and these
individuals tend to be lower income individuals. If the minimum wage is
binding (so that the wage does not change) the effects may show up in
increased employment and/or in increased profits to businesses.

Benefits for capital investments may be largely received by business
owners initially, although the eventual effects may spread to other parts of the
economy. Eligible businesses are likely to be smaller businesses because they
must operate within the designated area.

Rationale

These geographically targeted tax provisions were adopted in 1993,
although they had been under discussion for some time and had been included
in proposed legislation in 1992. Interest in these types of tax subsidies
increased after the 1992 Los Angeles riots.

The objective of the subsidies was to revitalize distressed areas through
expanded business and employment opportunities, especially for residents of
these areas, in order to alleviate social and economic problems, including
those associated with drugs and crime. Some of these provisions are
temporary and have been extended, most recently in December 2006 by H.R.
6111.

Assessment

The geographically targeted tax provisions should encourage increased
employment and income of individuals living and working in the zones and
increased incentives to businesses working in the zones. The small
magnitude of the program may be appropriate to allow time to assess how
well such benefits are working; current evidence does not provide clear
guidelines.

If the main target of these provisions is an improvement in the economic
status of individuals currently living in these geographic areas, it is not clear
to what extent these tax subsidies will succeed in that objective. None of the
subsidies are given directly to workers; rather they are received by businesses.
Capital subsidies may not ultimately benefit workers; indeed, it is possible
that they may encourage more capital intensive businesses and make workers
worse off. In addition, workers cannot benefit from higher wages resulting
from an employer subsidy if the wage is determined by regulation (the
minimum wage) and already artificially high. Wage subsidies are more likely
than capital subsidies to be effective in benefitting poor zone or community
residents.

Another reservation about enterprise zones is that they may make
surrounding communities, that may also be poor, worse off by attracting
businesses away from them. And, in general, questions have been raised
about the target efficiency of provisions that target all beneficiaries in a poor
area rather than poor beneficiaries in general.

Selected Bibliography

Bondino, Daniele and Robert T. Greenbaum, "Decomposing the Impacts:
Lessons from a Multistate Analysis of Enterprise Zone Programs," John
Glenn Working Paper Series, The Ohio State University, Working Paper,
June 2005.
Cordes, Joseph J., and Nancy A. Gardner. "Enterprise Zones and Property
Values: What We Know (Or Maybe Don't)." National Tax Association
Proceedings, 94th Annual Conference on Taxation. Washington, DC:
National Tax Association, 2002, pp. 279-287.
Couch, Jim F., and J. Douglas Barrett. "Alabama's Enterprise Zones:
Designed to Aid the Needy?" Public Finance Review, v. 32, no. 1 (January
2004), pp. 65-81.
-, Keith E. Atkinson, and Lewis H. Smith, "The Impact of Enterprise
Zones on Job Creation in Mississippi," Contemporary Economic Policy, v.
23, April, 2005, pp. 255-260.
Fisher, Peter S., and Alan H. Peters. "Tax and Spending Incentives and
Enterprise Zones." New England Economic Review (March-April 1997), pp.
109-130.
Garrison, Larry R. "Tax Incentives for Doing Business on Indian
Reservations." Taxes-The Magazine (May 2002), pp. 39-44.
Greenbaum, Robert. "Siting it Right: Do States Target Economic Distress
When Designating Enterprise Zones?" Economic Development Quarterly
(February 2004), pp. 67-80.
Greenbaum, Robert T. and John B. Engberg, "The Impact of State
Enterprise Zones on Urban Manufacturing Establishments," Journal of Policy
Analysis and Management, v. 23, spring 2004, pp. 315-339.
Hirasuna, Don and Joel Michel, "Enterprise Zones: A Review of the
Economic Theory and Empirical Evidence, " Policy Brief, Minnesota House
of Representatives Research Department, January 2005.

Papke, Leslie. "Enterprise Zones," in The Encyclopedia of Taxation and
Tax Policy, ed. Joseph J. Cordes, Robert W. Ebel, and Jane G. Gravelle
(Washington, D.C.: The Urban Institute, 2005).
- . "What Do We Know About Enterprise Zones?" In Tax Policy and the
Economy V. 7, ed. James Poterba, National Bureau of Economic Research,
Cambridge: MIT Press, 1993.
Rogers, Cynthia and Jill L. Tao, "Quasi-Experimental Analysis of Targeted
Economic Development Programs: Lessons from Florida," Economic
Development Quarterly, v. 18, August 2004, pp. 269-285.
Stoker, Robert P. And Michael J. Rich. "Lessons and Limits: Tax
Incentives and Rebuilding the Gulf Coast After Katrina," The Brookings
Institution, Survey Series, August 2006.
Sullivan, Martin A. D.C.: A Capitalist City? Arlington, VA: Tax
Analysts, 1997.
U.S. Congress, House Committee on Banking, Finance and Urban Affairs,
Subcommittee on Economic Growth and Credit Formation. The
Administration's Empowerment Zone and Enterprise Community Proposal.
Hearing, 103d Congress, 1st Session, May 27 and June 8, 1993.
-, Joint Committee on Taxation. Description of Present Law Regarding
Tax Incentives for Renewal Communities and Other Economically Distressed
Areas. (JCX-40-02), May 20, 2002.
-, Joint Committee on Taxation. General Explanation of Tax Legislation
Enacted in 1997. 105th Congress, 1st Session. Washington, DC: U.S.
Government Printing Office, December 17, 1997.
U.S. Government Accountability Office, Empowerment Zone and
Enterprise Community Program: Improvements Occurred in Communities,
but the Effect of the Program is Unclear, GAO-06-727, September 2006.
U.S. Department of Housing and Urban Development, Interim Assessment
of the Empowerment Zones and Enterprise Community (EZ/EC) Program: A
Progress Report and Appendices, November 2001.
Wilder, Margaret G. and Barry M. Rubin, "Rhetoric versus Reality: A
Review of Studies on State Enterprise Zone Programs." Journal of the
American Planning Association, v. 62, Autumn, 1996, pp. 473-490.

Community and Regional Development

NEW MARKETS TAX CREDIT AND
RENEWAL COMMUNITY TAX INCENTIVES

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.6

0.4

1.0

2007

0.8

0.5

1.3

2008

0.9

0.6

1.5

2009

0.9

0.5

1.5

2010

0.7

0.5

1.2

H.R. 6111 (December 2006) increased the loss by $0.1 billion
in FY2008 and $0.2 billion in FY2009.

Authorization

Sections 45D, 1400F, 1400H, 1400I, and 1400J.

Description

The New Markets Tax Credit (NMTC) is designed to generate private
sector equity investment to encourage private sector investment in
low-moderate income rural and urban communities nationwide. T he NMTC
is available for investors who invest in community development entities
(CDEs). The NMTC is a tax credit for investors equal to 5 percent of their
initial investment in the calendar year they made the investment. The credit
rates remains at 5 percent for the next two years and is then increased to 6
percent for each of four more years. The maximum amount of annual
investment eligible for the credit is $1.5 billion in 2002 and 2003; $2.0 billion
in 2004 and 2005; and $3.5 billion in 2006 through 2008.

In contrast to the NMTC, Renewal Community (RC) tax incentives target
businesses directly. The four RC tax incentives for businesses are (1) that
gains from the sale of assets designated as RC business are taxed at 0 percent,
(2) that a qualified RC business is eligible for a Federal tax credit worth 15
percent of the first $10,000 of wages for each qualified employee hired by the
RC business, (3) that each state can allocate up to $12 million for
"commercial revitalization expenditures" for businesses in a RC, and (4) that
RC businesses can claim up to $35,000 in section 179 expensing for qualified
RC property.

Impact

The NMTC is an investment credit. Thus investors, who are likely in
higher income brackets, are the direct beneficiaries. Business owners are the
direct beneficiaries of the RC tax incentives. Business owners, like investors,
are also likely to fall in higher income brackets. Nevertheless, the tax
incentives would likely encourage investment spending in economically
distressed communities. The additional investment would indirectly benefit
the workers and residents of these communities. A more direct means of
providing assistance to individuals in distressed communities might entail
direct aid to individuals.

Rationale

The Renewal Community provisions and the NMTC were enacted by the
Community Renewal Tax Relief Act of 2000 (P.L. 106-544). The tax
incentives in the RC legislation are designed to lower the cost of capital and
labor for RC businesses relative to non-RC businesses. Policymakers hope
the incentives will encourage investment in RC businesses and help lower the
cost of doing business in Renewal Communities. The NMTC is designed to
provide tax relief to investors in economically distressed communities through
providing a more certain rate of return with fixed credit rates. H.R. 6111
(December 2006) extended the RC coverage through 2008 and required that
non-metropolitan counties receive a proportional allocation.

Assessment

The NMTC program is still relatively new, so an evaluation of the
program's effectiveness difficult. The Community Development Financial
Institutions Fund (the CDFI Fund), which operates the MNTC program,
reports that as of December 31, 2004, New Markets Tax Credit allocatees had
raised nearly $1.5 billion in private equity to invest in low income
communities and invested $1.3 billion of that amount, with 99 percent of the
funds going into severely distressed communities. The CDFI also reports that
the businesses receiving funds are projected to create 3,000 full-time
equivalent jobs and are projected to develop or rehabilitate 13 million square
feet of commercial real estate, while generating 33,000 construction jobs.

The relative size of the credit program, however, may limit its influence on
economic growth and development in distressed communities. According to
a 2002 General Accounting Office (GAO) report, the $15 billion of potential
new investment over seven years must be assessed against the fact that the
potential target area includes approximately 35 percent of the U.S. population
and 40 percent of the land area. In addition, the fixed credit rate, 5 percent
for the first three years and 6 percent for the four final years, may not be
enough to compensate investors for the underlying risk of the principal
investment.

The capital gain exclusion for RC businesses may shift investment into the
RC. Investors could invest more money in a RC business because the after-
tax return is higher that for than similar investments in non-RC businesses.
The higher after-tax return will, in theory, encourage more investment in RC
businesses, perhaps at the expense of businesses just outside the RC. The
employee tax credit for RC businesses may encourage hiring the workers that
qualify under the program. The Federal tax credit should lower the per unit
labor costs of the RC business and may lead to either more workers being
hired or more hours worked. The relatively small size of the credit may limit
the impact on overall employment in the Renewal Community.

RC businesses that realize a tax savings for rehabilitation expenses
immediately, rather than over time, potentially encouraging more renovation.
The RC businesses could decide to renovate because the immediate tax
savings increases the after-tax rate of return on those expenditures. In short, a
tax savings today is worth more than an equal tax savings earned in the
future. The accelerated depreciation incentive is similar to the rehabilitation
tax benefit. The RC business realizes a tax saving because it can deduct the
entire cost of the capital equipment (and receive the tax savings) immediately
rather than in increments spread into the future. The accelerated depreciation
should lower the cost of capital and encourage more capital investment by RC
businesses.

Selected Bibliography

Armistead, P. Jefferson. "New Markets Tax Credits: Issues and
Opportunities," prepared for the Pratt Institute Center for Community and
Environmental Development, April 2005.
Cohen, Ann Burstein. "Community Renewal Tax Relief's Act's Incentives
for Investors-Form over Substance?," The Tax Adviser, v. 32, no. 6 (June
2001), pp. 383-384.
- . "Renewal Communities," The CPA Journal, March 2004, pp. 46-53.

Lambert, Thomas E. And Paul A. Coomes. "An Evaluation of the
Effectiveness of Louisville's Enterprise Zone," Economic Development
Quarterly, v. 15, no. 2, (May 2001), pp. 168-180.
Myerson, Deborah L. "Capitalizing on the New Markets Tax Credit," The
Urban Land Institute Land Use Policy Forum Report, September 2003.
Rubin, Julia Sass and Gregory M. Stankiewicz . "The New Markets Tax
Credit Program: A Midcourse Assessment," Federal Reserve Bank of San
Francisco, vol. 1, iss. 1, 2005.
Stoker, Robert P. And Michael J. Rich. "Lessons and Limits: Tax
Incentives and Rebuilding the Gulf Coast After Katrina," The Brookings
Institution, Survey Series, August 2006.
U.S. Congress, House Ways and Means Committee, Manager's Statement
on Community Renewal Tax Relief Act of 2000, statement to accompany
H.R. 5662 as incorporated in H.R. 4577, Dec. 15, 2001.
U.S. Congress, Joint Committee on Taxation. Description of Present Law
Regarding Tax Incentives for Renewal Communities and Other Economically
Distressed Areas, (JCX 40-02), May 20, 2002.
- . Summary of Provisions Contained in the Community Renewal Tax
Relief Act of 2000, (JCX 112-00), December 15, 2000.
U.S. Department of Housing and Urban Development. Tax Incentive
Guide for Businesses in Renewal Communities, Empowerment Zones, and
Enterprise Communities, FY2002.
U.S. Department of the Treasury, Community Development Financial
Institutions Fund (CDFI), The Difference the CDFI Fund Makes, website,
http://www.cdfifund.gov/impact_we_make/overview.asp, visited Oct. 20,
2006.
U.S. General Accounting Office. New Markets Tax Credit Program:
Progress Made in Implementation, But Further Actions Needed to Monitor
Compliance, GAO-04-326, January 30, 2004.
- . New Markets Tax Credit: Status of Implementation and Issues Related
to GAO's Mandated Reports, GAO-03-223R, December 6, 2002.

Community and Regional Development

EXPENSING OF REDEVELOPMENT COSTS IN CERTAIN
ENVIRONMENTALLY CONTAMINATED AREAS
("BROWNFIELDS")

Estimated Revenue Loss (1)

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

2007

2008

2009

2010

(1) In Senate Budget Committee's 2004 tax expenditure compendium,
the Joint Committee on Taxation (JCT) estimated the FY 2005 tax
expenditure at $200 million ($100 for corporations; $100 million for
individuals). Before the one-year extension under the Tax Increase and Relief
Act, that compendium reports an estimated tax expenditure for 2006 of less
than $50 million for corporations and less than $50 million for individuals. A
two year extension of this provision in H.R. 6111 (December 2006) cost $557
million in FY2007, and $123 million in FY2008, and is projected to increase
revenue by $44 million in FY2009 and $52 million in FY2010.

Authorization

Section 198, 280B, and 468, 1221(1), 1245, 1392(b)(4), and 1393(a)(9).

Description

Firms that undertake expenditures to control or abate hazardous substances
in a qualified contaminated business property or site in certain targeted
empowerment zones and enterprise communities are allowed to expense -
deduct the costs against income in the year incurred - those expenditures
that would otherwise be allocated to capital account. Upon the disposition of
the property, the deductions are subject to recapture as ordinary income.
Eligible expenses must be incurred before January 1, 2007. The deduction
applies to both the regular and the alternative minimum tax.

A qualified contaminated site, or "brownfield," is generally defined as any
property that 1) is held for use in a trade or business, and 2) on which there
has been an actual or threatened release or disposal of certain hazardous
substances as certified by the appropriate state environmental agency.
Superfund sites - sites that are on the national priorities list under the
Comprehensive Environmental Response, Compensation, and Liability Act of
1980 - do not qualify as brownfields.

Impact

Immediate expensing provides a tax subsidy for capital invested by
businesses, in this case for capital to be used for environmental cleanup and
community development. Frequently, the costs of cleaning up contaminated
land and water in abandoned industrial or commercial sites are a major barrier
to redevelopment of that site and of the community in general. By expensing
rather than capitalizing these costs, taxes on the income generated by the
capital expenditures are effectively set to zero. This should provide a financial
incentive to businesses and encourage them to invest in the cleanup and
redevelopment of "brownfields"- abandoned old industrial sites and dumps,
including properties owned by the federal and subnational government, that
could and would be cleaned up and redeveloped except for the costs and
complexities of the environmental contamination.

The provision broadens target areas in distressed urban and rural
communities that can attract the capital and enterprises needed to rebuild and
redevelop polluted sites. The tax subsidy is thus primarily viewed as an
instrument of community development, to develop and revitalize urban and
rural areas depressed due to environmental contamination. According to the
Environmental Protection Agency, there are thousands of such sites (30,000
by some estimates) in the United States.

Rationale

Section 198 was added by the Taxpayer Relief Act of 1997 (P.L. 105-34).
Its purpose is threefold: 1) As an economic development policy, its purpose
is to encourage the redevelopment and revitalization of depressed
communities and properties abandoned due to hazardous waste pollution; 2)
as an environmental policy, expensing of environmental remediation costs
provides a financial incentive to clean up contaminated waste sites; and 3) as
tax policy, expensing of environmental remediation costs establishes clear and
consistent rules, and reduces the uncertainty that existed prior to the law's
enactment, regarding the appropriate tax treatment of such expenditures.

The provision was originally to expire at the end of 2000, but was extended
to the end of 2001 by the Tax Relief Extension Act of 1999 (P.L. 106-170). It
was extended again by the Community Renewal Tax Relief Act of 2000 (P.L.
106-554). The provision expired again, this time on January 1, 2003, but was
retroactively extended through December 31, 2005, by the Working Families
Tax Relief Act of 2004 (P.L. 108-311). The Tax Increase Prevention and
Relief Act (P.L. 109-222) extended it through December 31, 2006. It also
expanded the list of hazardous substances to include any petroleum product.
A provision to extend expensing of brownfield costs by either one or two
years is part of so-called "extender" legislation, but these bills have not
moved in Congress partly because of concerns over other controversial tax
measures (such as estate tax cuts). H.R. 6111 in December 2006 extended
the provision through 2007.

Assessment

Section 198 specifically treats environmental remediation expenditures,
which would otherwise be capitalized, as deductible in the year incurred.
Such expenditures are generally recognized to be capital costs, which,
according to standard economic principles, should be recovered over the
income producing life of the underlying asset. As a capital subsidy, however,
expensing is inefficient because it makes investment decisions based on tax
considerations rather than inherent economic considerations.
As a community development policy, the effectiveness of the tax subsidy
has been questioned, as many view the main disincentive to development of
brownfield sites not the costs but rather the potential liability under current
environmental regulation. That is to say the main barrier to development
appears to be regulatory rather than financial. Barring such regulatory
disincentives, the market system ordinarily creates its own incentives to
develop depressed areas, as part of the normal economic cycle of growth,
decay, and redevelopment. As an environmental policy, this type of capital
subsidy is also questionable on efficiency grounds. Many economists believe
that expensing is a costly and inefficient way to achieve environmental goals,
and that the external costs resulting from environmental pollution are more
efficiently addressed by either pollution or waste taxes or tradeable permits.

Selected Bibliography

Carroll, Deborah A., and Robert J. Eger III. "Brownfields, Crime, and Tax
Increment Financing." American Review of Public Administration. December
1, 2006. v. 36. pp. 455-477.
Greenberg, Michael R., and Justin Hollander. "The Environmental
Protection Agency's Brownfields Pilot Program." American Journal of
Public Health. February 2006. v. 96. pp. 277-282.
Jackson, Pamela J. Temporary Tax Provisions ("Extenders") Expired in
2005. U.S. Library of Congress. Congressional Research Service. Report
RS32367, August 4, 2006.
Longo, Alberto, and Anna Alberini. "What Are the Effects of
Contamination Risks on Commercial and Industrial Properties? Evidence
from Baltimore, Maryland." Journal of Environmental Planning and
Management. September 2006. v.49. pp. 713-751.
Northeast-Midwest Institute. National Association of Local Government
Environmental Professionals. Unlocking Brownfields: Keys to Community
Revitalization. October 2004.
Reisch, Mark. Superfund and the Brownfields Issue. Library of Congress,
Congressional Research Service Report 97-731 ENR, Washington, DC, 1997.
-. Brownfields in the 109th Congress. U.S. Library of Congress.
Congressional Research Service. Report RS22502, September 8, 2006.
-. Environmental Cleanup and Development: Brownfield Tax Incentive
Survey. U.S. Library of Congress. Congressional Research Service. CRS
Report RS 21599, August 21, 2003.
-. Brownfield Tax Incentive Extension. U.S. Library of Congress.
Congressional Research Service. CRS Report RS 21599, October 17, 2006.
Segal, Mark A. "Environmental Cleanup Expenditures: An Inquiry Into
Their Proper Tax Treatment." Oil & Gas Tax Quarterly, v. 42, 1994: 715-
729.
Shi, J. Stephen, and Susan H. Cooper. "Tax Treatment of Environmental
Costs." Banking Law Journal v. 112, February. 1995, pp. 165-170.
Sims, Theodore S. "Environmental 'Remediation' Expenses and a Natural
Interpretation of the Capitalization Requirement. National Tax Journal, v.
47, September 1994, pp. 703-718.
Sterner, Thomas. Policy Instruments for Environmental and Natural
Resource Management. Resources for the Future, Washington, 2003.
U.S. Congress, Joint Committee on Taxation. Estimated Budget Effects of
H.R. 5970, the Estate Tax and Extension of Tax Relief Act of 2006
("Etetra"), as Introduced in the House of Representatives on July 28, 2006.
JCX-34-06 July 28, 2006 Washington.
U.S. Treasury Department. Treasury News: Statement of Treasury
Secretary Robert E. Rubin on a New Brownfields Tax Incentive. March 11,
1996. Washington.
Weld, Leonard G., and Charles E. Price. "Questions About the Deduction
of Environmental Cleanup Costs After Revenue Ruling 94-38." Taxes, v. 73,
May 1995, pp. 227-233.

Community and Regional Development

EXCLUSION OF INTEREST ON STATE AND LOCAL
GOVERNMENT BONDS FOR PRIVATE AIRPORTS, DOCKS,
AND MASS-COMMUTING FACILITIES

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.7

0.3

1.0

2007

0.8

0.3

1.1

2008

0.8

0.3

1.1

2009

0.9

0.3

1.2

2010

0.9

0.4

1.3

Authorization

Sections 103, 141, 142, and 146.

Description

Interest income on State and local bonds used to finance the construction of
government-owned airports, docks, wharves, and mass-commuting facilities,
such as bus depots and subway stations, is tax exempt. These airport, dock,
and wharf bonds are classified as private-activity bonds rather than
governmental bonds because a substantial portion of their benefits accrues to
individuals or business rather than to the general public. For more discussion
of the distinction between governmental bonds and private-activity bonds, see
the entry under General Purpose Public Assistance: Exclusion of Interest on
Public Purpose State and Local Debt.

Because private-activity mass commuting facility bonds are subject to the
private-activity bond annual volume cap, they must compete for cap
allocations with bond proposals for all other private activities subject to the
volume cap. The cap is equal to the greater of $80 per capita or $246.6
million in 2006. The cap has been adjusted for inflation since 2003. Bonds
issued for airports, docks, and wharves are not, however, subject to the annual
Federally imposed State volume cap on private-activity bonds. The cap is
forgone because government ownership requirements restrict the ability of the
State or local government to transfer the benefits of the tax exemption to a
private operator of the facilities.

Impact

Since interest on the bonds is tax exempt, purchasers are willing to accept
lower before-tax rates of interest than on taxable securities. These low-
interest rates enable issuers to provide the services of airport, dock, and wharf
facilities at lower cost. Some of the benefits of the tax exemption also flow to
bondholders. For a discussion of the factors that determine the shares of
benefits going to bondholders and users of the airport, dock, and wharf
facilities, and estimates of the distribution of tax-exempt interest income by
income class, see the "Impact" discussion under General Purpose Public
Assistance: Exclusion of Interest on Public Purpose State and Local Debt.

Rationale

Before 1968, State and local governments were allowed to issue tax-
exempt bonds to finance privately owned airports, docks, and wharves
without restriction. The Revenue and Expenditure Control Act of 1968
(RECA 1968) imposed tests that restricted the issuance of these bonds.
However, the Act also provided a specific exception which allowed
unrestricted issuance for airports, docks, and wharves, and mass commuting
facilities.

The Deficit Reduction Act of 1984 allowed bonds for non-government-
owned airports, docks, wharves, and mass-commuting facilities to be tax
exempt, but required the bonds to be subject to a volume cap applied to
several private activities. The volume cap did not apply if the facilities were
"governmentally owned."

The Tax Reform Act of 1986 allowed tax exemption only if the facilities
satisfied government ownership requirements, but excluded the bonds for
airports, wharves, and docks from the private-activity bond volume cap. This
Act also denied tax exemption for bonds used to finance related facilities such
as hotels, retail facilities in excess of the size necessary to serve passengers
and employees, and office facilities for nongovernment employees.

The Economic Recovery Tax Act of 1981 extended tax exemption to mass-
commuting vehicles (bus, subway car, rail car, or similar equipment) that
private owners leased to government-owned mass transit systems. This
provision allowed both the vehicle owner and the government transit system
to benefit from the tax advantages of tax-exempt interest and accelerated
depreciation allowances. The vehicle exemption expired on December 31,
1984.

Assessment

State and local governments tend to view these facilities as economic
development tools. The desirability of allowing these bonds to be eligible for
tax-exempt status hinges on one's view of whether the users of such facilities
should pay the full cost, or whether sufficient social benefits exist to justify
Federal taxpayer subsidy. Economic theory suggests that to the extent these
facilities provide social benefits that extend beyond the boundaries of the
State or local government, the facilities might be underprovided due to the
reluctance of State and local taxpayers to finance benefits for nonresidents.

Even if a case can be made for a Federal subsidy due to underinvestment at
the State and local level, it is important to recognize the potential costs. As
one of many categories of tax-exempt private-activity bonds, those issued for
airports, docks, and wharves increase the financing cost of bonds issued for
other public capital. With a greater supply of public bonds, the interest rate
on the bonds necessarily increases to lure investors. In addition, expanding
the availability of tax-exempt bonds increases the assets available to
individuals and corporations to shelter their income from taxation.

Selected Bibliography

Maguire, Steven. Private Activity Bonds: An Introduction. Library of
Congress, Congressional Research Service Report RL31457. June 9, 2006.
-. Tax-Exempt Bonds: A Description of State and Local Government
Debt. Library of Congress, Congressional Research Service Report
RL30638. March 10, 2006.
U.S. Congress, Congressional Budget Office. Statement of Donald B.
Marron before the Subcommittee on Select Revenue Measures Committee on
Ways and Means U.S. House of Representatives. "Economic Issues in the
Use of Tax-Preferred Bond Financing," March 16, 2006.
U.S. Congress, Joint Committee on Taxation, Present Law and
Background Related to State and Local Government Bonds, Joint Committee
Print JCX-14-06, March 16, 2006.
Zimmerman, Dennis. The Private Use of Tax-Exempt Bonds: Controlling
Public Subsidy of Private Activity. Washington, DC: The Urban Institute
Press, 1991.

Community and Regional Development

QUALIFIED GREEN BUILDING AND
SUSTAINABLE DESIGN PROJECT BONDS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

(1)

2007

(1)

2008

(1)

2009

(1)

2010

(1)

(1) Less than $50 million.

Authorization

Section 103, 142(l), and 146(g).

Description

Interest income on State and local bonds used to finance the construction of
"green building and sustainable design projects," as designated by the U.S.
Environmental Protection Agency (EPA), is tax exempt. Green buildings are
evaluated based on these criteria: (1) site sustainability; (2) water efficiency;
(3) energy use and atmosphere; (4) material and resource use; (5) indoor
environmental quality; and (6) innovative design. The program is designed as
a "demonstration" program, and requires that at least one designated project
shall be located in or within a 10-mile radius of an empowerment zone and at
least one shall be located in a rural state. These bonds are classified as
private-activity bonds rather than governmental bonds because a substantial
portion of their benefits accrues to individuals or business rather than to the
general public. For more discussion of the distinction between governmental
bonds and private-activity bonds, see the entry under General Purpose Public
Assistance: Exclusion of Interest on Public Purpose State and Local Debt.

Bonds issued for green building and sustainable design projects are not,
however, subject to the state volume cap on private activity bonds. This
exclusion arguably reflects a belief that the bonds have a larger component of
benefit to the general public than do many of the other private activities
eligible for tax exemption. The bonds are, however, subject to a an aggregate
face amount of $2 billion and must be issued before October 1, 2009.

Impact

Some of the benefits of the tax exemption also flow to bondholders. For a
discussion of both the factors that determine the shares of benefits going to
bondholders and users of the green buildings and associated projects, and
estimates of the distribution of tax-exempt interest income by income class,
see the "Impact" discussion under General Purpose Public Assistance:
Exclusion of Interest on Public Purpose State and Local Debt.

Rationale

Proponents of green bonds argue that the federal subsidy is necessary
because private investors are unwilling to accept the risk and relatively low
return associated with green building projects. Proponents argue that the
market has failed to produce green buildings because the benefits of these
projects extend well beyond the actual building to the surrounding community
and to the environment more generally. The owner of the green building is
not compensated for these external benefits, and it is unlikely, proponents
argue, that a private investor would agree to provide them without some type
of government subsidy.

Assessment

The legislation (P.L. 108-357) that created these bonds was enacted on
October 22, 2004, and the success of the program is still uncertain. Before
the legislation was enacted, some developers reportedly were voluntarily
adhering to green building standards to attract tenants. If so, the market
failure described earlier to justify the use of federal subsidy may be less
compelling. In addition, as one of many categories of tax-exempt private-
activity bonds, green bonds will likely increase the financing costs of bonds
issued for other public capital stock and increase the supply of assets available
to individuals and corporations to shelter their income from taxation.

Selected Bibliography

Ho, Cathy Lang. "Eco-fraud: 'Green Buildings' Might Not be all They're
Made Out to Be." Architecture, v. 92, July 2003, pp. 31-32.
International City-County Management Association. "Green Buildings."
Public Management, v. 82, May 2000, p. 36.
Maguire, Steven. Private Activity Bonds: An Introduction. Library of
Congress, Congressional Research Service Report RL31457. Washington,
D.C.: June 9, 2006.
-. Tax-Exempt Bonds: A Description of State and Local Government
Debt. Library of Congress, Congressional Research Service Report
RL30638. Washington, D.C.: March 10, 2006.
Temple, Judy. "Limitations on State and Local Government Borrowing for
Private Purposes." National Tax Journal, v. 46, March 1993, pp. 41-53.
Weisbrod, Burton A. The Nonprofit Economy. Cambridge, Mass.:
Harvard University Press, 1988.
Zimmerman, Dennis. The Private Use of Tax-Exempt Bonds: Controlling
Public Subsidy of Private Activities. Washington, DC: The Urban Institute
Press, 1991.

Education, Training, Employment and Social Services:
Education and Training

EXCLUSION OF INCOME ATTRIBUTABLE TO THE
DISCHARGE OF CERTAIN STUDENT LOAN DEBT
AND NHSC EDUCATIONAL LOAN REPAYMENTS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

(1)

2007

(1)

2008

(1)

2009

(1)

2009

(1)

(1) Less than $50 million.

Authorization

Section 108(f); 20 U.S.C. 1087ee(a)(5); and 42 U.S.C. 254l-1(g)(3).

Description

In general, cancelled or forgiven debt, or debt that is repaid on the
borrower's behalf is included as gross income for tax purposes.
However, section 108(f) of the IRC provides that in certain instances,
student loan cancellation and student loan repayment assistance may
be excluded from taxation.

Cancelled or forgiven student loan debt may be excluded from
gross income under section 108(f) if the relevant student loan
contains terms providing that some or all of the loan will be cancelled
for work for a specified period of time, in certain professions, and for
any of a broad class of employers; and if it was made by a qualified
lender. Qualified lenders are the government (federal, state, local,
or an instrumentality, agency, or subdivision thereof); tax-exempt
public benefit corporations that have assumed control of a state,
county, or municipal hospital and whose employees are considered
public employees under state law; and educational institutions if the
loan is made under an agreement with an entity described above, or
under a program of the institution designed to encourage students to
serve in occupations or areas with unmet needs and under the
direction of a governmental entity or a tax-exempt 501(c)(3)
organization.

There are three major federal student aid (FSA) loan programs:
the Federal Family Education Loan (FFEL) program, the William D.
Ford Direct Loan (DL) program, and the Federal Perkins Loan
program. Student loans made under each of these programs contain
provisions that if borrowers work for specified periods of time in
certain professions, for certain broad classes of employers, all or a
portion of their debt will be cancelled or forgiven. For example,
under each of the three loan programs, teachers who meet certain
criteria may have their loans cancelled. Some non-federal loans also
may meet the requirements of section 108(f).

Loans are made by different types of lenders under each of the
three FSA programs. Under the FFEL program, loans are
guaranteed by the federal government, but are made by a variety of
lenders, including commercial banks, non-profit entities, and state
entities. Thus, many FFEL loans are ineligible to be excluded from
taxation when forgiven because the lender does not meet the
requirements of section 108(f). Under the DL program, loans are
made directly by the federal government and are thus eligible to be
excluded from taxation when forgiven. Under the Federal Perkins
Loan program, loans are made by the public, non-profit, or for-profit
postsecondary institutions that borrowers attend. The statute
authorizing the Federal Perkins Loan program specifies that any part
of a Federal Perkins Loan cancelled for certain types of public
service shall not be considered income for purposes of the IRC (20
U.S.C. 1087ee(a)(5)).

Section 108(f) also excludes from income student loan repayment
assistance provided under the National Health Service Corps (NHSC)
Loan Repayment Program and state programs eligible to receive
funds under the Public Health Service Act. These two programs
provide payment on a borrower's behalf for principal, interest, and
related expenses of educational loans in return for the borrower's
service in a health professional shortage area. Government and
commercial education loans are eligible to be repaid under the NHSC
Loan Repayment Program.

Impact

Section 108(f) permits individuals to exclude loan cancellation and
payments under the NHSC and state loan repayment programs from their
gross income. The benefit provided to any individual taxpayer and the
corresponding loss of revenue to the federal government depends on the
taxpayer's marginal tax rate. CBO estimates that approximately 75,000
teachers will apply for loan forgiveness each year under the FFEL and DL
programs - the two largest FSA loan programs. Many of these applicants
may be able to exclude their forgiven debt from gross income. Additional
borrowers may be eligible to exclude debt forgiven under other loan
programs. It is unclear, however, how many individuals go into certain
professions because of available loan forgiveness programs, or how many
decide to borrow from eligible lenders because of the section 108(f) provision
which permits discharged student loan debt to be excluded from gross
income.

Rationale

Whether to include the forgiveness of student loan debt or the repayment of
debt through loan repayment assistance programs as part of gross income for
purposes of taxation has been a policy issue for the past 50 years. Following
the Supreme Court's decision in Bingler v. Johnson (1969), the primary issue
in determining whether loan forgiveness and loan repayment programs are
taxable has been whether there exists a quid pro quo between the recipient
and the lender. Generally, if borrowers must perform service for the entity
forgiving or repaying their loans, it is assumed that a quid pro quo exists and
so the amount forgiven or repaid is treated as taxable income. The policy
issue is whether the service borrowers provide in return for the
discharge of their loan is for the benefit of the grantor of debt
forgiveness and thus should be considered akin to income, or if the
service is for the benefit of the broader society and thus should
potentially be excluded from income. Following post-Bingler v.
Johnson rulings by the IRS that had established the discharge of
student loan indebtedness as taxable income, Congress has
periodically amended the IRC to override these rulings and
specifically exclude the discharge of broader categories of certain
student loan debt from taxation. As a result, the IRC currently
provides tax treatment for qualified loan forgiveness and loan
repayment programs that is similar to that of educational grants and
scholarships, which are not taxable.

Assessment

The value to an individual of excluding the discharge of student
loan indebtedness from gross income depends on that individual's
marginal tax rate in the tax year in which the benefit is realized.
Since beneficiaries generally are required to be serving in public
service jobs or in health professional shortage areas, in most cases
such individuals will be in lower tax brackets than if they had taken
higher paying jobs elsewhere. Prior to the enactment of P.L. 108-
357, the NHSC loan repayment program provided recipients of loan
repayment with an additional payment for tax liability equal to 39%
of the loan repayment amount (42 U.S.C. 254l-1(g)(3)). By
excluding NHSC loan repayment from income, tax relief is now
provided through foreign revenue as opposed to discretionary
outlays.

Selected Bibliography

Beck, Richard C.E., "Loan Repayment Assistance Programs for Public-
Interest Lawyers: Why Does Everyone Think They Are Taxable?" New York
Law School Law Review, vol. 40, (1996): 251-310.
Bingler v. Johnson, 394 U.S. 741 (1969).
Boe, Caroleen C., "Cancelled Student Loans: For the Benefit of the
Grantor?" Albany Law Review, vol. 39, (1974): 35-51.
Congressional Budget Office, Cost Estimate, "H.R. 4525: Second Higher
Education Extension Act of 2005," (Jan. 12, 2006).
Dauthtrey, Zoel, and Frank M. Messina, "Medical Student Loans: Making
Repayments Tax Free," The CPA Journal, (Jan. 1999).
Internal Revenue Service, Revenue Ruling 73-256, State Medical
Education Loan Scholarship Program, 1973-1 CB 56, (Jan. 01, 1973)
McCallion, Gail, Student Loan Forgiveness Programs. Library of
Congress, Congressional Research Service, Washington, D.C., (July 14,
2006).
Philipps, J. Timothy, and Timothy G. Hatfield, "Uncle Sam Gets the
Goldmine - Students Get the Shaft: Federal Tax Treatment of Student Loan
Indebtedness," Seton Hall Legislative Journal, vol. 15, (1991): 249-296.
Moloney v. Commissioner of Internal Revenue, United States Tax Court,
Summary Opinion 2006-53.
Oliver, Amy J., "Improving the Tax Code to Provide Meaningful and
Effective Tax Incentives for Higher Education," University of Florida
Journal of Law & Public Policy, vol. 12, (2000): 91-145.

Education, Training, Employment, and Social Services:
Education and Training

DEDUCTION FOR CLASSROOM EXPENSES OF
ELEMENTARY AND SECONDARY SCHOOL EDUCATORS

Estimated Revenue Loss*

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

2007

2008

2009

2010

*The tax credit was extended by H.R. 6111 (December 2006) for two
years to 2006-2007 at a cost of $0.2 billion in each year.

Authorization

Section 62.

Description

An eligible employee of a public (including charter) and private elementary
or secondary school may claim an above-the-line deduction for certain
unreimbursed expenses. An eligible educator is defined to be an individual
who, with respect to any tax year, is an elementary or secondary school
teacher, instructor, counselor, principal, or aide in a school for a minimum of
900 hours in a school year. The expenses must be associated with the
purchase of the following items for use by the educator in the classroom:
books; supplies (other than nonathletic supplies for health or physical
education courses); computer equipment, software, and services; other
equipment; and supplementary materials. The taxpayer may deduct up to
$250 spent on these items.

The amount of deductible classroom expenses is not limited by the
taxpayer's income. Educators must reduce the total amount they expend on
eligible items by any interest from an Education Savings Bond or distribution
from a Qualified Tuition (Section 529) Program or Coverdell Education
Savings Account that was excluded from income. In other words, if
educators or members of their tax filing units utilize earnings from these
savings vehicles to pay tuition and other qualified educational expenses, only
those classroom expenses that exceed the value of these income exclusions
are deductible.

Impact

Educators, as an occupation, are actively involved in improving the human
capital of the nation. The availability of the classroom expense deduction
may encourage educators who already are doing so to continue to use their
own money to make purchases to enhance their students' educational
experience, and potentially encourages other educators to start doing the
same. Alternatively, the deduction may be a windfall to educators. As noted
in the table below, more than 40% of the deductions are taken by tax filing
units with adjusted gross incomes of at least $75,000.

Distribution by Income Class of Classroom Expense
Deduction at 2003 Income Levels

Income Class
(in thousands of $)

Percentage
Distribution

Below $10

1.3

$10 to $20

4.0

$20 to $30

6.3

$30 to $40

10.5

$40 to $50

10.1

$50 to $75

24.6

$75 to $100

22.0

$100 to $200

19.3

$200 and over

1.8

Source: IRS Statistics of Income. This is not a distribution of the tax
expenditures, but of the deduction; it is classified by adjusted gross income.
Data are available for 2004 but are not reliable due to small sample size in the
higher income cells.

Rationale

Prior to the classroom deduction's enactment as part of the Job Creation
and Worker Assistance Act of 2002, the only tax benefit available to
educators for trade/business expenses was the permanent deduction at Section
162 of the Code. That deduction remains available to educators but in order
to take it, the total of their miscellaneous itemized deductions must exceed
2% of adjusted gross income. An above-the-line deduction targeted at
educators was considered socially desirable because teachers voluntarily
augment school funds by purchasing items thought to enhance the quality of
children's education. The provision expired at the end of 2005 but was
extended through 2007 by H.R. 6111 (December 2006).

Assessment

Taxpayers with teachers in their filing units who make trade/business
purchases in excess of $250 or who have other miscellaneous itemized
deductions may now have to compute tax liability twice - under Code
Sections 62 and 162 - to determine which provides the greater savings.
Taxpayers also must now consider how the educator expense deduction
interacts with other tax provisions. The temporary above-the-line deduction
means, for example, that higher income families with eligible educators may
not have to subject classroom expenditures of up to $250 to the 3% limit on
itemized deductions. (Higher income taxpayers must reduce total allowable
itemized deductions by 3% of their income in excess of an inflation-adjusted
threshold.) By lowering adjusted gross income, the classroom expense
deduction also allows taxpayers to claim more of those deductions subject to
an income floor (e.g., medical expenses).

In addition to increasing complexity, the classroom expense deduction
treats educators differently than others whose business-related expenses are
subject to the 2% floor on miscellaneous itemized deductions and the 3%
limit on total itemized deductions. Further, the above-the-line deduction is
allowed against the alternate minimum tax while the Section 162 deduction is
not.

Selected Bibliography

Levine, Linda. The Tax Deduction for Classroom Expenses of Elementary
and Secondary School Teachers. Congressional Research Service Report
RS21682. Washington, DC: updated August 30, 2006.
Joint Committee on Taxation. Description of Revenue Provisions
Contained in the President's Fiscal Year 2007 Budget Proposal. Committee
Print JCS-3-04. Washington, DC: Government Printing Office, March 2006.

Education, Training, Employment, and Social Services:
Education and Training

TAX CREDITS FOR TUITION
FOR POST-SECONDARY EDUCATION

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

4.9

2007

5.2

2008

5.1

2009

5.0

2010

5.0

Authorization

Section 25A.

Description

A Hope Scholarship Credit can be claimed for each eligible student in a
family (including the taxpayer, the spouse, or their dependents) for two
taxable years for qualified expenses incurred while attending an eligible
postsecondary education program, provided the student has not completed the
first two years of undergraduate education. An eligible student is one
enrolled on at least a half-time basis for at least one academic period during
the tax year in a program leading to a degree, certificate, or credential at an
institution eligible to participate in U.S. Department of Education student aid
programs; these include most accredited public, private, and proprietary
postsecondary institutions. The per student credit is equal to 100% of the first
$1,100 of qualified tuition and fees and 50% of the next $1,100. The
maximum credit is indexed for inflation. Tuition and fees financed with
scholarships, Pell Grants, veterans' education assistance, and other income
not included in gross income for tax purposes (with the exception of gifts and
inheritances) are not qualified expenses.

The Lifetime Learning Credit provides a 20% credit per return for the first
$10,000 of qualified tuition and fees that taxpayers pay for themselves, their
spouses, or their dependents. The credit is available for any number of years
for any level of postsecondary education at an eligible institution to acquire or
improve an individual's job skills.

Both credits are phased out for single taxpayers with modified adjusted
gross income between $45,000 and $55,000 ($90,000 and $110,000 for joint
return taxpayers). The income thresholds are indexed to inflation. Neither
credit is refundable. Both cannot be claimed for the same student in the same
tax year. Taxpayers claiming a credit cannot concurrently take the temporary
deduction for qualified higher education expenses.

Impact

The cost of investing in postsecondary education is reduced for those
recipients whose marginal (i.e., last) investment dollar is affected by these
credits. Other things equal, these individuals will either increase the amount
they invest or participate when they otherwise would not. However, some of
the federal revenue loss will be received by individuals whose investment
decisions are not altered by the credits.

As shown in the table below, the ceilings limit the benefit available to
higher income individuals. The lack of refundability limits the benefit
available to very low income individuals.

Distribution by Income Class of Education Tax
Credits at 2004 Income Levels

Income Class
(in thousands of $)

Percentage
Distribution

Below $10

0.3

$10 to $20

9.5

$20 to $30

16.1

$30 to $40

18.6

$40 to $50

13.1

$50 to $75

25.1

$75 to $100

16.5

$100 to $200

0.0

$200 and over

0.0

Source: IRS Statistics of Income. This is not a distribution of the tax
expenditures, but of the credits; it is classified by adjusted gross income.

Rationale

These credits were enacted in the Taxpayer Relief Act of 1997,
along with a number of other higher education tax benefits. Their
intent is to make postsecondary education more affordable for
middle-income families and students who might not qualify for much
need-based federal student aid.

Assessment

A federal subsidy of higher education has three potential economic
justifications: a capital market failure; external benefits; and nonneutral
federal income tax treatment of physical and human capital. Subsidies that
correct these problems are said to provide taxpayers with "social benefits."

Many students find themselves unable to finance their postsecondary
education from earnings and personal or family savings. Student mobility and
a lack of property to pledge as loan collateral would require commercial
lenders to charge high interest rates on education loans in light of the high
risk of default. As a result, students often find themselves unable to afford
loans from the financial sector. This financial constraint bears more heavily
on lower income groups than on higher income groups and accordingly, leads
to inequality of opportunity to acquire a postsecondary education. It also is an
inefficient allocation of resources because these students, on average, might
earn a higher rate of return on loans for education than the financial sector
could earn on alternative loans.

This "failure" of the capital markets is attributable to the legal restriction
against pledging an individual's future labor supply as loan collateral, that is,
against indentured servitude. Since modern society rejects this practice, the
federal government has strived to correct the market failure by providing a
guarantee to absorb most of the financial sector's default risk associated with
postsecondary loans to students. This financial support is provided through
the Federal Family Education Loan Program and the Direct Loan Program.
(See the entry "Exclusion of Interest on State and Local Government Student
Loan Bonds" for more information.) The guarantee is an entitlement and
equalizes the financing cost for some portion of most students' education
investment. When combined with Pell Grants for lower income students, it
appears that at least some portion of the capital market failure has been
corrected and inequality of opportunity has been diminished.

Some benefits from postsecondary education may accrue not to the
individual being educated, but rather to the members of society at large. As
these external benefits are not valued by individuals considering educational
purchases, they invest less than is optimal for society (even assuming no
capital market imperfections). External benefits are variously described as
taking the form of increased productivity and better citizenship (for example,
greater likelihood of participating in elections).

Potential students induced to enroll in higher education by the Hope
Scholarship and Lifetime Learning credits cause investment in education to
increase. The overall effectiveness of the tax credits depends upon whether
the cost of the marginal investment dollar of those already investing in higher
education is reduced, however. It is clear from the structure of these tax
credits that tuition and fee payments will exceed qualified tuition and fees for
a large number of credit-eligible students, and as a result, they will not
experience a price effect (e.g., the Hope credit will not reduce by 50% the last
dollar these students invest in postsecondary education). Although their
investment decision is unaffected by the credits, these students can claim
them (i.e., reap a "windfall gain") but federal taxpayers get no offsetting
social benefits in the form of an increased quantity of investment.

Selected Bibliography

Burman, Leonard E. with Elaine Maag, Peter Orszag, Jeffrey
Rohaly, and John O'Hare. The Distributional Consequences of
Federal Assistance for Higher Education: The Intersection of Tax and
Spending Programs, The Urban Institute, Discussion Paper No. 26.
Washington, DC: August 2005.
Dynarski, Susan. Hope for Whom? Financial Aid for the Middle
Class and Its Impact on College Attendance. National Bureau of
Economic Research, Working Paper 7756. Cambridge, MA: June
2000.
Hoblitzell, Barbara A. and Tiffany L. Smith. Hope Works: Student
Use of Education Tax Credits. Indianapolis, IN: Lumina Foundation
for Education Inc., November 2001.
Jackson, Pamela J. Higher Education Tax Credits: An Economic
Analysis. Congressional Research Service Report RL32507.
Washington, DC: updated January 17, 2006.
Levine, Linda. The Benefits of Education. Congressional
Research Service Report RL33238. Washington, DC: December
29, 2005.
Long, Bridget Terry. The Impact of Federal Tax Credits for
Higher Education Expenses. National Bureau of Economic
Research, Working Paper 9553. Cambridge, MA: March 2003.
Stoll, Adam and Linda Levine. Higher Education Tax Credits and
Deduction: An Overview of the Benefits and Their Relationship to
Traditional Student Aid. Congressional Research Service Report
RL31129. Washington, DC: updated October 2, 2006.
Wolanin, Thomas R. Rhetoric and Reality: Effects and
Consequences of the HOPE Scholarship. Washington, DC: Institute for
Higher Education Policy, Working Paper, April 2001.
Zimmerman, Dennis. "Education Tax Credits," in Joseph J. Cordes with
Robert D. Ebel and Jane G. Gravelle, Encyclopedia of Taxation and Tax
Policy, Washington, DC: Urban Institute, 2005.

Education, Training, Employment, and Social Services:
Education and Training

DEDUCTION FOR INTEREST ON STUDENT LOANS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.8

2007

0.9

2008

0.9

2009

0.9

2010

1.0

Authorization

Section 221.

Description

Taxpayers may deduct interest paid on qualified education loans in
determining their adjusted gross income. The deduction, which is limited to
$2,500 annually, is not restricted to itemizers. Taxpayers are not eligible for
the deduction if they can be claimed as a dependent by another taxpayer.
Between 2002 and 2010, the deduction is not restricted to interest paid
within the first 60 months during which interest payments are required and
the phase-out income thresholds are indexed for inflation. Allowable
deductions are phased out for taxpayers with modified adjusted gross income
between $50,000 and $65,000 on individual returns and between $105,000
and $135,000 on joint returns. A sunset provision in the Economic Growth
and Tax Relief Reconciliation Act of 2001 will cause the deduction to revert
to its pre-2002 structure after December 31, 2010, absent further
congressional action.

Qualified education loans are indebtedness incurred solely to pay qualified
higher education expenses of taxpayers, their spouse, or their dependents who
were at the time the debt was incurred students enrolled on at least a half-time
basis in a program leading to a degree, certificate, or credential at an
institution eligible to participate in U.S. Department of Education student aid
programs; these include most accredited public, private, and proprietary
postsecondary institutions. Other eligible institutions are hospitals and health
care facilities that conduct internship or residency programs leading to a
certificate or degree. Qualified higher education expenses generally equal the
cost of attendance (e.g., tuition, fees, books, equipment, room and board, and
transportation) minus scholarships and other education payments excluded
from income taxes. Refinancings are considered to be qualified loans, but
loans from related parties are not.

Impact

The deduction benefits taxpayers according to their marginal tax
rate (see Appendix A). Most education debt is incurred by students,
who generally have low tax rates immediately after they leave school
and begin loan repayment. However, some debt is incurred by
parents who are in higher tax brackets.

The cap on the amount of debt that can be deducted annually
limits the tax benefit's impact for those who have large loans. The
income ceilings limit the benefit's availability to higher income individuals,
as shown in the table below.

Distribution by Income Class of Student Loan
Deduction at 2004 Income Levels

Income Class
(in thousands of $)

Percentage
Distribution

Below $10

4.1

$10 to $20

7.2

$20 to $30

11.7

$30 to $40

14.3

$40 to $50

13.6

$50 to $75

24.2

$75 to $100

24.9

$100 to $200

0.0

$200 and over

0.0

Source: Data obtained from IRS Statistics of Income. This is not a
distribution of the tax expenditures, but of the deductions; it is classified by
adjusted gross income.

Rationale

The interest deduction for qualified education loans was authorized by the
Taxpayer Relief Act of 1997 as one of a number of benefits intended to make
postsecondary education more affordable for middle-income families who are
unlikely to qualify for much need-based federal student aid. The interest
deduction is seen as a way to help taxpayers repay education loan debt, which
has risen substantially in recent years.

Assessment

The tax deduction can be justified both as a way of encouraging persons to
undertake additional education and as a means of easing repayment burdens
when graduates begin full-time employment. Whether the deduction will
affect enrollment decisions is unknown; it might only change the way families
finance college costs. The deduction may allow some graduates to accept
public service jobs that pay low salaries, although their tax savings would not
be large. The deduction has been criticized for providing a subsidy to all
borrowers (aside from those with higher income), even those with little debt,
and for doing little to help borrowers who have large loans. It is unlikely to
reduce loan defaults, which generally are related to low income and
unemployment.

Selected Bibliography

State PIRGs' Higher Education Project. Paying Back, Not Giving Back:
Student Debt's Negative Impact on Public Service Career Opportunities.
Washington, DC: April 2006.
Stoll, Adam. Federal Student Loans: Terms and Conditions for
Borrowers. Congressional Research Service Report RL30655. Washington,
DC: updated January 26, 2006.

Education, Training, Employment, and Social Services:
Education and Training

EXCLUSION OF EARNINGS OF
COVERDELL EDUCATIONAL SAVINGS ACCOUNTS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.1

2007

0.1

2008

0.1

2009

0.2

2010

0.2

Authorization

Section 530.

Description

Coverdell Education Savings Accounts (ESAs), formerly known as
"Education IRAs," are trusts or custodial accounts created solely for the
purpose of paying qualified elementary, secondary, and postsecondary
education expenses of designated beneficiaries. The contribution limit was
raised from $500 annually to $2,000 annually effective from 2002 through
2010. It is phased-out for single taxpayers with modified adjusted gross
income between $95,000 and $110,000 ($190,000 and $220,000 for joint
return taxpayers) annually during the 9-year period. The income limits are
not adjusted for inflation and will revert to $95,000 and $150,000,
respectively, after December 31, 2010. Corporations, tax-exempt
organizations, or lower income individuals can contribute the maximum
annual amount to accounts of children in families whose income falls in the
phase-out range.

A contributor may fund multiple accounts for the same beneficiary,
and a student may be the designated beneficiary of multiple accounts.
A 6% tax is imposed if total contributions exceed the annual per-beneficiary
limit. Funds withdrawn from one Coverdell ESA in a 12-month period and
rolled over to another ESA on behalf of the same beneficiary or certain of
their family members are excluded from the annual contribution limit and are
not taxable.

Contributions may be made until beneficiaries reach age 18, although they
may continue beyond that age for special needs beneficiaries. Similarly, with
the exception of special needs beneficiaries, account balances typically must
be totally distributed when beneficiaries attain age 30. Contributions are not
deductible, but account earnings grow on a tax-deferred basis. Beginning in
2002, a contribution may be made to an ESA in the same year that a
contribution is made to a Qualified Tuition Program for the same beneficiary.

Distributions are excluded from gross income of the beneficiary if used for
tuition, fees, books, supplies, and equipment required for enrollment or
attendance; contributions to Qualified Tuition Programs; special needs
services; and room and board expenses for students enrolled on at least a half-
time basis at eligible institutions of higher education. Distributions also are
not taxed if they are used, from 2002 through 2010, toward the following
expenses of beneficiaries pursuing elementary and secondary (K-12)
education: tuition, fees, books, supplies, and other equipment incurred in
connection with enrollment or attendance; academic tutoring; special needs
services; room and board, uniforms, transportation, and supplementary items
or services required or provided by the school; and computer software,
hardware, or services if used by the beneficiary and the beneficiary's family
during any years the beneficiary is in school.

Eligible postsecondary institutions are those eligible to participate in U.S.
Department of Education student aid programs; these include most accredited
public, private, and proprietary postsecondary institutions. From 2002
through 2010, eligible institutions have been expanded to public and private
K-12 schools, either secular or religiously affiliated; they include
homeschools in some states.

Distributions are taxed to the beneficiary under section 72 annuity rules:
thus, each distribution is treated as consisting of principal, which is not taxed,
and earnings, some of which may be taxed depending on the amount of
qualified education expenses. Distributions included in gross income are
subject to a 10% penalty tax, with some exceptions. After 2001, beneficiaries
can exclude from gross income distributions made in the same year that either
the Hope Credit or the Lifetime Learning Credit is claimed (although not for
the same expenses). This and other previously mentioned changes to the
Coverdell ESA that went into effect in 2002 are set to expire after December
31, 2010 absent further congressional action.

Impact

Both the exclusion from gross income of account earnings withdrawn to
pay for qualified expenses and the deferral of taxes on accumulating earnings
confers benefits to tax filing units according to their marginal tax rate (see
Appendix A). These benefits are most likely to accrue to higher income
families that have the means to save on a regular basis.

Tax benefits from Coverdell ESAs might be offset by reductions in federal
student aid, most of which is awarded to students based on their financial
need. Generally, students have need when their cost of attendance exceeds
their expected family contribution (EFC). For purposes of need-based
federal student aid programs (other than Pell Grants), the Department of
Education provided guidance in 2006 based upon amendments to the Higher
Education Act of 1965 included in the Deficit Reduction Act of 2005.
According to the Department's guidance, a Coverdell ESA shall not be
considered an asset of the student in the EFC calculation; instead, it shall be
considered an asset of the parent if the parent is the account owner. The
phrase "account owner" is not normally used in connection with Coverdell
ESAs, however. In addition, other information the Department provides to
families applying for federal student aid suggests that students who are the
beneficiaries of Coverdell ESAs consider them their assets. This distinction
is an important one because a maximum of 5.64% of the assets of parents are
counted toward the EFC, while a fixed 35% of the assets of students are
counted toward the EFC.

Rationale

Tax-favored saving for higher education expenses was authorized by the
Taxpayer Relief Act of 1997 as one of a number of tax benefits for
postsecondary education. These benefits reflect congressional concern that
families are having increasing difficulty paying for college. They also reflect
an intention to subsidize middle-income families that otherwise do not
qualify for much need-based federal student aid. The Economic Growth and
Tax Relief Reconciliation Act of 2001 expanded eligible expenses to those
incurred in connection with enrollment in public and private K-12 schools. It
was intended, in part, to encourage families to exercise school choice (i.e.,
attend alternatives to the traditional public school).

Assessment

The tax exclusion could be justified both as a way of encouraging
families to use their own resources for college expenses and as a
means of easing their financing burdens. Families that have the
wherewithal to save are more likely to benefit. Whether families will
save additional sums might be doubted. Tax benefits for Coverdell
ESAs are not related to the student's cost of attendance or other
family resources, as is most federal student aid for higher education.

Higher-income families also are more likely than lower-income
families to establish accounts for their children's K-12 education
expenses. The amount of the tax benefit, particularly if the
maximum contribution to an account is not made each year, is
probably too small to affect a family's decision about whether to send
their children to public or private school.

Selected Bibliography

Davis, Albert J. "Choice Complexity in Tax Benefits for Higher
Education," National Tax Journal, v. 55, no. 3 (September 2002). pp. 509-
530.
Dynarksi, Susan M. Who Benefits from the Education Savings
Incentives? Income, Educational Expectations, and the Value of the
529 and Coverdell. National Bureau of Economic Research,
Working Paper 10470. Cambridge, MA: May 2004.
Investment Company Institute. Profile of Households Saving for
College. Washington, DC: Fall 2003.
Levine, Linda. Education Tax Benefits: Are They Permanent or
Temporary? Congressional Research Service Report RS21870.
Washington, DC: updated August 28, 2006.
Levine, Linda and Charmaine Mercer. Tax-Favored Higher
Education Savings Benefits and Their Relationship to Traditional
Federal Student Aid. Congressional Research Service Report
RL32155. Washington, DC: updated September 28, 2006.
Levine, Linda and David Smole. Federal Tax Benefits for Families'
K-12 Education Expenses in the Context of School Choice.
Congressional Research Service Report RL31439. Washington, DC:
updated January 27, 2006.
Ma, Jennifer. Education Savings Incentives and Household Saving:
Evidence from the 2000 TIAA-CREF Survey of Participant Finances.
National Bureau of Economic Research, Working Paper 9505.
Cambridge, MA: February 2003.
Ma, Jennifer. To Save or Not to Save: A Closer Look at Saving and
Financial Aid. TIAA-CREF Institute, Working Paper 18-120103.
NY, NY: December 2003.
Ma, Jennifer and Douglas Fore. "Saving for College with 529
Plans and Other Options," Journal of Retirement Planning,
September-October 2002.
Wolanin, Thomas R. "How Do Student Financial Aid and Tax Policy Fit
Together: Relating HEA Programs to Education Tax Breaks?" in
Reauthorizing the Higher Education Act. Washington, DC: Institute for
Higher Education Policy, March 2003.

Education, Training, Employment, and Social Services:
Education and Training

EXCLUSION OF INTEREST
ON EDUCATION SAVINGS BONDS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

(1)

2007

(1)

2008

(1)

2009

(1)

2010

(1)

(1)Less than $50 million.

Authorization

Section 135.

Description

Eligible taxpayers can exclude from their gross income all or part of the
interest on U.S. Series EE or Series I Savings Bonds when the bonds are
used to pay qualified higher education expenses of the taxpayer or the
taxpayer's spouse or dependents. Series EE Bonds are accrued bonds which
earn a variable interest rate equal to 90% of the average yield on 5-year
Treasury securities for the preceding six months. Series I Bonds are accrued
bonds which earn a fixed rate of return plus a variable semi-annual inflation
rate. The bonds must have been issued after 1989 and be both purchased and
owned by persons who are age 24 or over. If the total amount of principal
and interest on bonds redeemed during a year exceeds the amount of qualified
education expenses, the amount of the interest exclusion is reduced
proportionately.

Qualified higher education expenses generally are restricted to tuition and
fees required for enrollment or attendance at eligible institutions. Tuition and
fees are not taken into account if they are paid with tax-exempt scholarships,
veterans' education assistance, employer education assistance, and
distributions from Qualified Tuition Programs or from Coverdell ESAs, or if
a tax credit or deduction is claimed for them. Expenditures for courses in
sports, games, or hobbies are not considered unless they are part of a degree
program. Contributions to Qualified Tuition Programs or to Coverdell ESAs
are considered qualified expenses if made with redeemed proceeds. Eligible
institutions are those eligible to participate in U.S. Department of Education
student aid programs; these include most accredited public, private, and
proprietary postsecondary institutions.

The interest exclusion is phased out for middle- and upper-income
taxpayers. The phase-out ranges are based on the taxpayer's modified
adjusted gross income in the year in which the bond is applied toward
qualified expenses. The ranges are adjusted annually for inflation. The
phase-out range for a married couple filing jointly and for widow(er)s is
$94,700 to $124,700. (Married couples must file a joint return to take the
exclusion.) For all others, it was $63,100 to $78,100.

Impact

Education Saving Bonds provide lower- and middle-income families
with a tax-favored way to save for higher education that is convenient
and often familiar. The benefits are greater for families who live in
states and localities with high income taxes because the interest
income from Series EE and Series I Bonds is exempt from state and
local income taxes.

Rationale

The interest exclusion for Education Savings Bonds was created by
the Technical and Miscellaneous Revenue Act of 1988, making it
among the earliest congressional efforts to assist family financing of
postsecondary education. It reflects a long-held congressional
concern that families have difficulty paying for college, particularly
with the cost of higher education often rising faster than prices in
general. If families would save more prior to their children's
enrollment in college, they might find it easier to meet the cost
without relying on student aid or borrowing. Although the tax
provision has been subject to a number of technical and coordinating
amendments since its inception (e.g., to take into account more
recently enacted education tax benefits), the basic requirements have
remained the same.

Assessment

The benefits of Education Savings Bonds depend on several
factors, including how soon taxpayers begin to save, the return on
alternative savings plans, a taxpayer's marginal income tax rate, and
the burden of state and local income taxes. For many taxpayers, the
after-tax rate of return on Education Savings Bonds is approximately
the same as the after-tax rate of return on other government
securities with a similar term. Like other U.S. government securities,
the interest income from Series EE and Series I Savings Bonds is
exempt from state and local income taxes.

The tax savings from the exclusion are greater for taxpayers in
higher tax brackets. These savings would be partially offset by the
below-market yield of these savings bonds. However, both Series EE
and Series I Bonds are a safe way to save, and many taxpayers may
find it easier to purchase and redeem them than other Treasury
securities.

Since the interest exclusion for Education Savings Bonds can be
limited when the bonds are redeemed, families intending to use them
for college expenses must predict their income eligibility far in
advance. They must also anticipate the future costs of tuition and
fees and whether their children might receive scholarships. Further,
unless students are tax dependents of their grandparents for example,
the relatives cannot take the exclusion on bond interest used to pay
the students' qualified expenses. In these respects, the bonds may
not be as attractive an investment as some other education savings
vehicles.

Selected Bibliography

Davis, Albert J. "Choice Complexity in Tax Benefits for Higher
Education," National Tax Journal, v. 55, no. 3 (September 2002). pp. 509-
530.
Hubbard, R. Glenn and Jonathan S. Skinner. "Assessing the
Effectiveness of Saving Incentives," The Journal of Economic
Perspectives, v. 10, no. 4 (Fall 1996). pp. 73-90.
Investment Company Institute. Profile of Households Saving for
College. Washington, DC: Fall 2003.
Levine, Linda and Charmaine Mercer. Tax-Favored Higher
Education Savings Benefits and Their Relationship to Traditional
Federal Student Aid. Congressional Research Service Report
RL32155. Washington, DC: updated September 28, 2006.
U.S. Treasury. Bureau of the Public Debt. Savings Bonds for
Education. Accessible at http://www.publicdebt.treas.gov/sav/saveduca.htm

Education, Training, Employment, and Social Services:
Education and Training

DEDUCTION FOR HIGHER EDUCATION EXPENSES

Estimated Revenue Loss*

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

2007

2008

2009

2010

*The tax credit is effective through December 31, 2007. H.R. 6111 which
extended the deduction through 2006 and 2007 cost $1.6 billion in FY 2007
and $1.7 billion in FY2008.

Authorization

Section 222.

Description

Taxpayers may deduct qualified tuition and related expenses for
postsecondary education from their adjusted gross income. The deduction
is "above-the-line," that is, it is not restricted to itemizers. Taxpayers
are eligible for the deduction if they pay qualified expenses for
themselves, their spouses, or their dependents. Individuals who may
be claimed as dependents on another taxpayer's return, married
persons filing separately, and nonresident aliens who do not elect to
be treated as resident aliens cannot take the deduction.

The maximum deduction per return is $4,000 for taxpayers with
modified adjusted gross income that does not exceed $80,000
($160,000 on joint returns). Taxpayers with incomes above
$65,000 ($130,000 for joint returns) but not above $80,000
($160,000 for joint returns) can deduct up to $2,000 in qualified
expenses. These income limits are not adjusted for inflation and
there is no phase-out of the deduction based upon income.

The deduction may be taken for qualified tuition and related
expenses in lieu of claiming the Hope Scholarship Credit or Lifetime
Learning Credit for the same student. Taxpayers cannot deduct
qualified expenses under Section 222 if they deduct these expenses
under any other provision in the Code (e.g., the itemized deduction
for education that maintains or improves skills required in a
taxpayer's current profession).

Before the deduction can be taken, qualified expenses must be
reduced if financed with scholarships, Pell Grants, employer-provided
educational assistance, veterans' educational assistance, and any
other nontaxable income (other than gifts and inheritances).
Qualified expenses also must be reduced if paid with tax-free interest
from Education Savings Bonds, tax-free distributions from Coverdell
Education Savings Accounts, and tax-free earnings withdrawn from
Qualified Tuition Plans.

Qualified tuition and related expenses are tuition and fees required
for enrollment or attendance in an institution eligible to participate in
U.S. Department of Education student aid programs; these include
most accredited public, private, and proprietary postsecondary
institutions. The deduction may be taken for any year of
undergraduate or graduate enrollment. It is available to part-time
and full-time students, and the program need not lead to a degree,
credential, or certificate.

Impact

The deduction benefits taxpayers according to their marginal tax rate (see
Appendix A). Students usually have relatively low tax rates, but they may be
part of families in higher tax brackets. As shown in the table below, most of
the deductions are taken by higher income families. The maximum amount of
deductible expenses limits the tax benefit's impact on individuals attending
schools with comparatively high tuition and fees. Because the income limits
are not adjusted for inflation, the deduction might be available to fewer
taxpayers over time.

Distribution by Income Class of Education
Deduction at 2004 Income Levels

Income Class
(in thousands of $)

Percentage
Distribution

Below $10

17.3

$10 to $20

8.3

$20 to $30

6.4

$30 to $40

4.6

$40 to $50

7.4

$50 to $75

13.3

$75 to $100

16.2

$100 to $200

26.4

$200 and over

0.0

Source: Data obtained from IRS Statistics of Income. This is not a
distribution of the tax expenditures, but of the deduction; it is classified by
adjusted gross income.

Rationale

The temporary deduction, which was authorized by the Economic
Growth and Tax Relief Reconciliation Act of 2001 for 2002 through
2005, builds upon postsecondary tax benefits that were initiated by
the Taxpayer Relief Act of 1997. It is one additional means that
Congress has chosen to help families who are unlikely to qualify for
much need-based federal student aid pay for escalating college
expenses. H.R. 6111, passed in December 2006, extended the
benefit through 2007.

Assessment

The deduction has been criticized for adding to the complexity
faced by families trying to determine which higher education tax
benefits they are eligible for and what combination is their optimal
mix for financing postsecondary education. Between 2002 and
2005, for example, those taxpayers whose incomes fell below the
credit's lower income cutoff could claim either a higher education
tax credit or the deduction. In addition, the deduction must be
coordinated with tax-advantaged college savings vehicles (e.g., the
Coverdell Education Savings Accounts and Qualified Tuition Plans).

Selected Bibliography

Education, Training, Employment and Social Services:
Education and Training

EXCLUSION OF TAX ON EARNINGS
OF QUALIFIED TUITION PROGRAMS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.7

2007

0.8

2008

0.9

2009

1.0

2010

1.0

Authorization

Section 529.

Description

There are two types of Qualified Tuition Programs (QTPs) that
allow persons to pay in advance or save for college expenses for
designated beneficiaries: prepaid tuition plans and college savings
plans. The former enable account owners to make payments on
behalf of beneficiaries for a specified number of academic periods or
course units at current prices, thus providing a hedge against tuition
inflation. The latter enable payments to be made on behalf of
beneficiaries into a variety of investment vehicles offered by plan
sponsors (e.g., age-based portfolios whose mix of stocks and bonds
changes the closer the beneficiary's matriculation date or an option
with a guaranteed rate of return); the balances in college savings
accounts can be applied toward a panoply of qualified higher
education expenses (e.g., tuition and fees, books, supplies, and room
and board).

Initially, only states could sponsor QTPs. Starting in 2002, one or
more eligible institutions of higher education could establish prepaid
tuition plans. Eligible institutions are those eligible to participate in
U.S. Department of Education student aid programs; these include
most accredited public, private, and proprietary postsecondary
institutions. States remain the sole sponsors of tax-advantaged
college savings plans.

To be qualified, a QTP must receive cash contributions, maintain
separate accounting for each beneficiary, and not allow investments
to be directed by contributors and beneficiaries. (The last restriction
has been loosened somewhat as account owners now can make
tax-free transfers from one QTP to another for the same beneficiary
once in any 12-month period). A contributor may fund multiple
accounts for the same beneficiary in different states, and an
individual may be the designated beneficiary of multiple accounts.

The specifics of plans vary greatly from one state to another. Plan
sponsors may establish restrictions that are not mandated either by
the Code or federal regulation. There are no income caps on
contributors, unlike the limits that generally apply to taxpayers who
want to claim the other higher education benefits. Similarly, there is
no annual limit on contributions, unlike the case with the Coverdell
ESA.

There is no federal income tax deduction for contributions to
QTPs. Payments to QTPs are considered completed gifts of present
interest from the contributor to the beneficiary meaning that an
individual could contribute up to $12,000 in 2006 (subject to
indexation) as a tax-free gift per QTP beneficiary. A special gifting
provision allowed a QTP contributor to make an excludable gift of up
to $60,000 in one year by treating the payment as if it were made
over 5 years. By making QTP contributions completed gifts, their
value generally is removed from the contributor's taxable estate.

Earnings on contributions accumulate on a tax-deferred basis.
Starting in 2002 for state-sponsored plans and in 2004 for programs
of higher education institutions, earnings withdrawn to pay qualified
expenses are free from federal income tax. This change, as well as
other QTP amendments included in the Economic Growth and Tax
Relief Reconciliation Act of 2001, were due to expire after
December 31, 2010; however, Congress made the changes
permanent in the Pension Protection Act of 2006.

Except in the case of the beneficiary's death, disability, or receipt
of a scholarship, veterans educational assistance allowance or other
nontaxable payment for educational purposes (excluding a gift or
inheritance), a 10% tax penalty is assessed on the earnings portion of
distributions that exceed or are not used toward qualified higher
education expenses. Nonqualified earnings withdrawals are taxable
to the distributee as well. An account owner can avoid paying
income tax and a penalty on nonqualified distributions by
transferring the account to a new beneficiary who is a family member
of the old beneficiary.

Contributions can be made to a QTP and to a Coverdell ESA in the
same year for the same beneficiary effective after 2001. Also
starting in 2002, the higher education tax credits can be claimed for
tuition and fees in the same year that tax-free distributions are made
from a QTP or a Coverdell ESA on behalf of the same beneficiary,
provided that the distributions are not used toward the same expenses
for which the credits/deduction are claimed.

Impact

The tax deferral and more recently enacted exclusion from income of
account earnings used to pay qualified expenses benefits tax filing units
according to their marginal tax rate (see Appendix A). The tax benefits of
QTPs are more likely to accrue to higher income families because they have
higher tax rates and the means to save for college.

Tax benefits from QTPs might be offset by reductions in federal student
aid, much of which is awarded to students based on their financial need.
Generally, students have need when their cost of attendance exceeds their
expected family contribution (EFC). Until Congress amended the Higher
Education Act of 1965 in the Deficit Reduction Act of 2005, prepaid tuition
plans reduced a student's financial need to a much greater extent than college
savings plans. Both types of QTPs now are treated the same: according to
Department of Education guidance, the two shall be considered an asset of the
parent if the parent is the account owner. Because the law states that QTPs
shall not be considered an asset of the student, the Department's guidance
suggests that student-owned QTPs should not be considered in the EFC
calculation.

Rationale

QTPs have been established in response to widespread concern
about the rising cost of college. The tax status of the first program,
the Michigan Education Trust, was the subject of several federal
court rulings that left major issues unresolved. Congress eventually
clarified most questions in enacting section 529 as part of the Small
Business Job Protection Act of 1996.

Assessment

The tax benefit can be justified as easing the financial burden of
college expenses for families and encouraging savings for college.
The benefits are generally limited to higher income individuals,
however.

Families have preferred college savings plans over prepaid tuition
plans because the former potentially offer higher returns and because
college savings plans, until recently, received more favorable
treatment under some federal student aid programs. Despite the
steep decline in stock prices early in the current decade and the
increased awareness of the fees associated with plans sold by financial
advisors in particular, college savings accounts remain the most
popular type of 529 plan. (Broker-sold college savings plans impose
investment fees in addition to the administrative and other fees
charged by plans sold directly by the states.) While the changed
treatment of prepaid tuition plans in the EFC calculation could entice
more families to invest in them, they too have suffered from the poor
performance of the stock market (in which the funds of prepaid plans
typically are invested). In addition, the continuing rapid rise in
college costs has prompted some states to change the terms of their
prepaid tuition plans or to stop accepting contributions.

Selected Bibliography

Clancy, Margaret and Michael Sherraden. The Potential for Inclusion in
529 Savings Plans: Report on a Survey of States. Center for Social
Development, Washington University. St. Louis, MO: December 2003.
Crenshaw, Albert B. "Prepaid Tuition A Future Flunk-Out?," Washington
Post, Nov. 14, 2004.
Dynarksi, Susan M. Who Benefits from the Education Savings
Incentives? Income, Educational Expectations, and the Value of the
529 and Coverdell. National Bureau of Economic Research,
Working Paper 10470. Cambridge, MA: May 2004.
Investment Company Institute. Profile of Households Saving for
College. Washington, DC: Fall 2003.
Levine, Linda. Saving for College Through Qualified Tuition
(Section 529) Programs. Congressional Research Service Report
RL31214. Washington, DC: updated September 25, 2006.
Levine, Linda and Charmaine Mercer. Tax-Favored Higher
Education Benefits and Their Relationship to Traditional Federal
Student Aid. Congressional Research Service Report RL32155.
Washington, DC: updated September 28, 2006.
Lumina Foundation for Education. "When Saving Means Losing:
Weighing the Benefits of College-savings Plans," New Agenda Series,
July 2004.
Ma, Jennifer. Education Savings Incentives and Household Saving:
Evidence from the 2000 TIAA-CREF Survey of Participant Finances.
National Bureau of Economic Research, Working Paper 9505.
Cambridge, MA: February 2003.
Ma, Jennifer. To Save or Not to Save: A Closer Look at Saving and
Financial Aid. TIAA-CREF Institute, Working Paper 18-120103.
NY, NY: December 2003.

Education, Training, Employment, and Social Services:
Education and Training

EXCLUSION OF SCHOLARSHIP AND FELLOWSHIP INCOME

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

1.5

2007

1.6

2008

1.7

2009

1.8

2010

1.9

Authorization

Section 117.

Description

Scholarships and fellowships include awards based upon financial
need (e.g., Pell Grants) as well as those based upon scholastic
achievement or promise (e.g., National Merit Scholarships). In
recent years, interest has arisen in utilizing scholarships to promote
school choice at the elementary and secondary levels in lieu of
relying upon publicly funded vouchers.

Scholarships and fellowships can be excluded from the gross
income of students or their families provided: (1) the students are
pursuing degrees (or are enrolled in a primary or secondary school);
and (2) the amounts are used for tuition and fees required for
enrollment or for books, supplies, fees, and equipment required for
courses at an eligible educational institution. Eligible educational
institutions maintain a regular teaching staff and curriculum and have
a regularly enrolled student body attending classes where the school
carries out its educational activities. Amounts used for room, board,
and incidental expenses are not excluded from gross income.

Generally, amounts representing payment for services - teaching,
research, or other activities - are not excludable, regardless of when
the service is performed or whether it is required of all degree
candidates. An exception to the rule went into effect for awards
received after 2001 under the National Health Service Corps
Scholarship Program and the Armed Forces Health Professions
Scholarship and Financial Assistance Program.

Impact

The exclusion reduces the net cost of education for students who
receive financial aid in the form of scholarships or fellowships. The
potential benefit is greatest for students at private schools, where
higher tuition charges increase the amount of scholarship or
fellowship assistance that might be excluded. For students at public
institutions with low tuition charges, the exclusion may apply only to
a small portion of a scholarship or fellowship award since most ot the
award may cover room and board and other costs.

The effect of the exclusion may be negligible for students with little
additional income: they could otherwise use their standard deduction
or personal exemption to offset scholarship or fellowship income
(though their personal exemption would be zero if their parents could
claim them as dependents). On the other hand, the exclusion may
result in a more substantial tax benefit for married postsecondary
students who file joint returns with their employed spouses.

Rationale

Section 117 was enacted as part of the Internal Revenue Code of
1954 in order to clarify the tax status of grants to students;
previously, they could be excluded only if it could be established that
they were gifts. The statute has been amended a number of times.
Prior to the Tax Reform Act of 1986, the exclusion was also
available to individuals who were not candidates for a degree (though
it was restricted to $300 a month with a lifetime limit of 36 months),
and teaching and other service requirements did not bar use of the
exclusion, provided all candidates had such obligations.

Assessment

The exclusion of scholarship and fellowship income traditionally
was justified on the grounds that the awards were analogous to gifts.
With the development of grant programs based upon financial need,
which today probably account for most awards, justification now rests
upon the hardship that taxation would impose.

If the exclusion were abolished, awards could arguably be
increased to cover students' additional tax liability, but the likely
effect would be that fewer students would get assistance.
Scholarships and fellowships are not the only educational subsidies
that receive favorable tax treatment (e.g., government support of
public colleges, which has the effect of lowering tuition, is not
considered income to the students), and it might be inequitable to tax
them without taxing the others.

The exclusion provides greater benefits to taxpayers with higher
marginal tax rates. While students themselves generally have low (or
even zero) marginal rates, they often are members of families subject
to higher rates. Determining what ought to be the proper taxpaying
unit for college students complicates assessment of the exclusion.

Selected Bibliography

Abramowicz, Kenneth F. "Taxation of Scholarship Income," Tax Notes, v.
60. November 8, 1993, pp. 717-725.
Crane, Charlotte. "Scholarships and the Federal Income Tax Base,"
Harvard Journal on Legislation, v. 28. Winter 1991, pp. 63-113.
Dodge, Joseph M. "Scholarships under the Income Tax," Tax Lawyer, v.
46. Spring, 1993, pp. 697-754.
Evans, Richard, et. al. "Knapp v. Commissioner of Internal
Revenue: Tuition Assistance or Scholarship, a Question of Taxation,"
The Journal of College and University Law, v. 16. Spring 1990, pp.
699-712.
Hoeflich, Adam. "The Taxation of Athletic Scholarships: A
Problem of Consistency,." University of Illinois Law Review, 1991,
pp. 581-617.
Kelly, Marci. "Financing Higher Education: Federal Income-Tax
Consequences," The Journal of College and University Law, v. 17.
Winter 1991, pp. 307-328.
Levine, Linda and Bob Lyke. Federal Taxation of Student Aid: An
Overview. Congressional Research Service Report 97-225. Washington,
DC.
Levine, Linda and David Smole. Federal Tax Benefits for Families' K-12
Education Expenses in the Context of School Choice. Congressional
Research Service Report RL31439. Washington, DC.

Education, Training, Employment, and Social Services:
Education and Training

EXCLUSION OF EMPLOYER-PROVIDED
EDUCATION ASSISTANCE BENEFITS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.8

2007

0.9

2008

0.9

2009

0.9

2010

0.9

Authorization

Section 127.

Description

An employee may exclude from gross income amounts paid by the
employer for educational assistance (tuition, fees, books, supplies, etc.)
pursuant to a written qualified educational assistance program. The annual
limit is $5,250. Any excess is includable in the employee's gross income and
is subject to both employment and income taxes. Amounts that exceed the
limit may be excludable if they meet the working condition fringe benefits
provision of Code Section 132.

Courses do not have to be job related. Those involving sports, games, or
hobbies are covered only if they involve the employer's business, however.
Courses can help employees meet minimum requirements for current work or
prepare for a new career. Graduate education undertaken after December 31,
2001and before January 1, 2011 is covered.

The employer may make qualified assistance payments directly, by
reimbursement to the employee, or may directly provide the education. The
plan may not discriminate in favor of highly compensated employees. One
requirement is that no more than 5% of the total amount paid out during the
year may be paid to or for employees who are shareholders or owners of at
least 5% of the business. The employer must maintain records and file a plan
return.

Impact

The exclusion of these benefit payments encourages employers to offer
educational assistance to employees. Availability of the benefit varies across
firms, depending upon such things as industry and occupation of employment
as well as firm size. Availability also varies within firms, depending upon the
number of hours an employee works (i.e., full-time or part-time schedules) for
example. The U.S. Bureau of Labor Statistics reports on the percent of
employees in the private sector with access to employer-provided educational
assistance. In 2006, for example, almost one-half of employees had access to
work-related educational assistance while only a little more than one-tenth
had access to nonwork-related educational assistance. In the case of work-
related educational assistance, a much larger share of white-collar workers (60
percent) had access to this employee benefit compared to blue-collar and
service workers (42 percent and 30 percent, respectively). Similarly, many
more full-time workers (56 percent) compared to part-time workers (26
percent) had access to work-related educational assistance in 2006.

The exclusion allows certain employees, who otherwise might be unable to
do so, to continue their education. The value of the exclusion is dependent
upon the amount of educational expenses furnished and the marginal tax rate.

Rationale

Section 127 was added to the law by the passage of the Revenue Act of
1978, effective through 1983. Prior to enactment, the treatment of employer-
provided educational assistance was complex, with a case-by-case
determination of whether the employee could deduct the assistance as job-
related education.

Since its inception, the provision was reauthorized ten times. It first was
extended from the end of 1983 through 1985 by the Education Assistance
Programs. The Tax Reform Act of 1986 next extended it through 1987, and
raised the maximum excludable assistance from $5,000 to $5,250. The
Technical and Miscellaneous Revenue Act of 1988 reauthorized the exclusion
retroactively to January 1, 1989 and extended it through September 30, 1990.
The Revenue Reconciliation Act of 1990 then extended it through December
31, 1991, and the Tax Extension Act of 1991, through June 30, 1992. The
Omnibus Reconciliation Act of 1993 reauthorized the provision retroactively
and through December 31, 1994; the Small Business Job Protection Act re-
enacted it to run from January 1, 1995 through May 31, 1997. The Taxpayer
Relief Act of 1997 subsequently extended the exclusion - but only for
undergraduate education - with respect to courses beginning before June 1,
2000. The Ticket to Work and Work Incentives Improvement Act of 1999
extended the exclusion through December 31, 2001. With passage of the
Economic Growth and Tax Relief Reconciliation Act of 2001, the exclusion
was reauthorized to include graduate education undertaken through December
31, 2010. The act also extended the existing rules for employer provided
education assistance benefits until January 1, 2011. Congressional committee
reports indicate that the latest extension was designed to lessen the
complexity of the tax law and was intended to result in fewer disputes
between taxpayers and the Internal Revenue Service.

Assessment

The availability of employer educational assistance encourages employer
investment in human capital, which may be inadequate in a market economy
because of spillover effects (i.e., the benefits of the investment extend beyond
the individuals undertaking additional education and the employers for whom
they work). Because all employers do not provide educational assistance,
however, taxpayers with similar incomes are not treated equally.

Selected Bibliography

Black, Sandra and Lisa M. Lynch. "Human-Capital Investments and
Productivity," AEA Papers and Proceedings, v. 86 (May 1996), pp. 263-267.
Cappelli, Peter. Why Do Employers Pay for College?. National Bureau of
Economic Research. Working Paper 9225. Cambridge, MA: September
2002.
Levine, Linda. The Benefits of Education. Congressional Research
Service Report RL33238. Washington, DC: December 29, 2005.
Lyke, Bob and Linda Levine. The Current Tax Status of Employer
Education Assistance. Congressional Research Service Report 97-243.
Washington, DC: November 7, 2005.
Luscombe, Mark A. "Employer Educational Assistance Programs: Can the
Frustration of Lapses in Statutory Authority Be Avoided?" Taxes, v. 74 (April
1996), pp. 266-268.
Phillips, Lawrence C. and Thomas R. Robinson. "Financial Planning for
Education Expenditures." The CPA Journal, v. 72, no 4, (April 2002), pp.
34-39.
Selingo, Jeffrey. "Adult Education: The End of the Magic Carpet Ride?,"
Washington Post, November 9, 2003, p. W43.

U.S. General Accounting Office. Tax Expenditures: Information on
Employer-Provided Educational Assistance, GAO/GGD-97-28. Washington,
DC: December 1996.

Education, Training, Employment, and Social Services:
Education and Training

EXCLUSION OF EMPLOYER-PROVIDED
TUITION REDUCTION

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.2

2007

0.2

2008

0.2

2009

0.2

2010

0.2

Authorization

Section 11(d).

Description

Tuition reductions for employees of educational institutions may be
excluded from federal income taxes, provided they do not represent payment
for services. The exclusion applies as well to tuition reductions for an
employee's spouse and dependent children. Tuition reductions can occur at
schools other than where the employee works, provided they are granted by
the school attended, and not paid for by the employing school. Tuition
reductions cannot discriminate in favor of highly compensated employees.

Impact

The exclusion of tuition reductions reduces the net cost of education for
employees of educational institutions. When teachers and other school
employees take reduced-tuition courses, the exclusion provides a tax benefit
not available to other taxpayers unless their courses are job-related or
included under an employer education assistance plan (Section 127). When
their spouse or children take reduced-tuition courses, the exclusion provides a
unique benefit unavailable to other taxpayers.

Rationale

Language regarding tuition reductions was added by the Deficit Reduction
Act of 1984 as part of legislation codifying and establishing boundaries for
tax-free fringe benefits; similar provisions had existed in regulations since
1956.

Assessment

Tuition reductions are provided by education institutions to employees as
a fringe benefit, which may reduce costs of labor and turnover. In addition,
tuition reductions for graduate students providing research and teaching
services for the educational institution also contribute to reducing the labor
costs. Both employees and graduate students may view the reduced tuition as
a benefit of their employment that encourages education.

Selected Bibliography

Lyke, Bob and Linda Levine. The Current Tax Status of Employer
Education Assistance. Library of Congress, Congressional Research Service
Report 97-243. Washington, DC: February 4, 2002.
U.S. Congress, Joint Committee on Taxation, General Explanation of the
Revenue Provisions of the Deficit Reduction Act of 1984, JCS-41-84,
December 31, 1984.

Education, Training, Employment, and Social Services:
Education and Training

PARENTAL PERSONAL EXEMPTION
FOR STUDENTS AGE 19-23

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.5

1.1

2007

0.2

0.5

2008

0.2

0.3

2009

0.1

0.2

2010

(1)

(1)Positive tax expenditure of less than $50 million.

Authorization
Section 151.

Description

Taxpayers may claim dependency exemptions for children 19 through 23
years of age who are full-time students at least 5 months during the year, even
if the children have gross income in excess of the personal exemption amount
($3,300 in 2006) and could not normally be claimed. Other standard
dependency tests must be met, including the taxpayer's provision of one-half
of the dependents' support. These dependents cannot claim personal
exemptions on their own returns, however, and their standard deduction may
be lower. In 2006, with some exceptions, the standard deduction for students
is equal to the greater of $800 (in any combination of earned or unearned
income) or their earned income plus up to $250 of unearned income
providing it does not exceed the standard deduction amount of $5,150 for
single taxpayers. If the student's income is greater than these amounts in
2006, he or she must file a tax return.

Impact

The student dependency exemption generally results in additional tax
savings for families with college students. Parents typically have higher
income and higher marginal tax rates than their student children (who may
not even be taxed); thus, the exemption is worth more if parents claim it.
Parents lose some or all of the student dependency exemption if their adjusted
gross income is greater than the inflation adjusted threshold for phasing out
personal exemptions. In 2006 the threshold amounts begin at: $225,750 for
joint returns, $150,500 for single returns, or $188,150 for heads of household.

Rationale

With the codification in 1954, the Internal Revenue Code first allowed
parents to claim dependency exemptions for their children regardless of the
student's gross income, provided they were less than 19 years old or were
full-time students for at least 5 months. Under prior law, such exemptions
could not be claimed for any child whose gross income exceeded $600 (the
amount of the personal exemption at the time). Committee reports for the
legislation noted that the prior rule was a hardship for parents with children in
school and an inducement for the children to stop working before their
earnings reached that level.

Under the 1954 Code, dependents whose exemptions could be claimed by
their parents could also claim personal exemptions on their own returns. The
Tax Reform Act of 1986 disallowed double exemptions, limiting claims just
to the parents. It did allow a partial standard deduction for students equal to
the greater of $500 (earned and/or unearned income), or earned income up to
the generally applicable standard deduction amount. As a result, students
with no earned income were able to shelter up to $500 in unearned income
from taxation. The $500 is indexed for inflation as is the amount of the
standard deduction.

The Technical and Miscellaneous Revenue Act of 1988 restricted the
student dependency exemption to children under the age of 24. Students who
are older than 23 can be claimed as dependents only if their gross income is
less than the personal exemption amount.

The Taxpayer Relief Act of 1997 raised students' standard deduction to the
greater of $700 ($500 adjusted for inflation) or the total of earned income
plus $250 in unearned income provided the total did not exceed the full
standard deduction. This change, effective beginning in 1998, enables
students with earned income greater than $700 but less than the standard
deduction amount and with little unearned income to shelter their unearned
income from taxation and to no longer file a separate tax return (unless they
must do so to claim a refund of withheld tax). The limit on unearned income
is adjusted annually for inflation.

The Working Family Tax Relief Act of 2004 (P.L. 108-311) revised the
definition of a child for tax purposes, beginning with tax year 2005.
Specifically, the law replaced the definition of a dependent for the personal
exemption with requirements (or tests) that define new categories of
dependents. Under this definition, a child is a qualifying child of the taxpayer
if the child satisfies three tests: (1) the child has not yet attained a specified
age; (2) the child has a specified relationship to the taxpayer; and (3) the child
has the same principal place of abode as the taxpayer for more than half the
taxable year.

Assessment

The student dependency exemption was created before the development of
broad-based federal student aid programs, and some of its effects might be
questioned in light of their objectives. The exemption principally benefits
families with higher incomes, and the tax savings are not related to the cost of
education. In contrast, most federal student aid is awarded according to
financial need formulas that reflect both available family resources and
educational cost.

Nonetheless, the original rationale for the student dependency exemption
remains valid. If the exemption did not exist, as was the case before 1954,
students who earned more than the personal exemption amount would cause
their parents to lose a dependency exemption worth hundreds of dollars,
depending on the latter's tax bracket. Unless they would earn a lot more
money, students who knew of this consequence might stop working at the
point their earnings reached the personal exemption amount.

Selected Bibliography

Bittker, Boris I. "Federal Income Taxation and the Family," 27 Stanford
Law Review 1389, esp. pp. 1444-1456 (1975).
Jackson, Pamela J. Standard Deduction and Personal
Dependency Amounts for Children 14 and Over or Students, Library of
Congress, Congressional Research Service Report RS20072, (Washington,
DC, June 28, 2006).
Scott, Christine. Tax Benefits for Families: Changes in the
Definition of a Child, Library of Congress, Congressional Research
Service Report RS22016, (Washington, DC, March 10, 2006).
U.S. Congress, Joint Committee on Taxation. General Explanation of the
Tax Reform Act of 1986 (H.R. 3838, 99th Congress; Public Law 99-514),
(Washington, DC, May 4, 1987), pp. 22-24.

U.S. Department of Treasury, Internal Revenue Service, Publication 501:
Exemptions, Standard Deduction, and Filing Information, (Washington, DC:
2005).

Education, Training, Employment, and Social Services:
Education and Training

EXCLUSION OF INTEREST ON STATE AND
LOCAL GOVERNMENT STUDENT LOAN BONDS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.3

0.1

0.4

2007

0.3

0.1

0.4

2008

0.3

0.1

0.4

2009

0.4

0.1

0.5

2010

0.4

0.1

0.5

Authorization

Sections 103, 141, 144, and 146.

Description

Since interest on student loan bonds is tax exempt, purchasers are willing
to accept lower pre-tax rates of interest than on taxable securities. The
relatively low interest rate may increase the availability of student loans
because States may be more willing to lend to more students. The interest
rate paid by the students is not any lower since the rate is set by Federal law.
Student loan bonds also create a secondary market for student loans that
compares favorably with the private sector counterpart in the secondary
market for such loans, the Student Loan Marketing Association.

These student loan bonds are subject to the private-activity bond annual
volume cap, and must compete for cap allocations with bond proposals for all
other private activities subject to the volume cap.

Student loan bonds are related to direct subsidy assistance provided by the
Federal Family Education Loan Program that consists of Stafford loans
("subsidized" and "unsubsidized") and "PLUS loans."

The Stafford Loan program

(1) provides a guarantee to commercial lenders against loan default;

(2) makes an interest-rate subsidy in the form of a Special Allowance
Payment (SAP), which for commercial lenders (banks) fluctuates with the rate
on 3-month commercial paper and makes up the difference between the
interest rate the student pays and the interest that banks could earn on
alternative investments; and

(3) for Stafford "subsidized" loans only, forgoes both accrual and payment
of interest and principal while the student is in school and for six months after
the student leaves school.

(4) for Stafford "unsubsidized" loans, interest is paid while students are in
school, so the Federal subsidy is less than on Stafford "subsidized" loans.

PLUS loans are also guaranteed against default, but the maximum interest
rates are higher, and interest is paid while students are in school. The interest
rates that borrowers pay under the Stafford and PLUS programs are set by law
and are the same regardless of whether loan financing comes from taxable or
tax-exempt sources. Thus, tax-exempt borrowing does not provide lower
interest rates for borrowers, but it does broaden access to loans by enabling
State and local nonprofit authorities to make loans that may otherwise not be
provided.

Impact

Since interest on the student loan bonds is tax exempt, purchasers are
willing to accept lower pre-tax rates of interest than on taxable securities. The
relatively low interest rate may increase the availability of students loans
because States may be more willing to lend to more students. However, the
interest rate paid by the students is not any lower since the rate is set by
Federal law. Student loan bonds also create a secondary market for student
loans that compares favorably with the private sector counterpart in the
secondary market for students loans, the Student Loan Marketing Association.

Some of the benefits of the tax exemption also flow to bondholders. For a
discussion of the factors that determine the shares of benefits going to
bondholders and student borrowers, and for estimates of the distribution of
tax-exempt interest income by income class, see the "Impact" discussion
under General Purpose Public Assistance: Exclusion of Interest on Public
Purpose State and Local Debt.

Rationale

Although the first student loan bonds were issued in the mid-1960s, few
states used them in the next ten years. The use of student loan bonds began
growing rapidly in the late 1970s because of the combined effect of three
pieces of legislation.

First, the Tax Reform Act of 1976 authorized nonprofit corporations
established by State and local governments to issue tax-exempt bonds to
acquire guaranteed student loans. It exempted the special allowance payment
from tax-code provisions prohibiting arbitrage profits (borrowing at low
interest rates and investing the proceeds in assets (e.g., student loans) paying
higher interest rates). State authorities could use arbitrage earnings to make
or purchase additional student loans or turn them over to the State
government or a political subdivision. This provided incentives for State and
local governments to establish more student loan authorities. State authorities
could also offer discounting and other features private lenders could not
because of the lower cost of tax-exempt debt financing.

Second, the Middle Income Student Assistance Act of 1978 made all
students, regardless of family income, eligible for interest subsidies on their
loans, expanding the demand for loans by students from higher-income
families.

Third, legislation in late 1976 raised the ceiling on SAPs and tied them to
quarterly changes in the 91-day Treasury bill rate. The Higher Education
Technical Amendments of 1979 removed the ceiling, making the program
more attractive to commercial banks and other lenders, and increasing the
supply of loans.

In 1980, when Congress became aware of the profitability of tax-exempt
student loan bond programs, it passed remedial legislation that reduced by
one-half the special allowance rate paid on loans originating from the
proceeds of tax-exempt bonds.

Subsequently, the Deficit Reduction Act of 1984 mandated a
Congressional Budget Office study of the arbitrage treatment of student loan
bonds, and required that Treasury enact regulations if Congress failed to
respond to the study's recommendations.

Regulations were issued in 1989, effective in 1990, that required Special
Allowance Payments to be included in the calculation of arbitrage profits, and
that restricted arbitrage profits to 2.0 percentage points in excess of the yield
on the student loan bonds. The Tax Reform Act of 1986 allowed student
loans to earn 18 months of arbitrage profits on unspent (not loaned) bond
proceeds. This special provision expired one-and-a-half years after adoption,
and student loans are now subject to the same six-month restriction on
arbitrage earnings as other private-activity bonds.

The Tax Reform Act of 1986 also included student loan bonds under the
unified volume cap on private-activity bonds.

Assessment

The desirability of allowing these bonds to be eligible for tax-exempt status
hinges on one's view of whether students should pay the full cost of their
education, or whether sufficient social benefits exist to justify taxpayer
subsidy. Students present high credit risk due to their uncertain earning
prospects, high mobility, and society's unwillingness to accept human capital
as loan collateral (via indentured servitude or slavery). This suggests there
may be insufficient funds available for human, as opposed to physical, capital
investments.

Even if a case can be made for subsidy due to underinvestment in human
capital, it is not clear that tax-exempt financing is necessary to correct the
market failure. The presence of federally subsidized guaranteed and direct
loans already addresses the problem. In addition, it is important to recognize
the potential costs. As one of many categories of tax-exempt private-activity
bonds, bonds issued for student loans have increased the financing costs of
bonds issued for public capital stock, and have increased the supply of assets
available to individuals and corporations to shelter their income from
taxation.

Selected Bibliography

Maguire, Steven. Private Activity Bonds: An Introduction. Library of
Congress, Congressional Research Service Report RL31457. November 10,
2004.
-. Tax-Exempt Bonds: A Description of State and Local Government
Debt. Library of Congress, Congressional Research Service Report
RL30638. October 22, 2004.
Neubig, Tom. "The Needless Furor Over Tax-Exempt Student Loan
Bonds," Tax Notes, April 2, 1984, pp. 93-96.
Oosterbeek, Hessel. "Innovative Ways to Finance Education and Their
Relation to Lifelong Learning," Education Economics, v. 6, no. 3, (Dec.
1998), pp. 219-251.
Stoll, Adam. Federal Family Education Loan Program and William D.
Ford Direct Loan Program Student Loans: Terms and Conditions for
Borrowers. Library of Congress, Congressional Research Service Report
RL33673. September 29, 2006.

U.S. Congress, Congressional Budget Office. Statement of Donald B.
Marron before the Subcommittee on Select Revenue Measures Committee on
Ways and Means U.S. House of Representatives. "Economic Issues in the
Use of Tax-Preferred Bond Financing," March 16, 2006.
-. The Tax-Exempt Financing of Student Loans. August 1986.
Zimmerman, Dennis. The Private Use of Tax-Exempt Bonds: Controlling
Public Subsidy of Private Activity. Washington, DC: The Urban Institute
Press, 1991.
-, and Barbara Miles. "Substituting Direct Government Lending for
Guaranteed Student Loans: How Budget Rules Distorted Economic Decision
Making," National Tax Journal, v. 47, no. 4 (December 1994), pp. 773-787.

Education, Training, Employment and Social Services:
Education and Training

EXCLUSION OF INTEREST ON STATE AND LOCAL
GOVERNMENT BONDS FOR PRIVATE NONPROFIT
AND QUALIFIED PUBLIC EDUCATIONAL FACILITIES

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

1.1

0.4

1.5

2007

1.2

0.5

1.7

2008

1.2

0.5

1.7

2009

1.3

0.5

1.8

2010

1.3

0.5

1.8

Authorization

Section 103, 141, 142(k), 145, 146, and 501(c)(3).

Description

Interest income on State and local bonds used to finance the construction
of nonprofit educational facilities (usually university and college facilities
such as classrooms and dormitories) and qualified public educational facilities
is tax exempt. These nonprofit organization bonds are classified as private-
activity bonds rather than governmental bonds because a substantial portion
of their benefits accrues to individuals or business rather than to the general
public. For more discussion of the distinction between governmental bonds
and private-activity bonds, see the entry under General Purpose Public
Assistance: Exclusion of Interest on Public Purpose State and Local Debt.

Bonds issued for nonprofit educational facilities are not subject to the State
volume cap on private activity bonds. This exclusion probably reflects the
belief that the nonprofit bonds have a larger component of benefit to the
general public than do many of the other private activities eligible for tax
exemption. The bonds are subject to a $150 million cap on the amount of
bonds any nonprofit institution can have outstanding.

Bonds issued for qualified public education facilities are subject to a
separate state-by-state cap: the greater of $10 per capita or $5 million
annually.

Impact

Since interest on the bonds is tax exempt, purchasers are willing to accept
lower before-tax rates of interest than on taxable securities. These low
interest rates enable issuers to finance educational facilities at reduced interest
rates. Some of the benefits of the tax exemption also flow to bondholders.
For a discussion of the factors that determine the shares of benefits going to
bondholders and users of the nonprofit educational facilities, and estimates of
the distribution of tax-exempt interest income by income class, see the
"Impact" discussion under General Purpose Public Assistance: Exclusion of
Interest on Public Purpose State and Local Debt.

Rationale

An early decision of the U.S. Supreme Court predating the enactment of
the first Federal income tax, Dartmouth College v. Woodward (17 U.S. 518
[1819]), confirmed the legality of government support for charitable
organizations that provided services to the public. The income tax adopted in
1913, in conformance with this principle, exempted from taxation virtually
the same organizations now included under Section 501(c)(3). In addition to
their tax- exempt status, these institutions were permitted to receive the
benefits of tax-exempt bonds under The Revenue and Expenditure Control
Act of 1968. Almost all States have established public authorities to issue
tax-exempt bonds for nonprofit educational facilities.

The interest exclusion for qualified public educational facilities was
provided for in the Economic Growth and Tax Relief Reconciliation Act of
2001 and is intended to extend tax preferences to public school facilities
which are owned by private, for-profit corporations. The school must have,
however, a public-private agreement with the local education authority. The
private-activity bond status of these bonds subjects them to more severe
restrictions in some areas, such as arbitrage rebate and advance refunding,
than would apply if they were classified as traditional governmental school
bonds.

Assessment

Efforts have been made to reclassify nonprofit bonds as governmental
bonds. Central to this issue is the extent to which nonprofit organizations are
fulfilling their public purpose rather than using their tax-exempt status to
convert tax subsidies into subsidized goods and services for groups that might
receive more critical scrutiny if their subsidy were provided through direct
federal expenditure.

As one of many categories of tax-exempt private-activity bonds, nonprofit
educational facilities and public education bonds have increased the financing
costs of bonds issued for public capital stock and increased the supply of
assets available to individuals and corporations to shelter their income from
taxation.

Selected Bibliography

Maguire, Steven. Private Activity Bonds: An Introduction. Library of
Congress, Congressional Research Service Report RL31457. November 10,
2004.
-. Tax-Exempt Bonds: A Description of State and Local Government
Debt. Library of Congress, Congressional Research Service Report
RL30638. October 22, 2004.
U.S. Congress, Joint Committee on Taxation, General Explanation of Tax
Legislation Enacted in the 107th Congress, Joint Committee Print JCS-1-03,
January 24, 2003.
Weisbrod, Burton A. The Nonprofit Economy. Cambridge, Mass.:
Harvard University Press, 1988.
Zimmerman, Dennis. "Nonprofit Organizations, Social Benefits, and Tax
Policy," National Tax Journal. September 1991, pp. 341-349.
-. The Private Use of Tax-Exempt Bonds: Controlling Public Subsidy of
Private Activities. Washington, DC: The Urban Institute Press, 1991.

Education, Training, Employment and Social Services:
Education and Training

TAX CREDIT FOR HOLDERS OF
QUALIFIED ZONE ACADEMY BONDS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.1

2007

0.1

2008

0.1

2009

0.1

2010

0.1

Authorization

Section 1397E.

Description

Holders of qualified zone academy bonds (QZABs) can claim a credit
equal to the dollar value of the bonds held multiplied by a credit rate
determined by the Secretary of the Treasury. The credit rate is equal to the
percentage that will permit the bonds to be issued without discount and
without interest cost to the issuer. The maximum maturity of the bonds is that
which will set the present value of the obligation to repay the principal equal
to 50 percent of the face amount of the bond issue. The discount rate for the
calculation is the average annual interest rate on tax-exempt bonds issued in
the preceding month having a term of at least 10 years. The bonds must be
purchased by a bank, insurance company, or a corporation in the business of
lending money.

A qualified zone academy must be a public school below the college level.
It must be located in an Empowerment Zone or Enterprise Community, or
have a student body whose eligibility rate for free or reduced-cost lunches is
at least 35 percent. Ninety-five percent of bond proceeds must be used within
five years to renovate capital facilities, provide equipment, develop course
materials, or train personnel. The academy must operate a special academic
program in cooperation with businesses, and private entities must contribute
equipment, technical assistance, employee services, or other property worth at
least 10 percent of bond proceeds. The limit for new QZAB debt is $400
million in each year of 1998 through 2007.

Impact

The interest income on bonds issued by State and local governments
usually is excluded from Federal income tax (see the entry "Exclusion of
Interest on Public Purpose State and Local Debt"). Such bonds result in the
Federal Government paying a portion (approximately 25 percent) of the
issuer's interest costs. QZABs are structured to have the entire interest cost
of the State or local government paid by the Federal Government in the form
of a tax credit to the bond holders. QZABs are not tax-exempt bonds.

The cost has been capped at the value of federal tax credits generated by
the $3.2 billion QZAB volume. If the school districts in any state do not use
their annual allotment, the unused capacity can be carried forward for up to
two years.

Rationale

The Taxpayer Relief Act of 1997 created QZABs. Some low-income
school districts were finding it difficult to pass bond referenda to finance new
schools or to rehabilitate existing schools. Increasing the size of the existing
subsidy provided by tax-exempt bonds from partial to 100 percent Federal
payment of interest costs was expected to make school investments less
expensive and therefore more attractive to taxpayers in these poor districts.
The tax provision is also intended to encourage public/private partnerships,
and eligibility depends in part on a school district's ability to attract private
contributions that have a present value equal to at least 10 percent of the value
of the bond proceeds. H.R. 6111 (December 2006) extended QZAB's for
two years, introduced the five year spending horizon, and applied arbitrage
rules.

Assessment

One way to think of this alternative subsidy is that financial institutions can
be induced to purchase these bonds if they receive the same after-tax return
from the credit that they would from the purchase of tax-exempt bonds. The
value of the credit is included in taxable income, but is used to reduce regular
or alternative minimum tax liability. Assuming the taxpayer is subject to the
regular corporate income tax, the credit rate should equal the ratio of the
purchaser's forgone market interest rate on tax-exempt bonds divided by one
minus the corporate tax rate. For example, if the tax-exempt interest rate is 6
percent and the corporate tax rate is 35 percent, the credit rate would be equal
to .06/(1-.35), or about 9.2 percent. Thus, a financial institution purchasing a
$1,000 zone academy bond would receive a $92 tax credit for each year it
holds the bond.

With QZABs, the Federal Governments pays 100 percent of interest costs;
tax-exempt bonds that are used for financing other public facilities finance
only a portion of interest costs. For example, if the taxable rate is 8 percent
and the tax-exempt rate is 6 percent, the non-zone bond receives a subsidy
equal to two percentage points of the total interest cost, the difference
between 8 percent and 6 percent. The zone academy bond receives a subsidy
equal to all 8 percentage points of the interest cost. Thus, this provision
reduces the price of investing in schools compared to investing in other public
services provided by a governmental unit, and other things equal should cause
some reallocation of the units budget toward schools. In addition, the entire
subsidy (the cost to the Federal taxpayer) is received by the issuing
government in the form of reduced interest costs, unlike tax-exempt bonds in
which part of the Federal revenue loss is a windfall gain for some purchasers
and does not act to reduce the issuing government's interest cost.

Selected Bibliography

Education, Training, Employment, and Social Services:
Education and Training

DEDUCTION FOR CHARITABLE CONTRIBUTIONS
TO EDUCATIONAL INSTITUTIONS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

5.3

0.7

6.0

2007

5.9

0.7

6.2

2008

6.3

0.7

7.0

2009

6.8

0.8

7.6

2010

7.1

0.8

7.9

Authorization

Section 170 and 642(c).

Description

Subject to certain limitations, charitable contributions may be deducted by
individuals, corporations, and estates and trusts. The contributions must be
made to specific types of organizations, including scientific, literary, or
educational organizations.

Individuals who itemize may deduct qualified contribution amounts of up
to 50 percent of their adjusted gross income (AGI) and up to 30 percent for
gifts of capital gain property. For contributions to nonoperating foundations
and organizations, deductibility is limited to the lesser of 30 percent of the
taxpayer's contribution base, or the excess of 50 percent of the contribution
base for the tax year over the amount of contributions which qualified for the
50-percent deduction ceiling (including carryovers from previous years).
Gifts of capital gain property to these organizations are limited to 20 percent
of AGI.

The maximum amount deductible by a corporation is 10 percent of its
adjusted taxable income. Adjusted taxable income is defined to mean taxable
income with regard to the charitable contribution deduction, dividends-
received deduction, any net operating loss carryback, and any capital loss
carryback. Excess contributions may be carried forward for five years.
Amounts carried forward are used on a first-in, first-out basis after the
deduction for the current year's charitable gifts have been taken. Typically, a
deduction is allowed only in the year in which the contribution occurs.
However, an accrual-basis corporation is allowed to claim a deduction in the
year preceding payment if its board of directors authorizes a charitable gift
during the year and payment is scheduled by the 15th day of the third month of
the next tax year.

If a contribution is made in the form of property, the deduction depends on
the type of taxpayer (i.e., individual, corporate, etc.), recipient, and purpose.

As a result of the enactment of the American Jobs Creation Act of 2004,
P.L. 108-357, donors of noncash charitable contributions face increased
reporting requirements. For charitable donations of property valued at $5,000
or more, donors must obtain a qualified appraisal of the donated property.
For donated property valued in excess of $500,000, the appraisal must be
attached to the donor's tax return. Deductions for donations of patents and
other intellectual property are limited to the lesser of the taxpayer's basis in
the donated property or the property's fair market value. Taxpayers can claim
additional deductions in years following the donation based on the income the
donated property provides to the donee. The 2004 act also mandated
additional reporting requirements for charitable organizations receiving
vehicle donations from individuals claiming a tax deduction for the
contribution, if it is valued in excess of $500.

Taxpayers are required to obtain written substantiation from a donee
organization for contributions that exceed $250. This substantiation must be
received no later than the date the donor-taxpayer files the required income
tax return. Donee organizations are obligated to furnish the written
acknowledgment when requested with sufficient information to substantiate
the taxpayer's deductible contribution.

The Pension Protection Act of 2006 (P.L. 109-280) included several
provisions that temporarily expand charitable giving incentives. The
provisions, effective after December 31, 2005 and before January 1, 2008,
include enhancements to laws governing non-cash gifts and tax-free
distributions from individual retirement plans for charitable purposes. The
2006 law also tightened rules governing charitable giving in certain areas,
including gifts of taxidermy, contributions of clothing and household items,
contributions of fractional interests in tangible personal property, and record-
keeping and substantiation requirements for certain charitable contributions.

Impact

The deduction for charitable contributions reduces the net cost of
contributing. In effect, the federal government provides the donor with a
corresponding grant that increases in value with the donor's marginal tax
bracket. Those individuals who use the standard deduction or who pay no
taxes receive no benefit from the provision.

A limitation applies to the itemized deductions of high-income taxpayers.
Under this provision, in 2006, otherwise allowable deductions are reduced by
3 percent of the amount by which a taxpayer's adjusted gross income (AGI)
exceeds $150,500 (adjusted for inflation in future years). The table below
provides the distribution of all charitable contributions, not just those to
educational organizations.

Distribution by Income Class of the Tax Expenditure
for Charitable Contributions, 2005

Income Class
(in thousands of $)

Percentage
Distribution

Below $10

0.0

$10 to $20

0.1

$20 to $30

0.5

$30 to $40

1.1

$40 to $50

2.0

$50 to $75

8.3

$75 to $100

9.6

$100 to $200

28.7

$200 and over

49.7

Before the 2004 enactment, donors could deduct the fair market value of
donations of intellectual property. The new restrictions may result in fewer
such donations to universities and other qualified institutions. The need to
account for any increased income attributable to the donation might involve
more work for recipient institutions.

Rationale

This deduction was added by passage of the War Revenue Act of October
3, 1917. Senator Hollis, the sponsor, argued that high wartime tax rates
would absorb the surplus funds of wealthy taxpayers, which were generally
contributed to charitable organizations.

It was also argued that many colleges would lose students to the military
and charitable gifts were needed by educational institutions. Thus, the
original rationale shows a concern for educational organizations. The
deduction was extended to estates and trusts in 1918 and to corporations in
1935.

The provisions enacted in 2004 resulted from Internal Revenue Service
and congressional concerns that taxpayers were claiming inflated charitable
deductions, causing significant federal revenue loss. In the case of patent and
other intellectual property donations, the IRS expressed concern not only
about overvaluation of property, but also whether consideration was received
in return for the donation and whether only a partial interest, rather than full
interest, of property was being transferred. The 2006 enactments were, in
part, a result of continued concerns from 2004.

Assessment

Most economists agree that education produces substantial "spillover"
effects benefitting society in general. Examples include a more efficient
workforce, lower unemployment rates, lower welfare costs, and less crime.
An educated electorate fosters a more responsive and effective government.
Since these benefits accrue to society at large, they argue in favor of the
government actively promoting education.

Further, proponents argue that the Federal government would be forced to
assume some activities now provided by educational organizations if the
deduction were eliminated. However, public spending might not be available
to make up all the difference. Also, many believe that the best method of
allocating general welfare resources is through a dual system of private
philanthropic giving and governmental allocation.

Economists have generally held that the deductibility of charitable
contributions provides an incentive effect which varies with the marginal tax
rate of the giver. There are a number of studies which find significant
behavioral responses, although a study by Randolph suggests that such
measured responses may largely reflect transitory timing effects.

Types of contributions may vary substantially among income classes. For
example, contributions to religious organizations are far more concentrated at
the lower end of the income scale than contributions to educational
institutions. More highly valued contributions, like intellectual property and
patents, tend to be made by corporations to educational institutions.

It has been estimated by the American Association of Fund-Raising
Counsel Trust for Philanthropy, Inc. that giving to public and private colleges,
universities, elementary schools, secondary schools, libraries, and to special
scholarship funds, nonprofit trade schools, and other educational facilities
amounted to $38.56 billion in calendar year 2005.

Opponents say that helping educational organizations may not be the best
way to spend government money. Opponents further claim that the present
system allows wealthy taxpayers to indulge special interests (such as gifts to
their alma mater).

To the extent that charitable giving is independent of tax considerations,
federal revenues are lost without any corresponding increase in charitable
gifts. It is generally argued that the charitable contributions deduction is
difficult to administer and adds complexity to the tax code.

Selected Bibliography

Aprill, Ellen P. "Churches, Politics, and the Charitable Contribution
Deduction," Boston College Law Review, v. 42 (July 2001), pp. 843-873.
Arnone, Michael. "Congress Approves Lower Tax Benefits for Donations
of Intellectual Property," Chronicle of Higher Education, v. 51, iss. 9,
October 22, 2004, p. A36.
Broman, Amy J. "Statutory Tax Rate Reform and Charitable
Contributions: Evidence from a Recent Period of Reform," Journal of the
American Taxation Association. Fall 1989, pp. 7-21.
Giving USA 2006, The Annual Report on Philanthropy for the Year 2005,
The Center on Philanthropy At Indiana University. Indiana University-
Purdue University, Indianapolis: 2006.
Buckles, Johnny Rex. "The Case for the Taxpaying Good Samaritan:
Deducting Earmarked Transfers to Charity Under Federal Income Tax Law,
Theory and Policy," Fordham Law Review, v. 70 (March 2002), pp. 1243-
1339.
"Bush Signs Corporate Tax Legislation Restricting Donations of
Intellectual Property," Higher Education and National Affairs, October 27,
2004.
Crimm, Nina J. "An Explanation of the Federal Income Tax Exemption
for Charitable Organizations: A Theory of Risk Compensation," Florida Law
Review, v. 50 (July 1998), pp. 419-462.
Clotfelter, Charles T. "The Impact of Tax Reform on Charitable Giving:
A 1989 Perspective." In Do Taxes Matter? The Impact of the Tax Reform
Act of 1986, edited by Joel Slemrod, Cambridge, Mass.: MIT Press, 1990.
-. "The Impact of Fundamental Tax Reform on Nonprofit Organizations."
In Economic Effects of Fundamental Tax Reform, Eds. Henry J. Aaron and
William G. Fale. Washington, DC: Brookings Institution Press, 1996, pp.
211-246.
Colombo, John D. "The Marketing of Philanthropy and the Charitable
Contributions Deduction: Integrating Theories for the Deduction and Tax
Exemption," Wake Forest Law Review, v. 36 (Fall 2001), pp. 657-703.

Feenberg, Daniel. "Are Tax Price Models Really Identified: The Case of
Charitable Giving," National Tax Journal, v. 40, (December 1987), pp. 629-
633.
Feldman, Naomi and James Hines, Jr. "Tax Credits and Charitable
Contributions in Michigan," University of Michigan, Working Paper, October
2003.
Fisher, Linda A. "Donor-Advised Funds: The Alternative to Private
Foundations," Cleveland Bar Journal, v. 72 (July/August 2001), pp. 16-17.
Gravelle, Jane. Economic Analysis of the Charitable Contribution
Deduction for Nonitemizers, Library of Congress Congressional Research
Service Report RL31108, April 29, 2005.
Green, Pamela and Robert McClelland. "Taxes and Charitable Giving,"
National Tax Journal, v. 54 (September 2001), pp. 433-450.
Hasselback, James R. and Rodney L. Clark. "Colleges, Commerciality,
and the Unrelated Business Income Tax." Taxes, v. 74 (May 1996), pp. 335-
342.
Jones, Darryll K. "When Charity Aids Tax Shelters," Florida Tax Review,
v. 4 (2001), pp. 770-830.
Joulfaian, David and Mark Rider. "Errors-In-Variables and Estimated
Income and Price Elasticities of Charitable Giving," National Tax Journal, v.
57 (March 2004), pp. 25-43.
Kahn, Jefferey H. "Personal Deductions: A Tax "Ideal" or Just Another
"Deal"?," Law Review of Michigan State University, v. 2002 (Spring 2002),
pp. 1-55.
Lankford, R. Hamilton and James H. Wyckoff. "Modeling Charitable
Giving Using a Box-Cox Standard Tobit Model," Review of Economics and
Statistics, v. 73 (August 1991), pp. 460-470.
Omer, Thomas C. "Near Zero Taxable Income Reporting by Nonprofit
Organizations," Journal of American Taxation Association, v. 25, Fall 2003,
pp. 19-34.
Randolph, William C. "Charitable Deductions," in The Encyclopedia of
Taxation and Tax Policy, eds. Joseph J. Cordes, Robert O. Ebel, and Jane G.
Gravelle. Washington, DC: Urban Institute Press, 2005.
-. "Dynamic Income, Progressive Taxes, and the Timing of Charitable
Contributions," Journal of Political Economy, v. 103, August 1995, pp. 709-
738.
Rose-Ackerman, Susan. "Altruism, Nonprofits, and Economic Theory,"
Journal of Economic Literature, v. 34 (June 1996), pp. 701-728.
Stokeld, Fred, "ETI Repeal Bill Would Tighten Rules on Vehicle, Patent
Donations," Tax Notes, October 18, 2004, pp. 293-294.
"Tax Exempt Educational Organization," Journal of Law and Education,
v. 15. Summer 1986, pp. 341-346.
Teitell, Conrad. "Tax Primer on Charitable Giving," Trust & Estates, v.
139, (June 2000), pp. 7-16.
Tiehen, Laura. "Tax Policy and Charitable Contributions of Money,"
National Tax Journal, v. 54 (December 2001), pp. 707-723.

Tobin, Philip T. "Donor Advised Funds: A Value-Added Tool for
Financial Advisors," Journal of Practical Estate Planning, v. 3
(October/November 2001), pp. 26-35, 52.
U.S. Congress, Congressional Budget Office. Budget Options. See
Rev-12, Limit Deductions for Charitable Giving to the Amount Exceeding 2
Percent of Adjusted Gross Income. Washington, DC: Government Printing
Office (February 2005), p 281.
U.S. Congress, General Accounting Office. Vehicle Donations: Benefits to
Charities and Donors, but Limited Program Oversight, GAO Report GAO-
04-73, Washington, DC: U.S. General Accounting Office. November 2003,
pp. 1-44.
- . Vehicle Donations: Taxpayer Considerations When Donating Vehicles
to Charities, GAO Report GAO-03-608T, Washington, DC: U.S. General
Accounting Office. April 2003, pp. 1-15.
U.S. Congress, Joint Committee on Taxation, Technical Explanation Of
H.R. 4, The "Pension Protection Act Of 2006," as Passed by the House on
July 28, 2006, and as Considered by the Senate on August 3, 2006,
JCX-38-06, Washington, DC: U.S. Government Printing Office, August 3,
2006, pp. 1-386.
- , Senate Committee on Finance. Staff Discussion Draft: Proposals for
Reforms and Best Practices in the Area of Tax-Exempt Organizations,
Washington, DC, June 22, 2004, pp. 1-19.
U.S. Department of Treasury. "Charitable Giving Problems and Best
Practices," testimony given by Mark Everson, Commissioner of Internal
Revenue, Internal Revenue Service, IR-2004-81, June 22, 2004, pp. 1-17.
Wittenbach, James L. and Ken Milani. "Charting the Interacting
Provisions of the Charitable Contributions Deductions for Individuals,"
Taxation of Exempts, v. 13 (July/August 2001), pp. 9-22.
-, "Charting the Provisions of the Charitable Contribution Deduction for
Corporations," Taxation of Exempts, v. 13 (November/December 2001), pp.
125-130.
Yetman, Michelle H. and Robert J. Yetman. "The Effect of Nonprofits'
Taxable Activities on the Supply of Private Donations," National Tax
Journal, v. 56, March 2003, pp. 243-258.
Zimmerman, Dennis. "Nonprofit Organizations, Social Benefits, and Tax
Policy," National Tax Journal, v. 44. September 1991, pp. 341-349.

Education, Training, Employment, and Social Services:
Employment

EXCLUSION OF EMPLOYEE MEALS AND LODGING
(OTHER THAN MILITARY)

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.9

2007

0.9

2008

0.9

2009

1.0

2010

1.0

Authorization

Sections 119 and 132(e)(2).

Description

Employees do not include in income the fair market value of meals
furnished by employers if the meals are furnished on the employer's business
premises and for the convenience of the employer.

The fair market value of meals provided to an employee at a subsidized
eating facility operated by the employer is also excluded from income, if the
facility is located on or near the employer's business, and if revenue from the
facility equals or exceeds operating costs. In the case of highly compensated
employees, certain nondiscrimination requirements are met to obtain this
second exclusion.

Section 119 also excludes from an employee's gross income the fair market
value of lodging provided by the employer, if the lodging is furnished on
business premises for the convenience of the employer, and if the employee is
required to accept the lodging as a condition of employment.

Impact

Exclusion from taxation of meals and lodging furnished by an employer
provides a subsidy to employment in those occupations or sectors in which
such arrangements are common. Live-in housekeepers or apartment resident
managers, for instance, may frequently receive lodging and/or meals from
their employers. The subsidy provides benefits both to the employees (more
are employed and they receive higher compensation) and to their employers
(who receive the employees' services at lower cost).

Rationale

The convenience-of-the-employer exclusion now set forth in section 119
generally has been reflected in income tax regulations since 1918, presumably
in recognition of the fact that in some cases, the fair market value of
employer-provided meals and lodging may be difficult to measure.

The specific statutory language in section 119 was adopted in the 1954
Code to clarify the tax status of such benefits by more precisely defining the
conditions under which meals and lodging would be treated as tax free.

In enacting the limited exclusion for certain employer-provided eating
facilities in the 1984 Act, the Congress recognized that the benefits provided
to a particular employee who eats regularly at such a facility might not qualify
as a de minimis fringe benefit absent another specific statutory exclusion.
The record-keeping difficulties involved in identifying which employees ate
what meals on particular days, as well as the values and costs for each such
meal, led the Congress to conclude that an exclusion should be provided for
subsidized eating facilities as defined in section 132(e)(2).

Assessment

The exclusion subsidizes employment in those occupations or sectors in
which the provision of meals and/or lodging is common. Both the employees
and their employers benefit from the tax exclusion. Under normal market
circumstances, more people are employed in these positions than would
otherwise be the case and they receive higher compensation (after tax). Their
employers receive their services at lower cost. Both sides of the transaction
benefit because the loss is imposed on the U.S. Treasury in the form of lower
tax collections.

Because the exclusion applies to practices common only in a few
occupations or sectors, it introduces inequities in tax treatment among
different employees and employers.

While some tax benefits are conferred specifically for the purpose of
providing a subsidy, this one ostensibly was provided for administrative
reasons (based on the difficulty in determining their fair market value), and
the benefits to employers and employees are side effects. Some observers
challenge the argument that administrative problems are an adequate rationale
for excluding employer-provided meals and lodging. They note that a value is
placed on these services under some Federal and many State welfare
programs.

Selected Bibliography

Katz, Avery, and Gregory Mankiw. "How Should Fringe Benefits Be
Taxed?" National Tax Journal. v. 38. March 1985, pp. 37-46.
Kies, Kenneth J. "Analysis of the New Rules Governing the Taxation of
Fringe Benefits," Tax Notes. September 3, 1984, pp. 981-988.
Layne, Jonathan Keith. "Cash Meal Allowances Are Includible in Gross
Income and Are Not Excludible Under I.R.C. Section 119 as That Section
Permits an Exclusion Only for Meals Furnished in Kind," Emory Law
Review. Summer 1978, pp. 791-814.
Raby, Burgess J. W. and William L. Raby. "'Will Work for Food!': Room
Meals, and 'Convenience of the Employer,'" Tax Notes, Vol. 100, July 14,
2003, pp. 203-205.
Sunley, Emil M., Jr. "Employee Benefits and Transfer Payments,"
Comprehensive Income Taxation, ed. Joseph A. Pechman. Washington, DC:
The Brookings Institution, 1977, pp. 90-92.
Turner, Robert. "Fringe Benefits," in The Encyclopedia of Taxation and
Tax Policy, eds. Joseph J. Cordes, Robert O. Ebel, and Jane G. Gravelle.
Washington, DC: Urban Institute Press, 2005.
U.S. Congress, Joint Committee on Taxation. General Explanation of the
Revenue Provisions of the Deficit Reduction Act of 1984. Committee Print,
98th Congress, 2nd session. December 31, 1984, pp. 858-859.

Education, Training, Employment and Social Services:
Employment

EXCLUSION OF BENEFITS
PROVIDED UNDER CAFETERIA PLANS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

27.9

2007

30.6

2008

33.4

2009

36.6

2010

40.0

40.5

Authorization

Section 125.

Description

Cafeteria plans allow employees to choose among cash and certain
nontaxable benefits (such as health care benefits) without paying taxes if they
select the latter. A general rule of tax accounting is that when taxpayers have
the option of receiving both cash and nontaxable benefits they are taxed even
if they select the benefits since they are deemed to be in constructive receipt
of the cash (that is, since it is within their control to receive it). Section 125
of the Internal Revenue Code provides an express exception to this rule when
certain nontaxable benefits are chosen under a cafeteria plan. The tax
expenditure measures the loss of revenue from not including the nontaxable
benefits in taxable income when employees have this choice. Cafeteria plan
benefits are also not subject to employment taxes of either the employer or
employee.

"Cash" includes not only cash payments but also employment benefits that
are normally taxable, such as vacation pay. Nontaxable benefits include any
employment benefits that are excluded from gross income under a specific
section of the Code, other than long-term care insurance, scholarships or
fellowships, employer educational assistance, miscellaneous fringe benefits,
and most forms of deferred compensation. Nontaxable benefits typically
included in cafeteria plans are accident and health insurance, dependent care
assistance, group-term life insurance, and adoption assistance. Employer
contributions to health savings accounts are also an allowable nontaxable
benefit.

Most flexible spending accounts (FSAs) are governed by cafeteria plan
provisions, as are premium conversion arrangements under which employees
pay their share of health insurance premiums on a pretax basis. In both cases,
employees are choosing between cash wages (through voluntary salary-
reduction agreements) and nontaxable benefits.

Cafeteria plans must be in writing. The written plan must describe the
available benefits, eligibility rules, procedures governing benefit elections
(usually occurring during an annual open season), employer contributions,
and other matters. Under IRS regulations, midyear election changes generally
are allowed only for employee status changes (e.g., the birth of a child) or
benefit cost changes (e.g., child care fees increase), though midyear changes
on the basis of cost are not allowed for health benefits.

A highly compensated participant is taxed on all benefits if the cafeteria
plan discriminates in favor of highly compensated individuals as to eligibility,
benefits, or contributions. A highly compensated individual includes an
officer, a 5-percent shareholder, someone with high earnings, or a spouse or
dependent of any of these individuals. In addition, if more than 25 percent of
the total tax-favored benefits are provided to key employees, these key
employees will be taxed on all benefits. A key employee is an individual who
is an officer, a 5-percent owner, a 1-percent owner earning more than
$150,000, or one of the top 10 employee-owners. There are some exceptions
to these rules, including cafeteria plans maintained under collective
bargaining agreements.

Amounts in health care FSAs or Health Reimbursement Accounts (HRAs)
may be rolled over into Health Savings Accounts (HSAs) under legislation
adopted at the end of 2006 (H.R. 6111).

Impact

Cafeteria plans allow employees to choose among a number of nontaxable
employment benefits without incurring a tax liability simply because they
could have received cash. The principal effect is to encourage employers to
give employees some choice in the benefits they receive.

As with other tax exclusions, the tax benefits are greater for taxpayers with
higher incomes. Higher income taxpayers may be more likely to choose
nontaxable benefits (particularly health care benefits) instead of cash, which
would be taxable. Lower income taxpayers may be more likely to choose
cash, which they may value more highly and for which the tax rates would be
comparatively low.

More employers reportedly are offering cafeteria plans, but employee
access to them depends largely on firm size. Consider health care flexible
spending accounts (FSAs), one of the most common plan options, which the
2003 Medical Expenditure Panel Survey (MEPS) found were offered by 18
percent of private-sector firms and were available to 48 percent of private-
sector employees. According to this survey, 55 percent of larger firms (50 or
more workers) offered health care FSAs but only 5 percent of smaller firms
did. Similarly, 64 percent of workers in larger firms had access to health care
FSAs, but only 8 percent did in smaller firms.

Actual usage is considerably less. According to a 2004 Mercer survey,
20% of eligible employees in firms of 500 or more employees participated in
a health care FSA, as did 36% of eligible employees in firms of 10 or more
employees. Reasons for low FSA participation include employee perceptions
of complexity, concerns about end-of-year forfeitures, and limited employer
encouragement. For lower income employees, particularly those who do not
use much health care, the tax savings may not be sufficient incentive to
participate.

FSAs were made available to federal government employees starting on
July 1, 2003. In 2005, approximately 163,000 federal employees (less than
6% of the total) had an FSA.

Rationale

Under the Employee Retirement Income Security Act of 1974 (ERISA), an
employer contribution made before January 1, 1977 to a cafeteria plan in
existence on June 27, 1974 was required to be included in an employee's
gross income only to the extent the employee actually elected taxable
benefits. For plans not in existence on June 27, 1974, the employer con-
tribution was included in gross income to the extent the employee could have
elected taxable benefits.

The Tax Reform Act of 1976 extended these rules to employer
contributions made before January 1, 1978. The Foreign Earned Income Act
of 1978 made a further extension until the effective date of the Revenue Act
of 1978 (i.e., through 1978 for calendar-year taxpayers).

In the Revenue Act of 1978, the current provision as outlined above was
added to the Code to ensure that the tax exclusion was permanent, but no
specific rationale was provided.

The Deficit Reduction Act of 1984 limited permissible benefits and
established additional reporting requirements. The Tax Reform Act of 1986
imposed stricter nondiscrimination rules (regarding favoritism towards highly
compensated employees) on cafeteria and other employee benefit plans. In
1989, the latter rules were repealed by legislation to increase the public debt
limit (P.L. 101-140).

By administrative rulings, federal government employees were allowed to
start paying their health insurance premiums on a pretax basis in 2000 and to
establish flexible spending accounts in 2003.

Also by administrative ruling, in 2005 the Internal Revenue Service
allowed employees an additional 2 and � months to use remaining balances
in their health care FSAs at the end of the year. Previously, unused balances
at the end of the year were forfeited to employers.

Assessment

Cafeteria plans often are more attractive to employees than fixed benefit
packages since they can choose the benefits best suited to their individual
circumstances. Usually, choice extends to both the type of benefit (health
care, child care, etc.) as well as the amount, at least within certain limits.
Ability to fine-tune benefits increases the efficient use of resources and may
help some employees better balance competing demands of family and work.
As with other employment benefits, however, the favored tax treatment of
cafeteria plans leads to different tax burdens for individuals with the same
economic income. One justification for this outcome might be that it is in the
public interest for employers to provide social benefits to workers if otherwise
they would enroll in public programs or go without coverage. However,
providing social benefits through employment puts burdens on employers,
particularly those with a small number of workers, and may impede workers'
willingness and ability to move among jobs.

Health care flexible spending accounts (FSAs) funded through salary
reduction agreements allow employees to receive tax benefits for the first
dollars of their unreimbursed medical expenditures; in contrast, other
taxpayers get tax benefits only if they itemize deductions and their
unreimbursed expenditures exceed 7 � percent of adjusted gross income. It
is possible that FSAs encourage additional consumption of health care,
though many workers are reluctant to put large sums in their accounts since
unused amounts cannot be carried over to later years.

Selected Bibliography

Cavanaugh, Maureen B. On the Road to Incoherence: Congress,
Economics, and Taxation. UCLA Law Review, v. 49 (February, 2002).
Lyke, Bob. Tax Benefits for Health Insurance and Expenses: Overview of
Current Law and Legislation. Library of Congress. CRS Report RL33505.
Updated periodically.
Peterson, Chris L. and Bob Lyke. Health Care Flexible Spending
Accounts. Library of Congress. CRS Report RL32656. Updated
periodically.
Roberts, Gary E. Municipal Government Benefits Practices and Personnel
Outcomes: Results from a National Survey. Public Personnel Management.
v. 33 no. 1 (Spring, 2004).
Rubenstein, Sarah. Buying Health Insurance, Cafeteria Style. The Wall
Street Journal Online (October 19, 2004).
Ryan, Chris and Cathy Wells. FSA Rule Change a Mixed Bag for
Participants, Administrators. Benefits Law Journal. vol. 18 no. 3 (Autumn,
2005).
Simmons, John G. Flexible Benefits for Small Employers. Journal of
Accountancy. v. 191 no. 3 (March, 2001).
Turner, Robert. Fringe Benefits. The Encyclopedia of Taxation and Tax
Policy. 2nd edition. Washington, the Urban Institute Press, 2005.
U.S. Congress. Joint Committee on Taxation. General Explanation of the
Revenue Provisions of the Deficit Reduction Act of 1984, 98th Congress, 2nd
session, December 31, 1984, pp. 867-872.

Education, Training, Employment, and Social Services:
Employment

EXCLUSION OF HOUSING ALLOWANCES
FOR MINISTERS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.5

2007

0.5

2008

0.5

2009

0.6

2010

0.6

Authorization

Section 107.

Description

Under an exclusion available for a "minister of the gospel," gross income
does not include

(1) the fair rental value of a church-owned or church-rented home
furnished as part of his or her compensation, or

(2) a cash housing/furnishing allowance paid as part of the minister's
compensation.

The housing/furnishing allowance may provide funds for rental or
purchase of a home, including down payment, mortgage payments, interest,
taxes, repairs, furniture payments, garage costs, and utilities.

Ministers receiving cash housing allowances also may claim deductions on
their individual income tax returns for mortgage interest and real estate taxes
on their residences even though such expenditures were allocable, in whole or
in part, to tax-free receipt of the cash housing allowance. While excluded
from income taxes, the fair rental value or cash housing/furnishing allowance
is subject to Social Security payroll taxes.

Impact

As a result of the special exclusion provided for parsonage allowances,
ministers receiving such housing allowances pay less tax than other taxpayers
with the same or smaller economic incomes. The tax benefit of the exclusion
also provides a disproportionately greater benefit to relatively better-paid
ministers, by virtue of the higher marginal tax rates applicable to their
incomes.

Further, some ministers claim income tax deductions for housing costs
allocable to the receipt of tax-free allowances.

Rationale

The provision of tax-free housing allowances for ministers was first made a
part of the Internal Revenue Code by passage of the Revenue Act of 1921
(P.L. 98 of the 67th Congress), without any stated reason. The original
rationale may reflect the difficulty of placing a value on the provision of a
church-provided rectory. Since some churches provided rectories to their
ministers as part of their compensation, while other churches provided a
housing allowance, Congress may have wished to provide equal tax treatment
to both groups. Another suggested rationale is that originally the provision
was provided in recognition of the clergy as an economically deprived group
with low incomes.

The Internal Revenue Service reversed a 1962 ruling (Ruling 62-212) in
1983 (Revenue Ruling 83-3) providing that, to the extent of the tax-free
housing allowance, deductions for interest and property taxes may not be
itemized as a tax deduction. This change was based on the belief that it was
unfair to allow tax-free income to be used to generate individual itemized
deductions to shelter taxable income.

In the Tax Reform Act of 1986 (P.L. 99-514), Congress reversed the IRS
ruling because the tax treatment had been long-standing, and some Members
were concerned that the IRS might treat tax-free housing allowances provided
to U.S. military personnel similarly.

The Internal Revenue Service's position (Revenue Ruling 71-280) is that
the exclusion may not exceed the fair rental value of the home plus the cost of
utilities. The Tax Court held that amounts used to provide a home are
excludable even if the amount received exceeds the fair market rental value of
the home (Richard D. Warren, et ux. v. Commissioner; 114 T.C. No. 23 (May
16, 2000)). In that case, 100 percent of compensation was designated as a
housing allowance ($77,663 in 1993, $76,309 in 1994, and $84,278 in 1995).
The court dismissed the IRS's argument that its position prevents unequal
treatment between ministers for whom housing is provided and excluded and
those ministers receiving a rental allowance. That decision was appealed to
the Ninth Circuit Court of Appeals, which directed parties to submit briefs on
whether the court should address the constitutionality of the parsonage
exclusion.

In order to forestall action by the Ninth Circuit by making the underlying
issue in the Warren case moot, Congress clarified the parsonage housing tax
allowance with passage of the Clergy Housing Allowance Clarification Act of
2002 (P.L. 107-181). In large part Congress adopted the more conservative
IRS position such that the "allowance does not exceed the fair rental value of
the home, including furnishings and appurtenances such as a garage, plus the
cost of utilities." The Act says that it is intended to "minimize government
intrusion into internal church operations and the relationship between a
church and its clergy" and "recognize that clergy frequently are required to
use their homes for purposes that would otherwise qualify for favorable tax
treatment, but which may require more intrusive inquiries by the government
into the relationship between clergy and their respective churches with respect
to activities that are inherently religious."

Assessment

The tax-free parsonage allowances encourage some congregations to
structure maximum amounts of tax-free housing allowances into their
minister's pay and may thereby distort the compensation package.

The provision is inconsistent with economic principles of horizontal and
vertical equity. Since all taxpayers may not exclude amounts they pay for
housing from taxable income, the provision violates horizontal equity
principles. For example, a clergyman teaching in an affiliated religious
school may exclude the value of his housing allowance whereas a teacher in
the same school may not. This example shows how the tax law provides
different tax treatment to two taxpayers whose economic incomes may be
similar.

Ministers with higher incomes receive a greater tax subsidy than lower-
income ministers because of their higher marginal tax rates. Vertical equity is
a concept which requires that tax burdens be distributed fairly among people
with different abilities to pay. The disproportionate benefit of the tax
exclusion to individuals with higher incomes reduces the progressivity of the
tax system, which is viewed as a reduction in equity.

Ministers who have church-provided homes do not receive the same tax
benefits as those who purchase their homes and also have the tax deductions
for interest and property taxes available to them. Code Section 265 disallows
deductions for interest and expenses which relate to tax-exempt income
except in the case of military housing allowances and the parsonage
allowance. As such, this result is inconsistent with the general tax policy
principle of preventing double tax benefits.

Selected Bibliography

Aprill, Ellen P. "Parsonage and Tax Policy: Rethinking the Exclusion,"
Tax Notes, vol. 96, (Aug. 26, 2002), pp. 1243-1257.
Bader, Mary. "Clergy Housing Allowances: IRS Loses Battle, Wins War,"
The Tax Adviser, vol. 36, (Feb, 2005), pp. 82-84.
Bednar, Phil. "After Warren: Revisiting Taxpayer Standing and the
Constitutionality of Parsonage Allowances," Minnesota Law Review, vol. 87
(June 2003), pp. 2101-2131.
Dwyer, Boyd Kimball. "Redefining 'Minister of the Gospel' To Limit
Establishment Clause Issues," Tax Notes, vol. 95, (June 17, 2002), pp. 1809-
1815.
Frazer, Douglas H. "The Clergy, the Constitution, and the Unbeatable
Double Dip: The Strange Case of the Tax Code's Parsonage Allowance," The
Exempt Organization Tax Review, vol. 43. (February 2004), pp. 149-152.
Foster, Matthew W. "The Parsonage Allowance Exclusion: Past, Present,
and Future," Vanderbilt Law Review, vol. 44. January 1991, pp. 149-178.
Harris, Christine. "House Unanimously Clears Parsonage Exclusion Bill,"
Tax Notes, vol. 95 no. 4 (April 22, 2002), pp. 474-475.
Hiner, Ronald R. and Darlene Pulliam Smith. "The Constitutionality of the
Parsonage Allowance," Journal of Accountancy, vol. 194. (Nov 2002), pp.
92-93.
Koski, Timothy R. "Divine Tax Opportunities for Members of the
Clergy," Practical Tax Strategies, vol. 63 (October 1999), pp. 207-208, 241-
246.
Martin, Vernon M., Jr. and Sandra K. Miller. "The Clergy's Unique Tax
Issues," The Tax Adviser, vol. 29 (August 1998), pp. 557-561.
McNair, Frances E., Edward E. Milam, and Deborah L. Seifert "Tax
Planning for Servants of God," Journal of Accountancy, vol. 198, (Oct. 2004)
pp. 65-69.
Newman, Joel S. "On Section 107's Worst Feature: The Teacher-
Preacher," Tax Notes, vol. 61. December 20, 1993, pp. 1505-1508.
O'Neill, Thomas E. "A Constitutional Challenge to Section 107 of the
Internal Revenue Code," Notre Dame Lawyer, vol. 57. June 1982, pp. 853-
867.
Raby, Burgess J.W. and William L. Raby. "Some Thoughts on the
Parsonage Exemption Imbroglio," Tax Notes, vol. 96, (Sept. 9, 2002), p.
1497.

Rakowski, Eric. "The Parsonage Exclusion: New Developments," Tax
Notes, vol. 96, no. 3 (July 15, 2002), pp. 429-437.
Schloemer, Paul G. and Ryan Wilson, "Minister Housing Allowance
Presents New Challenge," The CPA Journal. Vol. 75, (Dec. 2005), pp. 44-49.
Stokeld, Fred. "No Surprises in Ninth Circuit's Decision in Parsonage
Case," Tax Notes, vol. 96, (Sept. 2, 2002), pp. 1318-1319.
U.S. Congress, Joint Committee on Taxation. General Explanation of the
Revenue Provisions of the Deficit Reduction Act of 1984, H.R. 4170, 98th
Congress, Public Law 98-369. Washington, DC: U.S. Government Printing
Office, December 31, 1984, pp. 1168-1169.
-. General Explanation of the Tax Reform Act of 1986, H.R. 3838, 99th
Congress, Public Law 99-514. Washington, DC: U.S. Government Printing
Office, May 4, 1987, pp. 53-54.
Zelinsky, Edward A. "Dr. Warren, Section 107, and the Court-Appointed
Amicus," Tax Notes, vol. 96, no. 8 (Aug. 26, 2002), pp. 1267-1272.

Education, Training, Employment, and Social Services:
Employment

EXCLUSION OF MISCELLANEOUS FRINGE BENEFITS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

6.6

2007

6.8

2008

7.0

2009

7.2

2010

7.7

Authorization

Sections 132 and 117(D).

Description

Individuals do not include in income certain miscellaneous fringe benefits
provided by employers, including services provided at no additional cost,
employee discounts, working condition fringes, de minimis fringes, and
certain tuition reductions. Special rules apply with respect to certain parking
facilities provided to employees and certain on-premises athletic facilities.

These benefits also may be provided to spouses and dependent children of
employees, retired and disabled former employees, and widows and widowers
of deceased employees. Certain nondiscrimination requirements apply to
benefits provided to highly compensated employees.

Impact

Exclusion from taxation of miscellaneous fringe benefits provides a
subsidy to employment in those businesses and industries in which such
fringe benefits are common and feasible. Employees of retail stores, for
example, may receive discounts on purchases of store merchandise. Such
benefits may not be feasible in other industries--for example, for
manufacturers of heavy equipment.

The subsidy provides benefits both to the employees (more are employed
and they receive higher compensation) and to their employers (who have
lower wage costs).

Rationale

This provision was enacted in 1984; the rules affecting transportation
benefits were modified in 1992 and 1997. The Congress recognized that in
many industries employees receive either free or discount goods and services
that the employer sells to the general public. In many cases, these practices
had been long established and generally had been treated by employers,
employees, and the Internal Revenue Service as not giving rise to taxable
income.

Employees clearly receive a benefit from the availability of free or
discounted goods or services, but the benefit may not be as great as the full
amount of the discount. Employers may have valid business reasons, other
than simply providing compensation, for encouraging employees to use the
products they sell to the public. For example, a retail clothing business may
want its salespersons to wear its clothing rather than clothing sold by its
competitors. As with other fringe benefits, placing a value on the benefit in
these cases is difficult.

In enacting these provisions, the Congress also wanted to establish limits
on the use of tax-free fringe benefits. Prior to enactment of the provisions,
the Treasury Department had been under a congressionally imposed
moratorium on issuance of regulations defining the treatment of these fringes.
There was a concern that without clear boundaries on use of these fringe
benefits, new approaches could emerge that would further erode the tax base
and increase inequities among employees in different businesses and
industries.

Assessment

The exclusion subsidizes employment in those businesses and industries in
which fringe benefits are feasible and commonly used. Both the employees
and their employers benefit from the tax exclusion. Under normal market
circumstances, more people are employed in these businesses and industries
than they would otherwise be, and they receive higher compensation (after
tax). Their employers receive their services at lower cost. Both sides of the
transaction benefit because the loss is imposed on the U.S. Treasury in the
form of lower tax collections.

Because the exclusion applies to practices which are common and may be
feasible only in some businesses and industries, it creates inequities in tax
treatment among different employees and employers. For example,
consumer-goods retail stores may be able to offer their employees discounts
on a wide variety of goods ranging from clothing to hardware, while a
manufacturer of aircraft engines cannot give its workers compensation in the
form of tax-free discounts on its products.

Selected Bibliography

Kies, Kenneth J. "Analysis of the New Rules Governing the Taxation of
Fringe Benefits," Tax Notes, v. 38. September 3, 1984, pp. 981-988.
McKinney, James E. "Certainty Provided as to the Treatment of Most
Fringe Benefits by Deficit Reduction Act," Journal of Taxation. September
1984, pp. 134-137.
Raby, Burgess J. W. and William L. Raby. "Working Conditions Fringes:
Fishing Trips to Telecommuting," Tax Notes, Vol. 101, October 27,2003, pp.
503-507.
Sunley, Emil M., Jr. "Employee Benefits and Transfer Payments,"
Comprehensive Income Taxation, ed. Joseph A. Pechman. Washington, DC:
The Brookings Institution, 1977, pp. 90-92.
Turner, Robert. "Fringe Benefits," in The Encyclopedia of Taxation and
Tax Policy, eds. Joseph J. Cordes, Robert O. Ebel, and Jane G. Gravelle.
Washington, DC: Urban Institute Press, 2005.
U.S. Congress, Joint Committee on Taxation. General Explanation of the
Revenue Provisions of the Deficit Reduction Act of 1984. Committee Print,
98th Congress, 2nd session. December 31, 1984, pp. 838-866.
-, Senate Committee on Finance. Fringe Benefits, Hearings, 98th
Congress, 2nd session. July 26, 27, 30, 1984.

Education, Training, Employment and Social Services:
Employment

EXCLUSION OF EMPLOYEE AWARDS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2005

0.2

2006

0.2

2007

0.2

2008

0.2

2009

0.2

Authorization

Sections 74(c), 274(j).

Description

Generally, prizes and awards to employees that do not qualify as a de
minimis fringe benefit under Section 132(e) are taxable to the employee.
Section 74(c), however, provides an exclusion for certain awards of tangible
personal property given to employees for length of service or for safety
achievement.

The amount of the exclusion (under subsection 74(c)) for the employee is
the value of the property awarded, and is generally limited by the employer's
deduction for the award (under Section 274(j)) - $400, or up to $1,600 for
awards granted as part of qualified employee achievement award plans.
Qualified employee achievement plans are established or written employer
programs which do not discriminate in favor of highly compensated
employees. In addition, the average cost per recipient of all awards granted
under all established plans for an employer cannot exceed $400.

For employees of non-profit employers, the amount of the exclusion is the
amount that would have been allowed if the employer were taxable (non-
profit organizations are generally not subject to federal income taxes) - $400,
and up to $1,600 if the non-profit employer has a qualified employee
achievement award plan.

Generally, the limitation on the exclusion for the employee is the cost to
(and deduction for) the employer related to the award. If however both the
cost to the employer for the award and the fair market value of the award
exceed the limitation, the employee must include the excess (fair market value
minus the limitation) in gross income.

Length of service awards which qualify for the exclusion (and the
employer deduction of cost), cannot be awarded to an employee in the first
five years of service, or to an employee who has received a length of service
award (other than an award excluded as a de minimis fringe benefit under
Section 132(e)) in that year or any of the prior four years of service. Awards
for safety achievement (other than an award excluded as a de minimis fringe
benefit under Section 132(e)) which qualify for the exclusion (and the
employer deduction of cost) cannot be awarded to a manager, administrator,
clerical employee, or other professional employee. In addition, awards for
safety achievement cannot have been awarded, in that year, to more than 10%
of employees.

The amount of an eligible employee award which is excluded from gross
income is also excluded under the Federal Insurance Contributions Act
(FICA) for Social Security and Medicare taxes (Old Age, Survivors and
Disability tax and Hospital tax).

Impact

Sections 74(c) and 274(j) exclude from gross income certain employee
awards of tangible personal property for length of service and safety
achievement that would otherwise be taxable.

Rationale

The exclusion for certain employee awards was adopted in the Tax Reform
Act of 1986. Prior to that Act, with exceptions that were complex and
difficult to interpret, awards received by employees generally were taxable.

Assessment

The exclusion recognizes a traditional business practice which may have
social benefits. The combination of the limitation on the exclusion as to
eligibility for qualifying awards, and the dollar amount of the exclusion not
being increased since 1986, keep the exclusion from becoming a vehicle for
significant tax avoidance. However, the lack of an increase in the exclusion
effectively reduces the tax-free portion of some awards.

Selected Bibliography

U.S. Congress, Joint Committee on Taxation. General Explanation of the
Tax Reform Act of 1986, 100th Congress, 1st session. May 4, 1987, pp.
30-38.

Education, Training, Employment, and Social Services:
Employment

EXCLUSION OF INCOME EARNED BY
VOLUNTARY EMPLOYEES' BENEFICIARY ASSOCIATIONS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

3.3

2007

3.4

2008

3.5

2009

3.7

2010

3.8

Authorization

Sections 419, 419A, 501(a), 501(c)(9), 4976

Description

Voluntary Employees' Beneficiary Associations (VEBAs) provide life
insurance, medical, disability, accident, and other welfare benefits to
employee members and their dependents and beneficiaries. Most VEBAs are
organized as trusts to be legally separate from employers. Provided certain
requirements are met, the income earned by a VEBA is exempt from federal
income taxes under Sections 501(a) and 501(c)(9). If the requirements are
not met however, the income is subject to the unrelated business income tax
(UBIT). With some exceptions, income earned by a VEBA used for
prefunding retiree health benefits is subject to this tax.

Employer contributions to VEBAs are deductible within limits
described below, while employee contributions are made with after-
tax dollars. When distributed, VEBA benefits are taxable income to
recipients unless there is a statutory exclusion explicitly pertaining to
those kinds of benefits. Thus, accident and health benefits are
excludable under Sections 104 and 105, but severance and vacation
pay benefits are taxable.

VEBAs must meet a number of general requirements, including:
(1) the organization must be an association of employees who share a
common employment-related bond; (2) membership in the
association must be voluntary (or, if mandatory, under conditions
described below); (3) the association must be controlled by its
members, by an independent trustee (such as a bank), or by trustees
or fiduciaries at least some of whom are designated by or on behalf of
the members; (4) substantially all of the organization's operations
must further the provision of life, sickness, accident, and other
welfare benefits to employees and their dependents and beneficiaries;
(5) none of the net earnings of the organization may accrue, other
than by payment of benefits, directly or indirectly to any shareholder
or private individual; (6) benefit plans (other than collectively-
bargained plans) must not discriminate in favor of highly
compensated individuals; and (7) the organization must apply to the
IRS for a determination of tax exempt status.

These general requirements have been refined and limited by both
IRS and court decisions. For example, employee members may have
a common employer or affiliated employers, common coverage
under a collective bargaining agreement, or membership in a labor
union or a specified job classification. In addition, members may be
employees of several employers engaged in the same line of business
in the same geographic area. Not all members need be employees,
but at least 90 percent of the membership one day each calendar
quarter must be employees. Membership may be required if
contributions are not mandatory or if it is pursuant to a collective
bargaining agreement or union membership. Permissible benefits
generally include those that safeguard or improve members' health
or that protect against contingencies that interrupt or impair their
earning power including vacation benefits, recreational activities, and
child care. Prohibited benefits include pension and annuities payable
at retirement and deferred compensation unless it is payable due to
an unanticipated event such as unemployment.

VEBA benefits may not discriminate in favor of the highly paid. In
addition, VEBAs used for prefunding of retiree medical or life
insurance benefits are required to establish separate accounts for
members who are key employees.

In general, employer deductions for VEBA contributions are
limited to the sum of qualified direct costs and additions to qualified
asset accounts, minus VEBA after-tax net income. These account
limits are specified in Internal Revenue Code Sections 419 and
419A. Qualified direct costs are the amounts employers could have
deducted for employee benefits had they used cash basis accounting
(essentially, benefits and account expenses actually paid during the
year). Qualified asset accounts include: (1) reserves set aside for
claims incurred but unpaid at the end of the year for disability,
medical, supplemental unemployment and severance pay, and life
insurance benefits; (2) administrative costs for paying those claims;
and (3) additional reserves for post-retirement medical and life
insurance benefits and for non-retirement medical benefits of bona
fide association plans. The reserve for post-retirement benefits must
be funded over the working lives of covered individuals on a level
basis, using actuarial assumptions incorporating current, not
projected, medical costs. For post-retirement life insurance,
amounts in excess of $50,000 per employee may not be taken into
account in determining the reserve. Special limits apply to certain
benefits. After-tax net income consists of net interest and investment
earnings plus employee contributions, minus any unrelated income
tax liability. Employer contributions are deductible only if they
would otherwise be deductible as a trade or business expense or as an
expense related to the production of income. In addition, employer
contributions are deductible only in the year actually paid.

The prefunding limits just described do not apply to collectively
bargained or employee pay-all plans (sometimes called 419A(f)(5)
plans) or to multiple employer welfare plans (MEWAs) of ten or more
employers in which no employer makes more than 10 percent of the
contributions (sometimes called 419A(f)(6) plans). The latter plans
(MEWAs) cannot have experienced rated contributions for single
employers.

VEBAs are subject to the UBIT to the extent they are overfunded
because contributions exceed account limits. However, the UBIT
does not apply on the following sources of income: (1) income that is
either directly or indirectly attributable to assets held by a VEBA as
of July 18, 1984 (the date of enactment of the Deficit Reduction Act
of 1984); (2) income on collectively bargained or employee pay-all
VEBAs; and (3) income on VEBAs for which substantially all
contributions came from tax-exempt employers. Tax rates applicable
to trusts are used to calculate the UBIT for VEBAs organized as
trusts.

Under Section 4976, any reversion of VEBA assets to the
employer is subject to a 100% excise tax.

Impact

VEBAs have been used by employers for a variety of reasons
including to segregate assets, earn tax free investment returns,
reduce future contribution requirements by prefunding, create an
offsetting asset for an employer liability and meet requirements of
rate making bodies and regulatory agencies. Funding a welfare
benefit through a VEBA often offers tax advantages to the employer.
The magnitude of the tax advantage depends on the amount of
benefits payable and the duration of the liability. Thus, the tax
advantage is greater for a VEBA that funds the disabled claim reserve
for a Long Term Disability plan than for a VEBA that funds the
Incurred but Not Paid claim reserve for a medical plan. The greatest
tax advantage accrues to an employer that uses a VEBA for
prefunding of a retiree health care plan, especially if the prefunding
is for a collectively bargained group of employees.

Unlike qualified defined benefit pension plans, employers are not
legally required to prefund retiree health plans. However, certain
employers have found it advantageous to prefund retiree health
benefits. Utilities such as electric, gas, water, and telephone
companies (prior to deregulation) were required by regulators to
prefund retiree benefits in order to include the cost of the benefits in
rates they charged to customers. Similarly, companies that did
business with the U.S. Department of Defense were required to
prefund retiree benefits in order to include the cost of benefits as
part of the contract charges.

Use of VEBAs for prefunding retiree health benefits gathered
momentum after the Financial Accounting Standards Board (FASB)
required accrual accounting for post-retirement benefits other than
pensions under Statement of Financial Accounting Standard 106
(FAS 106). This accounting standard, which was effective for
employers' fiscal years beginning after December 15, 1992, required
employers to calculate the net periodic postretirement health care
cost on an accrual basis and recognize it as an expense in the
employer's income statement. If the employer had segregated assets
dedicated to the payment of retiree health care benefits, the return
on these assets reduced the net periodic postretirement health care
cost. With the release of FAS 106, employers were in search of the
ideal funding vehicle that met all of the following conditions: (1) the
employer could make tax deductible contributions; (2) the rate of
return on the funding vehicle compared favorably to alternate uses of
employer funds; (3) adequate contributions could be made for
funding the plan obligations; and (4) assets were inaccessible to the
employer for any purpose other than specified in the plan. A
collectively bargained VEBA was the one funding vehicle that met all
of these criteria. Although non-collectively bargained VEBAs had
shortcomings, some employers used them nonetheless. Investment
strategies used to improve the after-tax rate of return for such
VEBAs included buying life insurance within the VEBA trust so that
the VEBA could benefit from the tax-free inside buildup of the
insurance policy.

Because of the more advantageous tax treatment for collectively
bargained VEBAs, employers used VEBAs for prefunding retiree
health benefits more frequently for unionized employees than for
non-union employees. Investment income on the funds accumulated
tax free and there were no limits on contributions. Some employers
also established employee-pay-all VEBAs for prefunding employee
out-of-pocket health care costs in retirement. In this type of VEBA,
employees make all of the contributions, with no contributions made
by employers, and the investment income on the VEBA accumulates
tax free. Employees can withdraw funds after retirement from the
VEBA to pay health care costs without paying taxes on the
withdrawals.

Recently, there has been interest in the use of employee-pay-all
VEBAs in order to provide medical benefits to retirees of bankrupt
companies. Retirees in bankrupt companies often lose some or all of
their health care coverage. By pooling the risk in a VEBA, retirees
may find that the premiums are more attractive than otherwise
available in the individual health insurance market.

The Survey of Employer Health Benefits conducted by the Kaiser
Family Foundation and the Health Research and Educational Trust
indicates that in 2006, 35 percent of large firms (200 or more
employees) offered retiree health benefits compared with 9 percent
of small firms (3 to199 employees). Among large firms, firms with
union employees were much more likely to offer retiree health
benefits (50 percent) than firms without union employees (27
percent).

Not all firms that offer retiree health benefits use a VEBA for
prefunding them. According to the 2005 Mercer National Survey of
Employer-Sponsored Health Plans, 9 percent of employers with 500
or more employees are currently using a VEBA for prefunding of
retiree medical benefits and another 7 percent are considering using
a VEBA for this purpose. The likelihood of funding retiree health
benefits with a VEBA increases with the size of the employer. While
25 percent of employers with 20,000 or more employees are
currently using a VEBA for prefunding of retiree health benefits, only
5 percent of employers with 500 to 999 employees use a VEBA for
this purpose. Mercer also reports that the use of a VEBA for
prefunding retiree health benefits is most common for employers in
the communication, transportation and utility industries.

Unlike pensions, VEBA health benefits accrue uniformly across all
income groups. Retiree health benefits unlike pension benefits are
not salary related. In fact, the benefits of VEBAs are more likely to
accrue in favor of the lower paid employees for two reasons. First,
VEBAs are used more often for unionized employees who are
typically paid less than management employees. And secondly, when
VEBAs are used for non-union employees, employers typically
exclude key employees from the VEBA in order to avoid
cumbersome administrative requirements to maintain separate
accounts within the VEBA.

Rationale

VEBAs were originally granted tax-exempt status by the Revenue
Act of 1928, which allowed associations to provide payment of life,
sickness, accident, or other benefits to their members and
dependents provided: (1) no part of their net earnings accrued (other
than through such payments) to the benefit of any private
shareholder or individual; and (2) 85 percent or more of their
income consisted of collections from members for the sole purpose of
making benefit payments and paying expenses. The House report
noted that these associations were common and, without further
explanation, that a specific exemption was desirable. Presumably,
VEBAs were seen as providing welfare benefits that served a public
interest and normally were exempt from taxation.

The Revenue Act of 1942 allowed employers to contribute to the
association without violating the 85-percent-of-income requirement.
In the Tax Reform Act of 1969, Congress completely eliminated the
85-percent requirement, allowing a tax exclusion for VEBAs that had
more than 15 percent of their income from investments. However,
the legislation imposed the UBIT on VEBA income (as well as the
income of similar organizations) to the extent it was not used for
exempt functions.

While VEBAs cannot be used for deferred compensation,
sometimes it has been difficult to distinguish such benefits.
Particularly after 1969, VEBAs presented opportunities for
businesses to claim tax deductions for contributions that would not be
paid out in benefits until many years afterwards, with investment
earnings building tax-free. In many cases, the benefits were
disproportionately available to corporate officers and higher-income
employees. After passage of the Tax Equity and Fiscal Responsibility
Act of 1982 (TEFRA), there was increased marketing of plans
providing readily available deferred benefits (for severance pay, for
example) to owners of small businesses that appeared to circumvent
restrictions the Act had placed on qualified pensions.

In response, the Deficit Reduction Act of 1984 (DEFRA) placed
tight restrictions on employer contributions (Section 419 of the
Code) and limitations on accounts (Section 419A). In addition,
tighter nondiscrimination rules were adopted with respect to highly
compensated individuals. These changes applied to welfare benefit
funds generally, not just VEBAs. The nondiscrimination rules were
further modified by the Tax Reform Act of 1986. The Tax Reform
Act of 1986 also exempted collectively bargained welfare benefit
funds and employee pay-all plans from account limits, thereby
exempting the investment income on such VEBA trusts from the
UBIT.

DEFRA did not apply these restrictions to collectively bargained
plans or the multiple employer welfare plans (MEWAs) described
above. In practice, both exemptions allowed arrangements that the
IRS and others criticized as tax shelters. In 2003, the IRS stated its
intention to issue regulations disallowing employer deductions for
arrangements set up through sham labor negotiations (by October,
2006 they had not yet been issued). It also issued final regulations
defining experienced-rating arrangements that preclude employer
deductions for MEWAs.

The Pension Protection Act of 2006 authorized an additional
reserve for non-retirement medical benefits of bona fide association
plans.

Assessment

Although there appears to be some abuse of VEBAs by small
employers for estate planning purposes, VEBAs have usually been
used in ways that further social goals. When VEBAs are used for
prefunding of retiree health benefits, they increase the likelihood of
employees receiving such benefits. Particularly in case of
bankruptcy, the presence of a VEBA with accumulated assets for
payment of retiree health benefits offers retirees a measure of
protection. Under current law, VEBAs offer an attractive way to
prefund retiree health benefits for union employees, but not for non-
union employees.

When an employer provides retiree health benefits, retirees
typically have significant out-of-pocket payments for premiums,
deductibles, and copayments. An employee-pay-all VEBA could be
used to allow employees to accumulate funds during their working
years for payment of out-of-pocket health care costs during
retirement. However, current law poses some problems in the use of
an employee-pay-all VEBA for this purpose. Amounts contributed by
an active employee cannot be refunded to the employee or his family
upon job termination or premature death. In addition, although
investment income on funds in an employee-pay-all VEBA is not
subject to the UBIT, if employee and employer contributions are
commingled in the same VEBA, all investment income is subject to
that tax. As concerns mount about the future of retiree health
benefits, Congress might reconsider some of these restrictions.

With the addition of prescription drug coverage to Medicare, it is
possible that some employers that are currently providing retiree
health benefits will eliminate or reduce prescription drug coverage.
To the extent that these employers have been prefunding retiree
health benefits through VEBAs, the new provision would reduce their
deductions for such prefunding.

Selected Bibliography

Elswick, Jill. VEBAs Gain Currency for Retiree Medical Benefits.
Employee Benefit News. (June 1, 2003).
Geisel, Jerry. Making Retiree Health Care Affordable. Business
Insurance. v. 40 no. 4 (January 23, 2006).
Joint Committee on Taxation. Welfare Benefit Plans. General
Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984.
JCS-41-84 (December, 1984), p. 774-806.
Kehoe, Danea M. 419A: A Legislative Odyssey. Journal of Financial
Service Professionals. v. 56 no. 2 (March, 2002).

Koresko, John J. and Jennifer S. Martin: VEBAs, Welfare Plans, and
Section 419(f)(6): Is the IRS Trying to Regulate or Spread Propaganda?
Southwestern University Law Review, v. 32 (2003)
Macey, Scott J. and George F. O'Donnell: Retiree Health Benefits - The
Divergent Paths. New York University Review of Employee Benefits and
Executive Compensation (2003)
Moran, Anne E. VEBAs: Possibilities for Employee Benefit Funding.
Employee Relations Law Journal. v. 29 no 1 (summer, 2003)
Ross, Allen F. Are VEBAs Worth Another Look? Journal of
Accountancy. v. 187 no. 5 (May, 1999).

Education, Training, Employment, and Social Services:
Employment

SPECIAL TAX PROVISIONS
FOR EMPLOYEE STOCK OWNERSHIP PLANS (ESOPs)

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.3

0.8

1.1

2007

0.3

0.9

1.2

2008

0.3

0.9

1.2

2009

0.3

1.0

1.3

2010

0.3

1.1

1.4

Authorization

Sections 133, 401(a)(28), 404(a)(9), 404(k), 415(c)(6), 1042, 4975(e)(7),
4978, 4979A

Description

An employee stock ownership plan (ESOP) is a defined-contribution plan
that is required to invest primarily in the stock of the sponsoring employer.
ESOPs are unique among employee benefit plans in their ability to borrow
money to buy stock. An ESOP that has borrowed money to buy stock is a
leveraged ESOP. An ESOP that acquires stock through direct employer
contributions of cash or stock is a nonleveraged ESOP.

ESOPs are provided with various tax advantages. Employer contributions
to an ESOP may be deducted by the employer as a business expense.
Contributions to a leveraged ESOP are subject to less restrictive limits than
contributions to other qualified employee benefit plans.

An employer may deduct dividends paid on stock held by an ESOP if the
dividends are paid to plan participants, if the dividends are used to repay a
loan that was used to buy the stock, or for dividends paid on stock in a
retirement plan. The deduction for dividends used to repay a loan is limited
to dividends paid on stock acquired with that loan. Employees are not taxed
on employer contributions to an ESOP or the earnings on invested funds until
they are distributed.

A stockholder in a closely held company may defer recognition of the gain
from the sale of stock to an ESOP if, after the sale, the ESOP owns at least 30
percent of the company's stock and the seller reinvests the proceeds from the
sale of the stock in a U.S. company.

To qualify for these tax advantages, an ESOP must meet the minimum
requirements established in the Internal Revenue Code. Many of these
requirements are general requirements that apply to all qualified employee
benefit plans. Other requirements apply specifically to ESOPs.

In particular, ESOP participants must be allowed voting rights on stock
allocated to their accounts. In the case of publicly traded stock, full voting
rights must be passed through to participants. For stock in closely held
companies, voting rights must be passed through on all major corporate
issues.

Closely held companies must give employees the right to sell distributions
of stock to the employer (a put option), at a share price determined by an
independent appraiser. An ESOP must allow participants who are
approaching retirement to diversify the investment of funds in their accounts.

Impact

The various ESOP tax incentives encourage employee ownership of stock
through a qualified employee benefit plan and provide employers with a tax-
favored means of financing. The deferral of recognition of the gain from the
sale of stock to an ESOP encourages the owners of closely held companies to
sell stock to the company's employees. The deduction for dividends paid to
ESOP participants encourages the current distribution of dividends.

Various incentives encourage the creation of leveraged ESOPs. Compared
to conventional debt financing, both the interest and principal on an ESOP
loan are tax-deductible. The deduction for dividends used to make payments
on an ESOP loan and the unrestricted deduction for contributions to pay
interest encourage employers to repay an ESOP loan more quickly.

According to an analysis of information returns filed with the Internal
Revenue Service, most ESOPs are in private companies, and most ESOPs
have fewer than 100 participants. But most ESOP participants are employed
by public companies and belong to plans with 100 or more participants.
Likewise, most ESOP assets are held by plans in public companies and by
plans with 100 or more participants.

Rationale

The tax incentives for ESOPs are intended to broaden stock ownership,
provide employees with a source of retirement income, and grant employers a
tax-favored means of financing.

The Employee Retirement Income Security Act of 1974 (P.L. 93-406)
allowed employers to form leveraged ESOPs. The Tax Reduction Act of
1975 established a tax-credit ESOP (called a TRASOP) that allowed
employers an additional investment tax credit of one percentage point if they
contributed an amount equal to the credit to an ESOP.

The Tax Reform Act of 1976 allowed employers an increased investment
tax credit of one-half a percentage point if they contributed an equal amount
to an ESOP and the additional contribution was matched by employee
contributions.

The Revenue Act of 1978 required ESOPs in publicly traded corporations
to provide participants with full voting rights, and required closely held
companies to provide employees with voting rights on major corporate issues.
The Act required closely held companies to give workers a put option on
distributions of stock.

The Economic Recovery Tax Act of 1981 (P.L. 97-34) replaced the
investment-based tax credit ESOP with a tax credit based on payroll (called a
PAYSOP). The 1981 Act also allowed employers to deduct contributions of
up to 25 percent of compensation to pay the principal on an ESOP loan.
Contributions used to pay interest on an ESOP loan were excluded from the
25-percent limit.

The Deficit Reduction Act of 1984 (P.L. 98-369) allowed corporations a
deduction for dividends on stock held by an ESOP if the dividends were paid
to participants. The Act also allowed lenders to exclude from their income 50
percent of the interest they received on loans to an ESOP.

The Act allowed a stockholder in a closely held company to defer
recognition of the gain from the sale of stock to an ESOP if the ESOP held at
least 30 percent of the company's stock and the owner reinvested the proceeds
from the sale in a U.S. company. The Act permitted an ESOP to assume a
decedent's estate tax in return for employer stock of equal value.

The Tax Reform Act of 1986 repealed the tax credit ESOP. The Act also
extended the deduction for dividends to include dividends used to repay an
ESOP loan. The Act permitted an estate to exclude from taxation up to 50
percent of the proceeds from the sale of stock to an ESOP. The Act allowed
persons approaching retirement to diversify the investment of assets in their
accounts.

The Omnibus Budget Reconciliation Act of 1989 limited the 50-percent
interest exclusion to loans made to ESOPs that hold more than 50 percent of a
company's stock. The deduction for dividends used to repay an ESOP loan
was restricted to dividends paid on shares acquired with that loan. The Act
repealed both estate tax provisions: the exclusion allowed an estate for the
sale of stock to an ESOP and the provision allowing an ESOP to assume a
decedent's estate tax. The Small Business Job Protection Act of 1996
eliminated the provision that allowed a 50% interest income exclusion for
bank loans to ESOPs. The Economic Growth and Recovery Tax Act of 2001
allowed firms to deduct dividends on stock held in retirement plans.

Assessment

One of the major objectives of ESOPs is to expand employee stock
ownership. These plans are believed to motivate employees by more closely
aligned their financial interests with the financial interests of their employers.
The distribution of stock ownership in ESOP firms is broader than the
distribution of stock ownership in the general population.

Some evidence suggests that among firms with ESOPs there is a greater
increase in productivity if employees are involved in corporate decision-
making. But employee ownership of stock is not a prerequisite for employee
participation in decision-making.

ESOPs do not provide participants with the traditional rights of stock
ownership. Full vesting depends on a participant's length of service and
distributions are generally deferred until a participant separates from service.
To provide participants with the full rights of ownership would be consistent
with the goal of broader stock ownership, but employees would be able to use
employer contributions for reasons other than retirement.

The requirement that ESOPs invest primarily in the stock of the sponsoring
employer is consistent with the goal of corporate financing, but it may not be
consistent with the goal of providing employees with retirement income. The
cost of such a lack of diversification was demonstrated with the failure of
Enron and other firms whose employees' retirement plans were heavily
invested in company stock. If a firm experiences financial difficulties, the
value of its stock and its dividend payments will fall. Because an ESOP is a
defined-contribution plan, participants bear the burden of this risk. The
partial diversification requirement for employees approaching retirement was
enacted in response to this issue.

A leveraged ESOP allows an employer to raise capital to invest in new
plant and equipment. But evidence suggests that the majority of leveraged
ESOPs involve a change in ownership of a company's stock, and not a net
increase in investment.

Although the deduction for dividends used to repay an ESOP loan may
encourage an employer to repay a loan more quickly, it may also encourage
an employer to substitute dividends for other loan payments.

Because a leveraged ESOP allows an employer to place a large block of
stock in friendly hands, leveraged ESOPs have been used to prevent hostile
takeovers. In these cases, the main objective is not to broaden employee stock
ownership.

ESOPs have been used in combination with other employee benefit plans.
A number of employers have adopted plans that combine an ESOP with a
401(k) salary reduction plan. Some employers have combined an ESOP with
a 401(h) plan to fund retiree medical benefits.

Selected Bibliography

Blasi, Joseph R. Employee Ownership: Revolution or Ripoff? Cambridge,
MA: Ballinger, 1988.
Blinder, Alan S., ed. Paying for Productivity: A Look at the Evidence.
Washington, DC: The Brookings Institution, 1990.
Conte, Michael A., and Helen H. Lawrence. "Trends in ESOPs," Trends
in Pensions 1992, eds. John A. Turner and Daniel J. Beller. Washington,
DC: U.S. Government Printing Office, 1992, pp. 135-148.
Gamble, John E. "ESOPs: Financial Performance and Federal Tax
Incentives," Journal of Labor Research, v. 19, Summer 1998, pp. 529-541.
Gravelle, Jane G., Employer Stock in Pension Plans: Economic and Tax
Issues, Library of Congress, Congressional Research Service Report
RL31551,Washongton, DC: September 4, 2002.
-. "The Enron Debate: Lessons for Tax Policy," Urban-Brookings Tax
Policy Center Discussion Paper 6, Washington, DC: The Urban Institute,
February 2003.
Kruse, Douglas, Richard Freeman, Joseph Blasi, Robert Buchele, and
Adria Scharf, "Motivating Employee-Owners in ESOP Firms: Human
Resource Policies and Company Performance," in Employee Participation,
Firm Performance and Survival, Advances in the Economic Analysis of
Participatory and Labor-Managed Firms, v. 8, Virginie Perotin and Andrew
Robinson, eds., Amsterdam: Elsevier, 2004.

Mayer, Gerald. Employee Stock Ownership Plans: Background and
Policy Issues. Library of Congress, Congressional Research Service Report
RL30038. Washington, DC: January 20, 1999.
-. "Employee Stock Ownership Plans," in The Encyclopedia of Taxation
and Tax Policy, eds. Joseph J. Cordes, Robert O. Ebel, and Jane G. Gravelle.
Washington, DC: Urban Institute Press, 2005.
Shorter, Gary W. ESOPs and Corporate Productivity. Library of
Congress, Congressional Research Service Report 91-557 E. Washington,
DC: July 12, 1991.
Snyder, Todd S., Employee Stock Ownership Plans (ESOPs):
Legislative History. Library of Congress, Congressional Research
Service Report RS21526, Washington, DC: May 20, 2003.
U.S. General Accounting Office. Employee Stock Ownership Plans:
Benefits and Costs of ESOP Tax Incentives for Broadening Stock Ownership,
PEMD-87-8. Washington, DC: General Accounting Office, December 29,
1986.
-. Employee Stock Ownership Plans: Little Evidence of Effects on
Corporate Performance, PEMD-88-1. Washington, DC: General
Accounting Office, October 29, 1987.

Education, Training, Employment, and Social Services:
Employment

WORK OPPORTUNITY TAX CREDIT

Estimated Revenue Loss*

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

(1)

0.2

2007

(1)

0.1

2008

(1)

0.1

2009

(1)

2010

(1)

*The tax credit is effective through December 31, 2007; H.R.
6111 (December 2006) increases the loss for FY2007 to FY2010 by
$0.4, $0.3, $0.2, and $0.1 for the combined work opportunity and
welfare to work credit.
(1)Less than $50 million.

Authorization

Sections 51 and 52.

Description

The Work Opportunity Tax Credit (WOTC) (to be combined with the
welfare to work credit in 2007) is available on a nonrefundable basis to for-
profit employers who hire individuals from the following groups:

(1) members of families receiving benefits under the Temporary Assistance
for Needy Families (TANF) program for a total of any 9 months during the
18-month period ending on the hiring date;

(2) qualified veterans who are members of families receiving benefits
under the Food Stamp program for at least a 3-month period ending during
the 15-month period ending on the hiring date;
(3) 18-24 year olds who are members of families receiving Food Stamp
benefits for the 6-month period ending on the hiring date, or receiving
benefits for at least 3 months of the 5-month period ending on the hiring date
in the case of family members no longer eligible for assistance under section
6(o) of the Food Stamp Act of 1977;
(4) high-risk youth (i.e., 18-24 year olds whose principal place of abode is
in an empowerment zone, renewal community, or an enterprise community);
(5) summer youth (i.e., 16-17 year olds hired for any 90-day period
between May 1 and September 15 whose principal place of abode is in an
empowerment zone, renewal community, or an enterprise community);
(6) economically disadvantaged ex-felons with hiring dates within 1 year of
the last date of conviction or release from prison;
(7) vocational rehabilitation referrals (i.e., individuals with physical or
mental disabilities that result in substantial handicaps to employment who
have been referred to employers by state vocational rehabilitation agencies or
employment networks upon completion of or while receiving rehabilitative
services under the Rehabilitation Act of 1973 or through a program carried
out under chapter 31 of title 38, United States Code); and
(8) Supplemental Security Income recipients who have received benefits
under Title XVI of the Social Security Act for any month ending within the
60-day period ending on the hiring date.

During the first year in which a WOTC-eligible person is hired, the
employer can claim an income tax credit of 40% of the first $6,000 earned if
the worker is retained for at least 400 hours. If the WOTC-eligible hire is
retained for 120-399 hours, the subsidy rate is 25%. For summer youth
employees, the 25% or 40% subsidy rate is applied against the first $3,000
earned. No credit can be claimed unless the eligible employee remains on the
employer's payroll for a minimum of 120 hours.

The maximum amount of the credit to the employer would be $1,500 or
$2,400 per worker ($750 or $1,200 per summer-youth hire) for persons
retained 120-399 hours or at least 400 hours, respectively. The actual value
could be less than these amounts, depending on the employer's tax bracket.
An employer's usual deduction for wages must be reduced by the amount of
the credit as well. The credit also cannot exceed 90% of an employer's
annual income tax liability, although the excess can be carried back 1 year or
carried forward 20 years for workers hired on or after January 1, 1998.

Impact

An employer completes a "pre-screening" notice by the date a job offer is
made to an applicant thought to belong to the WOTC-eligible population.
The IRS form must be mailed to the state's Employment Service (ES) agency
within 21 days after the new hire starts working. The ES then certifies
whether the new hire belongs to one of the WOTC's eligible groups.

The ES issued 598,101 certifications to employers for FY2005. In that
year, 36% of all certifications were for members of the 18-24 year old Food
Stamp group and 32% were for members of the TANF group. Another 12%
of certifications were issued to employers for hiring WOTC-eligible high-risk
youth ; 7% for economically disadvantaged ex-felons; and 6% for eligible SSI
recipients. Certifications will exceed the number of credits claimed unless all
WOTC-eligible hires remain on firms' payrolls for the minimum employment
period (i.e., certifications reflect eligibility determinations rather than credits
claimed).

Rationale

The temporary credit was authorized by the Small Business Job Protection
Act of 1996 effective through September 30, 1997. It subsequently was
extended several times, often after the provision had expired . Most recently,
it was extended (retroactive to its expiration date after having lapsed on
January 1, 2004) through December 31, 2005 by the Working Families Tax
Relief Act of 2004.

WOTC primarily is intended to help individuals, who have difficulty
obtaining employment in both good and bad economic times, get jobs in the
private sector. The credit is designed to reduce the relative cost of hiring
these low-skilled individuals by subsidizing their wages, and hence to
increase employers' willingness to give them jobs despite their presumed low
productivity. In recent years, eligible groups temporarily have been added in
response to disasters (i.e., New York Liberty Zone business employees after
the 2001 terrorist attack and Hurricane Katrina employees after the 2005
hurricane).

A prior tax credit aimed at encouraging firms to hire hard-to-employ
individuals, the Targeted Jobs Tax Credit (TJTC), was effective from 1978
through 1994. The TJTC was subject to criticism, but Congress, after making
some revisions, retained this approach to increasing employment of
disadvantaged workers. H.R. 6111(December (2006) extended the credit
through 2006 t and combined it with the welfare to work credit for 2007.

Assessment

Based upon a survey of employers in two states conducted by the General
Accounting Office (GAO) in 2001, the agency speculated that employers
were not displacing employees in order to replace them with individuals for
whom they could claim the credit. According to the GAO, the cost of
recruiting, hiring, and training WOTC-eligible workers appears to be higher
than the amount of the credit that employers could claim. As employees
certified for the credit were not terminated any more frequently than others
when their earnings reached about $6,000 (the credit-maximizing level), the
GAO surmised that employers were not churning their workforces to
maximize credit receipt.

Another limited analysis, released in 2001, yielded a fairly unfavorable
assessment of the credit's performance. Based on interviews with 16 firms in
5 states that claimed the credit, researchers found that the WOTC had little or
no influence on the employers' hiring decisions.

A third study looked specifically at the "take-up" rate among two WOTC-
eligible groups, namely, TANF recipients and food stamp youth. It estimated
that during the late 1990s relatively few newly employed members of either
group had the credit claimed for them.

Selected Bibliography

Hamersma, Sarah. "The Work Opportunity Tax Credit: Participation Rates
Among Eligible Workers." National Tax Journal, vol. 56, no. 4 (December
2003), pp. 725-738.
Hamersma, Sarah. The Work Opportunity and Welfare-to-Work Tax
Credits. Urban-Brookings Tax Policy Center, No. 15. Washington, DC:
October 2005.
Howard, Christopher. The Hidden Welfare State: Tax Expenditures and
Social Policy in the United States. Princeton: Princeton University Press,
1997.
Levine, Linda. The Work Opportunity Tax Credit (WOTC) and the
Welfare-to-Work Tax Credit. Congressional Research Service Report
RL30089. Washington, DC: updated August 2, 2006.
-. Targeted Jobs Tax Credit, 1978-1994, Congressional Research Service
Report 95-981. Washington, DC: September 19, 1995.
U.S. General Accounting Office. Work Opportunity Credit: Employers Do
Not Appear to Dismiss Employees to Increase Tax Credits, GAO-01-329.
Washington, DC: March 2001.
Westat and Decision Information Resources, Inc. Employers' Use and
Assessment of the WOTC and Welfare-to-Work Tax Credits Program.
Washington, DC: March 2001.

Education, Training, Employment, and Social Services:
Employment

WELFARE-TO-WORK TAX CREDIT

Estimated Revenue Loss*

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

(1)

2006

(1)

2008

(1)

2009

(1)

2010

(1)

*The tax credit is effective through December 31, 2007; H.R. 6111
(December 2006) increases the loss for FY2007 to FY2010 by $0.4, $0.3,
$0.2, and $0.1 for the combined work opportunity and welfare to work credit.

(1)Less than $50 million.

Authorization

Sections 51 and 52.

Description

The Welfare to Work (WtW) Credit is available on a nonrefundable basis
to for-profit employers who hire long-term recipients of Temporary
Assistance for Needy Families (TANF) benefits. For 2007 it is combined
with the Work Opportunity Tax Credit (WOTC). The eligible group is
defined as: (1) members of families that have received TANF benefits for at
least 18 consecutive months ending on the hiring date; (2) members of
families that have received TANF benefits for any 18 months beginning after
the credit's enactment (August 5, 1997), if they are hired within 2 years after
the date the 18-month total is reached; or (3) members of families that no
longer are eligible for TANF assistance after August 5, 1997 because of any
federal- or state-imposed time limit, if they are hired within 2 years after the
date of benefit cessation.

During the first year in which credit-eligible persons are hired, employers
can claim an income tax credit of 35% of the first $10,000 earned. During
the second year of their employment, employers can claim an income credit
of 50% of the first $10,000 earned. Earnings against which the subsidy rate
can be applied include, in addition to gross wages, certain tax-exempt
amounts received under accident and health plans as well as under
educational or dependent assistance programs. An eligible-hire must remain
on an employer's payroll for a minimum of 400 hours or 180 days in order for
the credit to be claimed.

The maximum amount of the credit to the employer would be $3,500 per
worker in the first year of employment and $5,000 in the second year of
employment. The actual value could be less than these amounts depending
on the employer's tax bracket. An employer's usual deduction for wages
must be reduced by the amount of the credit as well. The credit also cannot
exceed 90% of an employer's annual income tax liability, although the excess
can be carried back 1 years or carried forward 20 years. Employers cannot
claim both the WOTC and WtW credit for the same individuals.

In 2007, the maximum credit will be $4,000 in the first year.

Impact

An employer completes a "pre-screening notice" by the date a job offer is
made to an applicant thought to belong to the credit-eligible population. The
IRS form must be mailed to the state's Employment Service (ES) agency
within 21 days after the new hire starts working (28 days in 2007). The ES
then certifies whether the new hire is part of the eligible group. The employer
uses the certification of eligibility to claim the WtW credit.

According to the ES, the number of certifications issued to employers has
varied greatly over time. (Certifications will exceed the number of credits
claimed unless all eligible-hires remain on firms' payrolls for the minimum
employment period. Thus, certifications reflect eligibility determinations
rather than credits claimed.) In its first full year of operation (FY1999),
employers were issued 104,998 certifications. After certifications rose to
154,608 in FY2000, they declined steadily and markedly thereafter. The
2001 recession and subsequent slow recovery likely affected the figures
during the early years of the decade, with 33,068 certifications issued in
FY2003. The low number of certifications in more recent years (e.g., 15,601
in FY2004) likely reflects the expiration of the credit during much of the
period. In FY2005, ES agencies issued 32,817certifications to employers.

Rationale

The WtW credit is one of the initiatives meant to help welfare recipients
comply with the work requirements contained in welfare reform legislation
(P.L. 104-193). The credit is designed to lower the relative cost of hiring
long-term family assistance beneficiaries by subsidizing their wages, and
hence to increase private sector employers' willingness to hire them despite
their presumed low productivity.

Earlier tax credits aimed at encouraging firms to hire welfare recipients
were little used according to empirical studies. Despite this and other
criticisms, Congress opted to retain this approach to job creation for long-
term family assistance recipients.

H.R. 6111 (December 2006), extended the credit through 2006. That
legislation also combined it with the Work Opportunity Credit e to Work
credit for 2007.

Assessment

Since its inception, no funds have been included in legislation to conduct
an assessment of the WtW's effectiveness. With a target group very similar
to one of the Work Opportunity Tax Credit's eligible groups, its availability
has increased the complexity of the Code.

Selected Bibliography

Hamersma, Sarah. The Work Opportunity and Welfare-to-Work Tax
Credits. Urban-Brookings Tax Policy Center, No. 15. Washington, DC:
October 2005.
Levine, Linda. The Work Opportunity Tax Credit (WOTC) and the
Welfare-to-Work Tax Credit. Congressional Research Service Report
RL30089. Washington, DC: updated August 2, 2006.
-. Welfare Recipients and Employer Wage Subsidies, Library of Congress,
Congressional Research Service Report 96-738E. Washington, DC:
September 3, 1996.
Westat and Decision Information Resources, Inc. Employers' Use and
Assessment of the WOTC and Welfare-to-Work Tax Credits Program.
Washington, DC: March 2001.

Education, Training, Employment, and Social Services:
Employment

DEFERRAL OF TAXATION ON SPREAD ON ACQUISITION
OF STOCK UNDER INCENTIVE STOCK OPTION PLANS
AND EMPLOYEE STOCK PURCHASE PLANS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.4

2007

0.4

2008

0.4

2009

0.2

2010

0.1

Authorization

Sections 422-423.

Description

Qualified (or "statutory") options include "incentive stock options," which
are limited to $100,000 a year for any one employee, and "employee stock
purchase plans," which are limited to $25,000 a year for any employee.
Employee stock purchase plans must be offered to all full-time employees
with at least two years of service; incentive stock options may be confined to
officers and highly paid employees. Qualified options are not taxed to the
employee when granted or exercised (under the regular tax); tax is imposed
only when the stock is sold. If the stock is held one year from purchase and
two years from the granting of the option, the gain is taxed as long-term
capital gain. The employer is not allowed a deduction for these options.
However, if the stock is not held the required time, the employee is taxed at
ordinary income tax rates and the employer is allowed a deduction. The value
of incentive stock options is included in minimum taxable income in the year
of exercise.

Impact

Both types of qualified stock options receive some tax benefit under
current law. The employee recognizes no income (for regular tax purposes)
when the options are granted or when they are exercised. Taxes (under the
regular tax) are not imposed until the stock purchased by the employee is
sold. If the stock is sold after it has been held for at least two years from the
date the option was granted and one year from the date it was exercised, the
difference between the market price of the stock when the option was
exercised and the price for which it was sold is taxed at long-term capital
gains rates. If the option price was less than 100% of the fair market value of
the stock when it was granted, the difference between the exercise price and
the market price (the discount) is taxed as ordinary income (when the stock is
sold). Taxpayers with above average or high incomes are the primary
beneficiaries of these tax advantages.

Rationale

The Revenue Act of 1964 (P.L. 88-272) enacted special rules for qualified
stock options, which excluded these options from income when they were
granted or exercised and instead included the gains as income at the time of
sale of the stock. The Tax Reform Act of 1976 (P.L. 94-455) repealed these
special provisions and thus subjected qualified stock options to the same rules
as applied to nonqualified options. Therefore, if an employee receives an
option, which has a readily ascertainable fair market value at the time it is
granted, this value (less the option price paid for the option, if any)
constituted ordinary income to the employee at that time. But, if the option
did not have a readily ascertainable fair market value at the time it was
granted, the value of the option did not constitute ordinary income to the
employee at that time. However, when the option was exercised, the spread
between the option price and the value of the stock constituted ordinary
income to the employee. The Economic Recovery Tax Act of 1981 (P.L. 97-
34) reinstituted special rules for qualified stock options with the justification
that encouraging the management of a business to have a proprietary interest
in its successful operation would provide an important incentive to expand
and improve the profit position of the companies involved.

Assessment

Tax advantages for qualified stock options encourage companies to
provide them to employees rather than other forms of compensation that are
not tax favored. Paying for the services of employees, officers, and directors
by the use of stock options has several advantages for the companies. Start-
up companies often use the method because it does not involve the immediate
cash outlays that paying salaries involves; in effect, a stock option is a
promise of a future payment, contingent on increases in the value of the
company's stock. It also makes the employees' pay dependent on the
performance of the company's stock, giving them extra incentive to try to
improve the company's (or at least the stock's) performance. Ownership of
company stock is thought by many to assure that the company's employees,
officers, and directors share the interests of the company's stockholders.
Lastly, receiving pay in the form of stock options serves as a form of forced
savings, since the money cannot be spent until the restrictions expire.

Critics of the stock options, however, argue that there is no real evidence
that the use of stock options instead of cash compensation improves corporate
performance. (Many of the leading users of stock options were among the
companies suffering substantial recent stock losses.) Furthermore, stock
options are a risky form of pay, since the market value of the company's stock
may decline rather than increase. Some employees may not want to make the
outlays required to buy the stock, especially if the stock is subject to
restrictions and cannot be sold immediately. And some simply may not want
to invest their pay in their employer's stock.

Selected Bibliography

Bickley, James M. Employee Stock Options: Tax Treatment and Tax
Issues. Library of Congress, Congressional Research Service Report
RL31458. Washington, DC: updated September 1, 2006.
Gravelle, Jane G. Taxes and Incentive Stock Options. Library of
Congress, Congressional Research Service Report RS20874. Washington,
DC: January 30, 2003.
Johnson, Shane A. and Yisong S. Tian. "The Value and Incentive Effects
of Nontraditional Executive Stock Option Plans." Journal of Financial
Economics, vol. 57 (2000), pp. 3-34.
Biggs, John H. Testimony before the U.S. Senate Finance Committee.
April 18, 2002.

Education, Training, Employment, and Social Services:
Social Services

TAX CREDIT FOR CHILDREN UNDER AGE 17

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

46.0

2007

45.9

2008

46.1

2009

46.0

2010

46.0

Authorization

Section 24.

Description

Families with qualifying children are allowed a credit against their federal
individual income tax of $1,000 per qualifying child.

To qualify for the credit the child must be an individual for whom the
taxpayer can claim a dependency exemption. That means the child must be
the son, daughter, grandson, granddaughter, stepson, stepdaughter or an
eligible foster child of the taxpayer. The child must be under the age of 17 at
the close of the calendar year in which the taxable year of the taxpayer begins.

The child tax credit is phased out for taxpayers whose adjusted gross
incomes (AGIs) exceed certain thresholds. For married taxpayers filing joint
returns, the phaseout begins at AGI levels in excess of $110,000, for married
couples filing separately the phaseout begins at AGI levels in excess of
$55,000, and for single individuals filing as either heads of households or as
singles the phaseout begins at AGI levels in excess of $75,000. The child tax
credit is phased out by $50 for each $1000 (or fraction thereof) by which the
taxpayer's AGI exceeds the threshold amounts. Neither the child tax credit
amount nor the phaseout thresholds are indexed for inflation.

The child tax credit is refundable. For families with less than three
qualifying children, the maximum refundable credit cannot exceed 15% of a
taxpayer's earned income in excess of a given income threshold. For 2006,
the income threshold is $11,300. The threshold is indexed annually for
inflation. For families with three or more children, the maximum refundable
credit is limited to the extent that the taxpayer's Social Security taxes and
income taxes exceed the taxpayer's earned income tax credit or to the extent
of 15% of their earned income in excess of income threshold. In these cases,
the taxpayer can use whichever method results in the largest refundable
credit.

The child tax credit can be applied against both a taxpayer's regular
income tax and his or her alternative minimum tax.

Impact

The child tax credit will benefit all families with qualifying children whose
incomes fall below the AGI phaseout ranges.

Distribution by Income Class of the
Tax Credit for Children Under Age
17, 2005

Income Class
(in thousands of $)

Percentage
of Amount

Below $10

0.4

$10 to $20

4.0

$20 to $30

11.5

$30 to $40

13.9

$40 to $50

12.6

$50 to $75

23.7

$75 to $100

17.2

$100 to $200

16.5

$200 and over

0.0

Rationale

The child tax credit was enacted as part of the Taxpayer Relief Act of
1997. Initially, for tax year 1998, families with qualifying children were
allowed a credit against their federal income tax of $400 for each qualifying
child. For tax years after 1998, the credit increased to $500 for each
qualifying child. For families with three or more children, the credit was
refundable.

Congress indicated that the tax structure at that time did not adequately
reflect a family's reduced ability to pay as family size increased. The decline
in the real value of the personal exemption over time was cited as evidence of
the tax system's failure to reflect a family's ability to pay. Congress further
believed that the child tax credit would reduce a family's tax liabilities, would
better recognize the financial responsibilities of child rearing, and promote
family values.

The amount and coverage of the child tax credit was substantially
increased by the Economic Growth and Tax Relief Reconciliation Act of
2001. Proponents of this increase argued that a $500 child tax credit was
inadequate. It was argued that the credit needed to be increased in order to
better reflect the reduced ability to pay taxes of families with children.
Furthermore, it was felt that the credit should be refundable for all families
with children.

The 2001 Act increased the child tax credit to $1,000 with the increase
scheduled to be phased in between 2001and 2010. It also made the credit
refundable for families with less than three children. The Jobs and Growth
Tax Relief Reconciliation Act of 2003 increased the child tax credit to $1,000
for tax years 2003 and 2004. The Working Families Tax Relief Act of 2004
effectively extended the $1,000 child tax credit through 2010. The 2004 act
also included combat pay, which is not subject to income taxes, in earned
income for purposes of calculating the refundable portion of the credit.

The Katrina Emergency Tax Relief Act of 2005 allowed taxpayers affected
by hurricanes Katrina, Rita, and Wilma to use their prior year's (2004) earned
income to compute the amount of their 2005 refundable child credit.

Under current law, the changes made by the 2001 act will sunset at the end
of 2010. For tax years beyond 2010, the child tax credit will revert to its pre-
2001 law levels and refundability rules.

Assessment

Historically, the federal income tax has differentiated among families of
different size through the combined use of personal exemptions, child care
credits, standard deductions, and the earned income tax credit. These
provisions were modified over time so that families of differing size would
not be subject to federal income tax if their incomes fell below the poverty
level.

The child tax credit enacted as part of the Taxpayer Relief Act of 1997,
and expanded upon in the 2001, 2003, and 2004 tax Acts, represents a
departure from past policy practices because it is not designed primarily as a
means of differentiating between low-income families of different size, but
rather is designed to provide general tax reductions to middle income
families. The empirical evidence, however, suggests that for families in the
middle and higher income ranges, the federal tax burden has remained
relatively constant over the past 15 years.

Selected Bibliography

Esenwein, Gregg. "Child Tax Credit," Encyclopedia of Taxation and Tax
Policy, Ed. Joseph J. Cordes, Robert D. Ebel and Jane G. Gravelle. The
Urban Institute, Washington D.C. 2005.
Gravelle, Jane G. and Jennifer Gravelle. "Horizontal Equity and Family
Tax Treatment: The Orphan Child of Tax Policy". National Tax Journal,
September 2006.
Burman, Leonard E. and Laura Wheaton. "Who Gets the Child Tax
Credit?" Tax Notes, October 17, 2005.
Esenwein, Gregg. The Child Tax Credit. Library of Congress.
Congressional Research Service Report RS21860. 2006.
Esenwein, Gregg A. The Child Tax Credit After the Economic Growth
and Tax Relief Reconciliation Act of 2001 . Library of Congress,
Congressional Research Service Report RS20988. 2002.
U.S. Department of the Treasury. Internal Revenue Service. Child Tax
Credit. Publication 972. 2005.
U.S. Congress, Joint Committee on Taxation. Technical Explanation of
H.R. 3768, The "Katrina Emergency Tax Relief Act of 2005." JCX-69-05.
September 2005.
-, Joint Committee on Taxation. General Explanation of Tax Legislation
Enacted in the 107th Congress. January 2003.
-, Joint Committee on Taxation. Summary of the Provisions Contained in
the Conference Agreement for H.R. 1836, The Economic Growth and Tax
Relief Reconciliation Act of 2001. May 2001.
-, House of Representatives. Ticket to Work and Work Incentives
Improvement Act of 1999. Conference Report 106-478, November 1999.
-, Joint Committee on Taxation. General Explanation of Tax Legislation
Enacted in 1997. December 1997.

Education, Training, Employment, and Social Services:
Social Services

TAX CREDIT FOR CHILD
AND DEPENDENT CARE AND EXCLUSION OF EMPLOYER-
PROVIDED CHILD CARE

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

3.1

2007

2.7

2008

2.7

2009

2.6

2010

2.5

Authorization

Sections 21 and 129.

Description

A taxpayer may claim a nonrefundable tax credit (Section 21) for
employment-related expenses incurred for the care of a dependent child (or a
disabled dependent or spouse). The maximum dependent care tax credit is 35
percent of expenses up to $3,000, if there is one qualifying individual, and up
to $6,000 for two or more qualifying individuals. The credit rate is reduced
by one percentage point for each $2,000 of adjusted gross income (AGI), or
fraction thereof, above $15,000, until the credit rate of 20 percent is reached
for taxpayers with AGI incomes above $43,000. Married couples must file a
joint return in order to be eligible for the credit.

In addition, payments by an employer, under a dependent care assistance
program, for qualified dependent care assistance provided to an employee are
excluded from the employee's income and, thus, not subject to federal
individual income tax (Section 129). The qualified expenditures are not
counted as wages, and therefore, are also not subject to employment taxes.
The maximum exclusion amount is $5,000, and may not exceed the lesser of
the earned income of the employee or the employee's spouse if married. For
each dollar a taxpayer receives through an employer dependent care
assistance program, a reduction of one dollar is made in the maximum
qualified expenses for the dependent care tax credit.

To qualify, the employer assistance must be provided under a plan which
meets certain conditions, including eligibility conditions which do not
discriminate in favor of principal shareholders, owners, officers, highly
compensated individuals or their dependents, and the program must be
available to a broad class of employees. The law provides that reasonable
notification of the availability and terms of the program must be made to
eligible employees.

Qualified expenses (for both the tax credit and the income exclusion)
include expenses for household services, day care centers, and other similar
types of noninstitutional care which are incurred in order to permit the
taxpayer to be gainfully employed. Qualified expenses are eligible if they are
for a dependent under 13, or for a physically or mentally incapacitated spouse
or dependent who lives with the taxpayer for more than half of the tax year.
Dependent care centers must comply with state and local laws and regulations
to qualify. Payments may be made to relatives who are not dependents of the
taxpayer or a child of the taxpayer under age 19.

Impact

The credit benefits qualified taxpayers with sufficient tax liability to take
advantage of it, without regard to whether they itemize their deductions. It
operates by reducing tax liability, but not to less than zero because the credit
is nonrefundable. Thus, the credit does not benefit persons with incomes so
low that they have no tax liability.

Distribution by Income Class of the
Tax Expenditure for
Child and Dependent Care Services, 2005

Income Class
(in thousands of $)

Percentage
Distribution

Below $10

0.0

$10 to $20

0.6

$20 to $30

5.2

$30 to $40

11.7

$40 to $50

11.2

$50 to $75

21.0

$75 to $100

17.9

$100 to $200

27.2

$200 and over

5.2

The credit rate phases down from 35 to 20 percent as income rises from
$15,000 to $43,000, providing the largest monetary benefit to parents with
incomes of $43,000 or less. In the past, the absence of an inflation
adjustment has affected the ability of moderate-income taxpayers to receive
the maximum benefits under the credit.

The tax exclusion provides an incentive for employers to provide, and
employees to receive, compensation in the form of dependent-care assistance
rather than cash. The assistance is free from income and employment taxes,
while the cash is not. As is the case with all deductions and exclusions, this
benefit is related to the taxpayer's marginal tax rate and, thus, provides a
greater benefit to taxpayers in high tax brackets than those in low tax
brackets. To the extent employers provide dependent care assistance rather
than increases in salaries or wages, the Social Security Trust Fund and the
Hospital Insurance Trust Fund (for Medicare) lose receipts. Because of the
lower amounts of earnings reported to Social Security the employee may
receive a lower Social Security benefit during retirement years.

Rationale

The deduction for child and dependent care services was first enacted in
1954. The allowance was limited to $600 per year and was phased out for
families with income between $4,500 and $5,100. Single parents and
widow(er)s did not have an income limitation for the deduction. The
provision was intended to recognize the similarity of child care expenses to
employee business expenses and provide a limited benefit. Some believe
compassion and the desire to reduce welfare costs contributed to the
enactment of this allowance.

The provision was made more generous in 1964, and was revised and
broadened in 1971. Several new justifications in 1971 included encouraging
the hiring of domestic workers, encouraging the care of incapacitated persons
at home rather than in institutions, providing relief to middle-income
taxpayers as well as low-income taxpayers, and providing relief for
employment-related expenses of household services as well as for dependent
care.

The Tax Reduction Act of 1975 substantially increased the income limits
($18,000 to $35,000) for taxpayers who could claim the deduction.

The deduction was replaced by a nonrefundable credit with enactment of
the Tax Reform Act of 1976. Congress believed that such expenses were a
cost of earning income for all taxpayers and that it was wrong to deny the
benefits to those taking the standard deduction. Also, the tax credit provided
relatively more benefit than the deduction to taxpayers in the lower tax
brackets.

The Revenue Act of 1978 provided that the child care credit was available
for payments made to relatives. The stated rationale was that, in general,
relatives provide better attention and the allowance would help strengthen
family ties.

The tax exclusion was enacted in the Economic Recovery Tax Act of 1981
(P.L. 97-34), and was intended to provide an incentive for employers to
become more involved in the provision of dependent care services for their
employees. Also in 1981, the tax credit was converted into the current sliding-
scale credit and increased. The congressional rationale for increasing the
maximum amounts was due to substantial increases in costs for child care.
The purpose of switching to a sliding-scale credit was to target the increases
in the credit toward low- and middle-income taxpayers because Congress felt
that group was in greatest need of relief.

The Family Support Act of 1988 modified the dependent care tax credit.
First, the credit became available for care of children under 13 rather than 15.
Second, a dollar-for-dollar offset was provided against the amount of
expenses eligible for the dependent care credit for amounts excluded under an
employer-provided dependent care assistance program. Finally, the act
provided that the taxpayer must report on his or her tax return the name,
address, and taxpayer identification number of the dependent care provider.

With passage of the Economic Growth and Tax Relief Reconciliation Act
of 2001, the sliding-scale credit was increased 5 percent while the maximum
expenditure amounts for care were raised from $2,400 to $3,000 for one
qualifying individual and from $4,800 to $6,000 in the case of two or more
qualified individuals. It seems likely that these changes were made because
these provisions are not subject to an automatic inflation provision.

The provision was further amended by the Job Creation and Worker
Assistance Act of 2002 which determined that the amount of "deemed earned
income" in the case of a nonworking spouse incapable of self-care or a
student is increased to $250 if there is one qualifying child or dependent, or
$500 if there are two or more children.

In 2004, the Working Families Tax Relief Act was passed which made two
changes for dependent care expenses. The bill imposed a requirement that a
disabled dependent (or spouse), who is not a qualifying child under age 13,
live with the taxpayer for more than half the tax year. It also eliminated the
requirement that the taxpayer maintain a household in which the qualifying
dependent resides.

Assessment

An argument for the child and dependent care tax credit is that child care is
a cost of earning income; if this is the rationale, however, it can also be
argued that the amount should be a deductible expense that is available to all
taxpayers.

The issue of whether the tax credit is progressive or regressive lingers
because an examination of distribution tables shows that the greatest federal
revenue losses occur at higher rather than lower income levels. The
distribution table appearing earlier in this section shows that taxpayers whose
adjusted gross incomes were under $20,000 are estimated to claim 0.6
percent of the total value of the tax credit in 2005, while taxpayers in the $50-
$75,000 income class are estimated to claim 21.0 percent. However, the
determination of the dependent care tax credit progressivity cannot be made
simply by comparing an estimate of the federal tax expenditure. A more
appropriate measure is the credit amount relative to the taxpayer's income.

It is generally observed that the credit is regressive at lower income levels
primarily because the credit is non-refundable. Thus, the structure of the
credit (albeit, except at low-income levels) has been found to be progressive.

This is not meant to imply that if the credit were made refundable it would
solve all of the problems associated with child care for low-income workers.
For example, the earned income tax credit is refundable and designed so that
payments can be made to the provision's beneficiaries during the tax year. In
practice, few elect to receive advance payments, and wait to claim the credit
when their annual tax returns are filed the following year. This experience
illustrates the potential problems encountered in designing a transfer
mechanism for payment of a refundable child care credit. The truly poor
would need such payments in order to make payments to caregivers.

The child and dependent care tax credit still lacks an automatic adjustment
for inflation, while other code provisions are adjusted yearly. In the past, this
absence of an automatic yearly adjustment has affected the ability of low-
income taxpayers to use the credit.

Prior to tax year 2003, the qualifying expenditure amount had not been
increased since 1982. The current $3,000 and $6,000 limits for qualified
expenses, which expire in 2010, are equivalent to $58 per week for one
qualifying individual and $115 for two or more qualifying individuals. This
amount is equivalent to $1.45 per hour per individual (using a standard 40
hour work-week), which is far below the federal minimum wage level, and
below the median weekly cost of paid child care in 1999 ($69 a child).

In order to properly administer the dependent care tax credit, the Internal
Revenue Service requires submission of a tax identification number for the
provider of care. To claim the credit complicates income tax filing, although
the complexity aids in compliance by reducing fraudulent claims. To the
extent that payments are made to individuals, the taxpayer may also be
responsible for employment taxes on the payments.

The debate over the income exclusion for dependent care expenses turns
on whether the expenses are viewed as personal consumption or business
expenses (costs of producing income). Some have noted that the $5,000 limit
for the exclusion may be an attempt to restrict the personal consumption
element for middle and upper income taxpayers.

Since all employers will not provide a dependent care assistance program,
the tax exclusion violates the economic principle of horizontal equity, in that
all taxpayers with similar incomes are not treated equally. Since upper-
income taxpayers will receive a greater subsidy than lower-income taxpayers
because of their higher tax rate, the tax subsidy is inverse to need. If
employers substitute benefits for wage or salary increases, the benefits are not
subject to employment taxes, impacting the Social Security and Hospital
Insurance Trust Funds.

On the positive side, it is generally believed that the availability of
dependent care can reduce employee absenteeism and unproductive work
time. The tax exclusion may also encourage full participation of women in
the work force as the lower after-tax cost of child care may not only affect
labor force participation but hours of work. Further, it can be expected that
the provision affects the mode of child care by reducing home care and
encouraging more formal care such as child care centers. Those employers
that may gain most by the provision of dependent-care services are those
whose employees are predominantly female, younger, and whose industries
have high personnel turnover.

Selected Bibliography

Altshuler, Rosanne. and Amy Ellen Schwartz. "On the Progressivity of
the Child Care Tax Credit: Snapshot Versus Time-Exposure Incidence,"
National Tax Journal, v. 49 (March 1996), pp. 55-71.
Averett, Susan L.; H. Elizabeth Peters, and Donald M. Waldman. "Tax
Credits, Labor Supply, and Child Care," The Review of Economics and
Statistics, v. 79 (February 1997), pp. 125-135.
Benson, Joseph E. and Arthur A. Whatley. "Pros and Cons of Employer-
Sponsored Child Care," Journal of Compensation and Benefits, v. 9
(January/February 1994), pp. 16-20.
Connelly, Rachel, Deborah S. Degraff, and Rachel Willis. "The Value of
Employer-Sponsored Child Care to Employees," Industrial Relations, v. 43,
issue 4, October 2004, pp. 759-793.
Dickert-Conlin, Stacy, Katie Fitzpatrick, and Andrew Hanson, "Utilization
of Income Tax Credits by Low-Income Individuals, " National Tax Journal
v.58, no. 4, December 2005.
Dunbar, Amy E. "Child Care Expenses: The Child Care Credit," in The
Encyclopedia of Taxation and Tax Policy, eds. Joseph J. Cordes, Robert D.
Ebel, and Jane G. Gravelle. Washington, DC: Urban Institute Press, 2005,
pp. 53-55.
Fischer, Efrem Z. "Child Care: The Forgotten Tax Deduction," Cardozo
Women's Law Journal, v. 3, no. 1 (1996), pp. 113-134.
Gentry, William M. and Alison P. Hagy. "The Distributional Effects of
the Tax Treatment of Child Care Expenses." Cambridge, Mass., National
Bureau of Economic Research, 1995. 43 p. (Working Paper no. 5088).
Gravelle, Jane G. Federal Income Tax Treatment of the Family, Library of
Congress, Congressional Research Service Report 91-694 RCO. Washington,
DC (Available from the author).
Heen, Mary L. "Welfare Reform, Child Care Costs, and Taxes:
Delivering Increased Work-Related Child Care Benefits to Low-Income
Families. Yale Law and Policy Review, v. 13 (January 1996), pp. 173-217.
Hollingsworth, Joel S. "Save the Cleavers: Taxation of the Traditional
Family," Regents University Law Review, v. 13, no. 1, (2000/2001), pp. 29-
64.
Kelly, Erin L. "The Strange History of Employer-Sponsored Child Care:
Interested Actors, Uncertainty, and the Transformation of Law in
Organizational Fields," The American Journal of Sociology, v. 109, no. 3,
November 2003, pp. 606-649.
Koniak, Jaime. "Should the Street Take Care? The Impact of Corporate-
Sponsored Day Care on Business in the New Millenium." Columbia Business
Law Review, 2002, pp. 193-222.
McIntyre, Lee. "The Growth of Work-Site Daycare," Federal Reserve
Bank of Boston Regional Review, v. 10, no. 3, (2000) pp. 8-15.
National Women's Law Center, "Indexing the DCTC is Necessary to
Prevent Further Erosion of the Credit's Value to Low-Income Families,"
working paper, April 2003, pp. 1-4.

Rosenberg, Lee Fletcher. "Child Care Benefits May Get Boost From Tax
Credit," Business Insurance, v. 35, no. 31 (July 2001), pp. 3, 34.
Rothausen, Teresa J., Jorge A. Gonzalez and Nicole E. Clarke. "Family-
Friendly Backlash - Fact or Fiction? The Case of Organizations' On-Site
Child Care Centers," Personnel Psychology, v. 51, no. 3 (Autumn 1998), pp.
685-706.
Scott, Christine. Dependent Care: Current Tax Benefits and Legislative
Issues, Library of Congress, Congressional Research Service Report
RS21466, Washington, DC.
Seetharaman, Ananth and Govind S. Iyer. "A Comparison of Alternative
Measures of Tax Progressivity: The Case of the Child and Dependent Care
Credit," Journal of the American Taxation Association, v. 17 (Spring 1995),
pp. 42-70.
Sprang, Ginny, Mary Secret and Judith Bradford. "Blending Work and
Family: A Case Study," Affilia, v. 14, no. 1 (Spring 1999), pp. 98-116.
Steuerle, C. Eugene. "Systemic Thinking About Subsidies for Child
Care," Tax Notes 78 (1998): 749.
Stoltzfus, Emily. Citizen, Mother, Worker, University of North Carolina
Press, 2003.
Thomas, Ann F. and Alison P. Hagy. "Forum on Married Women and the
Income Tax: Marriage Penalties and Marriage Bonuses of the 105th Congress.
Panel III: Child Care and Federal Tax Policy," New York Law School
Journal of Human Rights, v. 16, pt. 1 (Symposium 1999), pp. 203-216.
U.S. Congress, Congressional Budget Office. Budget Options. "Eliminate
the Tax Exclusion for Employer-Sponsored Dependent Care." Washington,
DC: February 2001, p. 406.
U.S. Congress, House Committee on Ways and Means. 2004 Green
Book; Background Material and Data on Programs Within the Jurisdiction
of the Committee on Ways and Means, Committee Print, 108th Congress, 2d
Session. March 2004, pp. 13-49.
U.S. Congress, Joint Committee. General Explanation of the Economic
Recovery Tax Act of 1981 (H.R. 4242, 97th Congress; Public Law 97-34).
Washington, DC: U.S. Government Printing Office, December 31, 1981, pp.
53-56.
Wiley, Michael J. and Anthony P. Curatola. "Dependent Care Assistance
Programs," Strategic Finance Magazine, v. 83, no. 9 (March 2002), pp. 17-
18.
Woodward, Nancy Hatch. "Child Care to the Rescue," HR Magazine, v.
44, no. 8 (August 1999) pp. 82-84.

Education, Training, Employment, and Social Services:
Social Services

TAX CREDIT FOR EMPLOYER-PROVIDED CHILD CARE

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

(1)

2007

(1)

2008

(1)

2009

(1)

2010

(1)

(1)Less than $50 million.

Authorization

Section 45F.

Description

Employers are allowed a tax credit equal to 25 percent of qualified
expenses for employee child care and 10 percent of qualified expenses for
child care resource and referral services. Qualified child care expenses
include the cost of acquiring, constructing, rehabilitating or expanding
property used for a qualified child care facility, costs for the operation of the
facility (including training costs and certain compensation for employees, and
scholarship programs), or for contracting with a qualified child care facility to
provide child care.

A qualified child care facility must have child care as its principal purpose
and must meet all applicable state and local laws and regulations. A facility
operated by a taxpayer is not a qualified child care facility unless, in addition
to these requirements, the facility is open to all employees and, if qualified
child care is the principal trade or business of the taxpayer, at least 30 percent
of the enrollees at the facility are dependents of employees of the taxpayer.
Use of a qualified child care facility and use of child care resource and
referral services cannot discriminate in favor of highly paid employees.

The maximum total credit that may be claimed by a taxpayer cannot
exceed $150,000 per taxable year. The credit is reduced by the amounts of
any tax deduction claimed for the same expenditures. Any credit claimed for
acquiring, constructing, rehabilitating, or expanding property is recaptured if
the facility ceases to operate as a qualified child care facility, or for certain
ownership transfers within the first 10 years. The credit recapture is a
percentage, based on the year when the cessation as a qualified child care
facility or transfer occurs.

Impact

A 25 percent credit is a very large tax subsidy which should significantly
decrease the cost of on-site facilities for employers and encourage some firms
to develop on-site facilities. Firms have to be large enough to make the
facility viable, i.e. have enough employees with children in need of child care.
Thus, large firms will be those that provide on-site child care.

This nonrefundable tax credit has the potential to violate the principle of
horizontal equity, which requires that similarly situated taxpayers should bear
similar tax burdens. Mid- and small-sized firms may not have sufficient tax
liability to be able to take advantage of the credit. Even for those firms that
are able to claim the credit, they may not be able to claim the full amount
because of limited tax liability.

Although the credit is contingent on non-discrimination in favor of more
highly compensated employees, this provision, unlike child care tax benefits
in general, may provide greater benefits to middle and upper income
individuals because its relative cost effect is dependent on the size of the firm
and not the income of the employees. Indeed, lower income employees may
not be able to afford the higher quality child care facilities offered by some
firms (although some employers subsidize costs for lower income workers).

Rationale

This provision was adopted as part of the Economic Growth and Tax
Relief Reconciliation Act of 2001 (P.L. 107-16) and was designed to
encourage on-site employer child care facilities.

Assessment

Specific subsidies for on-site employer-provided child care would be
economically justified if there were a market failure that prevented firms from
providing this service. Few firms offer such facilities, although small firms
may not have enough potential clients to allow the center to be economically
viable. The limit on the subsidy amount is intended to target smaller firms,
but it is not clear why such activities are under-supplied by the market. Some
research has suggested that on-site care produces benefits that firms may not
take into account, such as reduced absenteeism and increased productivity,
but not all evidence is consistent with that view. In addition, employers may
be reluctant to commit to on-site child care because of uncertainties regarding
costs and return. There is also some concern that employer-provided child
care centers may create resentment among employees who are either childless
or on a waiting list for admittance of their children to the center.

Some firms have also begun offering emergency or back-up care, which is
a more limited proposition that may be more likely to reduce absenteeism.
The credits may encourage more firms of larger size to provide these benefits,
which may increase productivity because parents are not forced to stay home
with a sick child or a child whose care giver is temporarily not available.

Selected Bibliography

"Deciding How to Provide Dependent Care Isn't Child's Play." Personnel
Journal, v. 74, October 1995, p. 92.
Fitzpatrick, Christina Smith and Nancy Duff Campbell. "The Little Engine
that Hasn't: The Poor Performance of Employer Tax Credits for Child Care."
National Women's Law Center, November 2002.
Koniak, Jaime. "Should the Street Take Care? The Impact of Corporate-
Sponsored Day Care on Business in the New Millenium." Columbia Business
Law Review, 2002, pp. 193-222.
McIntyre, Lee. "The Growth of Work-Site Daycare." Federal Reserve
Bank of Boston Regional Review, Vol. 10, No. 3, 2000, pp. 8-15.
Rosenberg, Lee Fletcher. "Child Care Benefits May Get Boost from Tax
Credit." Business Insurance, Vol. 35, July 30, 2001, pp. 3, 34.
Rothausen, Teresa J, et al. "Family-Friendly Backlash - Fact or Fiction?
The Case of Organizations' On-Site Child Care Centers." Personnel
Psychology, v. 51 (Autumn 1998), pp. 685-706.
Woodward, Nancy Hatch. "Child Care to the Rescue." HRMagazine, Vol.
44, August 1999, pp. 82-84.

Education, Training, Employment, and Social Services:
Social Services

EXCLUSION OF CERTAIN FOSTER CARE PAYMENTS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.6

2007

0.6

2008

0.7

2009

0.7

2010

0.8

Authorization

Section 131.

Description

Qualified foster care payments are excluded from the foster care provider's
gross income. Qualified foster care payments are those payments made in
carrying out a state or local government foster care program. The payments
must be made by a state or local governmental agency or any qualified foster
care placement agency for either of two purposes: (1) for caring for a
qualified individual in the foster care provider's home. A "qualified foster
individual" is defined as an individual placed by a qualified foster care
placement agency, regardless of the individual's age at the time of
placement.; or (2) additional compensation for additional care, provided in the
foster care provider's home that is necessitated by an individual's physical,
mental, or emotional handicap for which the state has determined that
additional compensation is needed (referred to as a difficulty of care
payment).

The exclusion for foster care payments is limited. Foster care payments,
other than difficulty of care payments, are limited based on the number of
foster care individuals in the provider's home over age 18. Foster care
payments made for more than five qualified foster care individuals aged 19 or
older are not excluded from gross income.

For difficulty of care payments, there are two limitations. The first
limitation is based on the number of foster care individuals under age 19.
Difficulty of care payments made for more than 10 qualified foster care
individuals under age 19 in the provider's home are not excluded from gross
income. The second limitation is based on the number of foster care
individuals in the provider's home over age 18. Difficulty of care payments
made for more than five qualified foster care individuals aged 19 or older are
not excluded from gross income.

The Internal Revenue Service has ruled that foster care payments excluded
from income are not "earned income" for purposes of the Earned Income Tax
Credit (EITC).

Impact

Both foster care and difficulty of care payments qualify for a tax exclusion.
Since these payments are not counted as part of gross income, the tax savings
reflect the marginal tax bracket of the foster care provider. Thus, the
exclusion has greater value for taxpayers with higher incomes (and higher
marginal tax rates) than for those with lower incomes (and lower marginal tax
rates). In general, foster care providers who have other income, would
receive a larger tax benefit than foster care providers without other income.

Rationale

In 1977, the Internal Revenue Service, in Revenue Ruling 77-280, 1977-2
CB 14, held that payments made by charitable child-placing agencies or
governments (such as child welfare agencies) were reimbursements or
advances for expenses incurred on behalf of the agencies or governments by
the foster parents and therefore not taxable.

In the case of payments made to providers which exceed reimbursed
expenses, the Internal Revenue Service ruled that the foster care providers
were engaged in a trade or business with a profit motive and dollar amounts
which exceed reimbursements were taxable income to the foster care
provider.

The exclusion of foster care payments entered the tax law officially with
the passage of the Periodic Payments Settlement Tax Act of 1982 (P.L. 97-
473). That act codified the tax treatment of foster care payments and
provided a tax exclusion for difficulty of care payments made to foster parents
who provide additional services in their homes for physically, mentally, or
emotionally handicapped children.

In the Tax Reform Act of 1986 (P.L. 99-514), the provision was modified
to exempt all qualified foster care payments from taxation. This change was
made to relieve foster care providers from the detailed record-keeping
requirements of prior law. Congress feared that detailed and complex record-
keeping requirements might deter families from accepting foster children or
from claiming the full tax exclusion to which they were entitled. This act also
extended the exclusion of foster care payments to adults placed in a taxpayer's
home by a government agency.

Under a provision included in the Job Creation and Worker Assistance Act
of 2002 (P.L. 107-147), the definition of "qualified foster care payments" was
expanded to include for-profit agencies contracting with State and local
governments to provide foster home placements. The change was made in
recognition that States often contract services out to for-profit firms and that
the tax code had not recognized the role of private agencies in helping the
States provide foster care services for placement and delivery of payments.
The provisions are thought to reduce complexity with the hope that simpler
rules may encourage more families to provide foster care services.

Assessment

It is generally conceded that the tax law treatment of foster care payments
provides administrative convenience for the Internal Revenue Service, and
prevents unnecessary accounting and record-keeping burdens for foster care
providers. The trade-off is that to the extent foster care providers receive
payments over actual expenses incurred, monies which should be taxable as
income are provided an exemption from individual income and payroll
taxation.

Both the General Accounting Office (1989) and James Bell Associates
(1993; under contract from the Department of Health and Human Services)
have reported a shortage of foster parents. Included among the reasons for
this shortage are the low reimbursement rates paid to foster care providers,
with some providers dropping out of the program because the low payment
rates do not cover actual costs. Thus, to the extent that the exclusion
promotes participation in the program, it is beneficial from a public policy
viewpoint.

Selected Bibliography

U. S. Congress, Joint Committee on Taxation. General Explanation of the
Tax Reform Act of 1986, H.R. 3838, 99th Congress, Public Law 99-514.
Washington, DC: U.S. Government Printing Office, May 4, 1987, pp. 1346-
1347.
U.S. General Accounting Office, Child and Family Services Reviews:
Better Use of Data and Improved Guidance Could Enhance HHS's Oversight
of State Performance, GAO Report GAO-04-333 (Washington: April 2004),
pp. 1-55.
- , Foster Care: States Focusing on Finding Permanent Homes for
Children, but Long-Standing Barriers Remain, GAO Report GAO-03-626T
(Washington: April 8, 2003), pp. 1-24.

Education, Training, Employment, and Social Services:
Social Services

ADOPTION CREDIT AND
EMPLOYEE ADOPTION BENEFITS EXCLUSION

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.4

2007

0.4

2008

0.4

2009

0.4

2010

0.5

Authorization

Section 23, 137.

Description

The tax code provides a dollar-for-dollar adoption tax credit for qualified
adoption expenses and an income tax exclusion of benefits received under
employer-sponsored adoption assistance programs. Both have a limitation on
qualified expenses ($10,960 in tax year 2006) that is indexed for inflation.
The adoption tax credit is nonrefundable, but may be carried forward five
years. Employer-provided adoption assistance benefits must be received
under a written plan for an employer-sponsored adoption assistance program.
Both the tax credit and income tax exclusion amounts are phased-out
(allowable qualified adoption expenses are reduced) for taxpayers with high
adjusted gross incomes. For tax year 2006, a taxpayer with modified adjusted
gross income over $164,410 has qualified adoption expenses reduced. For a
modified adjusted gross income of $204,410 or more, the qualified adoption
expenses are reduced to zero. The phase-out range is adjusted for inflation.
The adoption credit is allowed against the alternative minimum tax. Unlike
some other tax exclusions, the exclusion for employer-provided adoption
assistance is only for the income tax. Benefits provided through an employer-
provided adoption assistance program are subject to employment taxes.

Qualified adoption expenses include reasonable and necessary adoption
fees, court costs, attorney fees, and other expenses directly related to a legal
adoption of a qualified child. A qualified child is under age 18; or an
individual of any age who is physically or mentally incapable of caring for
themself. In the case of special needs adoptions, state required expenses such
as construction, renovations, alterations, or other purchases may qualify as
adoption expenditures. In the case of a special needs adoption, the maximum
tax credit is allowed regardless of actual qualified adoption expenses. For
domestic adoptions, qualified adoption expenses are eligible for the tax credit
and income tax exclusion when incurred. For intercountry (foreign)
adoptions, qualified adoption expenses are not eligible for the tax credit or
income tax exclusion until after the adoption is finalized.

The provisions are unavailable for expenses related to surrogate parenting
arrangements, or the adoption of a spouse's child. The provisions are also
unavailable for expenditures contrary to state or federal law.

The code prohibits double benefits. Qualified adoption expenses cannot be
used for both the adoption tax credit and the income tax exclusion. If a
deduction or credit is taken for the qualified adoption expenses under other
Internal Revenue Code sections, the adoption tax credit and income tax
exclusion would not be available for any adoption expenses used for the other
deduction of credit. The adoption tax credit or income tax exclusion is also
not available for expenses paid by a grant received under a federal, state, or
local program.

Married couples are generally required to file a joint tax return to be
eligible for the credit. The Secretary of the Treasury is permitted to establish,
by regulation, procedures to ensure that unmarried taxpayers who adopt a
single child and who have qualified adoption expenses have the same dollar
limitation as a married couple. The taxpayer is required to furnish the name,
age, and Social Security number for each adopted child.

Impact

Both the tax credit and employer exclusion may reduce the costs associated
with adoptions through lower income taxes for taxpayers whose incomes fall
below the adjusted gross income level where qualified expenses are zero
($204,410 in tax year 2006). The tax credit is claimed by only a small
proportion of taxpayers. For tax year 2003, less than .05% of tax returns
claimed the adoption tax credit, with an average credit of $5,452. One factor
limiting the use of the credit is the nonrefundable nature of the credit. The
adoption tax credit is taken against tax liability after certain other
nonrefundable tax credits such as the child tax credit and the education
credits.

Distribution by Income Class of the Adoption Credit
in Tax Year 2003

Adjusted Gross Income Class
(in thousands of $)

Percentage
Distribution

Below $25

0.0

$25 to $50

15.6

$50 to $75

27.6

$75 to $100

27.4

$100 to $200

29.4

$200 and over

0.0

Source: Data compiled from IRS, Individual Complete Report, Publication
1304, Table 3.3.

Rationale

An itemized deduction was provided by the Economic Recovery Tax Act
of 1981 (P.L. 97-34) to encourage, through the reduction of financial
burdens, taxpayers who legally adopt children with special needs. The
deduction was repealed with passage of the Tax Reform Act of 1986 (P.L. 99-
514). The rationale for repeal was the belief that the deduction provided the
greatest benefit to higher-income taxpayers and that budgetary control over
assistance payments could best be handled by agencies with responsibility and
expertise in the placement of special needs children.

The tax credit and income tax exclusion provisions for qualified adoption
expenses were enacted by Congress as part of the Small Business Job
Protection Act of 1996 (P.L. 104-188). The credit was enacted because of the
belief that the financial costs associated with the adoption process should not
be a barrier to adoptions.

The Economic Growth and Tax Relief Reconciliation Act of 2001 (P.L.
107-16) increased the maximum qualified adoption expenses for the tax credit
and income exclusion to $10,000 per eligible child, including special needs
children. The act also extended the exclusion from income for employer
provided adoption assistance and increased the beginning point of the income
phase-out range to $150,000. Congressional reports noted that both the
credit and exclusion had been successful in reducing the after-tax
cost of adoption to affected taxpayers. It was felt that increasing the
size of both the credit and exclusion and expanding the number of
taxpayers who qualify for the tax benefit would encourage more
adoptions and allow more families to afford adoption. The legislation
intended to make portions of the law permanent which were
previously only temporary (those provisions will sunset after
December 31, 2010).

Changes made by the Job Creation and Worker Assistance Act of 2002
(P.L. 107-147) were designed to clarify the provisions contained in the
Economic Growth and Tax Relief Reconciliation Act of 2001.

Assessment

While federal tax assistance has been provided in the past for the
placement of special needs children, both the current law tax credit and
exclusion are more broadly based. The provisions apply to the vast majority
of adoptions (that are not by family members), and are not targeted only to the
adoptions of special needs children.

It appears that the credit and income tax exclusion are designed to provide
tax relief to moderate income families for the costs associated with adoptions
and to encourage families to seek adoptable children. Taxpayers with
adjusted gross incomes of less than $164,410 (in tax year 2006) can receive
the full tax exclusion or tax credit as long as they owe sufficient before-credit
taxes. The phase-out applies only to those taxpayers whose adjusted gross
incomes exceed $164,410 (in tax year 2006). It would appear that the
rationale for the cap is that taxpayers whose incomes exceed $164,410 (in tax
year 2006) have the resources for adoption so that the federal government
does not need to provide special tax benefits for adoption to be affordable.
The phase-out also reduces the revenue loss associated with these provisions.

The tax credit and income tax exclusion are in addition to a direct
expenditure program which was first undertaken in 1986 to replace the tax
deduction of that time. However, especially with regard to the carryforward
feature of the tax credit, the need for a direct federal assistance program for
adopting children with special needs may warrant re-examination. Under the
tax provision's "double benefit" prohibition, the receipt of a grant will offset
the tax credit or exclusion. The offset applies in all cases-including those
for special needs children. Thus, it can be said that only in special needs
adoption cases where a low or moderate income individual receives a grant
greater than $5,000 could the benefit from receiving the grant exceed that of
the tax credit for the same amount of out-of-pocket expenses.

Some have assumed that tax credits and direct government grants are
similar, since both may provide benefits at specific dollar levels. However,
some argue that tax credits are often preferable to direct government grants,
because they provide greater freedom of choice to the taxpayer. Such
freedoms include, for example, the timing of expenditures or the amount to
spend, while government programs typically have more definitive rules and
regulations. Additionally, in the case of grants, absent a specific tax
exemption, a grant may result in taxable income to the recipient.

Use of a tax mechanism does, however, add complexity to the tax system,
since the availability of the credit and tax exclusion must be made known to
all taxpayers, and space on the tax form must be provided (with
accompanying instructions). The enactment of these provisions added to the
administrative burdens of the Internal Revenue Service. A criticism of the tax
deduction available under prior law was that the Internal Revenue Service had
no expertise in adoptions and was therefore not the proper agency to
administer a program of federal assistance for adoptions.

Selected Bibliography

Brazelton, Julia K. "Tax Implications of New Legislation Designed to
Provide Adoption Incentives." Taxes, v. 75 (August 1997), pp. 426-436.
Cvach, Gary Q. and Martha Priddy Patterson. "Adoption Credit and
Assistance Exclusion," The Tax Adviser, v. 28 (June 1997), pp. 359-360.
Foster, Sheila and Cynthia Bolt-Lee. "Changes in Tax Law Benefit
Adopting Parents," The CPA Journal, v. 67 (October 1997), pp. 52-54.
Greenfield, Richard. "Tax Credits that are Not Child's Play," The CPA
Journal, v. 69 (September 1999), pp. 61-62.
Henney, Susan M. "Adoption From Foster Care in a Sociocultural
Context: An Analysis of Adoption Policies, Programs, and Legislation,"
Dissertation from The University of Texas at Austin, DAI, 62, no. 02A,
(2000), 774 p.
Hollingsworth, Leslie Doty. "Adoption Policy in the United States: A
Word of Caution," Social Work, v.45, no. 2 (Mar 2000), pp. 183-186.
Manewitz, Marilyn. "Employers Foster Assistance for Adoptive Parents,"
HRMagazine, v. 42 (May 1997), pp. 96-99.
Mickelson, Emily Maureen, and Christine Scott, Tax Benefits for Families:
Adoption, Library of Congress, Congressional Research Service Report 95-
928. Washington, DC: August 31, 2006.
O'Connor, M. "Federal Tax Benefits for Foster and Adoptive Parents and
Kinship Caregivers: 2001 Tax Year," Seattle: Casey Family Programs, 2001,
19 p.
Smith, Sheldon R. "Tax Benefits for Adoption," Tax Notes, v. 95 (May
13, 2002), pp. 1065-1071.
-, Adoption Tax Benefits: Policy Considerations," Tax Notes, v. 91 (May
14, 2001), pp. 1159-1164.
Smith, Sheldon R. and Glade K. Tew. "The Adoption Exclusion:
Complications for Employees," Tax Notes, v. 90 (Jan. 29, 2001), pp. 659-
664.

U.S. Congress, House Committee on Ways and Means. 2004 Green Book;
Background Material and Data on Programs Within the Jurisdiction of the
Committee on Ways and Means," Committee Print, 108th Congress, 2d
Session, March 2004, pp. 11-33 to 11-66.
U.S. Congress, House Committee on Ways and Means. Adoption
Promotion and Stability Act of 1996. House Report 104-542, Part 2, 104th
Congress, 2d session. Washington, DC: U.S. Government Printing Office,
May 3, 1996.
U.S. General Accounting Office, Child and Family Services Reviews:
Better Use of Data and Improved Guidance Could Enhance HHS's Oversight
of State Performance, GAO Report GAO-04-333 (Washington: April 2004),
pp. 1-55.
- , Foster Care: States Focusing on Finding Permanent Homes for
Children, but Long-Standing Barriers Remain, GAO Testimony GAO-03-
626T (Washington: April 8, 2003), pp. 1-24.
U.S. Treasury Department, Office of Tax Policy. Report to The Congress
on Tax Benefits for Adoption, October 2000, pp. 1-69.

Education, Training, Employment, and Social Services:
Social Services

DEDUCTION FOR CHARITABLE CONTRIBUTIONS,
OTHER THAN FOR EDUCATION AND HEALTH

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

29.1

1.7

29.8

2007

31.9

1.7

32.6

2008

34.2

1.7

34.9

2009

36.8

1.8

38.6

2010

38.4

1.8

40.2

Authorization

Section 170 and 642(c).

Description

Subject to certain limitations, charitable contributions may be deducted by
individuals, corporations, and estates and trusts. The contributions must be
made to specific types of organizations: charitable, religious, educational, and
scientific organizations, non-profit hospitals, public charities, and federal,
state, and local governments.

Individuals who itemize may deduct qualified contributions of up to 50
percent of their adjusted gross income (AGI) (30 percent for gifts of capital
gain property). For contributions to non-operating foundations and
organizations, deductibility is limited to the lesser of 30 percent of the
taxpayer's contribution base, or the excess of 50 percent of the contribution
base for the tax year over the amount of contributions which qualified for the
50 percent deduction ceiling (including carryovers from previous years).
Gifts of capital gain property to these organizations are limited to 20 percent
of AGI.

If a contribution is made in the form of property, the deduction depends on
the type of taxpayer (i.e., individual, corporate, etc.), recipient, and purpose.

As a result of the enactment of the American Jobs Creation Act of 2004,
P.L. 108-357, donors of noncash charitable contributions face increased
reporting requirements. For charitable donations of property valued at $5,000
or more, donors must obtain a qualified appraisal of the donated property.
For donated property valued in excess of $500,000, the appraisal must be
attached to the donor's tax return. Deductions for donations of patents and
other intellectual property are limited to the lesser of the taxpayer's basis in
the donated property or the property's fair market value. Taxpayers can claim
additional deductions in years following the donation based on the income the
donated property provides to the donee. The 2004 act also mandates
additional reporting requirements for charitable organizations receiving
vehicle donations from individuals claiming a tax deduction for the
contribution, if it is valued in excess of $500.

Taxpayers are required to obtain written substantiation from a donee
organization for contributions which exceed $250. This substantiation must
be received no later than the date the donor-taxpayer filed the required
income tax return. Donee organizations are obligated to furnish the written
acknowledgment when requested with sufficient information to substantiate
the taxpayer's deductible contribution.

Impact

The deduction for charitable contributions reduces the net cost of
contributing. In effect, the Federal Government provides the donor with a
corresponding grant that increases in value with the donor's marginal tax
bracket. Those individuals who use the standard deduction or who pay no
taxes receive no benefit from the provision.

Distribution by Income Class of the Tax Expenditure
for Charitable Contributions, 2005

Income Class
(in thousands of $)

Percentage
Distribution

Below $10

0.0

$10 to $20

0.1

$20 to $30

0.5

$30 to $40

1.1

$40 to $50

2.0

$50 to $75

8.3

$75 to $100

9.6

$100 to $200

28.7

$200 and over

49.7

Rationale

The provisions enacted in 2004 resulted from Internal Revenue Service and
congressional concerns that taxpayers were claiming inflated charitable
deductions, causing the loss of federal revenue. In the case of vehicle
donations, concern was expressed about the inflation of deductions. GAO
reports published in 2003 indicated that the value of benefit to charitable
organizations from donated vehicles was significantly less than the value
claimed as deductions by taxpayers. The 2006 enactments were, in part, a
result of continued concerns from 2004.

Assessment

Supporters note that contributions finance socially desirable activities.
Further, the federal government would be forced to step in to assume some
activities currently provided by charitable, nonprofit organizations if the
deduction were eliminated. However, public spending might not be available
to make up all of the difference. In addition, many believe that the best
method of allocating general welfare resources is through a dual system of
private philanthropic giving and governmental allocation.

Types of contributions may vary substantially among income classes.
Contributions to religious organizations are far more concentrated at the lower
end of the income scale than contributions to hospitals, the arts, and
educational institutions, with contributions to other types of organizations
falling between these levels. However, the volume of donations to religious
organizations is greater than to all other organizations as a group. For
example, the American Association of Fund-Raising Counsel Trust for
Philanthropy, Inc. estimated that giving to religious institutions amounted to
45 percent of all contributions ($93.2 billion) in calendar year 2005. This
was in comparison to the next largest component of charitable giving
recipients, educational institutions, at 14.8 percent ($38.56 billion).

Those who support eliminating this deduction note that deductible
contributions are made partly with dollars which are public funds. They feel
that helping out private charities may not be the optimal way to spend
government money.

Opponents further claim that the present system allows wealthy taxpayers
to indulge special interests and hobbies. To the extent that charitable giving
is independent of tax considerations, federal revenues are lost without having
provided any additional incentive for charitable gifts. It is generally argued
that the charitable contributions deduction is difficult to administer and adds
complexity to the tax code.

Selected Bibliography

Aprill, Ellen P. "Churches, Politics, and the Charitable Contribution
Deduction," Boston College Law Review, v. 42 (July 2001), pp. 843-873.
Boatsman, James R. and Sanjay Gupta. "Taxes and Corporate Charity:
Empirical Evidence From Micro-Level Panel Data," National Tax Journal, v.
49 (June 1996), pp. 193-213.
Broman, Amy J. "Statutory Tax Rate Reform and Charitable
Contributions: Evidence from a Recent Period of Reform," Journal of the
American Taxation Association. Fall 1989, pp. 7-21.
Brown, Melissa S., Managing Editor Giving USA 2004, The Annual
Report on Philanthropy for the Year 2003, American Association of Fund-
Raising Counsel Trust for Philanthropy. Indiana University-Purdue
University Indianapolis: 2004.
Buckles, Johnny Rex. "The Case for the Taxpaying Good Samaritan:
Deducting Earmarked Transfers to Charity under Federal Income Tax Law,
Theory and Policy," Fordham Law Review, v. 70 (March 2002), pp. 1243-
1339.
Cain, James E., and Sue A. Cain. "An Economic Analysis of Accounting
Decision Variables Used to Determine the Nature of Corporate Giving,"
Quarterly Journal of Business and Economics, v. 24 (Autumn 1985), pp. 15-
28.
Clotfelter, Charles T. "The Impact of Tax Reform on Charitable Giving:
A 1989 Perspective." In Do Taxes Matter? The Impact of the Tax Reform
Act of 1986, edited by Joel Slemrod, Cambridge, Mass.: MIT Press, 1990.
-."The Impact of Fundamental Tax Reform on Non Profit Organizations."
In Economic Effects of Fundamental Tax Reform, Eds. Henry J. Aaron and
William G. Gale. Washington, DC: Brookings Institution, 1996.
Colombo, John D. "The Marketing of Philanthropy and the Charitable
Contributions Deduction: Integrating Theories for the Deduction and Tax
Exemption," Wake Forest Law Review, v. 36 (Fall 2001), pp. 657-703.
Crimm, Nina J. "An Explanation of the Federal Income Tax Exemption
for Charitable Organizations: A Theory of Risk Compensation," Florida Law
Review, v. 50 (July 1998), pp. 419-462.
Cromer, Mary Varson. "Don't Give Me That!: Tax Valuation of Gifts to
Art Museums," Washington and Lee Law Review, v. 6, Spring 2006, pp.
777-809.
Eason, Pat, Raymond Zimmermann, and Tim Krumwiede. "A Changing
Environment in the Substantiation and Valuation of Charitable
Contributions," Taxes, v. 74 (April 1996), pp. 251-259.
Feenberg, Daniel. "Are Tax Price Models Really Identified: The Case of
Charitable Giving," National Tax Journal, v. 40, (December 1987), pp. 629-
633.
Feldman, Naomi and James Hines, Jr. "Tax Credits and Charitable
Contributions in Michigan," University of Michigan, Working Paper, October
2003.

Fisher, Linda A. "Donor-Advised Funds: The Alternative to Private
Foundations," Cleveland Bar Journal, v. 72 (July/August 2001), pp. 16-17.
Fullerton, Don. Tax Policy Toward Art Museums. Cambridge, MA:
National Bureau of Economic Research, 1990 (Working Paper no. 3379).
Gergen, Mark P. "The Case for a Charitable Contributions Deduction,"
Virginia Law Review, v. 74 (November 1988), pp. 1393-1450.
Gravelle, Jane. Economic Analysis of the Charitable Contribution
Deduction for Nonitemizers, Library of Congress, Congressional Research
Service Report RL31108, April 29, 2005.
Green, Pamela and Robert McClelland. "Taxes and Charitable Giving,"
National Tax Journal, v. 54 (Sept. 2001), pp. 433-450.
Gruber, Jonathan. "Pay or Pray? The Impact of Charitable Subsidies on
Religious Attendance," National Bureau of Economic Research Working
Paper, 10374, March, 2004, pp. 1-40.
Izzo, Todd. "A Full Spectrum of Light: Rethinking the Charitable
Contribution Deduction," University of Pennsylvania Law Review, v. 141
(June 1993), pp. 2371-2402.
Jacobson, Rachel. "The Car Donation Program: Regulating Charities and
For-Profits," The Exempt Organization Tax Review, v. 45, August 2004, pp.
213-229.
Jones, Darryll K. "When Charity Aids Tax Shelters," Florida Tax Review,
v. 4 (2001), pp. 770-830.
Joulfaian, David and Mark Rider. "Errors-In-Variables and Estimated
Income and Price Elasticities of Charitable Giving," National Tax Journal, v.
57 (March 2004), pp. 25-43.
Kahn, Jefferey H. "Personal Deductions: A Tax "Ideal" or Just Another
"Deal"?," Law Review of Michigan State University, v. 2002 (Spring 2002),
pp. 1-55.
Krumwiede, Tim, David Beausejour, and Raymond Zimmerman.
"Reporting and Substantiation Requirements for Charitable Contributions,"
Taxes, v. 72 (January 1994), pp. 14-18.
Omer, Thomas C. "Near Zero Taxable Income Reporting by Nonprofit
Organizations," Journal of American Taxation Association, v. 25, Fall 2003,
pp. 19-34.
O'Neil, Cherie J., Richard S. Steinberg, and G. Rodney Thompson.
"Reassessing the Tax-Favored Status of the Charitable Deduction for Gifts of
Appreciated Assets," National Tax Journal, v. 49 (June 1996), pp. 215-233.
Randolph, William C. "Charitable Deductions," in The Encyclopedia of
Taxation and Tax Policy, eds. Joseph J. Cordes, Robert D. Ebel, and Jane G.
Gravelle. Washington, DC: Urban Institute Press, 2005.
-. "Dynamic Income, Progressive Taxes, and the Timing of Charitable
Contributions," Journal of Political Economy, v. 103 (August 1995), pp.
709-738.
Robinson, John R. "Estimates of the Price Elasticity of Charitable Giving:
A Reappraisal Using 1985 Itemizer and Nonitemizer Charitable Deduction
Data," Journal of the American Taxation Association. Fall 1990, pp. 39-59.

Smith, Bernard. "Charitable Contributions: A Tax Primer," Cleveland Bar
Journal, v. 72 (Nov. 2000), pp. 8-11.
Stokeld, Fred, "ETI Repeal Bill Would Tighten Rules on Vehicle, Patent
Donations," Tax Notes, October 18, 2004, pp. 293-294.
Teitell, Conrad. "Tax Primer on Charitable Giving," Trust & Estates, v.
139, (June 2000), pp. 7-16.
Tiehen, Laura. "Tax Policy and Charitable Contributions of Money,"
National Tax Journal, v. 54 (Dec 2001), pp. 707-723.
Tobin, Philip T. "Donor Advised Funds: A Value-Added Tool for
Financial Advisors," Journal of Practical Estate Planning, v. 3
(October/November 2001), pp. 26-35, 52.
U.S. Congress, Congressional Budget Office. Budget Options. See
Rev-12, Limit Deductions for Charitable Giving to the Amount Exceeding 2
Percent of Adjusted Gross Income. Washington, DC: Government Printing
Office (February 2005), p 281.
U.S. Congress, Government Accountability Office. Vehicle Donations:
Benefits to Charities and Donors, but Limited Program Oversight, GAO
Report GAO-04-73, Washington, DC: U.S. Government Printing Office,
November 2003, pp. 1-44.
- . Vehicle Donations: Taxpayer Considerations When Donating Vehicles
to Charities, GAO Report GAO-03-608T, Washington, DC: U.S.
Government Printing Office, April 2003, pp. 1-15.
U.S. Congress, Joint Committee on Taxation, Technical Explanation Of
H.R. 4, The "Pension Protection Act Of 2006," as Passed by the House on
July 28, 2006, and as Considered by the Senate on August 3, 2006,
JCX-38-06, Washington, DC: U.S. Government Printing Office, August3,
2006, pp. 1-386.
- , Senate Committee on Finance. Staff Discussion Draft: Proposals for
Reforms and Best Practices in the Area of Tax-Exempt Organizations,
Washington, DC: U.S. Government Printing Office, June 22, 2004, pp. 1-19.
Wittenbach, James L. and Ken Milani. "Charting the Interacting
Provisions of the Charitable Contributions Deductions for Individuals,"
Taxation of Exempts, v. 13 (July/August 2001), pp. 9-22.
U.S. Department of Treasury. "Charitable Giving Problems and Best
Practices," testimony given by Mark Everson, Commissioner of Internal
Revenue, Internal Revenue Service, IR-2004-81, Washington, DC: U.S.
Government Printing Office, June 22, 2004, pp. 1-17.
Yetman, Michelle H. and Robert J. Yetman. "The Effect of Nonprofits'
Taxable Activities on the Supply of Private Donations," National Tax
Journal, v. 56, March 2003, pp. 243-258.
-. "Dynamic Income, Progressive Taxes, and the Timing of Charitable
Contributions," Journal of Political Economy, v. 103 (August 1995), pp.
709-738.

Education, Training, Employment, and Social Services:
Social Services

TAX CREDIT FOR DISABLED ACCESS EXPENDITURES

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.1

(1)

0.1

2007

0.1

(1)

0.1

2008

0.1

(1)

0.1

2009

0.1

(1)

0.1

2010

0.1

(1)

0.1

(1)Less than $50 million.

Authorization

Section 44.

Description

A nonrefundable tax credit equal to 50 percent of eligible access
expenditures is provided to small businesses, defined as those with gross
receipts of less than $1 million or those with no more than 30 full-time
employees. Eligible access expenditures must exceed $250 in costs to be
eligible but expenditures which exceed $10,250 are not eligible for the credit.
The expenditures must be incurred to make a business accessible to disabled
individuals.

The credit is included as a general business credit and subject to present
law limits. No further deduction or credit is permitted for amounts allowable
as a disabled-access credit. No increase in the property's adjusted basis is
allowable to the extent of the credit. The credit may not be carried back to tax
years before the date of enactment.

In 2002, the Internal Revenue Service (IRS) issued an alert (Internal
Revenue News Release 2002-17) to taxpayers concerning a fraudulent
disabled access credit scheme. That scheme involves the sale of coin-
operated pay telephones to individual investors. Investors were advised
incorrectly that they were entitled to claim the disabled access credit of up to
$5,000 on their individual income tax returns because the telephone is
equipped with a volume control. The IRS disallows this credit if claimed by a
taxpayer who is not operating as a business or who does not qualify as an
eligible small business and if the purchase does not make a business
accessible to disabled individuals. The IRS has continued to issue the alert,
including a notice in March 2006 (Internal Revenue News Release
IR-2006-45).

Impact

The provision lessens the after-tax cost to small businesses for
expenditures to remove architectural, communication, physical, or
transportation access barriers for persons with disabilities by providing a tax
credit for expenditures (which exceed $250 but are less than $10,250). The
tax credit allows taxpayers to reduce tax liability by the cost of qualified
expenditures.

The value of this tax treatment is twofold. First, a 50-percent credit is
greater than the tax rate of small businesses. Thus, a greater reduction in
taxes is provided by the credit than through immediate expensing of access
expenditures. Second, the value to small businesses is increased by the
amount to which the present value of the tax credit exceeds the present value
of periodic deductions which typically could be taken over the useful life of
the capital expenditure. The direct beneficiaries of this provision are small
businesses that make access expenditures.

Rationale

This tax credit was added to the Code with the passage of the Revenue
Reconciliation Act of 1990 (P.L. 101-508). The purpose was to provide
financial assistance to small businesses for compliance with the Americans
With Disabilities Act of 1990 (ADA; P.L. 101-336). For example, that act
requires restaurants, hotels, and department stores that are either newly
constructed or renovated to provide facilities that are accessible to persons
with disabilities, and calls for removal of existing barriers when readily
achievable in facilities previously built.

While the provision encourages compliance with ADA, subsequent access
improvements are not covered by the provision. A 2004 IRS ruling (Internal
Revenue Service Memorandum 200411042) clarified that eligible small
businesses already in compliance with the ADA may not claim the disabled
access credit for expenditures paid or incurred for the purpose of upgrading or
improving disabled access.

Assessment

A firm's ability to benefit from the credit is dependent on its income tax
liability. Some firms may not have sufficient tax liability to be able to take
advantage of the credit, and for those firms that are able to claim the credit,
some may not be able to claim the full amount.

The tax credit may not be the most efficient method for accomplishing the
objective because some of the tax benefit will go for expenditures the small
business would have made absent the tax benefit and because there is
arguably no general economic justification for special treatment of small
businesses over large businesses.

Alternatively, the requirements of the Americans with Disabilities Act
placed capital expenditure burdens that may be a hardship to small
businesses. These rules are designed primarily for social objectives, i.e. to
accommodate persons with disabilities; thus proponents assert that the
subsidy is justified in this instance.

Selected Bibliography

Bullock, Reginald Jr. "Tax Provisions of the Americans with Disabilities
Act," The CPA Journal, v. 63, no. 2, (February 1993), pp. 58-59.
Cook, Ellen D., Anne K. Judice, and J. David Lofton. "Tax Aspects of
Complying with the Americans with Disabilities Act," The CPA Journal, v.
66 (May 1996), pp. 38-42.
Cook, Ellen D. and Anita C. Hazelwood. "Tax Breaks Cut the Cost of
Americans With Disabilities Act Compliance," Practical Tax Strategies, v.
69 (Sept 2002), pp. 145-155.
Eisenstadt, Deborah E. "Current Tax Planning for Rehabilitation
Expenses, Low-Income Housing, and Barrier Removal Costs," Taxation for
Accountants, v. 34 (April 1985), pp. 234-238.
Ellentuck, Albert B. "Credit for Compliance," Nation's Business, v. 79,
(April 1991), p. 60.
Jackson, Pamela J. Business Tax Provisions that Benefit Persons with
Disabilities, Library of Congress, Congressional Research Service Report
RS21006, Washington, DC: June 28, 2005.
Lebow, Marc I., Wayne M. Schell, and P. Michael McLain. "Not All
Expenditures to Aid the Disabled Qualify for Credit," The Tax Adviser, v. 32,
(December 2001), pp. 810-811.

Health

EXCLUSION OF EMPLOYER CONTRIBUTIONS
FOR HEALTH CARE, HEALTH INSURANCE PREMIUMS, AND
LONG-TERM CARE INSURANCE PREMIUMS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

90.6

2007

99.7

2008

107.0

2009

114.5

2010

122.2

Authorization

Sections 105, 106, and 125.

Description

Employees pay no income or payroll taxes on employer contributions for
coverage under accident or health plans. This exclusion also applies to
certain health benefits received by employees who participate in so-called
cafeteria plans established by their employers. In general, employees covered
by these plans may exclude from taxable income their payments for employer-
provided health insurance. In addition, many employers offer health benefits
to employees through flexible spending accounts (FSAs). Under such an
account, an employee chooses a benefit amount at the start of a calendar year
and draws on the account to pay for medical expenses not covered by an
employer's health plans. FSAs are funded either through wage and salary
reductions or employer contributions, both of which are exempt from income
and payroll taxes.

The exclusion for employer contributions to health and accident plans is
available regardless of whether an employer self-insures or enters into
contracts with third-party insurers to provide group and individual health
plans. Unlike some fringe benefits, there are no limits on the amount of
employer contributions that may be excluded, with one notable exception.
The exception is so-called "excess reimbursements" paid to highly
compensated employees under self-insured medical plans that fail to satisfy
specified non-discrimination requirements; these reimbursements must be
included in an affected employee's taxable income.

Impact

The tax exclusion for employer contributions to employee health plans
benefits only those taxpayers who participate in employer-subsidized plans.
Beneficiaries consist of present employees and their spouses and dependents,
as well as retirees. In 2005, about 64 percent of the U.S. population received
health insurance coverage through employers, according to figures published
by the U.S. Census Bureau.

Although the tax exclusion benefits a majority of working Americans, it
provides greater benefits to higher-income taxpayers than to lower-income
ones. Such an outcome is to be expected for two reasons. First, highly paid
employees typically receive larger amounts of employer-paid health
insurance. Second, they naturally end up in higher tax brackets. The value of
an exclusion depends in part on a taxpayer's marginal tax rate.

As noted earlier, non-discrimination rules apply to health and accident
plans offered by self-insured employers. Under these rules, benefits paid to
highly compensated employees must be included in their taxable incomes if a
self-insured medical reimbursement plan discriminates in favor of these
employees. However, the same rules do not apply to plans purchased from
third-party insurers that offer more generous benefits to highly compensated
employees. In this case, these employees may exclude the benefits from
taxable income.

While the tax code encourages the provision of health insurance through
the workplace, not all workers receive health insurance coverage from their
employers. Those at greatest risk of being uninsured include workers under
age 25, workers in firms with fewer than 25 employees, part-time workers,
workers earning relatively low wages, and workers in the construction,
business and personal service, entertainment, and wholesale and retail trade
industries.

The following table presents data for 2005 on health insurance coverage by
income group for the entire non-institutionalized, non-elderly population of
the United States. Income is expressed as a percentage of the Federal poverty
income level for that year.

Health Insurance Coverage From Specified Sources, by Family Income Relative to the Federal
Poverty Level, 2005
(Percent of U.S. Civilian, Non-institutionalized Population
Under Age 65)

Type of Insurance

Income Relative to
the Poverty Levela

Population (in
millions)

Employment-basedb

Publicc

Otherd

Uninsured

Less than 100%

33.3

18.6

46.6

673

34.0

100% to 149%

21.3

34.0

33.0

8.0

31.9

150% to 199%

23.1

48.3

21.4

9.6

28.3

200% and above

179.8

78.6

6.0

10.6

11.8

Total

258.3

64.3%

15.0%

9.8%

17.9.%

People may have more than one source of health insurance; thus row percentages may total to more
than 100.
a The weighted average poverty threshold for a family with two adults and two children in 2005
was $19,806. Excluded from the poverty analysis of the data on health insurance coverage were
roughly 700,000 children who lived with families to which they were unrelated. Most of them were
foster children. As a result, the total size of the under-65 population is 0.6 million larger than the size
of the total population covered by the poverty analysis.
b Group health insurance through employer or union.
C Medicare, Medicaid, the State Children's Health Insurance Program, or other state programs
for low-income individuals.
d Private nongroup health insurance, veterans coverage, or military health care.

Note: Based on Congressional Research Service analysis of data from the March 2006 Current
Population Survey (CPS). Source: Peterson, Chris L. Health Insurance Coverage: Characteristics
of the Insured and Uninsured Populations in 2005. Library of Congress, Congressional Research
Service Report No. 96-891 EPW. Washington, DC: updated August 30, 2006. Table 2, p. 3.

It is clear from the data that the likelihood of being insured through an
employer increased substantially with household income. The percentage of
those covered by employment-based health insurance (column 3) in 2005
climbed from 18.8 percent for people whose income is less than the poverty-
income level to 78.6 percent for people whose family income is two or more
times that level.

At the same time, the likelihood of receiving public health insurance rose
as household income dropped. The percentage of those covered by public
insurance (column 4) declined in 2005 from 46.6 percent in the lowest
income group to 6.0 percent in the highest income group. A similar pattern
prevailed among the uninsured: the percentage of uninsured declined from
34.0 percent for those whose income was below the poverty level to 11.8
percent for those whose income was two or more times above the poverty
level.

Rationale

The exclusion of compensation received by individuals in the form of
employer-provided accident or health plans originated with the Revenue Act
of 1918. But it was not until 1943 that the Internal Revenue Service (IRS)
ruled that employer contributions to group health insurance policies were not
considered part of taxable income. But this ruling did not address all
outstanding concerns about the tax treatment of employer-provided health
benefits. For instance, it did not apply to employer contributions to individual
health insurance policies. The tax status of those contributions remained
unclear until the IRS ruled in 1953 that they were subject to taxation. This
ruling had but a brief existence, as the enactment of IRC section 106 in 1954
reversed it. Henceforth, employer contributions to all accident and health
plans were considered deductible expenses for employers and non-taxable
compensation for employees. The legislative history of section 106 indicates
that its principal purpose was to eliminate differences in the tax treatment of
employer contributions to group and individual health insurance plans.

The Revenue Act of 1978 added the non-discrimination provisions of
section 105(h). These provisions specified that the benefits paid to highly
compensated employees under self-insured medical reimbursement plans
were taxable if the plan discriminated in favor of these employees. The Tax
Reform Act of 1986 repealed section 105(h) and replaced it with a new
section 89 of the Internal Revenue Code, which extended non-discrimination
rules to group health insurance plans. In 1989, P.L. 101-140 repealed section
89 and reinstated the pre-1986 Act rules under section 105(h).

Under the Health Insurance Portability and Accountability Act of 1996
(P.L. 104-191), employer contributions to the cost of qualified long-term care
insurance may be excluded from employees' taxable income. But this
exclusion does not apply to long-term care benefits received under a cafeteria
plan or flexible spending account (FSA).

Assessment

The exclusion for employer-provided health insurance is thought to exert a
strong influence on health insurance coverage for a large share of the non-
elderly working population. Because of the subsidy, employees have a robust
incentive to prefer compensation in the form of health benefits rather than
taxable wages. On average, $1 in added health benefits is worth only $0.70
in added wages.

Such a preference, however, has a notable drawback: it may lead
employees to purchase more health insurance coverage then they need. Most
health economists think the unlimited exclusion for employer-provided health
benefits has led to excessive use of health care services, which in turn has put
upward pressure on health care costs.

This is not to suggest there are no social benefits from the exclusion.
Owing to the risk pooling that occurs in employment-based group health
insurance, it can be argued that the exclusion enables many employees to
purchase health insurance plans with few or no coverage exclusions at a lower
cost than they would be able to in the individual market.

Measured as a percentage of total wages and salaries, employer
contributions for group health insurance rose from 0.8 percent in 1955, to 1.6
percent in 1965, 3.1 percent in 1975, 5.4 percent in 1985, and 8.1 percent in
1993. The percentage dropped to 7.5 percent in 1995, to 7.3 percent in 1996,
and to 7.0 percent in 1997, where it remained in 1998 and 1999. In 2001, the
percentage stood at 6.6 percent.

Workers and their dependents who are covered by employer-provided
health insurance receive a much more generous tax subsidy than individuals
who purchase health insurance in the individual market or who have no health
insurance, pay out of pocket for their medical expenses, and claim the
medical-expense itemized income tax deduction. The cost of employer-paid
health care is completely excluded from the taxable income of those who
receive such care. By contrast, relatively few taxpayers can take advantage of
the medical expense deduction. To do so, they must itemize on their tax
returns, and their out-of-pocket spending on medical care (including health
insurance premiums) must exceed 7.5 percent of their adjusted gross income.
In addition to the tax exclusion, employer-paid health insurance is exempt
from payroll taxation.

Proposals to limit the tax exclusion for employer-provided health benefits
periodically attract serious consideration. Generally, their principal aim is to
retain the main social benefit of the exclusion - expanded access to health
insurance - while curbing its main social cost - an incentive to purchase
excessive insurance coverage. One way to achieve this goal would be to cap
the exclusion at or somewhat below the average cost of group health
insurance in major regions. A case in point is a proposal by the tax reform
panel created by President George W. Bush in January 2005. In its final
report issued in November 2005, the panel recommended capping the
exclusion at the average U.S. premiums for individual and family health
insurance coverage. But not all analysts favor such an approach. Critics of
limiting the exclusion say that it would be difficult to determine in an
equitable manner where to draw the line between reasonable and excessive
health insurance coverage. They also note that any limit on the exclusion
would have to reflect the key factors determining health insurance premiums,
including a firm's geographic location, size of its risk pool, and the risk
profile of its employees.

Selected Bibliography

Arnet, Grace-Marie, ed. Empowering Health Care Consumers Through
Tax Reform. Ann Arbor, MI, University of Michigan Press, 1999.
Burman, Leonard E., and Jack Rodgers. "Tax Preferences and
Employment-Based Health Insurance," National Tax Journal, v. 45, no. 3.
September 1992, pp. 331-46.
Burman, Leonard E., and Roberton Williams. Tax Caps on Employment-
Based Health Insurance. National Tax Journal, v. 47, no. 3. September
1994, pp. 529-45.
Carasso, Adam. "Growth in the Exclusion of Employer Health
Premiums." Tax Notes. June 27, 2005, p. 1697.
Feldstein, Martin, and Bernard Friedman. "Tax Subsidies, the Rational
Demand for Insurance and the Health Care Crisis," Journal of Public
Economics, v. 7. April 1977, pp. 155-78.
Fronstin, Paul. "Employment-Based Health Benefits: Trends in Access
and Coverage." Issue Brief. no. 284. Employee Benefit Research Institute.
Washington, DC: August 2005.
Gruber, Jonathan. Taxes and Health Insurance, Working Paper 8657.
Cambridge, MA: National Bureau of Economic Research, December 2001.
Gruber, Jonathan, and James M. Poterba. "Tax Subsidies to Employer-
Provided Health Insurance," in Martin Feldstein and James Poterba, eds.,
Empirical Foundations of Household Taxation. National Bureau of
Economic Research. Chicago and London: Univ. of Chicago Press, 1996.
-. "Fundamental Tax Reform and Employer-Provided Health Insurance,"
in Economic Effects of Fundamental Tax Reform, eds. Henry H. Aaron and
William G. Gale. Washington, DC: Brookings Institution Press, 1996, pp.
125-170.
Lyke, Bob. Tax Benefits for Health Insurance: Current Legislation.
Library of Congress Congressional Research Service Issue Brief IB 98037.
Washington, DC: updated regularly.
Marquis, Susan, and Joan Buchanan. "How Will Changes in Health
Insurance Tax Policy and Employer Health Plan Contributions Affect Access
to Health Care and Health Care Costs?" Journal of the American Medical
Association, v. 271, no. 12. March 23/30, 1994, pp. 939-44.
Pauly, Mark V. "Taxation, Health Insurance, and Market Failure in the
Medical Economy," Journal of Economic Literature, v. 24, no. 2. June 1986,
pp. 629-75.
Pauly, Mark V., and John C. Goodman. "Using Tax Credits for Health
Insurance and Medical Savings Accounts," in Henry J. Aaron, The Problem
That Won't Go Away. Washington, DC: Brookings Institution, 1996.
President's Advisory Panel on Federal Tax Reform. Simple, Fair, and
Pro-Growth: Proposals to Fix America's Tax System. Washington, DC:
November 2005.

Smart, Michael and Mark Stabile. Tax Credits and the Use of Medical
Care, Working Paper 9855. Cambridge, MA: National Bureau of Economic
Research, July 2003.
U.S. Congress, Congressional Budget Office. Tax Subsidies for Medical
Care: Current Policies and Possible Alternatives. Washington, DC: 1980.
-. The Tax Treatment of Employment-Based Health Insurance.
Washington, DC: March 1994.
-, House Committee on the Budget, Subcommittee on Oversight, Task
Force on Tax Expenditures and Tax Policy. Tax Expenditures for Health
Care, Hearings, 96th Congress, 1st session. July 9-10, 1979.
-, House Committee on Ways and Means. 1994 Green Book. Background
Material and Data on Programs within the Jurisdiction of the Committee on
Ways and Means. Overview of Entitlement Programs, Committee Print
WMCP 103-27, 103rd Congress, 2nd session. Washington, DC: U.S.
Government Printing Office, July 15, 1994, pp. 689-92, 943-50.
-, Joint Committee on Taxation. Overview of Administration Proposal to
Cap Exclusion for Employer Provided Medical Care and Tax Treatment of
Other Fringe Benefits. Committee Print, 98th Congress, 1st session. June
21, 1983.
Wilensky, Gail R. "Government and the Financing of Health Care,"
American Economic Review, v. 72, no. 2. May 1982, pp. 202-07.
-, and Amy K. Taylor. "Tax Expenditures and Health Insurance: Limiting
Employer-Paid Premiums," Public Health Reports, v. 97. September-October
1982, pp. 438-44.

Health

EXCLUSION OF MEDICAL CARE AND CHAMPUS/TRICARE
MEDICAL INSURANCE FOR MILITARY DEPENDENTS,
RETIREES, AND RETIREE DEPENDENTS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

1.9

2007

2.0

2008

2.1

2009

2.3

2010

2.5

Authorization

Sections 112 and 134 and certain court decisions [see specifically Jones v.
United States, 60 Ct. Cl. 552 (1925)].

Description

Active-duty military personnel are provided with a variety of benefits (or
cash payments in lieu of such benefits) that are not subject to taxation.
Among such benefits are medical and dental care. Dependents of active-duty
personnel, retired military personnel and their dependents, survivors of
deceased members, and reservists who have served on active duty since
September 11, 2001 and join in the Selected Reserve are also eligible for
these benefits.

Military dependents and retirees are permitted to receive some of their
medical care in military facilities and from military doctors, provided there is
adequate capacity. These individuals also have the option of being treated by
civilian health-care providers working under contract with the Department of
Defense (DOD). DOD currently relies on a program known as TriCare to
coordinate the medical care provided by military and civilian providers.
TriCare gives most beneficiaries three choices for receiving medical care:
TriCare Prime, a DOD-managed health maintenance organization (HMO);
TriCare Extra, a preferred-provider organization (PPO); or TriCare Standard
(formerly known as CHAMPUS), a fee-for-service option. In addition,
TriCare For Life is available for beneficiaries who are age 65 or over and thus
are eligible for Medicare. TriCare Extra and TriCare Standard reimburse
beneficiaries for a portion of their spending on civilian health care.

The FY2001 Defense Authorization Act included a provision allowing
military retirees and their dependents who are eligible for Medicare A and
participate in Medicare Part B to retain their TriCare coverage as a secondary
payer to Medicare. To be eligible, an individual must have served at least 20
years in the military. Under the plan, TriCare pays most of the cost of
treatments not covered by Medicare.

Impact

As with the exclusion for employer-provided health insurance, the benefits
from the tax exclusion for health care received by military personnel
dependents, retirees, and other eligible individuals depend on a recipient's tax
bracket. The higher the tax bracket, the greater the tax savings. For example,
an individual in the 10-percent tax bracket (the lowest Federal income tax
bracket) avoids $10 in tax liability for every $100 of health benefits he or she
may exclude; the tax savings rises to $35 for someone in the 35-percent tax
bracket.

The larger tax saving for higher-income military personnel may be partly
offset by higher deductibles under the TriCare Extra plan and higher co-
payments for outpatient visits under the TriCare Prime plan required of
dependents of higher-ranked personnel (E-5 and above). Retirees under age
65 and their dependents pay an enrollment fee for TriCare Prime and tend to
pay higher deductibles and co-payments than the dependents of active-duty
personnel. The FY2001 Defense Authorization Act eliminated these co-
payments and deductibles for retirees and their dependents over age 64 who
pay the Medicare Part B monthly premium.

Rationale

The tax exclusion for health care received by the dependents of active-duty
military personnel, retirees and their dependents, and other eligible
individuals has evolved over time. The main forces driving this evolution
have been legal precedent, legislative action by Congress, a series of
regulatory rulings by the Treasury Department, and long-standing
administrative practices.

In 1925, the United States Court of Claims, in its ruling in Jones v. United
States, 60 Ct. Cl. 552 (1925), drew a sharp distinction between the pay and
the allowances received by military personnel. The court ruled that housing
and housing allowances for these individuals were reimbursements similar to
other tax-exempt benefits received by employees in the executive and
legislative branches.

Before this decision, the Treasury Department maintained that the rental
value of living quarters, the value of subsistence allowances, and
reimbursements should be included in the taxable income of military
personnel. This view rested on an earlier federal statute, the Act of August
27, 1894 (which was found to unconstitutional by the courts), which imposed
a two-percent tax "on all salaries of officers, or payments to persons in the
civil, military, naval, or other employment of the United States."

Under the Dependent Medical Care Act of 1956, the dependents of active-
duty military personnel and retired military personnel and their dependents
were allowed to receive medical care at military medical facilities on a
"space-available" basis. Military personnel and their dependents gained
access to civilian health care providers through the Military Medical Benefits
Amendments Act of 1966, which created the Civilian Health and Medical
Program of the Uniformed Services (CHAMPUS), the precursor of the
Tricare system.

The Tax Reform Act of 1986 consolidated these rules into a new section
134 of the Internal Revenue Code. A principal aim of Congress in taking this
step was to make the tax treatment of military fringe benefits more transparent
and consistent with the tax treatment of fringe benefits under the Deficit
Reduction Act of 1984.

Even if there was no specific statutory exclusion for the health benefits
received by military personnel and their dependents, a case for excluding
them from taxation could be made on the basis of sections 105 and 106 of the
Internal Revenue Code. These sections make it possible to exclude from the
taxable income of employees any employer-provided health benefits they
receive.

Assessment

Some military fringe benefits mirror those offered by private employers,
such as allowances for housing, subsistence, moving and storage expenses,
higher living costs abroad, and uniforms. Others are similar to employer-
provided medical and dental benefits, education assistance, group term life
insurance, and disability and retirement benefits. While it can be argued that
health benefits for active-duty personnel are critical to the military's mission
and thus should not be taxed, health care for dependents of active-duty
personnel and retirees and their dependents has more in common with an
employer-provided fringe benefit.

Most of the economic issues raised by the tax treatment of military health
benefits are similar to those associated with the tax treatment of civilian and
employer-provided health benefits. A central issue is that a tax exclusion for
health benefits encourages individuals to purchase excessive health insurance
coverage. Another issue is that such coverage may lead covered individuals
to consume inefficient amounts of health care. For health economists, health
care is inefficient when its marginal cost exceeds its marginal benefit.

Nonetheless, some of the issues raised by military health benefits have no
counterpart in the civilian sector. Direct care provided in military facilities
may at times be difficult to value for tax purposes. At the same time, such
care may be the only feasible option for dependents living with service
members who have been assigned to geographic areas where adequate civilian
medical facilities are lacking.

Proposals to make the tax treatment of health care received by dependents
of active-duty personnel less generous may have important implications for
rates of enlistment in the military. It is conceivable that a reduction in the tax
exclusion for health care received by these dependents would need to be
coupled with an increase in military pay so that remaining in the military
would continue to be an appealing career choice for military personnel with
dependents and incomes high enough to incur tax liabilities.

Selected Bibliography

Best, Richard. Military Medical Care Services: Questions and Answers.
Library of Congress, Congressional Research Service Issue Brief IB93103,
updated periodically.
Binkin, Martin. The Military Pay Muddle. Washington, DC: The
Brookings Institution, April 1975.
Hanson, Marshall. "Is TRICARE Standard or TRICARE Extra the Right
Option?" The Officer, April 2004, p. 39.
Owens, William L. "Exclusions From, and Adjustments to, Gross
Income," Air Force Law Review, v. 19 (Spring 1977), pp. 90-99.
U.S. Congress, Congressional Budget Office. The Tax Treatment of
Employment Based Health Insurance. Washington, DC: March 1994.
-, House. Joint Committee on Taxation. General Explanation of the Tax
Reform Act of 1986, H.R. 3838, 99th Congress, Public Law 99-514.
Washington, DC: U.S. Government Printing Office, 1987, pp. 828-830.
Winkenwerder, William Jr. "Tricare: Your Military Health Plan," Soldiers
Magazine, February 1, 2004, p. S1.

Health

DEDUCTION FOR HEALTH INSURANCE PREMIUMS
AND LONG-TERM CARE INSURANCE PREMIUMS
PAID BY THE SELF-EMPLOYED

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

3.8

2007

4.2

2008

4.5

2009

4.9

2010

5.2

Authorization

Section 162(l).

Description

Generally, a self-employed individual may deduct the entire amount he or
she pays for health insurance (with some restrictions, which are discussed
below) or long-term care insurance for himself or herself and his or her
immediate family. The deductible share of eligible insurance expenses rose
from 25 percent in 1987 to 100 percent in 2003 and thereafter. For the
purpose of this deduction only, self-employed individuals are defined as sole
proprietors, working partners in a partnership, and employees of an S
corporation who own more than 2 percent of the corporation's stock. The
deduction is taken above-the-line, which is to say that it may be claimed
regardless of whether or not a self-employed individual itemizes on his or her
tax return.

Use of the deduction for health insurance expenditures by the self-
employed is subject to several limitations. First, the deduction cannot exceed
a taxpayer's net earned income from the trade or business in which the health
insurance plan was established, minus the deductions for 50 percent of the
self-employment tax and any contributions to qualified pension plans.
Second, the deduction is not available for any month when a self-employed
individual is eligible to participate in a health plan maintained by his or her
employer or his or by her spouse's employer. Third, if a self-employed
individual claims an itemized deduction for medical expenses under IRC
section 213, any deduction for health insurance premiums claimed under
section 162 must be subtracted from the medical expenses eligible for the
itemized deduction. Whatever health insurance premiums cannot be deducted
under section 162(1) may be included with these medical expenses, subject to
the statutory threshold of 7.5 percent of adjusted gross income (AGI). And
fourth, the self-employed must include their deductible health insurance
expenditures in computing their self-employment taxes.

Impact

In 2004, the most recent year for which data are available, claims for the
health insurance deduction for the self-employed totaled nearly 3.7 million,
(down from 3.8 million in 2003), and the total amount claimed came to $17.3
billion (up from $16.4 billion in 2003). It is not clear from available data how
many self-employed claimed the deduction for long-term care insurance
spending or what the total value of those claims came to.

The deduction under section 162(l) reduces the out-of-pocket cost of health
insurance or long-term care insurance for self-employed individuals and their
immediate families by an amount that hinges on marginal tax rates. As a
result, higher-income individuals benefit more from the deduction than do
lower-income individuals. Moreover, given that there is no statutory limit on
the amount of eligible health or long-term care insurance expenditures that
can be deducted, the deduction has the potential to encourage self-employed
individuals in higher tax brackets to purchase overly generous health
insurance coverage.

The bond between the size of the subsidy and income is illustrated in the
following table. It shows the percentage distribution by AGI of the total
deduction for health insurance expenditures by the self-employed claimed for
2004, and the average amount claimed per tax return for each income class.
On the whole, individuals with AGIs of less than $50,000 accounted for 38
percent of the total amount claimed. More telling was the distribution of the
average amount claimed per tax return for each AGI class. Not surprisingly,
the average claim increased with income to the extent that for individuals
with an AGI of $200,000 and above, it was more than double the average
claim for individuals with an AGI below $30,000. If the deductions were
translated by the application of weighted marginal tax rates into tax savings
by income class, the resulting tax expenditure values would be even more
heavily distributed among the higher-income groups.

Distribution of the Deduction for Medical Insurance
Premiums by the Self-employed by Adjusted Gross
Income Class in 2004

Adjusted Gross
Income Class
(in thousands of $)

Percentage
Distribution
of
Deductions
(%)

Average
Amount of
the
Deduction
Claimed per
Tax Return
($)

Below $15

3,224

$15 to under $30

3,646

$30 to under $50

4,005

$50 to under $100

4,495

$100 to under $200

5,757

$200 and over

7,822

Total

100

4,669

Note: This is not a distribution of tax expenditure values. Derived from
data taken from the following publication: Internal Revenue Service.
SOI Bulletin, Winter 2005-2006, table 1, p.15. Covers taxable and non-
taxable returns.

Rationale

The health insurance deduction for the self-employed first entered the tax
code as a temporary provision of the Tax Reform Act of 1986. Under the act,
the deduction was equal to 25 percent of qualified health insurance
expenditures and was set to expire on December 31, 1989. The Technical
and Miscellaneous Revenue Act of 19.8 made a few technical corrections to
the provision.

A series of laws extended the deduction for brief periods during the early
1990s: the Omnibus Budget Reconciliation Act of 1989 extended the
deduction for 9 months (through September 30, 1990) and made it available
to subchapter S corporation shareholders; the Omnibus Budget Reconciliation
Act of 1990 extended the deduction through December 31, 1991; the Tax
Extension Act of 1991 extended the deduction through June 30, 1992; and
the Omnibus Budget Reconciliation Act of 1993 extended it through
December 31, 1993. Throughout this period, the deductible share of eligible
health insurance expenditures remained at 25 percent.

Congress allowed the deduction to expire at the end of 1993, and it took no
action to extend it during 1994. A law enacted in April 1995, P.L. 104-7,
reinstated the deduction, retroactive to January 1, 1994, and made it a
permanent provision of the Internal Revenue Code. Under the act, the
deductible share of eligible health insurance expenditures was to remain at 25
percent for 1994 and then rise to 30 percent in 1995 and beyond.

The Health Insurance Portability and Accountability Act of 1996 (HIPAA,
P.L. 104-191) increased the deductible share of health insurance expenditures
by the self-employed from to 30 percent in 1995 and 1996 to 40 percent in
1997 and gradually to 80 percent by 2006 and thereafter. HIPAA also
allowed self-employed persons to include in the expenditures eligible for the
deduction their payments for qualified long-term care insurance, beginning
January 1, 1997. The act imposed dollar limits on the amount of long-term
care premiums that could be deducted in a single tax year and indexed these
limits for inflation. In 2006, these limits range from $280 for individuals age
40 and under to $3,530 for individuals over age 70.

The Omnibus Consolidated and Emergency Supplemental Appropriations
Act for FY1999 (P.L. 105-277) increased the deduction to its present level: it
rose to 70 percent of eligible expenditures in 2002, and to 100 percent in
2003 and thereafter.

Assessment

In enacting the deduction for spending on health insurance and long-term
care insurance by the self-employed, Congress seemed to be motivated by two
policy objectives. One was to provide those individuals with a tax benefit
comparable to the exclusion from the taxable income of employees of any
employer-provided health benefits they receive. A second objective was to
improve access to health care by the self-employed.

The deduction has the effect of lowering the after-tax cost of health
insurance purchased by the self-employed by a factor equal to a self-employed
individual's marginal income tax rate. Individuals who purchase health
insurance coverage in the non-group market but are not self-employed receive
no such tax benefit. There is some evidence that the deduction has fostered a
significant increase in health insurance coverage among the self-employed
and their immediate families. As one would expect, the gains appear to have
been concentrated in higher-income households.

Proponents of allowing the self-employed to deduct 100 percent of health
insurance expenditures cited equity as the main justification for such tax
treatment. In their view, simple fairness required that the self-employed
receive the same tax subsidy for those health insurance expenditures as
employees who receive health insurance through their employers. While the
section 162(l) a deduction greatly narrowed the gap between the self-
employed and the employed, it does not achieve strict equality in the tax
treatment of health insurance coverage for the two groups. Recipients of
employer-provided health insurance (including shareholder-employees of S
corporations who own more than 2 percent of stock) are permitted to exclude
employer contributions from the wage base used to determine their Social
Security and Medicare tax contributions. By contrast, the self-employed must
include their spending on health insurance in the wage base used to calculate
their self-employment taxes under the Self-Employment Contributions Act.

The deduction also raises some concern about its efficiency effects. Critics
of the current tax subsidies for health insurance contend that a 100-percent
deduction is likely to encourage self-employed individuals to purchase health
insurance coverage that contributes to wasteful or inefficient use of health
care. To reduce this likelihood, some favor capping the deduction at an
amount commensurate with a standardized health benefits package.

In addition, there is some evidence that health insurance may not be critical
to the utilization of health care by the self-employed. A 2001 study by
Harvey Rosen and Craig William Perry using data on health care spending in
1996 examined the use of health care by the self-employed. It found that
there were no significant differences in utilization rates between employees
and the self-employed in hospital admissions, hospital stays, dental checkups,
and optometrist visits, and that the self-employed had higher utilization rates
for alternative care and chiropractor visits - even though the self-employed
had a lower health insurance coverage rate than the employees. These
findings call into question one rationale for expanding health insurance
coverage through the use of tax subsidies: that access to adequate health care
hinges on having health insurance.

Selected Bibliography

Conly, Sonia. Self-Employment Health Insurance and Tax Incentives.
Proceedings of the Eighty-Eighth Annual Conference on Taxation, 1995.
Columbus, OH: National Tax Association, 1996, pp. 138-44.
Gruber, Jonathan and James Poterba. "Tax Incentives and the Decision to
Purchase Health Insurance: Evidence from the Self-Employed," The
Quarterly Journal of Economics, v. 109, issue 3. August 1994, pp. 701-33.
Guenther, Gary. Federal Tax Treatment of Health Insurance Expenditures
by the Self-Employed: Current Law and Issues for Congress. Library of
Congress, Congressional Research Service Report RL33311. Washington,
DC: March 13, 2006.

Gurley-Calvez, Tami. Health Insurance Deductibility and Entrepreneurial
Survival. Small Business Administration, Office of Advocacy. Washington,
DC: April 2006.
Lyke, Bob. Tax Benefits for Health Insurance and Expenses: Overview of
Current Law and Legislation. Library of Congress, Congressional Research
Service Report RL33505. Washington, DC: June 30, 2006.
Perry, William Craig and Harvey S. Rosen. Insurance and the Utilization
of Medical Services Among the Self-Employed. Working Paper 8490.
National Bureau of Economic Research. Cambridge, MA: September 2001.
U.S. Congress, House Committee on Ways and Means, Subcommittee on
Health. Health Insurance Premium Tax Deductions for the Self-Employed.
Hearing, Serial 104-36, 104th Cong., 1st Sess., January 27, 1995.
Washington, U.S. Govt. Print. Off., 1996.
-, Joint Committee on Taxation. General Explanation of the Tax Reform
Act of 1986, H.R. 3838, 99th Congress, P.L. 99-514, Joint Committee Print
JCS-10-87. Washington, DC: U.S. Government Printing Office, May 4, 1987,
pp. 815-17.
Wellington, Alison J. "Health Insurance Coverage and Entrepreneurship,"
Journal of Contemporary Economic Policy, v. 19, no. 4, October 2001, pp.
465-478.

Health

DEDUCTION FOR MEDICAL EXPENSES
AND LONG-TERM CARE EXPENSES

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

7.3

2007

8.2

2008

9.5

2009

10.7

2010

12.1

Authorization

Section 213.

Description

Most medical expenses that are paid for by an individual but not
reimbursed by an employer or insurance company may be deducted from
taxable income if they exceed 7.5 percent of his or her adjusted gross income
(AGI). In order to claim this deduction, individuals must itemize on their tax
returns. If an individual receives reimbursements for medical expenses
deducted in a previous tax year, the reimbursements must be included in
taxable income for the year when they are received. But any reimbursement
received for medical expenses incurred in a previous year for which no
deduction was claimed may be excluded from an individual's taxable income.

A complicated set of rules governs the expenses eligible for the deduction.
These expenses include amounts paid by the taxpayer on behalf of himself
or herself, his or her spouse, and eligible dependents for the following
purposes:

(1) health insurance premiums, including a variable portion of premiums
for long-term care insurance, employee payments for employer-sponsored
health plans, Medicare Part B premiums, and other self-paid premiums;

(2) diagnosis, treatment, mitigation, or prevention of disease, or for the
purpose of affecting any structure or function of the body, including dental
care;

(3) prescription drugs and insulin (but not over-the-counter medicines);

(4) transportation primarily for and essential to medical care; and

(5) lodging away from home primarily for and essential to medical care, up
to $50 per night for each individual.

In general, the cost of programs entered by an individual on his or her own
initiative to improve general health or alleviate physical or mental discomfort
unrelated to a specific disease or illness may not be deducted. But the cost of
similar programs prescribed by a physician to treat a particular disease are
deductible. The same distinction applies to procedures mainly intended to
improve an individual's appearance. For instance, the IRS does not consider
the cost of whitening teeth discolored by aging to be a deductible medical
expense, but the cost of breast reconstruction after a mastectomy and vision
correction through laser surgery are deductible expenses.

Impact

For individual taxpayers who itemize, the deduction can ease the financial
burden imposed by costly medical expenses. For the most part, the federal
tax code regards these expenses as involuntary expenses that reduce a
taxpayer's ability to pay taxes by absorbing a substantial part of income.

But the deduction is not limited to strictly involuntary expenses. It also
covers some costs of preventive care, rest cures, and other discretionary
expenses. A significant share of deductible medical expenses relate to
procedures and care not covered by many insurance policies (such as
orthodontia).

Like all deductions, the medical expense deduction yields the largest tax
savings per dollar of expense for taxpayers in the highest income tax brackets.
Nonetheless, relative to other itemized deductions, a larger percentage of the
tax benefits from the medical expense deduction goes to taxpayers in the
lower-to-middle income brackets. As the figures in the table below show, 61
percent of the deduction in 2004 was claimed by taxpayers with AGIs below
$50,000. There are several reasons why such an outcome is not as unlikely or
anomalous as it may seem. Lower-income taxpayers have relatively low rates
of health insurance coverage, either because of they cannot afford health
insurance coverage or it is not offered by their employers. As a result, many
of these taxpayers are forced to pay out of packet for the health care they and
their immediate families receive. In addition, medical spending represents a
larger fraction of household budgets among low-income taxpayers than it
does among high-income taxpayers, making it easier for low-income
taxpayers to exceed the 7.5-percent AGI threshold in a given tax year.
Finally, low-income households are more likely to suffer significant declines
in their incomes than high-income households when serious medical problems
cause working adults to lose time from work.

Distribution by Income Class of the Deduction for
Medical Expenses in 2004

Adjusted Gross Income
(in thousands of $)

Percentage
Distribution

Below $15

$15 to below $30

$30 to below $50

$50 to below $100

$100 to below $200

$200 and over

Source: Internal Revenue Service. "Individual Income Tax Returns,
Preliminary Data, 2004." Statistics of Income Bulletin. Washington, DC:
Winter 2005-2006. Table 1, p. 16.

Rationale

Since the early 1940s, numerous changes have been made in the rules
governing the deduction of medical expenses. For the most part, these
changes have focused on where to set the income threshold, whether to cap
the deduction and at what amount, the maximum deductible amount for
taxpayers who are 65 and over and disabled, whether to carve out a separate
income thresholds for spending on medicines and drugs and for health
insurance expenditures, and the medical expenses that qualify for the
deduction.

Taxpayers were first allowed to deduct health care expenses above a
specific income threshold in 1942. The deduction was a provision of the
Revenue Act of 1942. In adopting such a rule, Congress was trying to
encourage improved standards of public health and to ease the burden of high
tax rates during World War II. The original deduction covered medical ex-
penses (including spending on health insurance) above 5 percent of AGI and
was capped at $2,500 for a married couple filing jointly and $1,250 for a
single filer.

Under the Revenue Act of 1948, the 5-percent income threshold remained
intact, but the maximum deduction was changed so that it equaled the product
of the then personal exemption of $1,250 and the number of exemptions
claimed. The deduction could not exceed $5,000 for joint returns and $2,500
for all other returns.

The Revenue Act of 1951 repealed the 5-percent floor for taxpayers and
spouses who were age 65 and over. No changes were made in the maximum
deduction available to other taxpayers.

Congress passed legislation that substantially revised the Internal Revenue
Code in 1954. One of its provisions reduced the AGI threshold to 3 percent
and created a 1-percent floor for spending on drugs and medicines. In
addition, the maximum deduction was increased to $2,500 per exemption,
with a ceiling of $5,000 for an individual return and $10,000 for a joint or
head-of-household return.

In 1959, the maximum deduction was increased to $15,000 for taxpayers
who were 65 and over and disabled, and to $30,000 if their spouses also met
both criteria.

The threshold was removed on deductions for dependents age 65 and over
the following year.

In 1962, the maximum deduction was increased to $5,000 per exemption,
with a limit of $10,000 for individual returns, $20,000 for joint and head of
household returns, and $40,000 for joint returns filed by taxpayers and their
spouses who were 65 or over and disabled.

Congress eliminated the 1-percent floor on medicine and drug expenses for
those age 65 or older (taxpayer, spouse, or dependent) in 1964. In the
following year, a 3-percent floor for medical expenses and a 1-percent floor
for drugs and medicines were reinstated for taxpayers and dependents aged 65
and over. The limitations on maximum deductions were abolished, and a
separate deduction not to exceed $150 was established for health insurance
payments.

The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) made a
number of significant changes in the section 213 deduction. First, it raised
the floor from 3 percent to 5 percent of AGI. Second, it eliminated the
separate deduction for health insurance payments and allowed taxpayers to
add them to other qualified medical expenses in computing the section 213
deduction. Finally, TEFRA removed the separate 1-percent floor for drug
costs, excluded non-prescription or over-the-counter drugs from the
deduction, and merged the deduction for prescription drugs and insulin with
the deduction for other medical expenses.

Under the Tax Reform Act of 1986 (TRA86), the income threshold for the
medical expenses deduction increased from 5 percent of AGI to its present
level of 7.5 percent.

The Omnibus Budget Reconciliation Act of 1990 disallowed deductions
for the cost of cosmetic surgery, with certain exceptions. It also exempted the
medical expense deduction from the overall limit on itemized deductions for
high-income taxpayers.

Under the Health Insurance Portability and Accountability Act of 1996
(HIPAA, P.L. 104-191), spending on long-term care and long-term care
insurance was granted the same tax treatment as spending on health insurance
and medical expenses. This meant that as of January 1, 1997, taxpayers were
allowed to include expenditures for long-term care (including premium costs)
in the medical expenses eligible for the deduction. The act also imposed
annual dollar limits, indexed for inflation, on the of long-term care insurance
payments a taxpayer may deduct, subject to the 7.5 percent of AGI threshold.
The limits depend on the age of the insured person: in 2006, they range from
$280 for individuals age 40 and under to $3,530 for individuals over age 70.
HIPAA also specified that periodic reimbursements received under a
qualified long-term care insurance plan were considered payments for
personal injuries and sickness and could be excluded from gross income,
subject to a cap which was indexed for inflation. These payments could not
be claimed as part of the section 213 deduction because they were considered
reimbursement for health care received under a long-term care contract.
Insurance payments above the cap that did not offset the actual costs incurred
for long-term care services had to be included in taxable income.

Assessment

Changes in the tax laws during the 1980s substantially reduced the number
of tax returns claiming the itemized deduction for medical and dental
expenses. In 1980, 19.5 million returns, or 67 percent of itemized returns
and 21 percent of all returns, claimed the deduction. But in 1983, the first
full tax year reflecting the changes made by TEFRA, 9.7 million returns,
representing 28 percent of itemized returns and 10 percent of all returns,
claimed the deduction. The modifications made by TRA86 led to a further
decline in the number of individuals claiming the deduction. In 1990, for
instance, 5.1 million returns, or 16 percent of itemized returns and 4 percent
of all returns, claimed the deduction. Since then, however, the number of
individuals claiming the deduction has been steadily rising. For example, 9.5
million returns claimed the deduction for 2004, or 20 percent of all itemized
returns and 7 percent of all returns.

The deduction is intended to assist taxpayers with relatively high medical
expenses paid out of pocket relative to their taxable income. Taxpayers are
more likely to use the deduction if they can fit several large medical
expenditures into a single tax year. Unlike the itemized deduction for
casualty losses, a taxpayer cannot carry medical expenses that cannot be
deducted in the current tax year over to previous or future tax years.

Some argue that the deduction serves the public interest by expanding
health insurance coverage. In theory, it could have this effect, as it lowers the
after-tax cost of such coverage. This reduction can be as large as 35% for
someone in the highest tax bracket. Yet there appears to be a tenuous link, at
best, between the deduction and health insurance coverage. So few taxpayers
can claim the deduction that it is unlikely to have much impact on the
decision to purchase health insurance, especially among individuals whose
only option for coverage is to buy health insurance the non-group market,
where premiums tend to be higher and exclusions in benefits more numerous
than in the group market. What is more, few among those who itemize and
have health insurance coverage are likely to qualify for the deduction because
much of their use of medical care is covered by insurance.

Current tax law is inequitable in its treatment of health insurance
expenditures. Taxpayers who receive health benefits from their employers
receive a larger tax subsidy, at the margin, than taxpayers who purchase
health insurance on their own or self-insure. Employer-paid health care is
excluded from income and payroll taxes, whereas the cost of health insurance
bought in the non-group market can be deducted from taxable income only to
the extent that it exceeds 7.5 percent of AGI. Lowering or abolishing the
AGI threshold for the deduction would narrow the narrow gap between the
tax benefits for health insurance available to the two groups.

Selected Bibliography

Goldsberry, Edward, Ashley Tenney and David Luke. "Deductibility of
Tuition and Related Fees as Medical Expenses," The Tax Adviser, November
2002, pp. 701-702.
Guenther, Gary. Tax Subsidies for Expanding Health Insurance
Coverage: Selected Policy Issues for the 108th Congress. Library of
Congress, Congressional Research Service Report RL30762, Washington,
DC: August 5, 2003.
Jones, Lawrence T. "Long-Term Care Insurance: Advanced Tax Issues,"
Journal of Financial Service Professionals, September 2004, pp. 51-59.

Kaplow, Louis. "The Income Tax as Insurance: The Casualty Loss and
Medical Expense Loss Deductions and the Exclusion of Medical Insurance
Premiums," California Law Review, v. 79, December 1991, pp. 1485-1510.
Lyke, Bob. Tax Benefits for Health Insurance and Expenses: Overview of
Current Law and Legislation. Library of Congress, Congressional Research
Service Report RL33505, Washington, DC: June 30, 2006.
Pauly Mark V. "Taxation, Health Insurance, and Market Failure in the
Medical Economy," Journal of Economic Literature, v. 24, no. 2. June 1986,
pp. 629-75.
O'Shaughnessy, Carol and Bob Lyke. Long-Term Care: What Direction
for Public Policy?. Library of Congress, Congressional Research Service
Report RS20784, Washington, DC, January 18, 2005.
Rook, Lance W. "Listening to Zantac: The Role of Non-Prescription
Drugs in Health Care Reform and the Federal Tax System," Tennessee Law
Review, v. 62, Fall 1994, pp. 102-39.
Sheiner, Louise. "Health Expenditures, Tax Treatment," The
Encyclopedia of Taxation and Tax Policy, ed. Joseph J. Cordes, Robert D.
Ebel, and Jane G. Gravelle. Washington: Urban Institute Press, 2005, pp.
175-176.
Steuerle, Gene. "Tax Policy Concerns: Long-Term Care Needs and the
Government Response," Tax Notes, v. 83, May 10, 1999, pp. 917-918.
Talley, Louis Alan. Medical Expense Deduction: History and Rationale
for Past Changes. Library of Congress, Congressional Research Service
Report RL30833, Washington, DC: February 6, 2001.
U.S. Congress, Congressional Budget Office. Tax Subsidies for Medical
Care: Current Policies and Possible Alternatives. Washington, DC: 1980.
-, House Committee on the Budget. Tax Expenditures for Health Care,
Hearings, 96th Congress, 1st session, July 9-10, 1979.
-, House Committee on Ways and Means, Subcommittee on Health. Long-
Term Care Tax Provisions in the Contract with America. Hearing, Serial
104-1, 104th Congress, 1st session. Washington, DC: U.S. Govt. Print. Off.,
January 20, 1995.
Vogel, Ronald. "The Tax Treatment of Health Insurance Premiums as a
Cause of Overinsurance," National Health Insurance: What Now, What
Later, What Never? ed. M. Pauly. Washington: American Enterprise Institute
for Public Policy Research, 1980.
Wilensky, Gail R. "Government and the Financing of Health Care"
American Economic Review, v. 72, no. 2. May 1982, pp. 202-07.

Health

EXCLUSION OF WORKERS' COMPENSATION BENEFITS
(MEDICAL BENEFITS)

Estimated Revenue Loss*

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

6.5

2007

6.9

2008

7.4

2009

8.0

2010

8.5

Authorization

Section 104(a)(1).

Description

Payments for medical treatment of work-related injury or disease are
provided as directed by various State and Federal laws governing workers'
compensation. Employers finance workers' compensation benefits through
commercial insurance or self-insurance arrangements (with no employee
contribution) and their costs are deductible as a business expense. Employees
are not taxed on the value of insurance contributions for workers'
compensation medical benefits made on their behalf by employers, or on the
medical benefits or reimbursements they actually receive. This is similar to
the tax treatment of other employer-paid health insurance.

Impact

The exclusion from taxation of employer contributions for workers'
compensation medical benefits provides a tax benefit to any worker covered
by the workers' compensation program, not just those actually receiving
medical benefits in a particular year.

Figures are not available on employer contributions specifically for
workers' compensation medical benefits. As an approximation, however, in
2004, medical payments under workers' compensation programs totaled
$26.1 billion. This represented 47 percent of total workers' compensation
benefits. The rest consisted mainly of earnings-replacement cash benefits.
(See entry on Exclusion of Workers' Compensation Benefits: Disability and
Survivors Payments.)

Rationale

This exclusion was first codified in the Revenue Act of 1918. The
committee reports accompanying the Act suggest that workers' compensation
payments were not subject to taxation before the 1918 Act. No rationale for
the exclusion is found in the legislative history. But it has been maintained
that workers' compensation should not be taxed because it is in lieu of court-
awarded damages for work-related injury or death that, before enactment of
workers' compensation laws (beginning shortly before the 1918 Act), would
have been payable under tort law for personal injury or sickness and not
taxed.

Assessment

Not taxing employer contributions to workers' compensation medical
benefits subsidizes these benefits relative to taxable wages and other taxable
benefits, for both the employee and employer. The exclusion allows
employers to provide their employees with workers' compensation coverage
at a lower cost than if they had to pay the employees additional wages
sufficient to cover a tax liability on these medical benefits. In addition to the
income tax benefits, workers' compensation insurance benefits are excluded
from payroll taxation.

The tax subsidy reduces the employer's cost of compensating employees
for accidents on the job and can be viewed as blunting financial incentives to
maintain safe workplaces. Employers can reduce their workers'
compensation costs if the extent of accidents is reduced. If the insurance
premiums were taxable to employees, a reduction in employer premiums
would also lower employees' income tax liabilities. Employees might then be
willing to accept lower before-tax wages, thereby providing additional
savings to the employer from a safer workplace.

Selected Bibliography

Boyd, Lawrence W. "Workers Compensation Reform Past and Present:
An Analysis of Issues and Changes in Benefits," Labor Studies Journal,
Summer 1999. Pp. 45-62.
National Foundation for Unemployment Compensation and Workers'
Compensation. "Fiscal Data for State Workers' Compensation Systems:
1986-95," Research Bulletin 97 WC-2. September 15, 1997, pp. 1-17.
Sengupta, Ishita, et al. Workers' Compensation: Benefits, Coverage and
Costs, 2004. Washington, DC: National Academy of Social Insurance, 2006.
Social Security Administration, Office of Research and Statistics. "Social
Security Programs in the United States," Social Security Bulletin, v. 56.
Winter, 1993, pp. 28-36.
Thomason, Terry, Timothy Schmidle and John F. Burton. Workers'
Compensation, Benefits, Costs, and Safety under Alternative Insurance
Arrangements. Kalamazoo MI: Upjohn Institute for Employment Research.
2001.
U.S. Congress, House Committee on Ways and Means. 2000 Green Book:
Background Material and Data on Programs within the Jurisdiction of the
Committee on Ways and Means. Committee Pring WMCP 106-14, 106th
Congress, 2nd Session. Washington, DC: U.S. Government Printing Office,
October 6, 2000, pp. 983-989.
Wentz, Roy. "Appraisal of Individual Income Tax Exclusions," Tax
Revision Compendium. U.S. Congress, House Committee on Ways and
Means Committee Print. 1959, pp. 329-340.
Yorio, Edward. "The Taxation of Damages: Tax and Non-Tax Policy
Considerations," Cornell Law Review, v. 62. April 1977, pp. 701-736.

Health

HEALTH SAVINGS ACCOUNTS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.1

2007

0.3

2008

0.6

2009

0.9

2010

1.2

H.R. 6111 (December 2006) increased the cost by $0.1 billion in
FY2008, FY2009, and FY2010.

Authorization

Section 223.

Description

Health Savings Accounts (HSAs) are a tax-advantaged way that people can
pay for unreimbursed medical expenses such as deductibles, copayments, and
services not covered by insurance. Eligible individuals can establish and fund
these accounts when they have qualifying high deductible health insurance
(insurance with a deductible of at least $1,100 for single coverage and $2,200
for family coverage, plus other criteria described below) and no other health
care coverage, with some exceptions. The minimum deductible levels do not
apply to preventive care, which the IRS has defined by regulation.
Prescription drugs are not exempt from the deductibles unless they are for
preventive care. Qualifying health plans cannot have limits on out-of-pocket
expenditures that exceed $5,500 for single coverage and $11,000 for family
coverage. (The dollar amounts in this and other paragraphs are for 2007.)

The annual contribution limit for single coverage is $2,850 and the annual
contribution limit for family coverage is $5,650. Individuals who are at least
55 years of age but not yet enrolled in Medicare may make an additional
contribution of $800. The additional contribution amount will increase by
$100 each year through 2009, when it will be $1,000. Individuals may
deduct their HSA contributions from gross income in determining their
taxable income. Employer contributions are excluded from income and
employment taxes of the employee and from employment taxes of the
employer.

Individuals do not lose their HSA or the right to access it by obtaining
insurance with a low deductible; they simply cannot make further
contributions until they become eligible once again. Individual members of a
family may have their own HSA, provided they each meet the eligibility rules.
They can also be covered through the HSA of someone else in the family; for
example, a husband may use his HSA to pay expenses of his spouse even
though she has her own HSA.

Withdrawals from HSAs are exempt from federal income taxes if used for
qualified medical expenses, with the exception of health insurance premiums.
However, payments for four types of insurance are considered to be qualified
expenses: (1) long-term care insurance, (2) health insurance premiums during
periods of continuation coverage required by federal law (e.g., COBRA), (3)
health insurance premiums during periods the individual is receiving
unemployment compensation, and (4) for individuals age 65 years and older,
any health insurance premiums (including Medicare Part B premiums) other
than a Medicare supplemental policy.

Withdrawals from HSAs not used for qualified medical expenses are
included in the gross income of the account owner in determining federal
income taxes; they also are subject to a 10% penalty tax. The penalty is
waived in cases of disability or death and for individuals age 65 and older.
HSA account earnings are tax-exempt and unused balances may accumulate
without limit.

Under legislation adopted at the end of 2006, amounts can be rolled over
from Health Flexible Spending Accounts and Health Reimbursement
accounts on a one time basis before 2012. Amounts can also be withdrawn
from an IRA and contributed to an HSA without tax or penalty.

Impact

HSAs encourage people to purchase high deductible health insurance and
build a reserve for routine and other unreimbursed health care expenses.
They are more attractive to individuals with higher marginal tax rates since
their tax savings are greater, though some younger, lower income taxpayers
might try to build up account balances in anticipation of when their income
will be higher. Some higher income individuals may be reluctant to start or
continue funding HSAs if they have health problems for which low
deductible insurance would be more appropriate. Two important questions
affecting participation are whether some employers will only offer high
deductible insurance plans, giving employees no other options, and whether
they will make contributions to workers' accounts. After three years of
experience with HSAs (they were first authorized for 2004), there is little
publicly available information with which to answer these questions.

Interest in HSAs continues to grow in both the employer and individual
health insurance markets. Qualifying insurance was initially offered by
insurers that previously had been selling high deductible policies (including
policies associated with medical savings accounts, a precursor to HSAs), but
today many insurers and even some health maintenance organizations offer
qualifying coverage. Some of the first employers to offer HSA plans had
previously had health reimbursement accounts (HRAs) that were coupled
with high deductible coverage. (First authorized by the IRS in 2002, HRAs
are accounts that employees can use for unreimbursed medical expenses; they
can be established and funded only by employers and normally terminate
when employees leave.) More employers became interested after the IRS
issued guidance clarifying how HSA statutory provisions would be
interpreted. The federal government began offering HSA plans to its
employees in 2005.

According to a survey by America's Health Insurance Plans, as of January,
2006, nearly 3.2 million people were enrolled in qualifying high deductible
insurance plans. The number included both policy holders and their covered
family members. The January, 2006 figure was three times a March, 2005
count, which in turn was twice the September, 2004 count. While not all
these policy holders have HSAs, let alone put money in them, it is reasonable
to assume that the number of HSAs has been growing rapidly. Nonetheless,
it remains uncertain how popular HSAs will be in the long run. While most
people who consider them could reasonably expect to have gradually
increasing account balances, it is unclear whether this incentive will be
enough to offset the increased risks associated with high deductible insurance.
Many people are very risk averse with respect to health insurance, even when
they recognize that might be to their financial detriment.

Rationale

HSAs were authorized by the Medicare Prescription Drug, Improvement,
and Modernization Act of 2003 (P.L. 108-173). Congress adopted them as a
replacement for Archer medical savings accounts (MSAs), which proponents
considered unduly constrained by limitations on eligibility and contributions.
(Archer MSAs, which are still available, are restricted to self-employed
individuals and employees covered by a high deductible plan established by
their small employer (50 or fewer workers). MSA contributions are limited to
65 percent of the insurance deductible (75% for family policies) or earned
income, whichever is less. Individuals cannot make contributions if their
employer does. Only about 100,000 MSAs have ever been established.)
Like MSAs, HSAs were advanced as a way to slow the growth of
health care costs by reducing reliance on insurance, to preserve
freedom of choice in obtaining health care services, and to help
individuals and families finance future health care costs. Taxpayers
can carry their HSAs with them when they change jobs, which may
help maintain continuity of health care if their new employer offers
different or perhaps no health insurance coverage.

HSAs are seen as the cornerstone of consumer driven health care,
which some employers hope will limit their exposure to rising health
care costs. Some health care providers favor consumer driven health
care in order to avoid managed care restrictions on how they
practice medicine. HSAs are predicated upon market-based rather
than regulatory solutions to health care problems, as the 108th
Congress appeared to favor.

Assessment

HSAs could be an attractive option for many people. They allow
individuals to insure against large or catastrophic expenses while
covering routine and other minor costs out of their own pocket.
Properly designed, they may encourage more prudent health care
use and the accumulation of funds for medical emergencies. For
these outcomes to occur, however, individuals will have to put money
into their account regularly (especially if their employer doesn't) and
refrain from spending it for things other than health care. In
addition, they must be able to find out what health care providers
charge and be willing to switch to lower-cost providers. Despite
some promising small-scale studies and anecdotal evidence, it is too
early to tell whether many people would respond in these ways, or if
health care providers will be forthcoming about prices.

One issue surrounding HSAs is whether they drive up insurance
costs for everyone else. If HSAs primarily attract young, healthy
individuals, premiums for plans without high deductibles are likely to
rise since they would disproportionately cover the older and ill. Over
time, healthier people in higher cost plans would switch to lower cost
plans, raising their premiums but increasing premiums in higher cost
plans even more. If this process continued unchecked, eventually
people who need insurance the most would be unable to afford it.

HSAs have limits on their capacity to substantially reduce
aggregate health care spending, even assuming their widespread
adoption and significant induction (price elasticity) effects of
insurance. Most health care spending is attributable to costs that
exceed the high-deductible levels allowed under the legislation;
consumers generally have little control over these expenditures.
Even for smaller expenditures, the tax subsidies associated with HSAs
may effectively reduce patient cost-sharing compared to typical
comprehensive health insurance. A further complication is that HSAs
with large account balances (which will eventually occur for some
people) might be seen as readily-available funds for health care,
which could lead to increases in spending, just the opposite of the
usual prediction.

Regardless of their impact on aggregate expenditures, HSAs
provide more equitable treatment for taxpayers who choose to
self-insure more of their health care costs. Employer-paid health
insurance is excluded from employees' gross income regardless of the
proportion of costs it covers. Employers generally pay about 80% of
the cost of a plan that has a low deductible ($400 a year, for
example) and a 20% copayment requirement. If the plan instead
had a high-deductible ($2,000, for example) and the same
copayment requirement, employees normally would have to pay for
expenses associated with the increase in the deductible ($1,600
minus the $320 copayment they would otherwise have made) with
after-tax dollars. They would lose a tax benefit for assuming more
financial risk. HSAs restore this benefit as long as an account is used
for health care expenses. In this respect, HSAs are like flexible
spending accounts (FSAs), which also allow taxpayers to pay
unreimbursed health care expenses with pre-tax dollars. With FSAs,
however, account balances unused at the end of the year and a brief
grace period must be forfeited.

Selected Bibliography

Aaron, Henry J. The "Sleeper" in the Drug Bill. Tax Notes. v. 102 no. 8
(February 23, 2004).
Buntin, Melinda Beeuwkes et al. Consumer-Directed Health Care: Early
Evidence About Effects on Cost and Quality. Health Affairs. vol. 25 (2006).
Cannon, Michael F. Health Savings Accounts: Do the Critics Have a
Point? Cato Institute. Policy Analysis no. 569 (May 30, 2006).
Gabel, Jon R. et al. Employers' Contradictory Views about Consumer-
Driven Health Care: Results from a National Survey. Health Affairs, Web
exclusive (April 21, 2004).
Hall, Mark A. and Clark C. Havighurst. Reviving Managed Care with
Health Savings Accounts. Health Affairs. vol. 24 (2005).
Health Savings Accounts: January 2005 - December 2005. eHealth, Inc.
(May 10, 2006).
Herzlinger, Regina E. Consumer-Driven Health Care: Lessons from
Switzerland. JAMA, v. 292 no. 10 (September 8, 2004).
Kofman, Mila. Health Savings Accounts: Issue and Implementation
Decisions for States. Academy Health. Issue Brief. (September, 2004).
Lyke, Bob. Health Savings Accounts: Overview of Rules for 2006.
Library of Congress. Congressional Research Service. Report RL33257.

-------- Health Savings Accounts: Some Current Policy Issues. Library of
Congress. Congressional Research Service. Report RS22437.
--------, Chris Peterson, and Neela Ranade. Health Savings Accounts.
Library of Congress. Congressional Research Service Report RL32467.
Patterson, Martha Priddy. Defined Contribution Health Plan to Consumer-
Driven Health Benefits: Evolution and Experience. Benefits Quarterly, v. 20
no. 2 (Second quarter, 2004).
Peterson, Chris L. Data on Enrollment, Premiums, and Cost-Sharing in
HSA-Qualified Health Plans. Library of Congress. Congressional Research
Service. Report RS22417.
Protecting Consumers in an Evolving Health Insurance Market. National
Committee for Quality Assurance. (June, 2006).
Remler, Dahlia K. and Sherry A. Glied. How Much More Cost-Sharing
Will Health Savings Accounts Bring? Health Affairs. vol. 25 (2006).
Trude, Sally and Leslie Jackson Conwell. Rhetoric vs. Reality: Employer
Views on Consumer-Driven Health Care. Center for Studying Health System
Change. Issue Brief no. 86. (July, 2004).
U.S. Government Accountability Office: Consumer-Directed Health
Plans: Early Enrollee Experiences with Health Savings Accounts and
Eligible Health Plans. GAO-06-798 (August, 2006).
-------- Consumer-Directed Health Plans: Small but Growing Enrollment
Fueled by Rising Cost of Health Care Coverage. GAO-06-514. (April,
2006).

Health

EXCLUSION OF INTEREST
ON STATE AND LOCAL GOVERNMENT BONDS
FOR PRIVATE NONPROFIT HOSPITAL FACILITIES

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

1.7

0.6

2.3

2007

1.8

0.7

2.5

2008

1.9

0.7

2.6

2009

2.0

0.8

2.8

2010

2.1

0.8

2.9

Authorization

Section 103, 141, 145, 146, and 501(c)(3).

Description

Interest income on State and local bonds used to finance the construction of
nonprofit hospitals and nursing homes is tax exempt. These bonds are
classified as private-activity bonds rather than governmental bonds because a
substantial portion of their benefits accrues to individuals or businesses rather
than to the general public. For more discussion of the distinction between
governmental bonds and private-activity bonds, see the entry under General
Purpose Public Assistance: Exclusion of Interest on Public Purpose State
and Local Debt.

These nonprofit hospital bonds are not subject to the State private-activity
bond annual volume cap.

Impact

Some of the benefits of the tax exemption also flow to bondholders. For a
discussion of the factors that determine the shares of benefits going to
bondholders and users of the hospitals and nursing homes, and estimates of
the distribution of tax-exempt interest income by income class, see the
"Impact" discussion under General Purpose Public Assistance: Exclusion of
Interest on Public Purpose State and Local Debt.

Rationale

Pre-dating the enactment of the first Federal income tax, an early decision
of the U.S. Supreme Court, Dartmouth College v. Woodward (17 U.S. 518
[1819]), confirmed the legality of government support for charitable
organizations that were providing services to the public.

The income tax adopted in 1913, in conformance with this principle,
exempted from taxation virtually the same organizations now included under
Section 501(c)(3). In addition to their tax-exempt status, these institutions
were permitted to receive the benefits of tax-exempt bonds. Almost all States
have established public authorities to issue tax-exempt bonds for nonprofit
hospitals and nursing homes. Where issuance by public authority is not
feasible, Revenue Ruling 63-20 allows nonprofit hospitals to issue tax-exempt
bonds "on behalf of" State and local governments.

Before enactment of the Revenue and Expenditure Control Act of 1968,
States and localities were able to issue bonds to finance construction of
capital facilities for private (proprietary or for-profit) hospitals, as well as for
public sector and nonprofit hospitals.

After the 1968 Act, tax-exempt bonds for proprietary (for-profit) hospitals
were issued as small-issue industrial development bonds, which limited the
amount for any institution to $5 million over a six-year period. The Revenue
Act of 1978 raised this amount to $10 million.

The Tax Equity and Fiscal Responsibility Act of 1982 established
December 31, 1986 as the sunset date for tax-exempt small-issue IDBs. The
Deficit Reduction Act of 1984 extended the sunset date for bonds used to
finance manufacturing facilities, but left in place the December 31, 1986
sunset date for nonmanufacturing facilities, including for-profit hospitals and
nursing homes.

The private-activity status of these bonds subjects them to severe
restrictions that would not apply if they were classified as governmental
bonds.

Assessment

Recently, some efforts have been made to reclassify nonprofit bonds,
including nonprofit hospital bonds, as governmental bonds. The proponents
of such a change suggest that the public nature of services provided by
nonprofit organizations merit such a reclassification. Opponents argue that
the expanded access to subsidized loans coupled with the absence of
sufficient government oversight may lead to greater misuse than if the
facilities received direct federal spending. Questions have also been raised
about whether nonprofit hospitals fulfill their charitable purpose and if they
deserve continued access to tax-exempt bond finance.

Even if a case can be made for this federal subsidy for nonprofit
organizations, it is important to recognize the potential costs. As one of many
categories of tax-exempt private-activity bonds, bonds for nonprofit
organizations increase the financing cost of bonds issued for other public
capital. With a greater supply of public bonds, the interest rate on the bonds
necessarily increases to lure investors. In addition, expanding the availability
of tax-exempt bonds increases the assets available to individuals and
corporations to shelter their income from taxation.

Selected Bibliography

Barker, Thomas R. "Re-Examining the 501(c)(3) Exemption of Hospitals
as Charitable Organizations," The Exempt Organization Tax Review. July
1990, pp. 539-553.
Copeland, John and Gabriel Rudney. "Federal Tax Subsidies for Not-for-
Profit Hospitals," Tax Notes. March 26, 1990, pp. 1559-1576.
Freemont-Smith, Marion R. "The Role of Government Regulation in the
Creation and Operation of Conversion Foundations," Tax Notes. February 2,
1999.
Gentry, William M., and John R. Penrod. "The Tax Benefits of Not-For-
Profit Hospitals," Cambridge, MA, National Bureau of Economic Research,
1998. Working Paper No. 6435.
Gershberg, Alec I., Michael Grossman, and Fred Goldman. "Health Care
Capital Financing Agencies: the Intergovernmental Roles of Quasi-
government Authorities and the Impact on the Cost of Capital," Public
Budgeting and Finance, v. 20 (Spring 2000), pp. 1-23.
Gershberg, Alec Ian, Michael Grossman, and Fred Goldman.
"Competition and the Cost of Capital Revisited: Special Authorities and
Underwriters in the Market for Tax-exempt Hospital Bonds," National Tax
Journal. June 2001, pp. 255-280.

Jantzen, Robert and Patricia R. Loubeau. "Managed Care and U.S.
Hospitals' Capital Costs," International Advances in Economic Research, v.
9, no. 3. August 2003, pp. 206-217.
Maguire, Steven. Private Activity Bonds: An Introduction. Library of
Congress, Congressional Research Service Report RL31457. November 10,
2004.
-. Tax-Exempt Bonds: A Description of State and Local Government
Debt. Library of Congress, Congressional Research Service Report
RL30638. October 22, 2004.
Zimmerman, Dennis. "Nonprofit Organizations, Social Benefits, and Tax
Policy." National Tax Journal. September 1991, pp. 341-349.
-. The Private Use of Tax-Exempt Bonds: Controlling Public Subsidy of
Private Activities. Washington, DC: The Urban Institute Press, 1991.

Health

DEDUCTION FOR CHARITABLE CONTRIBUTIONS
TO HEALTH ORGANIZATIONS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

3.7

0.8

4.5

2007

4.0

0.8

4.8

2008

4.3

0.9

5.2

2009

4.7

0.9

5.6

2010

4.8

0.9

5.7

Authorization

Section 170 and 642(c).

Description

Subject to certain limitations, charitable contributions may be deducted by
individuals, corporations, and estates and trusts. The contributions must be
made to specific types of organizations, including organizations whose
purpose is to provide medical or hospital care, or medical education or
research. To be eligible, organizations must be not-for-profit.

If a contribution is made in the form of property, the deduction depends on
the type of taxpayer (i.e., individual, corporate, etc.), recipient, and purpose.

Taxpayers are required to obtain written substantiation from a donee
organization for contributions which exceed $250. This substantiation must
be received no later than the date the donor-taxpayer files the required income
tax return. Donee organizations are obligated to furnish the written
acknowledgment when requested with sufficient information to substantiate
the taxpayer's deductible contribution.

Impact

Distribution by Income Class of the Tax Expenditure
for Charitable Contributions, 2005

Income Class
(in thousands of $)

Percentage
Distribution

Below $10

0.0

$10 to $20

0.1

$20 to $30

0.5

$30 to $40

1.1

$40 to $50

2.0

$50 to $75

8.3

$75 to $100

9.6

$100 to $200

28.7

$200 and over

49.7

Rationale

Assessment

Supporters note that contributions finance desirable activities such as
hospital care for the poor. Further, the Federal Government would be forced
to step in to assume some of the activities currently provided by health care
organizations if the deduction were eliminated; however, public spending
might not be available to make up all of the difference. In addition, many
believe that the best method of allocating general welfare resources is through
a dual system of private philanthropic giving and governmental allocation.

Types of contributions may vary substantially among income classes.
Contributions to religious organizations are far more concentrated at the lower
end of the income scale than are contributions to health organizations, the
arts, and educational institutions, with contributions to other types of
organizations falling between these levels. However, the volume of donations
to religious organizations is greater than to all other organizations as a group.
In 2005, the American Association of Fund-Raising Counsel Trust for
Philanthropy, Inc. (AAFRC) estimated that contributions to religious
institutions amounted to 45 percent of all contributions ($93.2 billion), while
contributions to health care providers and associations amounted to less than
21 percent ($22.5 billion).

Using current dollars, AAFRC reported giving to health increased by 4.8
percent in 2000, declined in 2001 and 2002, rose by 8.2 percent in 2003, 5.1
percent in 2004, and 2.7 percent in 2005.

There has been a debate concerning the amount of charity care being
provided by health care organizations with tax-exempt status. In the 109th
Congress, hearings were held by both the Senate Committee on Finance and
the House Committee on Ways and Means to examine the charitable status of
nonprofit health care organizations. Those who support eliminating
charitable deductions note that deductible contributions are made partly with
dollars which are public funds. They feel that helping out private charities
may not be the optimal way to spend government money.

Selected Bibliography

Aprill, Ellen P. "Churches, Politics, and the Charitable Contribution
Deduction," Boston College Law Review, v. 42 (July 2001), pp. 843-873.
Bennett, James T. and Thomas J. DiLorenzo. Unhealthy Charities:
Hazardous to Your Health and Wealth, New York: Basic Books, c. 1994.
-. "What's Happening to Your Health Charity Donations?," Consumers'
Research, v. 77 (December 1994), pp. 10-15.
-. "Voluntarism and Health Care," Society, v. 31 (July-August 1994), pp.
57-65.
Bloche, M. Gregg. "Health Policy Below the Waterline; Medical Care and
the Charitable Exemption." Minnesota Law Review, v. 80 (December 1995),
pp. 299-405.
Giving USA 2006, The Annual Report on Philanthropy for the Year 2005,
The Center on Philanthropy At Indiana University. Indiana University-
Purdue University, Indianapolis: 2006.
Buckles, Johnny Rex. "The Case for the Taxpaying Good Samaritan:
Deducting Earmarked Transfers to Charity Under Federal Income Tax Law,
Theory and Policy," Fordham Law Review, v. 70 (March 2002), pp. 1243-
1339.
Burns, Jack. "Are Nonprofit Hospitals Really Charitable?: Taking the
Question to the State and Local Level," Journal of Corporation Law, v.29,
no. 3, pp. 665-681.
Clark, Robert Charles. "Does the Nonprofit Form Fit the Hospital
Industry?" Harvard Law Review, v. 93 (May 1980), pp. 1419-1489.
Clotfelter, Charles T. "The Impact of Tax Reform on Charitable Giving:
A 1989 Perspective." In Do Taxes Matter? The Impact of the Tax Reform
Act of 1986, edited by Joel Slemrod, Cambridge, Mass.: MIT Press, 1990.
-. "The Impact of Fundamental Tax Reform on Non Profit Organizations."
In Economic Effects of Fundamental Tax Reform, Eds. Henry J. Aaron and
William G. Gale. Washington, DC: Brookings Institution, 1996.
Colombo, John D. "The Marketing of Philanthropy and the Charitable
Contributions Deduction: Integrating Theories for the Deduction and Tax
Exemption," Wake Forest Law Review, v. 36 (Fall 2001), pp. 657-703.
Crimm, Nina J. "An Explanation of the Federal Income Tax Exemption
for Charitable Organizations: A Theory of Risk Compensation," Florida Law
Review, v. 50 (July 1998), pp. 419-462.

Feenberg, Daniel. "Are Tax Price Models Really Identified: The Case of
Charitable Giving," National Tax Journal, v. 40, no. 4 (December 1987), pp.
629-633.
Feldman, Naomi and James Hines, Jr. "Tax Credits and Charitable
Contributions in Michigan," University of Michigan, Working Paper, October
2003.
Fisher, Linda A. "Donor-Advised Funds: The Alternative to Private
Foundations," Cleveland Bar Journal, v. 72 (July/Aug. 2001), pp. 16-17.
Frank, Richard G., and David S. Salkever. "Nonprofit Organizations in the
Health Sector." Journal of Economic Perspectives, v. 8 (Fall 1994), pp. 129-
144.
Gentry, William M. and John R. Penrod. "The Tax Benefits of Not-For-
Profit Hospitals," National Bureau of Economic Research Working Paper
Series, w6435, February 1998, pp. 1-58.
Gravelle, Jane. Economic Analysis of the Charitable Contribution
Deduction for Nonitemizers, Library of Congress, Congressional Research
Service Report RL31108, April 29, 2005.
Green, Pamela and Robert McClelland. "Taxes and Charitable Giving,"
National Tax Journal, v. 54 (Sept. 2001), pp. 433-450.
Greenwald, Leslie, Jerry Cromwell, Walter Adamache, Shulamit Bernard,
et al. "Specialty Versus Community Hospitals: Referrals, Quality, And
Community Benefits,"Health Affairs; v. 25, Jan/Feb 2006, pp. 106-119.
Griffith, Gerald M. "What the IRS is Examining in CEP Audits of Health
Care Organizations," Journal of Taxation of Exempt Organizations, v. 11
(March/April 2000), pp. 201-212.
Hall, Mark A. and John D. Colombo. "The Charitable Status of Nonprofit
Hospitals: Toward a Donative Theory of Tax Exemption," Washington Law
Review, v. 66 (April 1991), pp. 307-411.
Horwitz, Jill R., "Making Profits And Providing Care: Comparing
Nonprofit, For-Profit, And Government Hospitals," Health Affairs, v. 24,
May/June 2005, pp.790-801.
- ,"Why We Need the Independent Sector: The Behavior, Law, and Ethics
of Not-For-Profit Hospitals," University of Michigan Public Law and Legal
Theory Research Paper No. 35, August 2003, pp. 1345-1411.
Hyman, David A. "The Conundrum of Charitability: Reassessing Tax
Exemption for Hospitals," American Journal of Law and Medicine, v. 16,
(1990), pp. 327-380.
Jacobson, Rachel. "The Car Donation Program: Regulating Charities and
For-Profits," The Exempt Organization Tax Review, v. 45, August 2004, pp.
213-229.
Jones, Darryll K. "When Charity Aids Tax Shelters," Florida Tax Review,
v. 4 (2001), pp. 770-830.
Joulfaian, David and Mark Rider. "Errors-In-Variables and Estimated
Income and Price Elasticities of Charitable Giving," National Tax Journal, v.
57 (March 2004), pp. 25-43.
Kahn, Jefferey H. "Personal Deductions: A Tax "Ideal" or Just Another
"Deal"?," Law Review of Michigan State University, v. 2002 (Spring 2002),
pp. 1-55.

Morrisey, Michael A., Gerald J. Wedig, and Mahmud Hassan. "Do
Nonprofit Hospitals Pay Their Way?" Health Affairs, v. 15 (Winter 1996),
pp. 132-144.
Omer, Thomas C. "Near Zero Taxable Income Reporting by Nonprofit
Organizations," Journal of American Taxation Association, v. 25 (Fall 2003),
pp. 19-34.
Owens, Bramer. "The Plight of the Not-for-Profit," Journal of Healthcare
Management, v. 50, July/August 2005, pp. 237-251.
Randolph, William C. "Dynamic Income, Progressive Taxes, and the
Timing of Charitable Contributions," Journal of Political Economy, v. 103
(August 1995), pp. 709-738.
-. "Charitable Deductions," in The Encyclopedia of Taxation and Tax
Policy, eds. Joseph J. Cordes, Robert D. Ebel, and Jane G. Gravelle.
Washington, DC: Urban Institute Press, 1999, pp. 52-54.
Sanders, Susan M., "Measuring Charitable Contributions: Implications for
the Nonprofit Hospital's Tax-exempt Status," Hospital and Health Services
Administration, v. 38 (Fall 1993), pp. 401-418.
Smith, Bernard. "Charitable Contributions: A Tax Primer," Cleveland Bar
Journal, v. 72 (November 2000), pp. 8-11.
Stokeld, Fred, "ETI Repeal Bill Would Tighten Rules on Vehicle, Patent
Donations," Tax Notes, October 18, 2004, pp. 293-294.
Teitell, Conrad. "Tax Primer on Charitable Giving," Trust & Estates, v.
139, (June 2000), pp. 7-16.
Tiehen, Laura. "Tax Policy and Charitable Contributions of Money,"
National Tax Journal, v. 54 (December 2001), pp. 707-723.
Tobin, Philip T. "Donor Advised Funds: A Value-Added Tool for
Financial Advisors," Journal of Practical Estate Planning, v. 3
(October/November 2001), pp. 26-35, 52.
U.S. Congress, Congressional Budget Office. Budget Options. See
Rev-12, Limit Deductions for Charitable Giving to the Amount Exceeding 2
Percent of Adjusted Gross Income. Washington, DC: Government Printing
Office (February 2005), p 281.
U.S. Congress, Government Accountability Office. Vehicle Donations:
Benefits to Charities and Donors, but Limited Program Oversight, GAO
Report GAO-04-73, Washington, DC: U.S. Government Printing Office
(November 2003), pp. 1-44.
- . Vehicle Donations: Taxpayer Considerations When Donating Vehicles
to Charities, GAO Report GAO-03-608T, Washington, DC: U.S.
Government Printing Office (April 2003), pp. 1-15.
- . Nonprofit Hospitals: Better Standards Needed for Tax Exemption.
Washington, DC: U.S. Government Printing Office (May 1990).
U.S. Congress, House Select Committee on Aging. Hospital Charity Care
and Tax Exempt Status: Resorting the Commitment and Fairness.
Washington, DC: U.S. Government Printing Office (June 1990).
- , Joint Committee on Taxation, Present Law and Background Relating to
the Tax-Exempt Status of Charitable Hospitals, JCX-40-06, Washington, DC:
U.S. Government Printing Office (September 2006), pp. 1-29.

__ , Technical Explanation Of H.R. 4, The "Pension Protection Act Of
2006," as Passed by the House on July 28, 2006, and as Considered by the
Senate on August 3, 2006, JCX-38-06, Washington, DC: U.S. Government
Printing Office (August 3, 2006), pp. 1-386.
- . Staff Discussion Draft: Proposals for Reforms and Best Practices in
the Area of Tax-Exempt Organizations, Washington, DC: U.S. Government
Printing Office (June 22, 2004), pp. 1-19.
U.S. Department of Treasury. "Charitable Giving Problems and Best
Practices," testimony given by Mark Everson, Commissioner of Internal
Revenue, Internal Revenue Service, IR-2004-81, Washington, DC: U.S.
Government Printing Office (June 22, 2004), pp. 1-17.
U.S. Government Accountability Office, Nonprofit, For-profit, and
Government Hospitals: Uncompensated Care and Other Community
Benefits, testimony of David M. Walker before the Committee on Ways and
Means, House of Representatives, GAO-05-743T, Washington, DC: U.S.
Government Printing Office (May 26, 2005), pp. 1-32.
Wittenbach, James L. and Ken Milani. "Charting the Interacting
Provisions of the Charitable Contributions Deductions for Individuals,"
Taxation of Exempts, v. 13 (July/August 2001), pp. 9-22.
- , "Charting the Provisions of the Charitable Contribution Deduction for
Corporations," Taxation of Exempts, v. 13 (November/December 2001), pp.
125-130.
Yetman, Michelle H. and Robert J. Yetman. "The Effect of Nonprofits'
Taxable Activities on the Supply of Private Donations," National Tax
Journal, v. 56 (March 2003), pp. 243-258.
Zimmerman, Dennis. "Nonprofit Organizations, Social Benefits, and Tax
Policy," National Tax Journal, v. 44 (September 1991), pp. 341-349.

Health

TAX CREDIT FOR ORPHAN DRUG RESEARCH

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.2

2007

0.3

2008

0.3

2009

0.3

2010

0.3

Authorization

Sections 41(b), 45C, and 280C.

Description

Business taxpayers may claim a tax credit equal to 50 percent of certain
clinical testing expenses they incur in developing drugs to treat rare diseases
or conditions. These drugs are often referred to as orphan drugs. To qualify
for the credit, the clinical testing expenses must be incurred or paid after an
orphan drug has been approved for human testing by the Food and Drug
Administration (FDA) but before the FDA has approved it for sale in the
United States. Under section 526 of the Federal Food, Drug, and Cosmetic
Act, a rare disease or condition is defined as one affecting fewer than 200,000
persons in the United States, or as one that may affect more than 200,000
persons, but for which there is no reasonable expectation of recovering
research and development costs from U.S. sales alone. The credit has been a
component of the general business credit since 1997, making it subject to its
limitations and carryback and carryforward rules. As a result, orphan drug
credits that cannot be used because they exceed the limitations in a tax year
may be carried back up to three years and forward up to 15 years.

Not all expenses incurred in connection with clinical trials for orphan drugs
qualify for the credit. Specifically, while the cost of supplies and salaries
does qualify, the cost of depreciable property does not. Expenses that qualify
for the orphan drug research credit may not also be used to claim the research
tax credit under section 41. What is more, qualified testing expenses
generally may be deducted in the year when they are incurred or paid as
qualified research expenditures under section 174. If a business taxpayer
claims the orphan drug tax credit, it must reduce any deduction for these
expenditures it claims by the amount of the credit.

Impact

The orphan drug tax credit reduces the cost of capital for private
investment in orphan drug development and increases the cash flow in the
short run of firms making such investments. Most of these benefits are
captured by pharmaceutical firms, which account for about 80 percent of all
claims for the credit.

In the long run, the burden of the corporate income tax (and any benefits
generated by reductions in the burden) probably extends beyond corporate
stockholders to owners of capital in general.

To the extent that the credit accelerates the development for orphan drugs,
it also benefits persons suffering from rare diseases. According to FDA's
Office of Orphan Products Development, more than 280 orphan drugs and
biological products have received regulatory approval for marketing in the
United States since the passage of the Orphan Drug Act of 1983; by contrast,
only 10 such medicines were approved in the decade before 1983. An
estimated 14 million Americans have been treated by the orphan drugs
developed since 1983.

Rationale

The orphan drug tax credit first entered the federal tax code through the
Orphan Drug Act of 1983. Its main purpose was to provide a robust incentive
for firms to invest in the development of drugs for diseases that were so rare
there was little realistic chance of recovering development costs without
federal support. The act established two other forms of government support
for orphan drugs: federal grants for the testing of drugs, and a seven-year
period of marketing exclusivity for orphan drugs approved by the FDA.
Under the act, the only test for determining a drug's eligibility was that there
be no reasonable expectation of recovering its cost of development from U.S.
sales alone.

This test soon proved unworkable, as it required business taxpayers to
provide detailed proof that a drug in development would end up being
unprofitable. So in 1984, Congress passed Public Law 98-551, which added
another eligibility test: namely, that the potential domestic market for a drug
not exceed 200,000 persons.

The initial tax credit was scheduled to expire at the end of 1987, but it was
extended in succession by the Tax Reform Act of 1986, the Omnibus Budget
Reconciliation Act of 1990, the Tax Extension Act of 1991, and the Omnibus
Reconciliation Act of 1993. The credit expired at the end of 1994 but was
reinstated for the period July 1, 1996, through May 31, 1997 by the Small
Business Job Protection Act of 1996, which also allowed taxpayers with
unused credits to carry them back up to three tax years or carry them forward
up to 15 tax years. The credit became a permanent part of the Internal
Revenue Code with the passage of the Taxpayer Relief Act of 1997.

To increase U.S. investment in the development of diagnostics and
treatments for patients with rare diseases and disorders, Congress passed the
Rare Diseases Act of 2002. Among other things, the act established an Office
of Rare Diseases at the National Institutes of Health and authorized increases
in annual funding from FY2003 through FY2006.

Assessment

Supporters of the Orphan Drug Act cite the fact that over 280 orphan drugs
have been approved for marketing since the passage of the act, and that over
14 million Americans have been treated with them, as conclusive proof that
the act's incentives are working as intended.

But not everyone takes such a rosy view of the act. Some critics charge
that more than a few pharmaceutical and biotechnology firms have taken
advantage of the incentives for orphan drug development to develop and
market drugs that have earned billions in sales revenue worldwide since their
approval by the FDA. In 2003, for example, a total of nine such drugs each
had worldwide sales in excess of $1 billion. These critics argue that many of
the highly profitable orphan drugs that have entered the market since 1983
would have been developed without government support. Supporters of the
act dismiss this argument by noting that it is impossible to know in advance
whether a drug intended to treat a very small population will eventually gain
blockbuster status.

Others have criticized the design of the Orphan Drug Act's incentives
without calling into question the need for government support. For example,
some argue that current regulations for orphan drugs permit firms to classify
drugs with multiple uses as being useful for a narrow range of applications
only, making it easier for the drugs to qualify as orphans.

The orphan drug tax credit encourages private investment in the
development of drugs to treat rare diseases. While some find this effect
laudable, others view it as problematic. For the latter, the credit raises the
question of whether it is appropriate or desirable for federal tax policy to
divert economic resources from the development of drugs that may benefit a
multitude of persons to the development of drugs that benefit relatively few,
albeit with dramatic results in some cases.

Selected Bibliography

Asbury, Carolyn H. "The Orphan Drug Act: the First 7 Years," Journal of
the American Medical Association, v. 265. February 20, 1991, pp. 893-897.
Biotechnology Industry Organization. Clarification Needed in the Orphan
Drug Tax Credit to Accelerate Research in Rare Diseases. Washington:
April 11, 2003.
Edgerly, Maureen. "Regulatory: Orphan Drug Regulation," Research
Practitioner, v. 3 (Jan.-Feb. 2002), pp. 21-23.
Flynn, John J. "The Orphan Drug Act: An Unconstitutional Exercise of
the Patent Power," Utah Law Review, no. 2 (1992), pp. 389-447.
Guenther, Gary. Federal Taxation of the Pharmaceutical Industry: Effects
on New Drug Development and Legislative Initiatives in the 109th Congress.
Congressional Research Service Report RL31511. Washington: June 1,
2005.
Haffner, Marlene E. "Orphan Products-Ten Years Later and Then Some,"
Food and Drug Law Journal, v. 49 (1994), pp. 593-601.
-. "Adopting Orphan Drugs: Two Dozen Years of Treating Rare
Diseases." New England Journal of Medicine, vol. 354, no. 5, February 2,
2006, p. 445.
Hamilton, Robert A. "'Orphans' Saving Lives," FDA Consumer, v. 24
(November 1990), pp. 7-10.
Henkel, John. "Orphan Products - New Hope for People with Rare
Disorders," FDA Consumer, 2nd. Ed. (1995), pp. 46-49.
Kiely, Tom. "Spoiled by Success? Biotechnology Companies Abused the
Intent of the Orphan Drug Act," Technology Review, v. 94, no. 3, (April
1991), pp. 17-18.
Lang, Jean and Susan C. Wood. "Development of Orphan Vaccines: An
Industry Perspective," Emerging Infectious Diseases, v. 5 (Nov.-Dec. 1999),
pp. 749-756.
Levitt, Joseph A. and John V. Kelsey. "The Orphan Drug Regulations and
Related Issues," Food and Drug Law Journal, v. 48 (1993), pp. 525-535.
Love, James and Michael Palmedo. Costs of Human Use Clinical Trials:
Surprising Evidence from the US Orphan Drug Act. Consumer Project on
Technology. November 28, 2001, available at http://www.cptech.org.
Shulman, Shelia R., Brigitta Bienz-Tadmor, Pheak Son Seo, Joseph A.
DiMasi, and Louis Lasagna. "Implementation of the Orphan Drug Act:
1983-1991," Food and Drug Law Journal, v. 47 (1992), pp. 363-403.

Thamer, Mae, Niall Brennan, and Rafael Semansky. "A Cross-National
Comparison of Orphan Drug Policies: Implications for the U.S. Orphan Drug
Act," Journal of Health Politics, Policy and Law, v. 23 (April 1998), pp.
265-290.
Thomas, Cynthia A. "Re-Assessing the Orphan Drug Act," Columbia
Journal of Law and Social Problems, v. 23, No. 3. 1990, pp. 413-440.
Treinish, Nathan J. "Developing Drugs for Tropical Diseases Rare in the
United States: A Case Study on African Sleeping Sickness," Food and Drug
Law Journal, v. 48 (1993), pp. 533-535.
U.S. Department of Health and Human Services, Public Health Service,
Food and Drug Administration. From Test Tube to Patient: New Drug
Development in the United States, Rockville, MD: 1995. 67 p.

Health

TAX CREDIT FOR PURCHASE OF HEALTH INSURANCE
BY CERTAIN DISPLACED PERSONS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.2

2007

0.2

2008

0.2

2009

0.2

2010

0.3

Authorization

Section 35.

Description

Eligible taxpayers are allowed a refundable tax credit for 65
percent of the premiums they pay for qualified health insurance for
themselves and family members. The credit is now known as the
health coverage tax credit (HCTC). Eligibility is limited to three
groups: (1) individuals who are receiving a Trade Readjustment
Assistance (TRA) allowance, or who would be except their state
unemployment benefits are not yet exhausted; (2) individuals who are
receiving an Alternative Trade Adjustment Assistance allowance for
people age 50 and over; and (3) individuals who are receiving a
pension paid in part by the Pension Benefit Guaranty Corporation
(PBGC), or who received a lump-sum PBGC payment, and are age
55 and over. For TRA recipients, eligibility for the HCTC generally
does not extend beyond two years, the maximum length of time most
can receive TRA allowances or benefits, and could be less in some
states.

The HCTC is not available to individuals who are covered under
insurance for which an employer or former employer pays 50
percent or more of the cost, who are entitled to benefits under
Medicare part A or an armed services health plan, or who are
enrolled in Medicare part B, Medicaid, the State Children's Health
Insurance Program (SCHIP), or the federal employees health plan.
The Treasury Department makes advance payments of the credit to
insurers for eligible taxpayers who choose this option.

The HCTC can be claimed only for ten types of insurance specified
in the statute. Seven require state action to become effective,
including coverage through a state high risk pool, coverage under a
plan offered to state employees, and, in some limited circumstances,
coverage under individual market insurance. As of October, 2006,
42 states and the District of Columbia made at least one of the seven
types of coverage available; in the remaining 8 states, only three
automatically qualified types not requiring state action were
available, though not necessarily to all individuals eligible for the
credit. For example, COBRA continuation coverage is available in
all states, but it applies only if the taxpayer had employment-based
insurance prior to losing his job and the employer continues to
provide the insurance to the remaining employed workers.

Impact

The HCTC substantially reduces the after-tax cost of health
insurance for eligible individuals and has enabled some to maintain or
acquire coverage. However, given the cost of health insurance,
which in 2006 approached $4,300 a year for typical comprehensive
single coverage and $11,500 a year for typical comprehensive family
coverage, a 65 percent credit has often not been sufficient to ensure
coverage for workers who are unemployed for extended periods (in
the case of TRA recipients) or who are early retirees (in the case of
those receiving pensions paid by the PBGC). For these workers,
paying the remaining 35 percent of the cost of the insurance can be
difficult. Sometimes cash-constrained individuals reassess their need
for insurance altogether, particularly if they are young and single. In
addition to not being able to afford the remaining 35% of the cost,
taxpayers have had difficulty learning about eligibility, finding
qualifying insurance, and quickly arranging for advance payments.

According to the Treasury Department Inspector General, during
2005 approximately 22,000 taxpayers participated in the advance
payment arrangements while some 2,200 claimed the credit on their
tax returns after the end of the year. (The two groups might not be
mutually exclusive.)

Rationale

The HCTC was authorized by the Trade Act of 2002 (P.L.
107-210). One impetus for the legislation was to assist workers who
had lost their jobs, and consequently their health insurance coverage,
due to economic dislocations in the wake of the September 11, 2001
terrorist attacks. Difficulties in reaching consensus on who should be
included in this group contributed to the decision to restrict eligibility
for the credit primarily to workers adversely affected by international
trade (e.g., imported goods contributed importantly to their
unemployment, or their companies shifted production to other
countries). Extension to taxpayers receiving pensions paid by the
PBGC occurred late in the legislative process.

By adopting a tax credit, Congress signaled its intention to help
individuals maintain or acquire private market health insurance
rather than expand public insurance programs like Medicaid or
SCHIP. Both proponents and opponents see the credit as a
legislative precedent for a broader tax credit that may become the
principal strategy for reducing the number of uninsured, who by one
measure now exceed 45 million. Thus, the rationale for the credit
may lie more in what it indicates for future policy than in what it
presently accomplishes.

Assessment

Tax credits for health insurance can be assessed by their
effectiveness in continuing and expanding coverage, particularly for
those who would otherwise be uninsured, as well as from the
standpoint of equity. The HCTC is helping some unemployed and
retired workers keep their insurance, at least temporarily; the impact
may be greatest in the case of individuals who most need insurance
(those with chronic medical conditions, for example) and who have
the ability to pay the 35% of the cost not covered by the credit. For
many eligible taxpayers, the effectiveness of the credit may depend
on the advance payment arrangements; these might work well where
there is a concentration of eligible taxpayers (where a plant is closed,
for example) and if the certification process is simple and not
perceived as part of the welfare system.

The HCTC has not reached many of the people it was intended to
benefit. According to estimates by Stan Dorn and others of the
Economic and Social Research Institute, in July, 2005 there were
about 234,000 eligible workers and retirees, of whom about
118,000 did not have disqualifying coverage from another source
(through a spouse, for example). They estimated that at most
25,500 taxpayers might receive the credit (a higher number than the
later Treasury estimate cited above), or about 11% of all the eligibles
and 22% of all eligibles without other coverage. Considering the
administrative cost of establishing and implementing the HCTC
program (estimated by the GAO as $69 million through April, 2004,
and $40 million a year thereafter), one might ask whether the HCTC
costs exceed the benefits.

The 65% HCTC rate is available to all eligible taxpayers with
qualified insurance, regardless of income. From the standpoint of
inclusiveness, this seems equitable. Using ability to pay as a measure,
however, the one rate appears inequitable since it provides the same
dollar subsidy to taxpayers regardless of income. An unemployed
taxpayer with an employed spouse, for example, can receive the
same credit amount as a taxpayer in a household where no one
works. At the same time, the credit is refundable, so it is not limited
to the taxpayer's regular tax liability.

The 65% rate approaches the proportion of insurance typically
paid by employers; from this perspective, the HCTC continues what
employers would be paying if the workers had not lost their jobs.
However, employers can claim a tax deduction for their insurance
expense and likely shift most of their after-tax cost back to the
workers in the form of reduced wages and other benefits. By an
economic measure, employer subsidies for health insurance probably
are far less than 65%. But if a 65% tax credit provides a more
generous subsidy than employers, it apparently is still not high
enough to help many cash-constrained families purchase insurance.

The HCTC is limited to taxpayers in one of the three eligibility
groups described above, who likely consider it appropriate to receive
tax benefits for health insurance since most other taxpayers receive
some as well. However, unemployed workers who do not receive
TRA allowances or benefits may question why they are denied the
credit, as may early retirees whose pensions are not paid by the
PBGC, or who receive no pension at all.

The present tax credit is available to families that have individual
market insurance only in limited circumstances. (If they do not
purchase such insurance through a state qualified plan, they must
have had it during the entire 30-day period prior to the separation
from employment that qualified the worker for the TAA or PBGC
assistance. ) Some observers criticize these restrictions for limiting
consumer choice; they argue that younger and healthier families
could find less expensive individual coverage than what they must pay
for group plans. Others see the restriction as helping to preserve
larger insurance pools, which help keep rates down for older and less
healthy individuals.

Some observers also criticize the requirements that state-operated
health plans must meet in order to be considered qualified insurance
for purpose of the credit, including guaranteed issue, no preexisting
condition exclusions, nondiscriminatory premiums, and similar
benefit packages. In their view, these requirements drive up the cost
of insurance and lead some to forego coverage altogether. Other
observers, however, maintain that these requirements are essential
consumer protections.

Selected Bibliography

Gabel, Jon R. et al. Are Tax Credits Alone the Solution to
Affordable Health Insurance? Comparing Individual and Group
Insurance Costs in 17 U.S. Markets. Task Force on the Future of
Health Insurance. The Commonwealth Fund. (May, 2002).
Dorn, Stan, Janet Varon, and Fouad Pervez, Limited Take-Up of
Health Coverage Tax Credits and the Design of Future Tax Credits
for the Uninsured. Economic and Social Research Institute.
(November, 2005)

Graney, Paul J. Trade Adjustment Assistance for Workers: A Fact
Sheet. Library of Congress, Congressional Research Service Report
94-478 EPW, Updated periodically.
Institute for Health Policy Solutions. Individual Tax Credits and
Employer Coverage: Assessing and Reducing the Downside Risks.
(August, 2002).
Kaiser Family Foundation. Retired Steelworkers and Their Health
Benefits: Results from a 2004 Survey. (May, 2006).
Lyke, Bob. Tax Benefits for Health Insurance. Library of
Congress, Congressional Research Service Issue Brief 98037.
Updated regularly.
Pauly, Mark, and John Hoff. Responsible Tax Credits for Health
Insurance. The AEI Press (2002).
Pauly, Mark, and Paul Hogan. Expanding Coverage via Tax
Credits: Trade-Offs and Outcomes. Health Affairs. v. 20 no. 1
((January/February, 2001), pp. 9-26.
Stone-Axelrad, Julie and Bob Lyke. Health Coverage Tax Credit
Authorized by the Trade Act. Library of Congress, Congressional
Research Service Report RL32620. (October, 2004).
U.S. Government Accountability Office. Health Coverage Tax
Credit: Simplified and More Timely Enrollment Process Could
Increase Participation. GAO-04-1029. (September, 2004).
----- Trade Adjustment Assistance: Most Workers in Five Layoffs
Received Services, but Better Outreach Needed on New Benefits.
GAO-06-43 (January, 2006)
U.S. Internal Revenue Service. Information about the Health
Coverage Tax Credit is available through the IRS website
http://www.irs.gov/individuals/article/0,,id=109915,00.html.
U.S. Treasury Inspector General for Tax Administration.
Financial Controls Over the Health Coverage Tax Credit Advance
Payment Process Need to be Enhanced. Reference no. 2006-10-
085 (May, 2006).

Medicare

EXCLUSION OF UNTAXED MEDICARE BENEFITS:
HOSPITAL INSURANCE

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

18.5

2007

20.7

2008

22.5

2009

24.5

2010

26.7

Authorization

Rev. Rul. 70-341, 1970-2 C.B. 31.

Description

The Medicare program has main three components: A, B, and D. In
essence, part A offers hospital insurance (HI). More specifically, it helps pay
for most in-patient hospital care and up to 100 days a year of skilled nursing
facility care, home health care, and hospice care for individuals who are age
65 or over or disabled. In 2005, an estimated 42 million aged and disabled
persons were enrolled in Part A, and expenditures for Part A benefits totaled
an estimated $182.9 billion.

Medicare Part A is financed primarily by a payroll tax levied on the
earnings of current workers. The tax rate is 2.90 percent, and there is no
ceiling on the earnings subject to the tax. Self-employed individuals pay the
full rate, while employees and employers each pay 1.45 percent. The revenue
from the tax is placed in a trust fund, from which payments are made to health
care providers. Such a financing scheme is intended to make it possible for
individuals to contribute to the fund during their working years so that they
can receive Part A benefits during their retirement years.

The employer's share of the payroll tax is excluded from an employee's
taxable income. In addition, the expected lifetime value of Part A benefits
under current law exceeds the amount of payroll tax contributions by current
beneficiaries. The projected excess benefits are excluded from the taxable
income of Medicare Part A beneficiaries.

Impact

All Medicare Part A beneficiaries are assumed to receive the same dollar
value of in-kind insurance benefits per year. Nonetheless, there is substantial
variation among individuals in the portion of those benefits covered by their
payroll tax contributions - or the portion considered untaxed benefits.

The portion of benefits received by a Medicare beneficiary that is
considered untaxed depends on an individuals's history of taxable earnings
and life expectancy when benefits are received. Untaxed benefits are likely to
be larger for persons who became eligible in the earliest years of the Medicare
program, for persons who had low taxable wages in their working years or
who qualified as a spouse with little or no payroll contributions of their own,
and for persons who have a relatively long life expectancy. Beyond these
considerations, the tax expenditure arising from any dollar of untaxed
insurance benefits depends on a beneficiary's marginal income tax rate during
retirement.

Rationale

The exclusion of Medicare Part A benefits from the federal income tax has
never been established or endorsed by statute. Although the Medicare
program was created in 1965, it was not until 1970 when the Internal
Revenue Service ruled (Rev. Rul. 70-341) that the benefits under Part A of
Medicare may be excluded from gross income because they are in the nature
of disbursements intended to achieve the social welfare objectives of the
Federal Government. The ruling also made clear that in determining an
individual's gross income under section 61 of the Internal Revenue Code,
Medicare Part A benefits had the same legal status as the monthly Social
Security payments to an individual. An earlier IRS ruling (Rev. Rul. 70-217,
1970-1 C.B. 13) allowed these payments to be excluded from gross income.

Assessment

In effect, the tax subsidy for Part A benefits lowers the after-tax cost to the
elderly for the hospital care they receive under Medicare. Consequently, it is
thought to divert more resources to the delivery of medical care through
hospitals than otherwise might be the case.

Those who favor curtailing this subsidy, as a means of increasing federal
revenue or dampening the use of hospitals by the elderly, would find it
difficult to so in an equitable manner. There are at least two reasons for this
difficulty. First, Medicare benefits receive the same tax treatment as most
other health insurance benefits: they are untaxed. Second, taxing the value of
the health care benefits actually received by an individual would have a
disproportionately large impact on people who suffer health problems that are
costly to treat, many of whom are elderly and living on relatively small
incomes.

Under the Omnibus Budget Reconciliation Act of 1993 (OBRA93), some
of the Social Security payments received by taxpayers whose so-called
provisional income exceeds certain income thresholds is subject to taxation,
and the revenue is deposited in the HI trust fund. A taxpayer's provisional
income is his or her adjusted gross income, plus 50 percent of any Social
Security benefit and the interest received from tax-exempt bonds. If a
taxpayer's provisional income falls between income thresholds of $25,000
($32,000 for a married couple filing jointly) and $34,000 ($44,000 for a
married couple), then the portion of Social Security benefits that are taxed is
the lesser of 50 percent of the benefits or 50 percent of provisional income
above the first threshold. If a taxpayer's provisional income is greater than
the second threshold, then the portion of Social Security benefits subject to
taxation is the lesser of 85 percent of the benefits or 85 percent of provisional
income above the second threshold, plus the smaller of $4,500 ($6,000 for
married couples) or 50 percent of benefits. (See the entry on the exclusion of
untaxed Social Security and railroad retirement benefits for more details).
The same rules apply to railroad retirement tier 1 benefits.

For future retirees, the share of HI benefits they receive beyond their
payroll tax contributions is likely to decrease gradually over time, as the
contribution period will cover more of their work years. In addition, the
absence of a cap on worker earnings subject to the Medicare HI payroll tax
means that today's high-wage earners will contribute more during their
working years and consequently receive a smaller (and possibly negative)
subsidy once they begin to receive Medicare Part A benefits.

Before 1991, the taxable earnings base for Medicare Part A was the same
as the earnings base for Social Security. But the Omnibus Budget
Reconciliation Act of 1990 (P.L. 101-508) drove a wedge between the two
bases by raising the annual cap on employee earnings subject to the Medicare
HI tax to $125,000 in 1991 and indexing it for inflation in succeeding years.
OBRA93 repealed the cap on wages and self-employment income subject to
the Medicare HI tax, as of January 1, 1994.

In adopting changes in the HI payroll tax in 1990 and 1993, Congress
chose a more progressive approach to financing the HI trust fund than the
chief alternative of raising HI payroll tax rates on the Social Security earnings
base.

Selected Bibliography

Bryant, Jeffrey J. "Medicare HI Tax Becomes a Factor in Planning for
Compensation and SE Income," The Journal of Taxation. January, 1995, pp.
32-34.
Christensen, Sandra. "The Subsidy Provided Under Medicare to Current
Enrollees," Journal of Health Politics, Policy, and Law, v. 17, no. 2.
Summer 1992, pp. 255-64.
Nuschler, Dawn. Social Security and Medicare Taxes and Premiums: Fact
Sheet. Library of Congress, Congressional Research Service Report 94-28,
Washington, DC: January 13, 2004.
O'Sullivan, Jennifer. Medicare: Financing the Part A Hospital Insurance
Program. Library of Congress, Congressional Research Service Report
RS20173, Washington, DC: May 3, 2006.
U.S. Congress, Congressional Budget Office. Budget Options.
Washington, DC: February 2001, p. 412.
-, House Committee on Ways and Means. 2004 Green Book. Committee
Print, 108th Congress, 2nd Session. Washington, DC: U.S. Govt. Print. Off.,
March 2004. pp. 2-1 to 2-155.
Wilensky, Gail R. "Bite-Sized Chinks of Health Care Reform--Where
Medicare Fits In," in Henry J. Aaron, The Problem That Won't Go Away.
Washington, DC: The Brookings Institution, 1996.

Medicare

EXCLUSION OF MEDICARE BENEFITS:
SUPPLEMENTARY MEDICAL INSURANCE

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

12.5

2007

14.2

2008

15.4

2009

16.7

2010

18.1

Authorization

Rev. Rul. 70-341, 1970-2 C.B. 31.

Description

The Medicare program currently has three main components: A, B, and C.
Part B of Medicare provides supplementary medical insurance (SMI).
Among the services covered under Part B are certain physician services,
outpatient hospital services, and durable medical equipment. In 2005, an
estimated 39.6 million aged and disabled Americans were enrolled in SMI,
and expenditures for SMI totaled $153.5 billion.

Unlike Part A of Medicare, participation in SMI is voluntary. Enrollees
must pay a monthly premium that varies over time; in 2006, it is $88.50. The
program generally pays for 80 percent of Medicare's fee schedule or other
approved amount once a beneficiary has met an annual deductible, which is
$124 in 2006. Premiums are permanently set to cover 25 percent of the
program's costs for most recipients; the remaining 75 percent is funded out of
general revenues. Starting in 2007, certain high-income Medicare enrollees
will pay higher percentages of their Part B premiums.

Transfers from the general fund of the U.S. Treasury to cover the cost of
covered services are excluded from the taxable income of enrollees.

Impact

The tax expenditure associated with this exclusion hinges on the marginal
tax rates of enrollees. Unlike many other tax expenditures (where the amount
of the subsidy can vary considerably among individual taxpayers), the
general-fund premium subsidy for SMI is the same for all enrollees. All
enrollees are assumed to receive the same dollar value of in-kind benefits and
hence are charged the same monthly premium. As a result, they receive the
same subsidy, which is measured as the difference between the value of
insurance benefits and the premium. Nonetheless, the tax savings from the
exclusion are greater for enrollees in higher tax brackets. Taxpayers who
claim the itemized deduction for medical expenses under section 213 may
include any Part B premiums they pay or have deducted from their monthly
Social Security benefits.

Rationale

The exclusion of Medicare benefits has never been expressly established or
endorsed by statute. Rather, it emerged from two related regulatory rulings by
the Internal Revenue Service (IRS).

In 1966, the Internal Revenue Service (IRS) ruled (Rev. Rul. 66-216) that
the premiums paid for coverage under Part B of Medicare may be deducted as
a qualified medical expense under section 213. But the ruling did not address
the tax treatment of the benefits received through Part B.

The IRS did address this issue four years later. In 1970, the agency ruled
(Rev. Rul. 70-341) that Medicare Part B benefits should be excluded from
taxable income on the grounds that they have the same status under the tax
code as "amounts received through accident and health insurance for personal
injuries or sickness." These amounts are excluded from taxable income under
section 104(a).

It is not clear from Rev. Rul. 70-341whether the exclusion of Part B
benefits applies to all such benefits, or only to the portion of benefits financed
out of premiums. Nevertheless, the exclusion has applied to all Part B
benefits (including the portion financed out of general revenues) received by a
taxpayer in the years since 1970. This tax treatment is supported by a line of
reasoning used by the IRS to justify the exclusion of Medicare Part A
benefits. In Rev. Rul. 70-341, the agency noted that the benefits received by
an individual under Part A are not "legally distinguishable from the monthly
payments to an individual under title II of the Social Security Act." The IRS
also noted that the agency had ruled in an earlier revenue ruling (Rev. Rul.
70-217) that monthly Social Security payments should not be included in the
gross income of recipients, because they are "made in furtherance of the
social welfare objectives of the Federal government." Thus, it followed, in
the view of the IRS, that the "basic medicare benefits received by (or on
behalf of) an individual under part A title XVIII of the Social Security Act are
not includible in the gross income of the individual for whom they are paid."

Assessment

Medicare benefits are similar to most other health insurance benefits in that
they are exempt from taxation.

Initially, Part B premiums were set to cover 50 percent of projected SMI
program costs. But between 1975 and 1983, that share gradually fell to less
than 25 percent. From 1984 through 1997, premiums were set to cover 25
percent of program costs for the aged under successive laws (an exact dollar
figure rather than a percentage applied over the 1991-1995 period). The
Balanced Budget Act of 1997 (P.L. 105-33) permanently made the Part B
premium equal to 25 percent of projected program costs.

The tax subsidy for Part B reduces the after-tax cost of supplementary
medical insurance to retirees. One possible result is that individuals end up
purchasing excessive or inefficient amounts of health care. Moreover, as the
subsidy is not means-tested, many high-income elderly individuals do benefit
from it.

Some have proposed adding the value of the subsidy to taxable income.
There appear to be no insurmountable administrative barriers to doing so.
The value of the subsidy could be estimated, assigned to beneficiaries, and
reported as income on their tax returns. One drawback to such a proposal is
that it would impose a burden on older individuals of moderate means who
have little flexibility in their budgets to absorb an additional tax.

Legislation to lower or eliminate the subsidy for high-income individuals
would have the same effect as taxing it. Several proposals introduced in
recent Congresses would effectively raise the Part B premiums for high-
income enrollees - in some cases, the increase would cover 100 percent of
average benefits per enrollee - by recapturing the subsidy through the
individual income tax. All revenues raised by taxing the subsidy would be
added to the Medicare SMI Trust Fund. An individual would be permitted to
deduct the recaptured amount to the same extent that is allowed with other
health insurance premiums. Any employer reimbursement of the recaptured
amount would be excluded from the recipient's taxable income.

Selected Bibliography

Christensen, Sandra. "The Subsidy Provided Under Medicare to Current
Enrollees," Journal of Health Politics, Policy, and Law, v. 17, no. 2. summer
1992, pp. 255-64.

O'Sullivan, Jennifer. Medicare: Part B Premiums. Library of Congress,
Congressional Research Service Report RL32582. Washington, DC: October
19, 2006.
U.S. Congress. Congressional Budget Office. Budget Options.
Washington, DC: February 2001, p. 412.
-, House Committee on Ways and Means. 2004 Green Book. Committee
Print, 108th Congress, 2nd Session. Washington, DC: U.S. Govt. Print. Off.,
March 2004. pp. 2-1 to 2-155.
Wilensky, Gail R. "Bite-Sized Chinks of Health Care Reform - Where
Medicare Fits In," in Henry J. Aaron, The Problem That Won't Go Away.
Washington, DC: The Brookings Institution, 1996.

Medicare

EXCLUSION OF SUBSIDY PAYMENTS TO EMPLOYERS
OFFERING CERTAIN PRESCRIPTION DRUG BENEFITS TO
RETIREES ELIGIBLE FOR MEDICARE

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.7

2007

1.2

2008

1.4

2009

1.5

2010

1.6

Authorization

Section 139A and Section 1860D-22 of the Social Security Act (42 U.S.C.
1395w-132)

Description

The Medicare program has three main elements: Parts A , B, and D. Part
D offers a voluntary outpatient prescription drug benefit that began on
January 1, 2006. Every individual enrolled in Medicare Parts A or B, or who
receives Medicare benefits through a private heath plan under Part C, is
eligible to take advantage of this benefit by enrolling in a qualified
prescription drug plan.

Under Part D, beneficiaries have the choice of purchasing standard drug
coverage or alternative coverage with actuarially equivalent benefits from any
approved plan. In 2006, standard coverage has the following elements: a
$250 deductible; 25-percent coinsurance for qualified drug expenses from
$251 to an initial coverage limit of $2,250; no coverage above this amount
until an annual out-of-pocket threshold of $3,600 is reached; then unlimited
coverage for expenses above $3,600, with enrollees paying the greater of $2
for generic drugs and $5 for branded drugs or a 5-percent coinsurance fee.
An enrollee's out-of-pocket spending on drugs counting toward the out-of-
pocket threshold does not include amounts paid or reimbursed by most third
parties, including retiree health plans. In future years, the deductible, initial
coverage limit, and the out-of-pocket threshold will be indexed to annual
growth in per-capita spending by Medicare beneficiaries on drugs covered
under Part D.

Coverage is obtained through private prescription drug plans or Medicare
comprehensive plans that integrate Part A and B benefits under a revised Part
C known as Medicare Advantage. Enrollees pay premiums that are intended
to cover 26 percent of the overall cost of drug benefits under Part D; in 2006,
the average premium is expected to be $35 a month. Substantial subsidies are
available to encourage extensive participation by low-income Medicare
beneficiaries, and to dissuade large numbers of public and private employers
and unions that offer prescription drug benefits to retirees from dropping or
sharply curtailing such coverage.

Public and private employers and unions providing prescription drug
benefits to retirees eligible for Medicare face several options under Part D, all
of which are intended to encourage them to retain or enhance these benefits.
First, they can elect to receive subsidy payments from Medicare, if the drug
benefits they offer to qualified retirees are actuarially equivalent to the
standard drug coverage under Part D. Second, they can coordinate their drug
benefits for retirees with the standard drug coverage under Part D by
supplementing the Medicare coverage. Third, they can enter into a contract
with an approved Medicare drug plan or a Medicare Advantage plan to
provide drug benefits to retirees. Finally, they can stop providing drug
benefits to retirees altogether, forcing those who are eligible for Medicare to
enroll in a Part D plan.

Public and private employers and unions that choose to receive the subsidy
payments must adhere to certain rules in order to remain eligible to receive
them. Under a ruling by the Centers for Medicaid and Medicare, so-called
account-based health plans (e.g., flexible spending accounts, health savings
accounts, and Archer medical savings accounts) do not qualify as creditable
coverage under this standard. A qualified retiree is an individual who is
eligible for coverage under part D but not enrolled in it, and who is covered
under an employment-based group health plan. The Secretary of Health and
Human Services (HHS) has the authority to audit the prescription drug
benefits offered to qualified retirees by employers or unions seeking or
receiving subsidy payments to determine whether they conform to this
standard. In addition, to continue to receive the payments, an employer or
union must provide HHS with annual proof that the prescription drug benefits
it provides Medicare-eligible retirees are actuarially equivalent to the standard
coverage under Part D.

In 2006, the subsidy payments are equal to 28 percent of a retiree's
allowable gross prescription drug costs between $250 to $5,000. These costs
are defined as the combined amounts paid by a qualified retiree and his or her
employer for prescription drugs covered under Part D, less rebates and
discounts. The maximum payment per retiree in 2006 is $1,330. In future
years, the upper limit will be indexed to annual growth in per-capita spending
by Medicare beneficiaries on prescription drugs covered under Part D.

Employers who choose to receive subsidy payments are allowed to exclude
them from their taxable income under both the regular income tax and the
alternative minimum tax. In addition, the allowable drug costs used to
determine the subsidy payments received by an employer may be included in
the employer's deduction for contributions to health and accident plans for
current and retired workers.

Impact

Generally, all sources of income are subject to taxation, except those
specifically excluded by statute. Section 61 identifies the sources of income
that are usually taxed, including employee compensation, capital gains,
interest, and dividends. Nonetheless, some sources of income are granted a
statutory exemption from taxation, including certain death benefits, interest
on state and local bonds, amounts received under employer accident and
health plans, certain other fringe benefits, and disaster relief payments.
Sections 101 to 140 identify those sources and explain their tax treatment.
The new Medicare subsidy payments for certain employers under section
139A are one of these sources. Their exclusion from taxable income is
considered a tax expenditure.

In combination, the subsidy and its preferential tax treatment significantly
reduce the after-tax cost to employers of providing prescription drug benefits
to retirees eligible for Medicare. The exclusion for the subsidy payments
means that they are equivalent to larger taxable payments tied to an
employer's marginal tax rate. For example, for employers taxed at a marginal
rate of 35 percent, a subsidy payment of $1,000 would be equivalent to a
taxable payment of $1,538: $1,000/(1-.35) = $1,538.

Rationale

In passing the Medicare Prescription Drug, Improvement, and
Modernization Act of 2003 (MMA, P.L. 108-173), Congress added a
voluntary outpatient prescription drug benefit to Medicare. Among other
things, the act allows Medicare to make subsidy payments beginning in 2006
to employers offering qualified prescription drug benefits to retirees eligible
for Medicare. The MMA also permits employers receiving such payments to
exclude them from taxable income and to disregard the payments in
determining their deductions for contributions to health and accident plans for
current employees and retirees.

In August 2005, the Internal Revenue Service announced (Rev. Rul. 2005-
60) that business taxpayers do not have to take into account any Medicare
Part D employer subsidy payments they receive in computing their minimum
cost requirements for the transfer of excess pension assets to retiree health
benefit accounts under section 420.

The tax exclusion for the subsidy payments means that the effective
subsidy rate over the range of qualified spending is 28 percent rather than
some lower rate. Any such lower rate would hinge on an employer's
marginal tax rate. For example, if an employer is taxed at a rate of 35 percent
and there were no exclusion for the subsidy payments, then its effective
subsidy rate would be 18.2 percent: .28 x (1-.35) = .182.

The subsidy payments and their preferential tax treatment are intended to
prevent a large number of employers that currently provide prescription drug
benefits to Medicare-eligible retirees from shifting them into the government
program. Supporters of the subsidy also maintain that it will end up saving
the federal government money, even after allowing for the subsidy payments,
while giving retirees better prescription drug coverage than they could obtain
through any of the Part D plans.

Assessment

The Medicare Part D prescription drug benefit went into effect against a
backdrop of eroding health benefits for retirees. According to a 2005 survey
of retiree health benefits jointly conducted by Hewitt Associates and the
Kaiser Family Foundation, the percentage of employers with 200 or more
employees offering health benefits to retirees fell from 66 percent in 1988 to
33 percent in 2005. What is more, in recent years, retirees receiving health
benefits from former employers have been forced to pay larger shares of the
premiums for those benefits, as well as higher co-payments and deductibles
for the health care they receive under employer plans. One of the key factors
driving this erosion has been a sustained double-digit increase in the cost to
employers of providing those benefits. In the congressional debate leading up
to the creation of the Part D drug benefit, a central concern was that the
advent of the benefit would accelerate the decline in retiree health benefits.
To allay this concern, the law establishing the new Medicare benefit included
a robust incentive for employers to continue to provide or enhance drug
benefits for their retirees.

The incentive comes in the form of subsidy payments for employers who
offer drug benefits to their retirees that are comparable to the standard drug
coverage under Part D, and the exclusion of these payments from the taxable
income of recipients. This tax treatment serves to enhance the value of the
new Medicare subsidy for employers that pay taxes. For example, assume
that an employer is taxed at a rate of 35 percent and receives part D subsidy
payments totaling $1,000 in 2006. Because of the exclusion, its after-tax cost
of prescription drug benefits for retirees falls by $1,000; but if the payments
were subject to taxation, this cost would fall by only $650.

While the exclusion boosts the value of the subsidy payments to recipients,
it also entails a revenue loss that adds to the total cost to the federal
government of the Part D employer subsidies. The extent of the revenue loss
in a particular year hinges on the number of employers that receive the
subsidy, their marginal tax rates, and the total amount of subsidy payments
they receive. In 2006, more than 4,400 public and private employers and
unions opted to receive subsidy payments covering about 6.5 million retirees.

The question of how many employers will opt for the subsidy payments in
the future has important implications for the welfare of retirees eligible for
Medicare, the financial health of larger employers, and the condition of the
federal budget.

It appears that most experts agree that the typical drug benefit available to
retirees through employer health plans is more generous than the standard
drug benefit available under Part D. Therefore, a marked decrease in the
number of employers claiming the subsidy payments in the next few years
could have an adverse effect on the welfare of their retirees. Such a decrease
might mean that many (or most) of these retirees would be forced to enroll in
a Part D prescription drug plan, whose coverage could be less generous than
the drug benefit they had through their employer health plans.

Large employers are much more likely than small or medium employers to
provide health benefits to retirees. Thus it comes as no surprise that many
large employers have viewed the Part D benefit as an unprecedented
opportunity to cut their spending on retiree health benefits, or to unburden
themselves entirely of the responsibility of providing such benefits.
According to a variety of surveys, around three-quarters of firms that were
eligible for the Part D subsidy payments at the outset of the program opted to
receive the payments in 2006. The remaining firms chose to supplement the
Medicare drug benefit through their own health plans, become a Part D drug
plan sponsor and shift all their retirees into the plan, or discontinue coverage
of prescription drugs for their retirees altogether. There are reasons to think
that the share of employers claiming the subsidy payments will shrink in the
next few years. As employers become more familiar with the options
available to them under Part D, they may see financial or administrative
advantages in following a course of action other than claiming the payments.
A survey of 163 employers conducted by Watson Wyatt Worldwide in June
2006 found that only 29% of them expect to claim the payments in the future.
Many of them showed a strong interest in giving their retirees incentives to
enroll in Medicare Advantage plans. In addition, according to a study
released by the Society of Actuaries in December 2005, the average employer
could more than double its expected cost savings from 2006 to 2021 by
dropping its current drug benefit for retirees and paying the premium for a
Part D drug plan to cover the same retirees, instead of retaining its current
drug benefit for retirees and receiving the subsidy payments.

A decline over time in the number of employers receiving the subsidy
payments could also lead to substantial increases in the cost to the federal
government of the Part D drug benefit. The Congressional Budget Office has
estimated that the net federal subsidy for drug benefits under part D will be
$1,211 per enrollee in 2006 for beneficiaries with no access to employer
health plans but $766 per enrollee for beneficiaries who receive qualified
drug benefits through employers that opt to receive the subsidy payments.

Selected Bibliography

Hewitt Associates and the Kaiser Family Foundation. Prospects for
Retiree Health Benefits as Medicare Prescription Drug Coverage Begins.
Washington, DC: December 2005.
Marchel, Richard and Kevin Dolsky. Estimated Impact of Medicare Part
D On Retiree Prescription Drug Costs. Actuarial & Health Care Solutions,
LLC, Mequon, WI: December 6, 2005.
Neuman, Patricia. The State of Retiree Health Benefits: Historical Trends
and Future Uncertainties. Prepared statement for a hearing of Senate Special
Committee on Aging held on May 17, 2004. Available at www.kff.org.
O'Sullivan, Jennifer. Medicare Drug Benefit: Retiree Benefits. Library of
Congress, Congressional Research Service Report RL33041. Washington,
DC: February 9, 2006.
Shea, Dennis G., Bruce C. Stuart, and Becky Briesacher. "Participation
and Crowd-Out in a Medicare Drug Benefit: Simulation Estimates," Health
Care Financing Review, no. 2, v. 25, December 22, 2003.
U.S. Congress, Congressional Budget Office. Issues in Designing a
Prescription Drug Benefit for Medicare. Washington, DC: October 2002.
-, A Detailed Description of CBO's Cost Estimate for the Medicare
Prescription Drug Benefit. Washington, DC: July 2004.
U.S. Congress, Government Accountability Office. Retiree Health
Benefits: Options for Employment-Based Prescription Drug Benefits under
the Medicare Modernization Act. GAO-05-205, Washington, DC: February
2005.
U.S. Congress, Senate Committee on Finance, Implementing the Medicare
Prescription Drug Benefit and Medicare Advantage Program: Perspectives
on the Proposed Rules, Hearing, 108th Congress, 2nd session, September 14,
2004. Available at www.finance.senate.gov.
U.S. Department of Health and Human Services, Centers for Medicare and
Medicaid Services. The Retiree Drug Subsidy. Available at:
www.cms.hhs.gov/EmployerRetireeSubsid/01_Overview.asp.
Yamamoto, Dale H. "What Comes After the Retiree Drug Subsidy?"
Benefits Quarterly, vol. 22, no. 3, Third Quarter 2006, p. 13.

Income Security

EXCLUSION OF WORKERS' COMPENSATION BENEFITS
(DISABILITY AND SURVIVORS PAYMENTS)

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

2.5

2007

2.6

2008

2.7

2009

2.7

2010

2.8

Authorization

Section 104(a)(1).

Description

Workers' compensation benefits to employees in cases of work-related
injury, and to survivors in cases of work-related death, are not taxable.
Employers finance benefits through insurance or self-insurance arrangements
(with no employee contribution), and their costs are deductible as a business
expense.

Benefits are provided as directed by various State and Federal laws and
consist of cash earnings-replacement payments, payment of injury-related
medical costs, special payments for physical impairment (regardless of lost
earnings), and coverage of certain injury or death-related expenses (e.g.,
burial costs). Employees and survivors receive compensation if the injury or
death is work-related. No proof of employer negligence is needed, and
workers' compensation is treated as the sole remedy for work-related injury or
death.

Cash earnings replacement payments typically are set at two-thirds of lost
pre-tax earning capacity, up to legislated maximum amounts. They are
provided for both total and partial disability, generally last for the term of the
disability, may extend beyond normal retirement age, and are paid as periodic
(e.g., monthly) payments or lump-sum settlements.

Impact

Generally, any amounts received for personal injury or sickness through an
employer-paid accident or health plan must be reported as income for tax
purposes. This includes disability payments and disability pensions, as well
as sick leave payments. In contrast, an exception is made for the monthly
cash payments paid under State workers' compensation programs, which are
excluded from income taxation.

Workers' compensation benefits in 2004 totaled $56.0 billion, about 53
percent of which consisted of cash payments to injured employees and
survivors replacing lost earnings, and 47 percent of which was paid for
medical and rehabilitative services. The costs to employers in 2004 came to
$87.4 billion, equivalent to 1.76 percent of covered payrolls (up from 1.30
percent in 2000 but still down from 2.16 percent as recently as 1993).

The Census Bureau's Current Population Survey gives the following
profile of those who reported receiving workers' compensation in 2001:

Workers' compensation cash benefits were less than $5,000 for 58 percent
of recipients, between $5,000 and $10,000 for 19 percent, between $10,000
and $15,000 for 12 percent, and more than $15,000 for 11 percent.

Recipients' income (including workers' compensation) was below $15,000
for 24 percent, between $15,000 and $30,000 for 33 percent, between
$30,000 and $45,000 for 22 percent, and above $45,000 for 21 percent.

Total family income (including workers' compensation) was below
$15,000 for about 9 percent of recipients, between $15,000 and $30,000 for
18 percent, between $30,000 and $45,000 for 21 percent, and above $45,000
for 51 percent. Seven percent had family income below the Federal poverty
thresholds.

Rationale

Assessment

Exclusion of workers' compensation benefits from taxation increases the
value of these benefits to injured employees and survivors, without direct cost
to employers, through a tax subsidy. Taxation of workers' compensation
would put it on a par with the earned income it replaces. It also would place
the "true" cost of workers' compensation on employers if compensation
benefits were increased in response to taxation. It is possible that "marginal"
claims would be reduced if workers knew their benefits would be taxed like
their regular earnings.

Furthermore, exclusion of workers' compensation payments from taxation
is a relatively regressive subsidy because it replaces more income for (and is
worth more to) those with higher earnings and other taxable income than for
poorer households. While States have tried to correct for this with legislated
maximum benefits and by calculating payments based on replacement of
after-tax income, the maximums provide only a rough adjustment and few
jurisdictions have moved to after-tax income replacement.

On the other hand, a case can be made for tax subsidies for workers'
compensation because the Federal and State Governments have required
provision of this "no-fault" benefit. Moreover, because most workers'
compensation benefit levels, especially the legal maximums, have been
established knowing there would be no taxes levied, it is likely that taxation
of compensation would lead to considerable pressure to increase payments.

If workers' compensation were subjected to taxation, those who could
continue to work or return to work (such as those with partial or short-term
disabilities) or who have other sources of taxable income (such as a working
spouse or investment earnings) are likely to be the most affected. These
groups represent the majority of beneficiaries. Those who receive only
workers' compensation payments (such as permanently and totally disabled
beneficiaries) would be less affected, because their income is likely to be
below the taxable threshold level.

Some administrative issues would arise in implementing a tax on workers'
compensation. Although most workers' compensation awards are made as
periodic cash income replacement payments, with separate payments for
medical and other expenses, a noticeable proportion of the awards are in the
form of lump-sum settlements. In some cases, the portion of the settlement
attributable to income replacement can be distinguished from that for medical
and other costs, in others it cannot. A procedure for pro-rating lump-sum
settlements over time would be called for. If taxation of compensation were
targeted on income replacement and not medical payments, some method of
identifying lump-sum settlements (e.g., a new kind of "1099") would have to
be devised. In addition, a reporting system would have to be established for
insurers (who pay most benefits), State workers' compensation insurance
"funds," and self-insured employers, and a way of withholding taxes might be
needed.

Equity questions also would arise in taxing compensation. Some of the
work force is not covered by traditional workers' compensation laws. For
example, interstate railroad employees and seafaring workers have a special
court remedy that allows them to sue their employer for negligence damages,
similar to the system for work-related injury and death benefits that workers'
compensation laws replaced for most workers. Their jury-awarded
compensation is not taxed. Some workers' compensation awards are made for
physical impairment, without regard to lost earnings. Under current tax law,
employer-provided accident and sickness benefits generally are taxable, but
payments for loss of bodily functions are excludable. Here, equity might call
for continuing to exclude those workers' compensation payments that are
made for loss of bodily functions as opposed to lost earnings. Finally, States
would face a decision on taxing compensation and jurisdictions that use
after-tax income replacement would be called on to change.

Selected Bibliography

Boyd, Lawrence W. "Workers Compensation Reform Past and Present:
An Analysis of Issues and Changes in Benefits," Labor Studies Journal,
Summer 1999. Pp. 45-62.
National Foundation for Unemployment Compensation and Workers'
Compensation. "Fiscal Data for State Workers' Compensation Systems:
1986-95," Research Bulletin 97 WC-2. September 15, 1997, pp. 1-17.
Sengupta, Ishita, et al. Workers' Compensation: Benefits, Coverage and
Costs, 2000. Washington, DC: National Academy of Social Insurance, 2002.
Social Security Administration, Office of Research and Statistics. "Social
Security Programs in the United States," Social Security Bulletin, v. 56.
Winter, 1993, pp. 28-36.
Thomason, Terry, Timothy Schmidle and John F. Burton. Workers'
Compensation, Benefits, Costs, and Safety under Alternative Insurance
Arrangements. Kalamazoo MI: Upjohn Institute for Employment Research.
2001.
U.S. Congress, House Committee on Ways and Means. 2004 Green Book:
Background Material and Data on Programs within the Jurisdiction of the
Committee on Ways and Means. Committee Print WMCP 108-6, 108th
Congress, 2nd Session. Washington, DC: U.S. Government Printing Office,
March, 2004, pp. 15-137 to 15-148.
Wentz, Roy. "Appraisal of Individual Income Tax Exclusions," Tax
Revision Compendium. U.S. Congress, House Committee on Ways and
Means Committee Print. 1959, pp. 329-340.
Yorio, Edward. "The Taxation of Damages: Tax and Non-Tax Policy
Considerations," Cornell Law Review, v. 62. April 1977, pp. 701-736.

Income Security

EXCLUSION OF DAMAGES ON ACCOUNT OF
PERSONAL PHYSICAL INJURIES OR PHYSICAL SICKNESS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

1.4

2007

1.5

2008

1.5

2009

1.5

2010

1.5

Authorization

Sections 104(a)(2)-104(a)(5)

Description

Damages paid, either through a court award or a settlement, to compensate
for physical injury and sickness are not included in income of the recipient.
This exclusion applies to both lump sum payments and periodic payments.
They do not include punitive damages (except in certain cases where States
only permit the awarding of punitive damages).

Impact

Income received in the form of damages is not taxable to individuals even
though it may substitute for wages that would have been taxable. The tax
treatment constitutes a benefit compared to some forms of income. To the
extent that payments substitute for medical payments that would have been
received from insurance companies the tax treatment is consistent with the
treatment that would otherwise have occurred for these payments. To the
extent that the compensation compensates for forgone wages, the payments
are beneficially treated by comparison with the wages (which would have
been taxed). To the extent that awards are successful in reflecting the actual
costs of injuries, the benefit of the provision, including the lack on tax on the
interest earnings included in annuities or periodic payments, accrues to the
recipients.

Rationale

A provision allowing an exclusion for damages had been part of the tax
law since 1918, based on the notion that these payments were compensating
for a loss. The statute was amended by the Periodic Payment Settlement Act
of 1982 to allow full exclusion of periodic payments as well as lump sum
payments. Normally periodic payments would have been partially taxable to
reflect the interest element. An argument for encouraging the full exclusion of
periodic payments was to avoid circumstances where individuals used up
lump sum payments and might then require public assistance.

The provision was amended in 1996 by the Small Business Job Protection
Act to make it clear that punitive damages (except for those cases where State
law requires all damages to be paid as punitive damages) and damages arising
from discrimination and emotional distress were not to be excluded. This
change was intended to settle and clarify the law, following considerable
variation in the interpretation by the courts.

Victims of Terrorism Tax Relief Act of 2001 (P.L. 107-134) expanded the
present-law exclusion from gross income for disability income of U.S.
civilian employees attributable to a terrorist attack outside the United States to
apply to disability income received by any individual attributable to a terrorist
or military action. The provision is effective for taxable years ending on or
after September 11, 2001.

In general, interpretation of the provisions of these sections of the Code is
frequently affected by case law.

Assessment

The tax benefit is largely a benefit to individuals receiving compensation
for injuries and illness. It parallels the treatment of workers compensation
which covers on-the-job injuries. However, since it is not paid for by
excluded insurance and since the size of the payments is (at least in theory)
tied specifically to the magnitude of the injury, the benefit accrues to the
recipients. It therefore especially benefits higher income individuals whose
payments would typically be larger, reflecting larger lifetime earnings, and
subject to higher tax rates.

By restricting tax benefits to compensatory rather than punitive damages,
the provision encourages plaintiffs to settle out of court so that the damages
can be characterized as compensatory (an outcome that may usually be
preferred by the defendant as well). There is also an incentive to characterize
damages as physical in nature, for example, to demonstrate that emotional
distress led to physical symptoms.

Selected Bibliography

Hanson, Randall K and James K. Smith. "Taxability of Damages." The
CPA Journal, vol. 68, May 1998, pp. 22-28.
Oestreich, Nathan, Will Snyder, and James E. Williamson. "New Rules
for Personal Injury Awards." The National Public Accountant, vol. 43, May
1997, pp. 16-22.
U.S. Congress. Joint Committee on Taxation. General Explanation of Tax
Legislation in the 104th Congress. U.S. Government Printing office,
Washington, DC, December 18, 1996, pp. 222-224.
Wood, Robert W. "Tax Language in Settlement Agreements: Binding or
Not? Tax Notes, vol. 93, December 31, 2001, pp. 1872-1874.
-. "Why Every Settlement Agreement Should Address Tax
Consequences." Tax Notes, vol. 93, July 16, 2001, pp. 405-409.

Income Security

EXCLUSION OF SPECIAL BENEFITS
FOR DISABLED COAL MINERS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.1

2007

0.1

2008

(1)

2009

(1)

2010

(1)

(1)Less than $50 million.

Authorization

30 U.S.C. 922(c), Section 104(a)(1), Revenue Ruling 72-400, 1972-2 C.B.
75.

Description

Cash and medical benefits to coal mine workers or their survivors for total
disability or death resulting from coal workers' pneumoconiosis (black lung
disease) paid under the Black Lung Benefits Act generally are not taxable.
Comparable benefits paid under State workers' compensation laws also are
not taxed.

Black lung eligibility claims must meet the following general conditions:
the worker must be totally disabled from, or have died of, pneumoconiosis
arising out of coal mine employment. However, the statute's broad definition
of total disability makes it possible for a beneficiary to be working outside the
coal industry (although earnings tests apply in some cases).

Black lung benefits consist of monthly cash payments and payment of
black-lung-related medical costs. There are two distinct black lung programs,
known as Part B and Part C. They pay the same benefits, but differ in
eligibility rules and funding sources.

The Part B program provides cash benefits to those miners who filed
eligibility claims prior to June 30, 1973 (or December 31, 1973, in the case of
survivors). It is financed by annual Federal appropriations. The Part C
program pays medical benefits for all eligible beneficiaries (both Parts B and
C) and cash payments to those whose eligibility claims were filed after the
Part B deadlines. Part C benefits are paid either by the "responsible" coal
mine operator or, in most cases, by the Black Lung Disability Trust Fund.

To pay their obligations under the Part C program, coal mine operators
may set up special "self-insurance trusts," contributions to which are tax-
deductible and investment earnings on which are tax-free. Otherwise, they
may fund their liability through a third-party insurance arrangement and
deduct the insurance premium costs. The Black Lung Disability Trust Fund
is financed by an excise tax on coal mined in and sold for use in the United
States and by borrowing from the Federal Treasury.

Impact

Generally, any income-replacement amounts received for personal injury or
sickness through an employer-paid accident or health plan must be reported as
income for tax purposes. This includes disability payments and disability
pensions, as well as sick leave. An exception is made for the monthly cash
payments paid under the Federal black lung program, and comparable cash
benefits paid under State workers' compensation programs, which are
excluded from income taxation.

Black lung medical benefits, however, are treated like other employer-paid
or government-paid health insurance. Recipients are not taxed on the
employer or Federal contributions for their black lung health insurance, or on
the value of medical benefits or reimbursements actually received.

In fiscal year 2006 cash benefits were paid to over 81,000 primary
beneficiaries and 13,000 dependents. Seventy-four percent of the primary
beneficiaries were widows of miners. Part B cash payments totaled $316
million and Part C cash payments $266 million for the fiscal year. In
addition, $41 million in payments for black-lung related medical treatment
were made to, or on behalf of, miners enrolled in Part B and Part C. Both the
Part B and the Part C rolls are declining as elderly recipients die, although
some new claims continue to be approved under Part C. In calendar year
2006, monthly black lung cash payments under both Part B and Part C ranged
from $574 for a miner or widow alone to $1,149 for a miner or widow with
three or more dependents.

Rationale

Part B payments are excluded from taxation under the terms of title IV of
the original Federal Coal Mine Health and Safety Act of 1969 (now entitled
the Black Lung Benefits Act). No specific rationale for this exclusion is
found in the legislative history. Part C benefits have been excluded because
they are considered to be in the nature of workers' compensation under a 1972
revenue ruling and fall under the workers' compensation exclusion of Section
104(a)(1) of the Internal Revenue Code. Like workers' compensation and in
contrast to other disability payments, eligibility for black lung benefits is
directly linked to work-related injury or disease (see entry on Exclusion of
Workers' Compensation Benefits: Disability and Survivors Payments).

Assessment

Excluding black lung payments from taxation increases their value to some
beneficiaries, those with other taxable income. The payments themselves fall
well below Federal income tax thresholds. The effect of taxing black lung
benefits and the factors to be considered in deciding on their taxation differ
between Part B and Part C payments.

Part B benefits could be viewed as earnings replacement payments and,
thus, appropriate for taxation, as has been argued for workers' compensation.
However, it would be difficult to argue for their taxation, especially now that
practically all recipients are elderly miners or widows. When Part B benefits
were enacted, the legislative history emphasized that they were not workers'
compensation, but rather a "limited form of emergency assistance." They also
were seen as a way of compensating for the lack of health and safety
protections for coal miners prior to the 1969 Act and for the fact that existing
workers' compensation systems rarely compensated for black lung disability
or death. Furthermore, it can be maintained that, in effect, taxation of Part B
payments would take back with one hand what Federal appropriations give
with the other, although almost no beneficiaries would likely pay tax, given
their age, retirement status, and low income.

A stronger argument can be made for taxing Part C benefits. If workers'
compensation were to be made taxable, Part C benefits would automatically
be taxed because their tax-exempt status flows from their treatment as
workers' compensation. Taxing Part C payments would give them the same
treatment as the earnings they replace. It would remove a subsidy to those
with other taxable income. On the other side, black lung benefits are
legislatively established (as a percentage of minimum Federal salaries). They
are not directly reflective of a worker's pre-injury earnings as is workers'
compensation. They can be viewed as a special kind of disability or death
"grant" that should not be taxed. Because the number of beneficiaries on both
the Part B and Part C rolls is declining, the revenue forgone from not taxing
their benefits should decrease over time.

Selected Bibliography

Barth, Peter S. The Tragedy of Black Lung: Federal Compensation for
Occupational Disease. Kalamazoo, Mich.: W.E. Upjohn Institute for
Employment Research, 1987.
-. "Revisiting Black Lung: Can the Feds Deliver Workers' Compensation
for Occupational Disease?" In Workplace Injuries and Diseases: Prevention
and Compensation, ed. Karen Roberts, John F. Burton Jr., and Matthew M.
Bodah, 253-74. Kalamazoo, Mich.: W.E. Upjohn Institute for Employment
Research, 2005.
Lazzari, Salvatore. The Black Lung Excise Tax on Coal. Library of
Congress. Congressional Research Service Report RS21935. Washington,
DC: September 15, 2004.
McClure, Barbara. Federal Black Lung Disability Benefits Program.
Library of Congress, Congressional Research Service Report 81-239 EPW.
Washington, DC: October 27, 1981.
-. Summary and Legislative History of P.L. 97-119, Black Lung Benefits
Revenue Act of 1981. Library of Congress, Congressional Research Service
Report 82-59 EPW. Washington, DC: March 29, 1982.
Rappaport, Edward. The Black Lung Benefits Program. Library of
Congress, Congressional Research Service Report RS21239. Washington,
DC: June 12, 2002.
U.S. Congress, House Committee on Education and Labor. Black Lung
Benefits Reform Act and Black Lung Benefits Revenue Act of 1977.
Committee Print, 96th Congress, 1st session, February 1979.
-, Committee on Ways and Means. Black Lung Benefits Trust. Report to
Accompany H.R. 13167. House Report No. 95-1656, 95th Congress, 2nd
session, 1978.
-. 2004 Green Book: Background Material and Data on the Programs
within the Jurisdiction of the Committee on Ways and Means. Committee
Print WMCP No. 108-6, 108th Congress, 1st session, March 2004, pp. 13:51-
52; 15:145.
-, Senate Committee on Finance. Tax Aspects of Black Lung Benefits
Legislation. Hearing, 94th Congress, 2nd session, on H.R. 10706, September
21, 1976.
-, Committee on Finance, Subcommittee on Taxation and Debt
Management Generally. Tax Aspects of the Black Lung Benefits Reform Act
of 1977. Hearing, 95th Congress, 1st session, on S. 1538, June 17, 1977.
Walter, Douglas H. "Tax Changes Effected by the Black Lung Revenue
Act of 1977," Taxes, v. 56, May 1978, pp. 251-254.

Income Security

EXCLUSION OF CASH PUBLIC ASSISTANCE BENEFITS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

3.4

2007

3.6

2008

3.7

2009

3.9

2010

4.0

Authorization

The exclusion of public assistance payments is not specifically authorized
by law. However, a number of revenue rulings under Section 61 of the
Internal Revenue Code, which defines "gross income," have declared specific
types of means-tested benefits to be nontaxable.

Description

The Government provides public assistance benefits tax free to individuals
either in the form of cash welfare or noncash transfers (in-kind benefits such
as certain goods and services received free or for an income-scaled charge).
Cash payments come from programs such as Temporary Assistance for Needy
Families (TANF), which replaced Aid to Families with Dependent Children
during FY 1997, Supplemental Security Income (SSI) for the aged, blind, or
disabled, and state and local programs of General Assistance (GA), known
also by other names such as Home Relief or Safety Net.

Traditionally, the tax benefits from in-kind payments have not been
included in the tax expenditure budget because of the difficulty of
determining their value to recipients. (However, the Census Bureau publishes
estimates of the value and distribution of major noncash welfare benefits.)

Impact

Exclusion of public assistance cash payments from taxation gives no
benefit to the poorest recipients and has little impact on the incomes of many.
This is because welfare payments are relatively low and many recipients have
little if any non-transfer cash income. For example, TANF payments per
family (averaging 2.4 persons) averaged $360 monthly in FY2004; and the
weighted average maximum benefit (for a family of three with no other
income) was $483 monthly, far below the federal income tax threshold.
Further, relatively few TANF families have earnings (19% of adult recipients
reported earnings in FY2004), and these earnings usually qualify for the
earned income tax credit. If family cash welfare payments were made
taxable, most recipients still would owe no tax.

However, some welfare recipients do benefit from the exclusion of public
assistance cash payments. They are persons who receive relatively high cash
aid (including aged, blind, and disabled persons enrolled in SSI in States that
supplement the basic federal income guarantee, which is $564 monthly per
individual and $846 per couple in 2004) and persons who have earnings for
part of the year and public assistance for the rest of the year (and whose actual
annual cash income would exceed the taxable threshold if public assistance
were counted). Public assistance benefits are based on monthly income, and
thus families whose fortunes improve during the year generally keep welfare
benefits received earlier.

During FY2004, TANF ongoing cash benefits were received by a monthly
average of about 5.4 million persons in 2.2 million families. As of
December, 2004, 6.7 million persons received federal SSI benefits (and
another 293,000 received federally administered SSI supplements paid with
state funds). Most recipients of cash help also receive some non-cash aid.

An unpublished Census Bureau table (Income Distribution Measures, by
Definition of Income, 2004) estimates that in 2004, $37.9 billion was received
in means-tested cash transfers from TANF, SSI, GA, and veterans' pensions.
Per recipient household, cash payments averaged $5,594. A total of 6.4
million households (5.7% of all U.S. households) were estimated to have
received aid from one of the means-tested cash programs, and 52.2% of these
households were in the bottom quintile of the income distribution. (Note:
Means-tested veterans' benefits are included in cash transfers by the Census
Bureau.) The Census Bureau estimated that other means-tested cash aid
totaling $27.0 billion was received in the form of federal and state earned
income tax credits. These credits went to an estimated 15.7 million
households, 59.7% of whom were in the two lowest quintiles of the income
distribution. The average value of earned income tax credits in 2004 was
estimated to be $1,715 per recipient household.

In addition, the Census Bureau estimates that the 2004 value of major
noncash means-tested benefits at $91.0 billion. The Bureau estimated the
noncash transfer for Medicaid at $45.9 billion ($4,371 on average per
recipient household, counting only households with a Medicaid transfer), and
the value of other noncash aid at $31.4 billion. On average, recipient
households received an estimated $2,121 in other noncash aid. Of the 13.6
million estimated households receiving a noncash transfer for Medicaid,
49.2% were in the lowest two quintiles of the income distribution.

Rationale

Revenue rulings generally exclude government transfer payments from
income because they have been considered to have the nature of "gifts" in aid
of the general welfare. While no specific rationale has been advanced for this
exclusion, the reasoning may be that Congress did not intend to tax with one
hand what it gives with the other.

Assessment

Several reasons are advanced for treating means-tested cash payments as
taxable income. First, excluding these cash payments results in treating
persons with the same cash income differently.

Second, removing the exclusion would not harm the poorest because their
total cash income still would be below the income tax thresholds.

Third, the general view of cash welfare has changed. Cash benefits to
TANF families now widely are regarded not as "gifts" but as payments that
impose obligations on parents to work or prepare for work through schooling
or training, and many GA programs require work. Thus, it may no longer be
appropriate to treat cash welfare transfers as gifts. (The SSI program imposes
no work obligation, but offers a financial reward for work.)

Fourth, the exclusion of cash welfare increases the work disincentives
inherent in need-tested aid. A welfare recipient who goes to work replaces
some nontaxable cash with taxable income. This increases his/her potential
"marginal tax" rate. (When recipients work, they face a reduction in need-
tested benefits. The loss in benefits serves as a "tax", which increases the
marginal tax rate.)

Fifth, using the tax system to subsidize needy persons without direct
spending masks the total cost of aid and is inefficient.

Sixth, taxing welfare payments would increase the ability to integrate the
tax and transfer system.

Several objections are made to the removal of the tax exemption from
means-tested cash transfers. First, cash welfare programs have the effect of
providing guarantees of minimum cash income; these presumably represent
target levels of disposable income. Making these benefits taxable might
reduce disposable income below the targets.

Second, unless the income tax thresholds were set high enough, some
persons deemed needy by their state might be harmed by the change (a
recipient may be subject to federal, state, or local income taxes based on
different income thresholds). TANF and SSI minimum income guarantees
differ by state, but the federal tax threshold is uniform for taxpayers with the
same filing status and family size. If cash welfare payments were made
taxable, the actual effect would vary among the states.

Third, if cash welfare were made taxable, it is argued that noncash welfare
also should be counted (raising difficult measurement issues). Further, if
noncash means-tested benefits were treated as income, it is argued that other
noncash income (ranging from employer-paid health insurance to tax
deductions for home mortgage interest) also should be counted, raising new
problems. Fourth, the public might perceive the change (to taxing cash or
noncash welfare) as violating the social safety net, and, thus, object.

Selected Bibliography

AFL-CIO. Recommendations on tax treatment of welfare-to-work
payments. Memo prepared on May 8, 1998 on behalf of the AFL-CIO, and at
the request of the Treasury. See Tax Notes, June 8, 1998, p. 1239.
Entin, Stephen J. "Fundamental Tax Reform: The Inflow Outflow Tax __.
A Savings-Deferred Neutral Tax System." Prepared testimony before the
House Committee on Ways and Means, April 13, 2000.
Weisbach, David A. and Jacob Nussim. "The Integration of Tax and
Spending Programs," Yale Law Journal, March 2004, p. 955.

Income Security

NET EXCLUSION OF PENSION CONTRIBUTIONS AND
EARNINGS PLANS FOR EMPLOYEES AND
SELF-EMPLOYED INDIVIDUALS (KEOGHS)

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

113.5

2007

120.5

2008

126.0

2009

132.1

2010

138.3

Authorization

Sections 401-407, 410-418E, and 457.

Description

Employer contributions to qualified pension, profit-sharing, stock-bonus,
and annuity plans on behalf of an employee are not taxable to the employee.
The employer is allowed a current deduction for these contributions (within
limits). Earnings on these contributions are not taxed until distributed.

The employee or the employee's beneficiary is generally taxed on benefits
when benefits are distributed. (In some cases, employees make direct
contributions to plans that are taxed to them as wages; these previously taxed
contributions are not subject to tax when paid as benefits).

A pension, profit-sharing, or stock-bonus plan is a qualified plan only if it
is established by an employer for the exclusive benefit of employees or their
beneficiaries. In addition, a plan must meet certain requirements, including
standards relating to nondiscrimination, vesting, requirements for
participation, and survivor benefits. Nondiscrimination rules are designed to
prevent the plans from primarily benefitting highly paid, key employees.
Vesting refers to the period of employment necessary to obtain non-forfeitable
pension rights.

Tax-favored pension plans, referred to as Keogh plans, are also allowed for
the self-employed; they account for only a relatively small portion of the cost
($9.4, $10.3, $10.8, $11.3, and $11.6 billion in 2006-2010).

There are two major types of pension plans: defined-benefit plans, where
employees are ensured of a certain benefit on retirement, and defined-
contribution plans, where employees have a right to accumulated
contributions (and earnings on those contributions).

The tax expenditure is measured as the tax revenue that the government
does not currently collect on contributions and earnings amounts, offset by the
taxes paid on pensions by those who are currently receiving retirement
benefits.

Impact

Pension plan treatment allows an up-front tax benefit by not including
contributions in wage income. In addition, earnings on invested contributions
are not taxed, although tax is paid on both original contributions and earnings
when amounts are paid as benefits. The net effect of these provisions,
assuming a constant tax rate, is effectively tax exemption on the return. (That
is, the rate of return on the after-tax contributions is equal to the pre-tax rate
of return). If tax rates are lower during retirement years than during the years
of contribution and accumulation, there is a "negative" tax. (In present value
terms, the government loses more than it receives in taxes).

The employees who benefit from this provision consist of taxpayers whose
employment is covered by a plan and whose service has been sufficiently
continuous for them to qualify for benefits in a company or
union-administered plan. The benefit derived from the provision by a
particular employee depends upon the level of tax that would have been paid
by the employee if the provision were not in effect.

Analysis of the March 2006 Current Population Survey shows that pension
income constituted less than 7 percent of total family income for elderly
individuals in the poorest two income quintiles (the poorest 40 percent of
elderly individuals). Pension income, however, accounted for about 20
percent of total family income for those in the richest two income quintiles.

There are several reasons that the tax benefit accrues disproportionately to
higher-income individuals. First, employees with lower salaries are less likely
to be covered by an employer plan. In 2005, only 16 percent of working
prime-aged (25 to 54 years of age) individuals earning less than $20,000 were
covered by a pension plan. In contrast, almost three-quarters of working
prime-aged individuals earnings over $65,000 were covered by a pension
plan.

Although some of these differences reflect the correlation between low
income and age, the differences in coverage by income level hold across age
groups. For example, in the 45 to 49 age group, only 19 percent with wage
income less than $20,000 were covered, 49 percent with income $20,000 to
$35,000 were covered, 67 percent with income $35,000 to $50,000 were
covered, 70 percent with income $50,000 to $65,000, and 76 percent with
income over $65,000 were covered.

Second, in addition to fewer lower-income individuals being covered by
the plans, the dollar contributions are much larger for higher-income
individuals. This disparity occurs not only because of their higher salaries,
but also because of the integration of many plans with social security. Under
a plan that is integrated with social security, employer-derived social security
benefits or contributions are taken into account as if they were provided under
the plan in testing whether the plan discriminates in favor of employees who
are officers, shareholders, or highly compensated. These integration rules
allow a smaller fraction of income to be allocated to pension benefits for
lower-wage employees.

Finally, higher-income individuals derive a larger benefit from tax benefits
because their tax rates are higher and thus the value of tax reductions are
greater.

In addition to differences across incomes, workers are more likely to be
covered by pension plans if they work in certain industries, if they are
employed by large firms, or if they are unionized.

Rationale

The first income tax law did not address the tax treatment of pensions, but
Treasury Decision 2090 in 1914 ruled that pensions paid to employees were
deductible to employers. Subsequent regulations also allowed pension
contributions to be deductible to employers, with income assigned to various
entities (employers, pension trusts, and employees). Earnings were also
taxable. The earnings of stock-bonus or profit-sharing plans were exempted
in 1921 and the treatment was extended to pension trusts in 1926.

Like many early provisions, the rationale for these early decisions was not
clear, since there was no recorded debate. It seems likely that the exemptions
may have been adopted in part to deal with technical problems of assigning
income. In 1928, deductions for contributions to reserves were allowed.

In 1938, because of concerns about tax abuse (firms making contributions
in profitable years and withdrawing them in loss years), restrictions were
placed on withdrawals unless all liabilities were paid.

In a major development, in 1942 the first anti-discrimination rules were
enacted, although these rules allowed integration with social security. These
regulations were designed to prevent the benefits of tax deferral from being
concentrated among highly compensated employees. Rules to prevent over-
funding (which could allow pension trusts to be used to shelter income) were
adopted as well.

Non-tax legislation in the Taft-Hartley Act of 1947 affected collectively
bargained multi-employer plans and the Welfare and Pensions Plans
Disclosure Act of 1958 added various reporting, disclosure and other
requirements.

In 1962, the Self-Employed Individuals Retirement Act allowed self-
employed individuals to establish tax-qualified pension plans, known as
Keogh (or H.R. 10) plans, which also benefitted from deferral.

Another milestone in the pension area was the Employee Retirement
Income Security Act of 1974, which provided minimum standards for
participation, vesting, funding, and plan asset management, along with
creating the Pension Benefit Guaranty Corporation (PBGC) to provide
insurance of benefits. Limits were established on the amount of benefits paid
or contributions made to the plan, with both dollar limits and percentage-of-
pay limits.

A variety of changes have occurred since this last major revision. In 1978,
simplified employee pensions (SEPS) and tax-deferred savings (401(k)) plans
were allowed. The limits on SEPS and 401(k)'s were raised in 1981. In
1982, limits on pensions were cut back and made the same for all employer
plans, and special rules were established for "top-heavy" plans. The 1982
legislation also eliminated disparities in treatment between corporate and
noncorporate (i.e., Keogh) plans, and introduced further restrictions on
vesting and coverage.

The Deficit Reduction Act of 1984 maintained lower limits on
contributions, and the Retirement Equity Act of that same year revised rules
regarding spousal benefits, participation age, and treatment of breaks in
service.

In 1986, a variety of changes were enacted, including substantial
reductions in the maximum contributions under defined-contribution plans,
and a variety of other changes (anti-discrimination rules, vesting, integration
rules). In 1987, rules to limit under-funding and over-funding of pensions
were adopted. The Small Business Job Protection Act of 1996 made a
number of changes to increase access to plans for small firms, including safe-
harbor nondiscrimination rules. In 1997, taxes on excess distributions and
accumulations were eliminated.

The 2001 tax cut raised the contribution and benefit limits for pension
plans, allowed additional contributions for those over 50, increased the full-
funding limit for defined benefit plans, allowed additional ability to roll over
limits on 401(k) and similar plans, and provided a variety of other regulatory
changes. These provisions were to sunset at the end of 2010, but were made
permanent by the Pension Protection Act of 2006.

The Economic Growth and Tax Relief Reconciliation Act of 2001 created
the Roth 401(k), which went into effect on January 1, 2006. Contributions to
Roth 401(k)s are taxed, but qualified distributions are not taxed.

Assessment

To tax defined-benefit plans can be very difficult since it is not always easy
to allocate pension accruals to specific employees. It might be particularly
difficult to allocate accruals to individuals who are not vested. This
complexity would not, however, preclude taxation of trust earnings at some
specified rate.

The major economic justification for the favorable tax treatment of pension
plans is that they are argued to increase savings and increase retirement
security. The effects of these plans on savings and overall retirement income
are, however, subject to some uncertainty.

The incentive to save relies on an individual's realizing tax benefits on
savings about which he can make a decision. Since individuals cannot
directly control their contributions to plans in many cases (defined-benefit
plans), or are subject to a ceiling, the tax incentives to save may not be very
powerful, because tax benefits relate to savings that would have taken place in
any case. At the same time, pension plans may force saving and retirement
income on employees who otherwise would have total savings less than their
pension-plan savings. The empirical evidence is mixed, and it is not clear to
what extent forced savings is desirable.

There has been some criticism of tax benefits to pension plans, because
they are only available to individuals covered by employer plans. Thus they
violate the principle of horizontal equity (equal treatment of equals). They
have also been criticized for disproportionately benefitting high-income
individuals.

The Enron collapse focused attention on another important issue in pension
plans: the displacement of defined benefit plans by defined contribution plans
(particularly those with voluntary participation, such as the 401(k) plan)
which are not insured) and the instances in which defined contribution plans
were heavily invested in employer securities, increasing the risk to the
employee who could lose retirement savings (as well as a job) when his firm
failed. Research has suggested that individuals do not diversify their
portfolios in the way that investment advisors would suggest, that they
actually increase the share of their own contributions invested in employer
stock when the employer stock is also used to make matching contributions,
and that they are strongly affected by default choices in the level and
allocation of investment.

Selected Bibliography

Cagan, Philip. The Effect of Pension Plans on Aggregate Savings. New
York: Columbia University Press, 1965.
Choi, James J., David Laibson, and Brigitte C. Madrian, "Plan Design and
401(k) Savings Outcomes,"National Tax Journal, v. 57, June 2004, pp. 275-
298.
Gale, William G. "The Effects of Pensions on Household Wealth: A Re-
Evaluation of Theory and Evidence," Journal of Political Economy, v. 106,
August 1998, pp. 706-723.
Gravelle, Jane G. Economic Effects of Taxing Capital Income, ch. 8.
Cambridge, MA: MIT Press, 1994.
Even, William E. and David Macpherson. "Company Stock in Pension
Plans," National Tax Journal, v. 57, June 2004, pp. 299-314.
Gravelle, Jane G., Employer Stock in Pension Plans: Economic and Tax
Issues, Library of Congress, Congressional Research Service Report
RL31551, September 4, 2002.
-. "The Enron Debate: Lessons for Tax Policy," Urban-Brookings Tax
Policy Center Discussion Paper 6, Washington, DC: The Urban Institute,
February 2003.
Engen, Eric M., William G. Gale and John Karl Scholz. "The Effects of
Tax-Based Saving Incentives on Saving and Wealth," National Bureau of
Economic Research Working Paper 5759. September 1996.
-. "Personal Retirement Saving Programs and Asset Accumulation:
Reconciling the Evidence," National Bureau of Economic Research Working
Paper 5599. May 1996.
-. "The Illusory Effects of Savings Incentives on Saving," Journal of
Economic Perspectives, v. 10, Fall 1996, pp. 113-138.
Fox, John O. "The Troubling Shortfalls and Excesses of Tax Subsidized
Pension Plans," ch. 11, If Americans Really Understood the Income Tax,
Boulder Colorado, Westview Press, 2001.
Friedberg, Leora. and Michael T. Owyang, "Not Your Father's Pension
Plan: The Rise of 401(k) and Other Defined Contribution Plans." Federal
Reserve Bank of St. Louis Review, v. 84, January-February, 2002, pp. 23-34.
Gale, William G., J. Mark Iwry, and Gordon McDonald. "An Analysis of
the Roth 401(k)." Tax Notes, January 9, 2006, pp. 163-167.
Howard, Christopher. The Hidden Welfare State: Tax Expenditure and
Social Policy in the United States. Princeton, NJ: Princeton Univ. Press,
1997.
Hubbard, R. Glenn. "Do IRAs and Keoghs Increase Savings?" National
Tax Journal, v. 37. March 1984, pp. 43-54.
-, and Jonathan S. Skinner. "Assessing the Effectiveness of Savings
Incentives." Journal of Economic Perspectives, v. 10 (Fall 1996), pp. 73-90.
Hungerford, Thomas L. Saving Incentives: What May Work, What May
Not. Library of Congress, Congressional Research Service Report RL33482,
Washington, DC: June 20, 2006.
Ippolito, Richard. "How Recent Tax Legislation Has Affected Pension
Plans," National Tax Journal, v. 44. September 1991, pp. 405-417.

Johnson, Richard W. and Cori E. Uccello, "Cash Balance Plans: What Do
They Mean for Retirement Security?"National Tax Journal, v. 57, June 2004,
pp. 315-328.
Joulfaian, David and David Richardson. "Who Takes Advantage of Tax-
Deferred Saving Programs? Evidence from Federal Income Tax Data."
National Tax Journal, v. 54, September 2001, pp. 669-688.
Katona, George. Private Pensions and Individual Savings, Survey
Research Center, Institute for Social Research, University of Michigan, 1965.
Madrian, Brigette C. and Dennis F. Shea. " The Power of Suggestion:
Inertia in 401(k) Participation and Savings Behavior," Quarterly Journal of
Economics, v. 116, November 2001, pp. 1149-1187.
Lindeman, David, and Larry Ozanne. Tax Policy for Pensions and Other
Retirement Savings. U.S. Congress, Congressional Budget Office.
Washington, DC: U.S. Government Printing Office, April 1987.
Munnell, Alicia. "Are Pensions Worth the Cost?" National Tax Journal,
v. 44, September 1991, pp. 406-417.
-. "Current Taxation of Qualified Plans: Has the Time Come?" New
England Economic Review. March-April 1992, pp. 12-25.
-. "The Impact of Public and Private Pension Schemes on Saving and
Capital Formation," Conjugating Public and Private: The Case of Pensions.
Geneva: International Social Security Association, Studies and Research No.
24, 1987.
-. "Private Pensions and Saving: New Evidence," Journal of Political
Economy, v. 84. October 1976, pp. 1013-1032.
Munnell, Alicia H. and Annika Sunden. Coming Up Short: The Challenge
of 401(k) Plans. Washington, DC: Brookings Institution Press, 2004.
Pence, Karen. "Nature or Nurture,: Why do 401(k) Participants Save
Differently than Other Workers?"National Tax Journal, v. 55, September
2002, pp. 596-616.
-. "Reducing Bias in Estimates of the Effect of the 401(K) Program on
Savings," in Proceedings of the 94th Annual Conference 2001, Washington
DC, National Tax Association, 2002, pp. 130-135.
Poterba, James M., Steven F. Venti and David Wise. "Do 401(K)
Contributions Crowd Out Other Personal Saving?" Journal of Public
Economics, v. 58. 1995, pp. 1-32.
-. "How Retirement Saving Programs Increase Savings," Journal of
Economic Perspectives, v. 10, Fall 1996, pp. 91-112.
-. "Targeted Retirement Saving and the Net Worth of Elderly Americans,"
American Economic Review, v. 84, May 1995, pp 180-185.
Purcell, Patrick. Pension Reform: The Economic Growth and Tax Relief
Reconciliation Act of 2001. Library of Congress, Congressional Research
Service Report RS20629, Washington, DC.: Updated June 18, 2002.
_. Pensions and Retirement Savings Plans: Sponsorship and
Participation. Library of Congress, Congressional Research Service Report
RL30122, Washington, DC.: Updated September 10, 2004.
Turner, John A. "Pension Tax Treatment," in The Encyclopedia of
Taxation and Tax Policy, eds. Joseph J. Cordes, Robert O. Ebel, and Jane G.
Gravelle. Washington, DC: Urban Institute Press, 2005.

U.S. Congress, House Committee on Ways and Means. Background
Material: 2004 Green Book, Committee Print, 108th Congress, 2nd session.
March, 2004, pp. 13-3 to 13-15.
U.S. Department of Labor, Pension and Welfare Benefits Administration,
Trends in Pensions. Washington, DC: U.S. Government Printing Office,
1989.
U.S. Department of Treasury. Report to Congress on the Effect of the Full
Funding Limit on Pension Benefit Security. Department of the Treasury, May
1991.
U.S. General Accounting Office. Answers to Key Questions About Private
Pensions. Washington, DC: U.S. Government Printing Office, GAO-02-
7455P, September 18, 2002.
_. Effects of Changing the Tax Treatment of Fringe Benefits. Washington,
DC: U.S. Government Printing Office, April 1992.
_. Private Pensions: Improving Worker Coverage and Benefits.
Washington, DC: U.S. Government Printing Office, GAO-2-225. April 16,
2002.
_. Private Pensions: Key Issues to Consider Following the Enron
Collapse. Testimony of David Walker, Washington, DC: U.S. Government
Printing Office, GAO-02-480T, February 27, 2002.
Utgoff, Kathleen. "Public Policy and Pension Regulation," National Tax
Journal, v. 44, September 1991, pp. 383-391.

Income Security

NET EXCLUSION OF PENSION CONTRIBUTIONS AND
EARNINGS: INDIVIDUAL RETIREMENT PLANS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

11.2

2007

14.0

2008

15.5

2009

16.9

2010

18.4

Authorization

Sections 219 and 408.

Description

There are two types of individual retirement accounts (IRAs): the
traditional IRA and the Roth IRA. The traditional IRA allows for the tax
deferred accumulation of investment earnings, and some individuals are
eligible to make tax-deductible contributions to their traditional IRAs while
others are not. Some or all distributions from traditional IRAs are taxed at
retirement. In contrast, contributions to Roth IRAs are not tax deductible, but
distributions from Roth IRAs are not taxed on withdrawal in retirement.

The deduction for contributions is phased out for active participants in a
pension plan. Individuals not covered by a pension plan and whose spouse is
also not covered can deduct the full amount of their IRA contribution. The
deduction for IRA contributions is phased out for pension plan participants.
For 2006, the phase-out range for single taxpayers is $50,000 to $60,000 in
modified adjusted gross income and $75,000 to $85,000 for joint returns.
Individuals may choose a backloaded IRA (a Roth IRA) where contributions
are not deductible but no tax applies to withdrawals. These benefits are
phased out at $150,000 to $160,000 for a joint return and $95,000 to
$110,000 for singles.

The annual limit for IRA contributions is the lesser of $4,000 or 100
percent of compensation . The ceiling will rise to $5,000 in 2008. It will
then be indexed for inflation in $500 increments. Individuals age 50 and
older may make an additional catch-up contribution of $1,000.

There is a nonrefundable tax credit of up to $1,000 for contributions to a
qualified retirement plan by individuals with adjusted gross income less than
$25,000 and couples with adjusted gross income under $50,000.

A married taxpayer who is eligible to set up an IRA is permitted to make
deductible contributions up to $4,000 to an IRA for the benefit of the spouse.

Distributions made before age 59 � (other than those attributable to
disability or death) are subject to an additional 10-percent income tax unless
they are rolled over to another IRA or to an employer plan. Exceptions
include withdrawals of up to $10,000 used to purchase a first home, education
expenses, or for unreimbursed medical expenses.

Distributions must begin after age 70 �. Contributions may, however, still
be made to a Roth IRA after that age.

The tax expenditure estimates reflect the net of tax losses due to failure to
tax contributions and current earnings in excess of taxes paid on withdrawals.

Under legislation adopted at the end of 2006 (H.R. 6111), amounts may be
withdrawn, on a one-time basis, from IRAs and contributed to Health Savings
Accounts (HSAs) without tax or penalty.

Impact

Deductible IRAs allow an up-front tax benefit by deducting contributions
along with not taxing earnings, although tax is paid when earnings are
withdrawn. The net overall effect of these provisions, assuming a constant
tax rate, is the equivalent of tax exemption on the return (as in the case of
Roth IRAs). (That is, the individual earns the pre-tax rate of return on his
after-tax contribution). If tax rates are lower during retirement years than they
were during the years of contribution and accumulation, there is a "negative"
tax on the return. Non-deductible IRAs benefit from a postponement of tax
rather than an effective forgiveness of taxes, as long as they incur some tax on
withdrawal.

IRAs tend to be less focused on higher-income levels than some types of
capital tax subsidies, in part because they are capped at a dollar amount.
Their benefits do tend, nevertheless, to accrue more heavily to the upper half
of the income distribution. This effect occurs in part because of the low
participation rates at lower income levels. Further, the lower marginal tax
rates at lower income levels make the tax benefits less valuable.

The current tax expenditure reflects the net effect from three types of
revenue losses and gains. The first is the forgone taxes from the deduction of
IRA contributions by certain taxpayers. The distribution table below shows
that almost half of this tax benefit goes to low- and middle-income taxpayers
with adjusted gross income below $75,000. (The median tax return in 2004
had adjusted gross income of about $25,000.)

The second is the forgone taxes from not taxing IRA earnings. The
distribution table shows that about a quarter of these tax benefits accrue to
low- and middle-income taxpayers. The primary reason is upper income
taxpayers have larger IRA balances and the higher marginal tax rate makes
this tax benefit more valuable to upper income taxpayers.

The final type is the tax revenue gain from the taxation of IRA
distributions. Distributions from traditional IRAs are taxed. If the
contributions were deductible, then the entire distribution is taxed. Only the
investment earnings are taxed for distributions from nondeductible traditional
IRAs. Qualified distributions from Roth IRAs are not taxed. The distribution
table shows that low- and middle-income taxpayers account for about one
third of the tax revenue gain.

The total tax benefit of IRAs are the combination of these three effects.
The final column of the distribution table reports the net tax benefit by
income class. The table shows that less than 25 percent of the net tax benefit
accrues to low- and middle-income taxpayers with income below $75,000.

Estimated Percentage Distribution of IRA Benefits

Income Class

Deductions

Earnings

Distributions

Net Effect

less than $10,000

1.1

1.2

1.1

1.4

$10,000-30,000

8.5

5.8

7.2

4.5

$30,000-50,000

20.2

8.6

10.2

7.9

$50,000-75,000

17.8

11.4

14.0

9.1

$75,000-100,000

17.0

15.9

18.6

13.0

$100,000-
200,000

23.4

25.6

27.5

23.4

Over $200,000

12.1

31.6

21.4

40.8

Note: Derived from 2004 IRS, Statistics of Income data.

Rationale

The provision for IRAs was enacted in 1974, but it was limited to
individuals not covered by pension plans. The purpose of IRAs was to reduce
discrimination against these individuals.

In 1976, the benefits of IRAs were extended to a limited degree to the
nonworking spouse of an eligible employee. It was thought to be unfair that
the nonworking spouse of an employee eligible for an IRA did not have
access to a tax-favored retirement program.

In 1981, the deduction limits for all IRAs were increased to the lesser of
$2,000 or 100 percent of compensation ($2,250 for spousal IRAs). The 1981
legislation extended the IRA program to employees who are active
participants in tax-favored employer plans, and permitted an IRA deduction
for qualified voluntary employee contributions to an employer plan.

The current rules limiting IRA deductions for higher-income individuals
not covered by pension plans were phased out at $40,000 to $50,000
($25,000 to $35,000 for singles) as part of the Tax Reform Act of 1986. Part
of the reason for this restriction arose from the requirements for revenue and
distributional neutrality. The broadening of the base at higher income levels
through restrictions on IRA deductions offset the tax rate reductions. The
Taxpayer Relief Act of 1997 increased phase-outs and added Roth IRAs to
encourage savings.

The 2001 tax cut act raised the IRA contribution limit to $3,000, with an
eventual increase to $5,000 and inflation indexing. These provisions were to
sunset at the end of 2010, but were made permanent by the Pension
Protection Act of 2006. The 2001 tax act also added the tax credit and catch
up contributions. The elimination of the income limit on Roth IRA
conversions starting in 2010 was added by the Tax Increase Prevention and
Reconciliation Act of 2005.

Assessment

The tendency of capital income tax relief to benefit higher-income
individuals has been reduced in the case of IRAs by the dollar ceiling on the
contribution, and by the phase-out of the deductible IRAs as income rises for
those not covered by a pension plan. Providing IRA benefits to those not
covered by pensions may also be justified as a way of providing more equity
between those covered and not covered by an employer plan.

Another economic justification for IRAs is that they are argued to increase
savings and increase retirement security. The effects of these plans on
savings and overall retirement income are, however, subject to some
uncertainty, and this issue has been the subject of a considerable literature.

Selected Bibliography

Attanasio, Orazio and Thomas De Leire. "The Effect of Individual
Retirement Accounts on Household Consumption and Savings," Economic
Journal, v. 112, July 2002, pp. 504-538.
Burman, Leonard, Joseph J. Cordes, and Larry Ozanne. "IRAs and
National Savings," National Tax Journal, v. 43. September 1990, pp. 123-
128.
Burman, Leonard, William G. Gale, and David Weiner, "The Taxation of
Retirement Saving: Choosing Between Front-Loaded and Back-Loaded
Options." National Tax Journal, v. 54, September 2001, pp. 689-702.
Burnham, Paul and Larry Ozanne. "Individual Retirement Accounts," in
The Encyclopedia of Taxation and Tax Policy, eds. Joseph J. Cordes, Robert
O. Ebel, and Jane G. Gravelle. Washington, DC: Urban Institute Press, 2005.
Engen, Eric M., William G. Gale and John Karl Scholz. "The Illusory
Effects of Saving Incentives on Saving," Journal of Economic Perspectives,
v. 10, Fall 1996, pp. 113-138.
-. "Personal Retirement Saving Programs and Asset Accumulation:
Reconciling the Evidence," National Bureau of Economic Research Working
Paper 5599. May 1996.
Feenberg, Daniel, and Jonathan Skinner. "Sources of IRA Savings," Tax
Policy and the Economy 1989, ed. Lawrence H. Summers. Cambridge,
Mass.: M.I.T. Press, 1989, pp. 25-46.
Gale, William G., and John Karl Scholz. "IRAs and Household Savings,"
American Economic Review, v. 84, no. 5, December 1994, pp. 1233-1260.
Gravelle, Jane G. "Do Individual Retirement Accounts Increase Savings?"
Journal of Economic Perspectives, v. 5, Spring 1991, pp. 133-148.
-. Economic Effects of Taxing Capital Income, ch. 8. Cambridge, MA:
MIT Press, 1994.
Gravelle, Jane G. and Maxim Shvedov, Proposed Savings Accounts:
Economic and Budgetary Effects, Library of Congress, Congressional
Research Service Report RL32228. Updated April 2, 2004.
Hubbard, R. Glenn and Jonathan S. Skinner. "Assessing the Effectiveness
of Savings Incentives," Journal of Economic Perspectives, v. 10, Fall 1996,
pp. 73-90.
Hungerford, Thomas L. and Jane G. Gravelle. Individual Retirement
Accounts (IRAs): Issues and Proposed Expansion, Library of Congress,
Congressional Research Service Report RL30255. Updated July 31, 2006.
Imrohoroglu, Selahattn and Douglas Joins. "The Effect of Tax Favored
Retirement Accounts on Capital Accumulation," American Economic Review,
v. 88 (September 1988), pp. 749-768.
Joulfaian, David and David Richardson. "Who Takes Advantage of Tax-
Deferred Saving Programs? Evidence from Federal Income Tax Data."
National Tax Journal, v. 54, September 2001, pp. 669-688.
Kotlikoff, Laurence J. "The Crisis in U.S. Saving and Proposals to
Address the Crisis," National Tax Journal, v. 43, September 1990, pp. 233-
246.

Poterba, James, Steven Venti, and David A. Wise. "How Retirement
Savings Programs Increase Saving," Journal of Economic Perspectives, v. 10,
Fall 1996, pp. 91-112.
Purcell, Patrick. "Pension Reform: The Economic Growth and Tax Relief
Reconciliation Act of 2001," Library of Congress, Congressional Research
Service Report RS20629, Washington, DC.: Updated June 18, 2002.
Stevens, Kevin T., and Raymond Shaffer. "Expanding the Deduction for
IRAs and Progressivity," Tax Notes. August 24, 1992, pp. 1081-1085.
Venti, Steven F., and David A. Wise. "Have IRAs Increased U.S.
Savings?" Quarterly Journal of Economics, v. 105, August 1990, pp. 661-
698.
U.S. Congress, Congressional Budget Office. Tax Policy for Pensions and
Other Retirement Savings, by David Lindeman and Larry Ozanne.
Washington, DC: U.S. Government Printing Office, April 1987.
-, House Committee on Ways and Means. Background Materials: 2000
Green Book, Committee Print, 106th Congress, 2nd session. October 6, 2000,
pp. 789-792.
-, Joint Committee on Taxation. Present Law, Proposals, and Issues
Relating to Individual Retirement Arrangements and Other Savings
Incentives, Joint Committee Print, 101st Congress, 2nd session. March 26,
1990.
-. General Explanation of the Tax Legislation Enacted in 1997, Joint
Committee Print, 105th Congress, 1st Session, December 17, 1997.
-. Description and Analysis of S. 612 (Savings and Investment Incentive
Act of 1991), Joint Committee Print.
-. Senate Committee on Finance. Hearing on Bentson-Roth IRA, 102nd
Congress, 1st session. May 16, 1991.

Income Security

TAX CREDIT FOR CERTAIN INDIVIDUALS FOR
ELECTIVE DEFERRALS AND IRA CONTRIBUTIONS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.9

2007

0.6

2008

(1)

2009

2010

(1) Less than $50 million.

Authorization

Section 25B.

Description

Taxpayers who are 18 or over and not full time students or dependents can
claim a tax credit for elective contributions to qualified retirement plans or
IRAs. The maximum amount eligible for the credit is $2,000. Credit rates
depend on filing status and adjusted gross income. For joint returns the credit
is 50% for adjusted gross income under $30,000, 20% for incomes between
$30,000 and $32,500, and 10% for incomes above $32,500 and less than
$50,000. Income categories are half as large for singles ($15,000, $16,250,
and $25,000) and between those for singles and joint returns for heads of
household ($22,500, $24,375, and $37,500). The income thresholds are
indexed to inflation. The credit may be taken in addition to general
deductions or exclusions.

Impact

Because of the phaseout, the credit's benefits are targeted to lower income
individuals. However, the ability to use the credit is limited because so many
lower income individuals have no tax liability. According to the Treasury
Department, about 57 million taxpayers would be eligible for the credit, but
about 26 million would receive no credit because they have no tax liability.
Of those actually able to benefit from the credit, the amount of benefit will
probably be relatively small. The average credit for the 2004 tax year was
less than $200. One study finds that the credit has a modest effect on take-up
and on amounts contributed to retirement savings plans by low and moderate
income families.

Historically, most lower income individuals do not tend to save or
participate in voluntary plans such as individual retirement accounts, perhaps
because of pressing current needs. Thus, the number of families and
individuals claiming the credit may be relatively small. In tax year 2004,
about 6% of taxpayers with adjusted gross income of $50,000 or less took the
retirement savings contribution credit.

Rationale

This provision was enacted as part of the Economic Growth and Tax Relief
Reconciliation Act of 2001 and was set to expire after 2006. The Pension
Protection Act of 2006 made this credit permanent. Its purpose was to
provide savings incentives for lower income individuals who historically have
had inadequate retirement savings or none at all. The credit is comparable to
a matching contribution received by many 401(k) participants from their
employers.

Assessment

The expectation is that the credit would have limited impact on increasing
savings for its target group because so many lower income individuals will
not have enough tax liability to benefit from the credit. Among those who are
eligible, the higher incomes necessary for them to have tax liability mean that
the credit rate will be lower. The credit could be redesigned to cover more
lower income individuals by stacking it first, before the refundable child
credit, or making the credit refundable. Gale, Iwry, and Orszag (2005)
estimate that the annual revenue cost of a refundable retirement savings
contribution credit would be about $4.2 billion between 2007 and 2015.

As with other savings incentives, there is no clear evidence that these
incentives are effective in increasing savings. The credit also has a cliff
effect: because the credit is not phased down slowly, a small increase in
income can trigger a shift in the percentage credit rate and raise taxes
significantly.

Selected Bibliography

Brady, Peter and Warren B. Hrung. Assessing the Effectiveness of the
Saver's Credit: Preliminary Evidence from the First Year. Paper presented at
the National Tax Association Meetings, Miami, Fl. November 2005.
Duflo, Ester, et al., "Saving Incentives for Low- and Middle-Income
Families: Evidence from a Field Experiment with H&R Block," National
Bureau of Economic Research working paper 11680, September 2005.
Gale, William G., J. Mark Iwry, and Peter R. Orszag, "The Saver's Credit:
Expanding Retirement Savings for Middle- and Lower-Income Americans,"
The Retirement Security Project, No. 2005-2. March 2005.
Kiefer, Donald, et al., "The Economic Growth and Tax Relief
Reconciliation Act of 2001: Overview and Assessment of Effects on
Taxpayers." National Tax Journal, v. 55, March 2002, pp. 89-118
Orszag, Peter. "The Retirement Savings Component of Last Year's Tax
Bill: Why it is Premature to Make Them Permanent." Center on Budget
Policies and Priorities. September 18, 2003.
White, Craig G. "Does the Saver's Credit Offer an Incentive to Lower
Income Families?" Tax Notes, v. 96, September 16, 2002, pp. 1633-1640.
Sullivan, Martin. "Economic Analysis: With Little Fanfare, Gephardt
Introduces Sweeping Pension Reform." Tax Notes, v. 95, June 17, 2002, pp.
1709-1710.

Income Security

TAX CREDIT FOR NEW RETIREMENT PLAN EXPENSES
OF SMALL BUSINESSES

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2005

(1)

2006

(1)

2007

(1)

2008

(1)

2009

(1)

(1)Less than $50 million.

Authorization

Section 45E.

Description

Eligible small employers that began to offer qualified pension plans to their
employees starting in 2002 and each year thereafter may claim a tax credit for
qualified costs they incur in starting the plans and maintaining them in their
first few years. The credit is equal to 50 percent of up to $1,000 in these costs
incurred in each of the first three years the plans are in effect, beginning with
the tax year in which the plans become effective.

An eligible small employer is one that had no more than 100 employees
receiving a minimum of $5,000 in total compensation in the preceding tax
year. The credit applies to the following new pension plans: defined benefit
plans, defined contribution plans (including 401(k) plans), savings incentive
match plans for employees (SIMPLE), and simplified employee pension
(SEP) plans. At least one employee who is not considered highly
compensated must participate. Qualified costs are any ordinary and necessary
expenses incurred to establish and administer an eligible plan or to educate
employees about the plan and retirement planning. Qualified costs offset by
any credit claimed may not also be deducted as ordinary and necessary
business expenses.

The credit is part of the general business credit, and therefore is subject to
its limitations and carryover rules. It is scheduled to expire at the end of
2010.

Impact

The provision is intended to encourage smaller employers to set up and
maintain retirement savings plans for their employees. Survey data for 2002
collected by the Employee Benefit Research Institute indicated that the cost of
establishing a pension plan was the most important reason for not having such
a plan for 10 percent of firms and a major reason for a third of them. In
addition, the survey results suggested that most small business owners were
unaware of the credit in its first year of existence. Arguably, it is too soon to
tell how effective the credit will be in spurring the creation of new pension
plans among eligible small employers.

Rationale

This provision was enacted as part of the Economic Growth and Tax Relief
Reconciliation Act of 2001. Its principal purpose was to expand access to
retirement savings plans in the private sector by removing an administrative
obstacle to such plans among small businesses. According to data collected
by the Employee Benefit Research Institute, in 1999, 64 percent of full-time
employees at firms with more than 100 employees were covered by an
employment-based retirement plan, whereas only 34 percent of full-time
employees at firms with 100 or fewer employees were covered by such a plan.

Assessment

The credit reduces the after-tax cost to qualified small employers of setting
up qualified pension plans for their employees. In effect, the Federal
Government assumes a small share of the cost of starting up and maintaining
these plans.

A reduction in start-up costs may lead some small firms to set up pension
plans that otherwise would not come into existence. Yet it is unclear how
responsive eligible small firms will be to the cost reduction. Because of the
small annual limit on the size of the credit ($500), it may prove more
influential with very small firms than larger eligible firms. While the credit is
of no benefit to firms with more than 100 employees, it could be viewed as an
attempt to create a more level playing field in that the credit may offset some
or all of the cost advantage they may enjoy in establishing employee
retirement plans. Some argue that there are at least two reasons why it is
reasonable to expect that the credit will have little effect on overall saving for
retirement. First, it is unlikely that the credit will induce many eligible firms
to set up pension plans. Second, there is little evidence that pension plans
actually increase the savings of individuals.

Selected Bibliography

Lee, Karen. "Taking the Plunge: Economy Keeps Small Employers
Nervous About Offering Retirement Plans." Employee Benefit News, April 1,
2004.
Lurie, Alvin D. "The 2001 Tax Law: A Congressional Vanishing Act,
But With Real Magic for Retirement Plans," Compensation & Benefits
Management; V. 17, autumn 2001, pp. 1-9.
Employee Benefit Research Institute. "The 2003 Small Employer
Retirement Survey (SERS): Summary of Findings." Available at
http://www.ebri.org/sers.
Storey, James R. Pension Reform: SIMPLE Plans for Small Employers.
Library of Congress, Congressional Research Service Report 96-758,
Washington, DC: February 9, 2001.
U.S. Department of the Treasury. Internal Revenue Service. Retirement
Plans for Small Businesses, 2003 tax year, Publication 560.

Income Security

EXCLUSION OF OTHER EMPLOYEE BENEFITS:
PREMIUMS ON GROUP TERM LIFE INSURANCE

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

2.5

2007

2.6

2008

2.6

2009

2.7

2010

2.7

Authorization

Section 79 and L.O. 1014, 2 C.B. 8 (1920).

Description

The cost of group-term life insurance purchased by an employer for an
employee is excluded from the employee's gross income to the extent that the
insurance is less than $50,000.

If a group-term life insurance plan discriminates in favor of any key
employee (generally an individual who is an officer, a five-percent owner, a
one-percent owner earning more than $150,000, or one of the top 10
employee-owners), the full cost of the group-term life insurance for any key
employee is included in the gross income of the employee.

The cost of an employee's share of group-term life insurance generally is
determined on the basis of uniform premiums, computed with respect to
five-year age-brackets and provided in a table furnished by the tax authorities.
In the case of a discriminatory plan, however, the amount included in income
will be measured by the actual cost rather than by the table cost prescribed by
the Treasury.

Impact

These insurance plans, in effect, provide additional income to employees.
Because the full value of the insurance coverage is not taxable, this income
can be provided at less cost to the employer than the gross amount of taxable
wages that would have to be paid to an employee to purchase an equal
amount of insurance. Group term life insurance is a significant portion of total
life insurance. However, since neither the value of the insurance coverage
nor the life insurance proceeds are included in gross income, the value of this
fringe benefit is never subject to income tax.

Individuals who are self-employed or who work for an employer without
such a plan do not have the advantage of this tax subsidy for life insurance
protection. While there is little information on the distributional consequence
of this provisions, if the coverage is similar to that of other fringe benefits,
higher-income individuals are more likely to be covered by group life
insurance.

Rationale

This exclusion was originally allowed, without limitation of coverage, by
administrative legal opinion (L.O. 1014, 2 C.B. 8 (1920)). The reason for the
ruling is unclear, but it may have related to supposed difficulties in valuing
the insurance to individual employees, since the value is closely related to age
and other mortality factors. Studies later indicated valuation was not a
problem.

The $50,000 limit on the amount subject to exclusion was enacted in 1964.
Reports accompanying that legislation reasoned that the exclusion would
encourage the purchase of group life insurance and assist in keeping the
family unit intact upon death of the breadwinner.

The further limitation on the exclusion available for key employees in
discriminatory plans was enacted in 1982, and expanded in 1984 to apply to
post-retirement life insurance coverage. In 1986, more restrictive rules
regarding anti-discrimination were adopted, but were repealed in the debt
limit legislation (P.L. 101-140) of 1989.

The President's Advisory Panel on Federal Tax Reform, which issued its
final report in November 2005, recommended elimination of the group-term
life insurance exemption, on equity grounds. The Advisory Panel argued that
providing this tax benefit to a small number of employees requires higher tax
rates on others. Congress has adopted no legislation that would implement
recommendations of the Advisory Panel.

In January 2005, Representative Michael Burgess introduced H.R.51,
which would amend the Internal Revenue Code of 1986 to increase the dollar
limitation on employer-provided group term life insurance that can be
excluded from the gross income of the employee. This bill was referred to the
Committee on Ways and Means. No further action has been taken.

Assessment

There may be some justification for encouraging individuals to purchase
more life insurance than they would otherwise do on their own. Since society
is committed to providing a minimum standard of living for dependent
individuals, it may be desirable to subsidize life insurance coverage.

There is, however, no evidence on the extent to which the subsidy
increases the amount of insurance rather than substituting for insurance that
would be privately purchased. Moreover, by restricting this benefit to
employer-provided insurance, the subsidy is only available to certain
individuals, depending on their employer, and probably disproportionally
benefits high-income individuals. These limitations in coverage may raise
questions of both horizontal and vertical equity.

Selected Bibliography

Butler, Richard J. The Economics of Social Insurance and Employee
Benefits. Berlin: Springer, 1999.
Hacker, Jacob S. The Divided Welfare State: The Battle over Public and
Private Social Benefits in the United States. New York: Cambridge, 2002.
Internal Revenue Service. Employer's Tax Guide to Fringe Benefits For
Benefits Provided in 2006. Publication 15-B, revised December 2005.
International Fiscal Association, The Taxation of Employee Fringe
Benefits: A Report Based on the Proceedings of a Seminar Held in Florence,
Italy, in 1993, IFA Congress Seminar Series, No 18b. Dordrecht, The
Netherlands: Kluwer, September 1995.
Sunley, Emil. "Employee Benefits and Transfer Payments,"
Comprehensive Income Taxation, ed. Joseph A. Pechman. Washington, DC:
The Brookings Institution, 1977, pp. 75-106.
Turner, Robert W. "Fringe Benefits," in The Encyclopedia of Taxation
and Tax Policy (2nd ed.), eds. Joseph J. Cordes, Robert O. Ebel, and Jane G.
Gravelle. Washington, DC: Urban Institute Press, 2005, pp.159-162.
President's Advisory Panel on Federal Tax Reform. Simple, Fair, and
Pro-Growth: Proposals to Fix America's Tax System: Report of the
President's Advisory Panel on Federal Tax Reform. Washington, DC:
November 2005, p. 85.
U.S. General Accounting Office. Effects of Changing the Tax Treatment
of Fringe Benefits. Washington, DC: U.S. Government Printing Office, April
1992.

Income Security

EXCLUSION OF OTHER EMPLOYEE BENEFITS:
PREMIUMS ON ACCIDENT AND DISABILITY INSURANCE

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

2.6

2007

2.8

2008

2.9

2009

3.0

2010

3.1

Authorization

Sections 105 and 106.

Description

Premiums paid by employers for employee accident and disability
insurance plans are not included in the gross income of employees. Although
in general benefit payments to employees are taxable, an exclusion is
provided for payments related to permanent injuries and computed without
regard to the period the employee is absent from work.

Impact

As with term life insurance, since the value of this insurance coverage is
not taxable, the employer's cost is less than he would have to pay in wages
that are taxable, to confer the same benefit on the employee. Employers thus
are encouraged to buy such insurance for employees. Because some proceeds
from accident and disability insurance plans, as well as the premiums paid by
the employer, are not included in gross income, the value of the fringe benefit
is never subject to income tax.

While there is little information on the distributional effects of this
provisions, if the coverage is similar to that of other fringe benefits, higher-
income individuals are more likely to be covered by accident and disability
insurance.

Rationale

This provision was enacted in 1954. Previously, only payments for plans
contracted with insurance companies could be excluded from gross income.
The committee report indicated this provision equalized the treatment of
employer contributions regardless of the form of the plan.

Assessment

Since public programs (social security and workman's compensation)
provide a minimum level of disability payments, it is not clear what
justification there is for providing a subsidy for additional benefits.
Moreover, by restricting this benefit to employer-provided insurance, the
subsidy is only available to certain individuals, depending on their employer,
and probably disproportionally benefits high-income individuals. These
limitations in coverage may raise questions of both horizontal and vertical
equity.

The computation of the value of the premiums could, however, be difficult
to calculate, especially if they are combined with health plans.

Selected Bibliography

Butler, Richard J. The Economics of Social Insurance and Employee
Benefits. Berlin: Springer, 1999.
Hacker, Jacob S. The Divided Welfare State: The Battle over Public and
Private Social Benefits in the United States. New York: Cambridge, 2002.
International Fiscal Association, The Taxation of Employee Fringe
Benefits: A Report Based on the Proceedings of a Seminar Held in Florence,
Italy, in 1993, IFA Congress Seminar Series, No 18b. Dordrecht, The
Netherlands: Kluwer, September 1995.
"Taxation of Employee Accident and Health Plans Before and Under the
1954 Code," Yale Law Journal, v. 64, no. 2. December 1954, pp. 222-247.
Turner, Robert W. "Fringe Benefits," in The Encyclopedia of Taxation
and Tax Policy (2nd ed.), eds. Joseph J. Cordes, Robert O. Ebel, and Jane G.
Gravelle. Washington, DC: Urban Institute Press, 2005, pp.159-162.
U.S. Congress, House Committee on Ways and Means, "An Appraisal of
Individual Income Tax Exclusions" (Roy Wentz), Tax Revision Compendium.
Committee Print, 1959, pp. 329-40.
U.S. General Accounting Office. Effects of Changing the Tax Treatment
of Fringe Benefits. Washington, DC: U.S. Government Printing Office, April
1992.

Income Security

ADDITIONAL STANDARD DEDUCTION
FOR THE BLIND AND THE ELDERLY

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

1.6

2007

1.6

2008

1.7

2009

1.7

2010

1.8

Authorization

Section 63(f).

Description

An additional standard deduction is available for blind and elderly
taxpayers. To qualify for the additional standard deduction amount, a
taxpayer must be age 65 (or blind) before the close of the tax year. The added
standard deduction amounts, $1,000 for a married individual or surviving
spouse or $1,250 for an unmarried individual for tax year 2006, are added to
the basic standard deduction amounts. A couple could receive additional
deductions totaling $4,500 if both were blind and elderly. These amounts are
adjusted for inflation.

Impact

The additional standard deduction amounts raise the income threshold at
which taxpayers begin to pay taxes. The benefit depends on the marginal tax
rate of the individual. Most benefits go to taxpayers with incomes under
$50,000.

Distribution by Income Class of the Tax Expenditure
for the Additional Standard Deduction Amount for
the Blind and Elderly
at 2004 Income Levels

Adjusted Gross Income Class
(in thousands of $)

Percentage
Distribution

Below $10

18.7

$10 to $20

30.9

$20 to $30

16.4

$30 to $40

10.1

$40 and over

21.4

Source: Data obtained from IRS Statistics of Income,
http://www.irs.gov/pub/irs-soi/04in14ar.xls visited Oct. 6, 2006. Amounts may not
add up due to rounding.
Note: This is not a distribution of the tax expenditures, but of the deductions. It is
classified by adjusted gross income, not expanded adjusted gross income.

Rationale

Special tax treatment for the blind first became available under a provision
of the Revenue Act of 1943 (P.L. 78-235) which provided a $500 itemized
deduction. The purpose of the deduction was to help cover the additional
expenses directly associated with blindness, such as the hiring of readers and
guides. The deduction evolved to a $600 personal exemption in the Revenue
Act of 1948 (P.L. 80-471) so that the blind did not forfeit use of the standard
deduction and so that the tax benefit could be reflected directly in the
withholding tables.

At the same time that the itemized deduction was converted to a personal
exemption for the blind, relief was also provided to the elderly by allowing
them an extra personal exemption. Relief was provided to the elderly because
of a heavy concentration of small incomes in that population, the rise in the
cost of living, and to counterbalance changes in the tax system resulting from
World War II. It was argued that those who were retired could not adjust to
these changes and that a general personal exemption was preferable to
piecemeal exclusions for particular types of income received by the elderly.

As the personal and dependency exemption amounts increased over the
years, so too did the amount of the additional exemption. The exemption
amount increased to $625 in 1970, $675 in 1971, $750 in 1972, $1,000 in
1979, $1,040 in 1985 and $1,080 in 1986.

A comprehensive revision of the Code was enacted in 1986 designed to
lead to a fairer, more efficient and simpler tax system. Under a provision in
the Tax Reform Act of 1986 (P.L. 99-514) the personal exemptions for age
and blindness were replaced by an additional standard deduction amount.
This change was made because higher income taxpayers are more likely to
itemize and because a personal exemption amount can be used by all
taxpayers whereas the additional standard deduction will be used only by
those who forgo itemizing deductions. Thus, the rationale is to target the
benefits to lower and moderate income elderly and blind taxpayers.

Assessment

Advocates of the blind justify special tax treatment based on higher living
costs and additional expenses associated with earning income. However,
other taxpayers with disabilities (deafness, paralysis, loss of limbs) are not
accorded similar treatment and may be in as much need of tax relief. Just as
the blind incur special expenses so too do others with different handicapping
impairments.

Advocates for the elderly justify special tax treatment based on need,
arguing that the elderly face increased living costs primarily due to inflation;
medical costs are frequently cited as one example. However, social security
benefits are adjusted annually for cost inflation and the federal government
has established the Medicare Program. Opponents of the provision argue that
if the provision is retained the eligibility age should be raised. It is noted that
life expectancy has been growing longer and that most 65 year olds are
healthy and could continue to work. The age for receiving Social Security
benefits has been increased for future years.

One notion of fairness is that the tax system should be based on ability-to-
pay and that ability is based upon the income of taxpayers-not age or
handicapping condition. The additional standard deduction amounts violate
the economic principle of horizontal equity in that all taxpayers with equal net
incomes are not treated equally. The provision also fails the effectiveness test
since low-income blind and elderly individuals who already are exempt from
tax without the benefit of the additional standard deduction amount receive no
benefit from the additional standard deduction but are most in need of
financial assistance.

Nor does the provision benefit those blind or elderly taxpayers who itemize
deductions (such as those with large medical expenditures in relation to
income). Additionally, the value of the additional standard deduction is of
greater benefit to taxpayers with a higher rather than lower marginal income
tax rate. Alternatives would be a tax credit or a direct grant.

Selected Bibliography

Chen, Yung-Ping. "Income Tax Exemptions for the Aged as a Policy
Instrument," National Tax Journal, v. 16, no. 4. December 1963, pp. 325-
336.
Ehrenhalt, Alan. "The Temptation to Hand Out Irrelevant Entitlements,"
Governing, v. 9 (November 1995), pp. 7-8.
Forman, Jonathan Barry. "Reconsidering the Income Tax Treatment of the
Elderly: It's Time for the Elderly to Pay Their Fair Share," University of
Pittsburgh Law Review, v. 56, Spring 1995, pp. 589-626.
Groves, Harold M. Federal Tax Treatment of the Family. Washington,
DC: The Brookings Institution, 1963, pp. 52-55.
Kahn, Jeffrey. "Personal Deductions - A Tax "Ideal" or Just Another
"Deal"?" Law Review of Michigan State University - Detroit College of Law,
Spring 2002, pp. 1-55.
Lightman, Gary P. "Tax Expenditure Analysis of I.R.C. 151(d), The
Additional Exemption for the Blind: Lack of Legislative Vision?" Temple
Law Quarterly, v. 50, no. 4. 1977, pp. 1086-1104.
Livsey, Herbert C. "Tax Benefits for the Elderly: A Need for Revision."
Utah Law Review, v. 1969, No. 1. 1969, pp. 84-117.
Jackson, Pamela J. Additional Standard Tax Deduction for the Blind: A
Description and Assessment, Library of Congress, Congressional Research
Service Report RS20555. July 12, 2006.
-. Additional Standard Tax Deduction for the Elderly: A Description and
Assessment, Library of Congress, Congressional Research Service Report
RS20342. June 28, 2006.
Tate, John. "Aid to the Elderly: What Role for the Income Tax?"
University of Cincinnati Law Review, v. 41, no. 1. 1972, pp. 93-115.
U.S. Congress, House Committee on Ways and Means. 2000 Green
Book; Background Material and Data on Programs Within the Jurisdiction
of the Committee on Ways and Means. Committee Print, 106th Congress, 2d
Session. October 6, 2000, pp. 822-823.
-. Overview of Entitlement Programs. May 15, 1992, pp. 1035-1037.
U.S. President (Reagan). The President's Tax Proposals to the Congress
for Fairness, Growth and Simplicity. Washington, DC: U.S. Government
Printing Office, 1985, pp. 11-14.

Income Security

TAX CREDIT FOR THE ELDERLY AND DISABLED

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

(1)

2007

(1)

2008

(1)

2009

(1)

2010

(1)

(1)Positive tax expenditure of less than $50 million.

Authorization

Section 22.

Description

Individuals who are 65 years of age or older may claim a tax credit equal to
15 percent of their taxable income up to a base amount. The credit is also
available to individuals under the age of 65 if they are retired because of a
permanent and total disability and have disability income from either a public
or private employer based upon that disability. The maximum base amount
for a married couple where both spouses are 65 or over is $7,500. When one
spouse is 65 or over and the other spouse is under 65 but disabled, the
maximum amount is the lesser of $7,500 or $5,000 plus "disability income"
(income from wages, or payments in lieu of wages, due to disability).

A maximum base amount of $5,000 is provided for a single taxpayer 65 or
over and a married couple where only one spouse is over 65. Where both are
under 65 and both are disabled, the maximum base amount is the lesser of
$7,500 or total "disability income." When one is disabled but neither is 65 or
over or in the case of a single disabled individual under 65, the maximum
base amount is the lesser of $5,000 or "disability income." For a married
individual filing separately the maximum base amount is $3,750 (the lesser of
$3,750 or the "disability income" received if disabled).

The maximum base amount is reduced by certain amounts received as
pensions or disability benefits which are excluded from gross income (such as
nontaxable pension or annuity income, social security benefits, railroad
retirement, and veterans benefits). Also, a reduction from the maximum base
amount is made by one-half of the excess over the following amounts: $7,500
adjusted gross income (AGI) for a single individual, $10,000 for a joint
return, or $5,000 for a married individual filing a separate return.

Impact

The maximum credit per individual is $750 (15 percent of $5,000) and
$1,125 in the case of a married couple both 65 or over (15 percent of $7,500).
Because the base amount is reduced by Social Security benefits, the primary
beneficiaries are persons with disabilities and retirees who are not eligible to
receive tax-exempt Social Security benefits.

Because the provision is a credit, its value to the taxpayer is affected only
by the level of benefits and the credit rate, and not by the tax bracket of the
taxpayer. However, the adjusted gross income phaseout serves to limit relief
to low- and very-moderate-income taxpayers. Additionally, tax credits are
used to reduce income tax liability, as opposed to tax deductions which
reduce income available to be taxed. Individuals with low tax liabilities may
be ineligible to claim the credit, or the full value of the credit, since it is
nonrefundable.

Preliminary Distribution by Income Class
of the Tax Expenditure for Credit
for the Elderly and Disabled at 2004 Income Levels

Adjusted Gross Income Class
(in thousands of $)

Percentage
Distribution

Below $10

0.2%

$10 to $20

79%

$20 to $30

20.8%

$30 and over

0.0%

Source: Data obtained from IRS Statistics of Income,
http://www.irs.gov/pub/irs-soi/04in33ar.xls visited Oct. 6, 2006. Amounts may not
add up due to rounding.
Note: This table classifies by adjusted gross income, not expanded adjusted gross
income.

Rationale

The retirement income credit first enacted with the codification of the
Internal Revenue Code of 1954 (P.L. 83-591) was intended to remove the
inequity between individuals who received taxable retirement income with
those who received tax-exempt Social Security payments. In 1976, the
retirement income credit was redesigned into the tax credit for the elderly.

In the Social Security Amendments of 1983 (P.L. 98-21), Social Security
benefits were made taxable above certain income levels. In response to this
change the tax credit's base amounts were increased to provide some
coordination with the level at which Social Security benefits became taxable.
In addition, the credit for the elderly was expanded to include those
permanently and totally disabled. This change was designed to provide the
same tax relief to aged and disabled taxpayers who do not receive tax-free
Social Security retirement or disability payments.

Assessment

While the tax credit affords some elderly and disabled taxpayers receiving
taxable retirement or disability income a measure of comparability with those
receiving tax-exempt (or partially tax-exempt) Social Security benefits, it does
so only at low-income levels because of the adjusted gross income phaseout.
Social Security recipients with higher levels of income always continue to
receive at least a portion of their Social Security income tax free. Such is not
the case for those who use the tax credit.

The Congress has not reviewed the tax credit to provide inflation
adjustments since 1983. Therefore, tax relief currently provided by the tax
credit lags behind tax relief provided to Social Security recipients. Thus, as
Social Security income continues to increase with the consumer price index
(CPI), a greater differential will exist between the value of the tax credit and
the portion of Social Security income that is tax exempt.

The provision has been criticized for being relatively complex, with some
taxpayers unaware of its availability.

Selected Bibliography

Butrica, Barbara A., Richard W. Johnson, Karen E. Smith, and C. Eugene
Steuerle. The Implicit Tax on Work at Older Ages, National Tax Journal,
vol. 59, (June 2006.), pp. 211-234.
Cairns, Scott N. and Diane A. Riordan. "Nonbusiness Credits: A Proposal
for Change Based on Break-Even Analysis. Reforming the Elderly or
Permanently Disabled Credit and the Dependent and Child Care Credit,"
Taxes, v. 70 (May 1992), pp. 347-356.

Dickert-Conlin, Stacy, Katie Fitzpatrick, and Andrew Hanson. "Utilization
of Income Tax Credits by Low-Income Individuals," National Tax Journal,
vol.58, iss. 4 (Dec. 2005), pp. 743-785.
Forman, Jonathan Barry. "Reconsidering the Income Tax Treatment of the
Elderly: It's Time for the Elderly to Pay Their Fair Share," University of
Pittsburgh Law Review, v. 56, Spring 1995, pp. 589-626.
Hulse, David S. "Is Inflation Phasing Out the Credit for the Elderly," Tax
Notes, v. 60 (July 12, 1993), pp. 211-216.
U.S. Department of the Treasury. Internal Revenue Service. Publication
524: Credit for the Elderly or the Disabled. 2003.
U.S. Department of the Treasury. Internal Revenue Service. National
Taxpayer Advocate, FY 2001 Annual Report to Congress. December 31,
2001, pp. 218-219.
U.S. Congress, House Committee on Ways and Means. "2000 Green
Book; Background Material and Data on Programs Within the Jurisdiction
of the Committee on Ways and Means." Committee Print, 106th Congress, 2d
Session. October 6, 2000, pp. 823-824.
-. Overview of Entitlement Programs; 1998 Green Book; Background
Material and Data on Programs Within the Jurisdiction of the Committee on
Ways and Means. Washington, DC: U.S. Government Printing Office, May
19, 1998, pp. 882-883.
U.S. Congress, Joint Committee on Taxation. General Explanation of the
Tax Reform Act of 1976 (H.R. 10612, 94th Congress, Public Law 94-455).
Washington, DC: U.S. Government Printing Office, December 29, 1976, pp.
117-123.
U.S. President (1981-1989: Reagan). The President's Tax Proposals to the
Congress for Fairness, Growth and Simplicity. 1985, pp. 11-14.

Income Security

DEDUCTIBILITY FOR CASUALTY
AND THEFT LOSSES

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.7

2007

0.8

2008

0.3

2009

0.3

2010

0.3

Authorization

Sections 165(c)(3), 165(e), 165(h) - 165(k).

Description

An individual may claim an itemized deduction for unreimbursed personal
casualty or theft losses in excess of $100 per event and in excess of 10
percent of adjusted gross income (AGI) for combined net losses during the
tax year. Eligible losses are those arising from fire, storm, shipwreck, or other
casualty, or from theft. The cause of the loss should be considered a sudden,
unexpected, and unusual event.

The Katrina Emergency Tax Relief Act of 2005 (P.L. 109-73) eliminated
limitations of deductible losses arising from the consequences of Hurricane
Katrina. Such losses are deductible without regard to whether aggregate net
losses exceed 10 percent of the taxpayer's adjusted gross income, and need
not exceed $100 per casualty or theft.

Impact

The deduction grants some financial assistance to taxpayers who suffer
substantial casualties and itemize deductions. It shifts part of the loss from
the property owner to the general taxpayer and thus serves as a form of
government coinsurance. Use of the deduction is low for all income groups.
There is no maximum limit on the casualty loss deduction. If losses exceed
the taxpayer's income for the year of the casualty, the excess can be carried
back or forward to another year without reapplying the $100 and 10 percent
floors. A dollar of deductible losses is worth more to taxpayers in higher
income tax brackets because of their higher marginal tax rates. The deduction
is unavailable for taxpayers who do not itemize. Typically, lower income
taxpayers tend to be less likely to itemize the deductions.

Rationale

The deduction for casualty losses was allowed under the original 1913
income tax law without distinction between business-related and
non-business-related losses. No rationale was offered then. The Revenue Act
of 1964 (P.L. 88-272) placed a $100-per-event floor on the deduction for
personal casualty losses, corresponding to the $100 deductible provision
common in property insurance coverage at that time. The deduction was
intended to be for extraordinary, nonrecurring losses which go beyond the
average or usual losses incurred by most taxpayers in day-to-day living. The
$100 floor was intended to reduce the number of small and often improper
claims, reduce the costs of record keeping and audit, and focus the deduction
on extraordinary losses.

The Tax Equity and Fiscal Responsibility Act of 1982 (P.L. 97-248)
provided that the itemized deduction for combined nonbusiness casualty and
theft losses would be allowed only for losses in excess of 10 percent of the
taxpayer's AGI. While Congress wished to maintain the deduction for losses
having a significant effect on an individual's ability to pay taxes, it included a
percentage-of-adjusted-gross-income floor because it found that the size of a
loss that significantly reduces an individual's ability to pay tax varies with
income.

The casualty loss deduction is exempt from the overall limit on itemized
deductions for high-income taxpayers which took effect in 1991.

Assessment

Critics have pointed out that when uninsured losses are deductible but
insurance premiums are not, the income tax discriminates against those who
carry insurance and favors those who do not. It similarly discriminates
against people who take preventive measures to protect their property but
cannot deduct their expenses. No distinction is made between loss items
considered basic to maintaining the taxpayer's household and livelihood
versus highly discretionary personal consumption. The taxpayer need not
replace or repair the item in order to claim a deduction for an unreimbursed
loss.

Up through the early 1980s, while tax rates were as high as 70 percent and
the floor on the deduction was only $100, high income taxpayers could have a
large fraction of their uninsured losses offset by lower income taxes,
providing them reason not to purchase insurance. IRS statistics for 1980
show a larger percentage of itemized returns in higher income groups
claiming a casualty loss deduction.

The imposition of the 10-percent-of-AGI floor effective in 1983, together
with other changes in the tax code during the 1980s, substantially reduced the
number of taxpayers claiming the deduction. In 1980, 2.9 million tax returns,
equal to 10.2 percent of all itemized returns, claimed a deduction for casualty
or theft losses. In 2001, the latest available year, only 97,424 returns claimed
such a deduction.

Use of the casualty and theft loss deduction can fluctuate widely from year
to year. Deductions have risen substantially for years witnessing a major
natural disaster - such as a hurricane, flood, or earthquake. In some years
(such as 1989, 1993, and 1994) the increase in deductions is due to a jump in
the number of returns claiming the deduction. In other years (such as 1992) it
reflects a large increase in the average dollar amount of deductions per return
claiming the loss deduction.

Selected Bibliography

Fulcher, Bill. "Casualty Losses Can Be Deductible," National Public
Accountant, v. 44 (July 1999), pp. 46-47.
Kahn, Jeffrey H. "Personal Deductions: A Tax 'Ideal' or Just Another
'Deal'?," Law Review of Michigan State University, v. 2002, Spring 2002,
pp. 1-55.
Kaplow, Louis. "The Income Tax as Insurance: The Casualty Loss and
Medical Expense Loss Deductions and the Exclusion of Medical Insurance
Premiums," California Law Review, v. 79. December 1991, pp. 1485-1510.
-. "Income Tax Deductions for Losses as Insurance," American Economic
Review, v. 82, no. 4. September 1992, pp. 1013-1017.
Ritter, Gregory J. and Joel S. Berman. "Casualty Losses (A Tax
Perspective)," Florida Bar Journal, v. 67 (April 1993), pp. 43-38.
Milam, Edward E. and Donald H. Jones, Jr. "Casualty and Theft Losses
Can Provide Significant Tax Deductions," Taxes, The Tax Magazine, v. 80,
no. 10, October 2002, pp. 45-50.
Thompson, Steven C. and Nell Adkins. "Casualty Gains-An Oxymoron,
or Just a Trap for Unwary Taxpayers?," Taxes, v. 73. June 1995, pp. 318-24.
Internal Revenue Service. Casualties, Disasters, and Thefts. Publication
547, for use in preparing 2006 returns.

Income Security

EARNED INCOME CREDIT (EIC)

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

42.1

2007

42.8

2008

43.5

2009

44.5

2010

45.4

Authorization

Section 32.

Description

Eligible married couples and single individuals meeting certain earned
income and adjusted gross income (AGI) limits may be eligible for an earned
income credit (EIC). For purposes of the credit, earned income includes
wages, salaries, tips, and net income from self employment. In addition to
earned income and AGI, the value of the credit will depend on whether or not
the taxpayer has a qualifying child. A qualifying child for the EIC must meet
the following three criteria for a qualifying child for the personal exemption:
(1) relationship - the child must be a son, daughter, stepson, stepdaughter, or
descendent of such a relative; a brother, sister, stepbrother, stepsister, or
descendent of such a relative cared for by the taxpayer as his/her own child;
or a foster child; (2) residence - the child must live with the taxpayer for more
than half the year; and (3) age - the child must be under age 19 (or under age
24, if a full-time student) or be permanently and totally disabled. If a
taxpayer does not have a qualifying child, the taxpayer must be at least 25
years of age but not more than 64 years of age, be a resident of the United
States for more than half of the year, and not be claimed as a dependent on
another taxpayer's return. A taxpayer will be disqualified from receiving the
credit if investment income exceeds a specified amount ($2,800 in tax year
2006, the amount is indexed for inflation). Married couples generally must
file a joint tax return.

The EIC increases with earnings up to a maximum, remains flat for a
given range of income, and then declines to zero as income continues to
increase. The credit is calculated as a percentage of the taxpayer's earned
income up to a statutory maximum earned income amount. The credit
remains at this maximum until earned income or AGI (whichever is larger)
reaches a point at which it begins to phase out. Above this level, the EIC is
reduced (phased out) by a percentage of the income above the phase out
income amount. The maximum earned income and phase out income
amounts are adjusted for inflation.

For tax year 2006, the maximum EIC is equal to 34.0 percent of the first
$8,080 of earned income for one qualifying child (i.e. the maximum basic
credit is $2,747) and 40.0 percent of earned income up to $11,340 for two or
more qualifying children (i.e. the maximum basic credit is $4,536).

For individuals with children, in tax year 2006, the EIC begins to phase
out at $14,810 of earned income or AGI, whichever is larger. For married
couples with children the phase out begins at an income level that is $2,000
higher ($16,810). For families above the phase out income amount, the
credit is phased out at a rate of 15.98 percent of income above the phase out
income level for one qualifying child, and 21.06 percent for two or more
qualifying children.

For married couples and individuals without children, in tax year 2006, the
EIC is 7.65 percent of the first $5,380 for a maximum credit of $412. The
credit begins to phase out at $6,740 of earned income (or AGI whichever is
larger) and at a 7.65 percent rate. For married couples with children the
phase out begins at an income level that is $2,000 higher ($8,740). The
maximum earned income and phase out income amounts are adjusted for
inflation.

If the credit is greater than Federal income tax owed, the difference is
refunded. The portion of the credit that offsets (reduces) income tax is a tax
expenditure, while the portion refunded to the taxpayer is treated as an outlay.
Working parents may arrange with their employers to receive the credit in
advance (before filing an annual tax return) through reduced tax withholding
during the year.

While gross income for tax purposes does not generally include certain
combat pay earned by members of the armed forces, P.L. 108-311 allowed
members of the armed forces to include this combat pay for purposes of
computing the earned income credit for tax years that ended after October 4,
2004 and before January 1, 2007.

Impact

The earned income credit increases the after-tax income of lower- and
moderate-income working couples and individuals, particularly those with
children. Alternative measures of income by the U.S. Census Department,
which are designed to show the impact of taxes and transfers on poverty,
estimate that the earned income credit reduced the number of people in
poverty in 2004 by approximately 5.8 million. Because the number of
people in poverty is 42.4 million before the EIC (using an alternative income
definition, and not the official definition), the reduction due to the EIC is
13.7%.

The following table provides estimates of the distribution of the earned
income credit by income level, and includes the refundable portion of the
credit. Because the estimates use an expanded definition of income, the
estimates contain a distribution for incomes above the statutory limits. For
further information on the definition of income see page 5 of the introduction
to this document.

Distribution by Income Class of the Tax Expenditure
for the Earned Income Credit, 2005

Income Class
(in thousands of $)

Percentage
Distribution

Below $10

15.3

$10 to $20

38.8

$20 to $30

28.5

$30 to $40

13.6

$40 to $50

3.2

$50 to $75

0.5

$75 to $100

0.0

$100 to $200

0.0

$200 and over

0.0

Rationale

The earned income credit was enacted by the Tax Reduction Act of 1975
as a temporary refundable credit to offset the effects of the social security tax
and rising food and energy costs on lower income workers and to provide a
work incentive for parents with little or no earned income.

The credit was temporarily extended by the Revenue Adjustment Act of
1975, the Tax Reform Act of 1976, and the Tax Reduction and Simplification
Act of 1977. The Revenue Act of 1978 made the credit permanent, raised
the maximum amount of the credit, and provided for advance payment of the
credit. The 1978 Act also created a range of income for which the maximum
credit is granted before the credit begins to phase out.

The maximum credit was raised by both the Deficit Reduction Act of 1984
and the Tax Reform Act of 1986. The 1986 Act also indexed the maximum
earned income and phase out income amounts to inflation. The Omnibus
Budget Reconciliation Act (OBRA) of 1990 increased the percentage used to
calculate the credit, created an adjustment for family size, and created
supplemental credits for young children (under age 1) and health insurance.

OBRA 1993 increased the credit, expanded the family-size adjustment,
extended the credit to individuals without children, and repealed the
supplemental credits for young children and health insurance. To increase
compliance, the Taxpayer Relief Act of 1997 included a provision denying
the credit to persons improperly claiming the credit in prior years.

The Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of
2001 simplified calculation of the credit by excluding nontaxable employee
compensation from earned income, eliminating the credit reduction due to the
alternative minimum tax, and using adjusted gross income rather than
modified adjusted gross income for calculation of the credit phase out.
EGTRRA also expanded the phase out range for married couples filing a joint
return to reduce the marriage penalty. The EGTRRA changes do not apply to
tax years after 2010.

Assessment

The earned income credit raises the after-tax income of several million
lower- and moderate-income families, especially those with children. The
credit has been promoted as an alternative to raising the minimum wage, as a
method for reducing the burden of social security tax increases, and as an
incentive to work. The credit has, in dollar terms, become the largest cash
welfare program.

Up to the maximum earned income amount (at which the credit reaches a
maximum) the credit generally provides a work incentive: the more a person
earns, the greater the amount of the credit. But within the income range over
which the credit is phased out, the credit may act as a work disincentive: as
the credit declines, the taxes owed increase. As income increases a credit
recipient may switch from receiving a refund (because of the credit) to
receiving no credit or paying taxes. The combination of higher taxes and a
lower credit increases the marginal tax rate of the individual. The marginal
tax rate may in many cases be higher than the rate for taxpayers with
substantially higher incomes. This creates an incentive for the individual to
reduce work hours (to avoid the increase in taxes and maintain the credit).

While the credit encourages single parents to enter the work force, the
decline of the credit above the phase out amount can discourage the spouse of
a working parent from entering the workforce. This "marriage penalty" may
also discourage marriage when one or both parties receive the earned income
credit. EGTRRA may have moderated this effect somewhat.

Some eligible individuals do not receive the credit because of incorrect or
incomplete tax return information, or because they do not file. Conversely,
payments to ineligible individuals, and overpayments to eligible recipients,
have been a source of concern, resulting in IRS studies of EIC compliance
and federally funded initiatives to improve administration of the credit. For
tax year 2003, the IRS conducted a pre-certification study in which
approximately 25,000 tax filers were asked to certify, before filing their tax
returns, that the child claimed for the credit had lived with the tax filer for
more than half of the tax year (making the child a qualifying child for the
taxpayer to claim the EIC). The final report estimated that erroneous claims
related to the child residency requirement were $2.9 to $3.3 million.
However, the study also estimated that there was a reduction in the credit
claimed by eligible claimants of between $1.1 and $1.4 million due to the
unintended deterrence effect of the pre-certification study.

The credit also differs from other transfer payments in that most
individuals receive it as an annual lump sum rather than as a monthly benefit.
Very few credit recipients elect advance payments. There are a number of
reasons why a recipient may not choose advance payments, including not
wanting to inform an employer that he/she is a credit recipient. A recipient
may also be making a choice between consumption (using advance payments
for current needs) and savings (using an annual payment for future needs or
wants).

Selected Bibliography

Dickert-Conlin, Stacy, and Scott Houser. "EITC and Marriage," National
Tax Journal, v. 55, no. 1, March 2002, pp. 25-43.
Ellwood, David T. "The Impact of the Earned Income Tax Credit and
Social Policy Reforms on Work, Marriage, and Living Arrangements,"
National Tax Journal, v. 53, no. 4, part 2, December 2000, pp. 1063 - 1106.
Gravelle, Jane G. The Earned Income Tax Credit (EITC): Effects on Work
Effort, Library of Congress, Congressional Research Service Report 95-928.
Washington, DC: August 30, 1995.(Available upon request from author)
Gravelle, Jane G. The Marriage Penalty: An Overview of the Issues,
Library of Congress, Congressional Research Service Report RL30419.
Washington, DC: June 21, 2001.
Holtzblatt, Janet, and Robert Rebelein. "Measuring the Effect of the EITC
on Marriage Penalties and Bonuses," National Tax Journal, v. 53, no. 4, part
2, December 2000, pp. 1107 - 1129.
Horowitz, John B. "Income Mobility and the Earned Income Credit,"
Economic Inquiry, v. 40, n. 3, July 2001, pp. 334-347.

Hotz, V. Joseph, and John Karl Scholz, The Earned Income Tax Credit,
National Bureau of Economic Research Working Paper 8078, January 2001.
Liebman, Jefferey B. "Who are the ineligible EITC Recipients?" National
Tax Journal, v. 53, n. 4, part 2, December 2000, pp. 1165 - 1190.
McCubbin, Janet. "EITC Noncompliance: the Determinants of the
Misreporting of Children," National Tax Journal, v. 53, no. 4, part 2,
December 2000, pp. 1135 - 1163.
Meyer, Bruce and Dan T. Rosenbaum, "Making Single Mothers Work:
Recent Tax and Welfare Policy and its Effects," National Tax Journal, v. 53,
no. 4, part 2, December 2000, pp. 1027 - 1054.
Moffit, Robert. Welfare Programs and Labor Supply, National Bureau of
Economic Research Working paper 9168, September 2002.
Neumark, David, and William Wascher. "Using the EITC to Help Poor
Families: New Evidence and a Comparison with the Minimum Wage,"
National Tax Journal, v.54, no. 2, June 2001, pp. 281-317.
Scholz, John Karl. In "Work Benefits in the United States: The Earned
Income Tax Credit, Economic Journal, v. 106, n. 1, January 1996, pp. 159-
169.
Scott, Christine, The Earned Income Credit (EITC): Legislative Issues,
Library of Congress, Congressional Research Service Report RS21477.
Washington, DC.
Scott, Christine, The Earned Income Credit (EITC): An Overview, Library
of Congress, Congressional Research Service Report RL31768. Washington,
DC.
Smeeding, Timothy M., Katherine Ross Phillis and Michael O'Conner,
"The EITC: Expectation, Knowledge, Use, and Economic and Social
Mobility", National Tax Journal, v. 53, no. 4, part 2, December 2000, pp.
1187 - 2109.
U.S. Census Department, Poverty in the United States: 2001, September
2002.
U. S. Census Department, Current Population Survey, Annual
Demographic Supplement, Historical Poverty Tables - Table 5, September
2002.
U.S. Congress, House Committee on Ways and Means. Background
Materials: 1998 Green Book, Committee Print, 106th Congress, 2nd session.
December 22, 2000, pp. 547-552.
U.S. General Accounting Office. "Earned Income Tax Credit:
Qualifying Child Certification Test Appears Justified, but Evaluation
Plan Is Incomplete." GAO-03-794. Washington, D.C., September
2003.
U.S. Department of Treasury, Internal Revenue Service, Compliance
Estimates for Earned Income Tax Credit Claimed on 1999 Returns. February
2002.
U.S. Department of the Treasury, Internal Revenue Service, IRS Earned
Income Tax Credit (EITC) Initiative, Final Report to Congress, October
2005.
Ventry, Dennis J. "The Collision of Tax and Welfare Politics: The Political
History of the Earned Income Credit, 1969-99", National Tax Journal, v. 53
n. 4, part 2, pp. 983 - 1026.

Income Security

EXCLUSION OF CANCELLATION OF INDEBTEDNESS
INCOME OF HURRICANE KATRINA VICTIMS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.2

2007

0.1

2008

2009

2010

(1) Less than $50 million.

Authorization

Sections 61(a)(12), and 108.

Description

When a debt is forgiven, the amount of the forgiveness is included income,
with some exceptions, such as in the case of bankruptcy. One of those
exemptions is forgiveness of non-business debt of an individual between
August 24, 2005 and January 1, 2007 for an individual who either lived in the
core disaster area of Hurricane Katrina, or who lived in the covered disaster
area and incurred an economic loss due to the hurricane. The covered disaster
area designated by the Federal Emergency Management Agency (FEMA) is
eligible for public assistance and includes all of Louisiana and Mississippi,
counties in western Alabama and counties in western Florida panhandle. The
core disaster area is designated by FEMA as eligible for individual aid as well
and covers the southern part of Louisiana and Mississippi, and southwestern
counties in Alabama. This core emergency area was also designated the Gulf
Opportunity Zone (GO Zone). Debt secured by property outside the disaster
area is not eligible.

Individuals with loans secured by property with basis, such as home or
rental property, must reduce basis by the amount of the loan forgiveness
which could result in tax liability in the future through capital gains taxes or
depreciation deductions.

Impact

Forgiveness of debt reduces the taxes that would be immediately due when
debt is forgiven. Individuals affected by a disaster may, as is the case with
bankruptcy, be relieved of a tax they do not have the cash flow to pay, and
one that could be large relative to current income.

To the extent the provision affects debt related to property, the benefit is
more concentrated among higher income individuals, although other forms of
debt may be involved as well.

Rationale

This provision was enacted as part of the Katrina Emergency Relief Act of
2005 (P.L. 109-73). While no official reports exist, the purpose of this
legislation, adopted within a month of the hurricane, was largely directed at
providing relief to the hurricane victims.

Assessment

This provision provides relief to those who were forgiven debt after the
disaster, by eliminating the tax that would be due.

While the provision was aimed at individuals who had suffered a loss,
some questions might be raised as to why relief provisions were allowed for a
major disaster, such as a large scale hurricane, but not for smaller scale
disasters (e.g. tornadoes) or losses proceeding from other sources.

Selected Bibliography

Gravelle, Jane, Tax Policy Options After Hurricane Katrina, Library of
Congress, Congressional Research Service Report RL33088, October 23,
2006.
Internal Revenue Service, Information for Taxpayers Affected by
Hurricanes Katrina, Wilma and Rita, Publication 4492, January 1, 2006.
U.S. Congress, Joint Committee on Taxation, Technical Explanation of the
Revenue Provisions of H.R. 3768, The Katrina Emergency Relief Act of
2005, As Passed by the House of Representatives and the Senate, JC69-05,
Washington, DC, September 21, 2005.

Social Security and Railroad Retirement

EXCLUSION OF UNTAXED SOCIAL SECURITY
AND RAILROAD RETIREMENT BENEFITS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

23.1

2007

24.1

2008

24.8

2009

25.9

2010

27.2

Authorization

Sec. 86 I.R.C. 1954 and I.T. 3194, 1938-1 C.B. 114 and I.T. 3229,
1938-2136, as superseded by Rev. Ruling 69-43, 1969-1 C.B. 310; I.T. 3447,
1941-1 C.B. 191, as superseded by Rev. Ruling 70-217, 1970-1 C.B. 12.

Description

In general, the Social Security and Railroad Retirement benefits of most
recipients are not subject to tax. A portion of Social Security and certain
(Tier I) Railroad Retirement benefits is included in income for taxpayers
whose "provisional income" exceeds certain thresholds.

Tier I Railroad Retirement benefits are those provided by the Railroad
Retirement System that are equivalent to the Social Security benefit that
would be received by the railroad worker were he or she covered by Social
Security. "Provisional income" is adjusted gross income plus one-half the
Social Security benefit and otherwise tax-exempt "interest" income (i.e.,
interest from tax-exempt bonds).

The thresholds below which no Social Security or Tier I Railroad
Retirement benefits are taxable are $25,000 (single), and $32,000 (married
couple filing a joint return).

If provisional income is between the $25,000 threshold ($32,000 for a
married couple) and a second-level threshold of $34,000 ($44,000 for a
married couple), the amount of benefits subject to tax is the lesser of: (1) 50
percent of benefits; or (2) 50 percent of provisional income in excess of the
first threshold.

If provisional income is above the second threshold, the amount of benefits
subject to tax is the lesser of:
(1) 85 percent of benefits or
(2) 85 percent of income above the second threshold, plus
the smaller of (a) $4,500 ($6,000 for a married couple) or,
(b) 50 percent of benefits.

For a married person filing separately who has lived with his or her spouse
at any time during the tax year, taxable benefits are the lesser of 85 percent of
benefits or 85 percent of provisional income.

The tax treatment of Social Security and Tier I Railroad Retirement
benefits differs from that of pension benefits. For pension benefits, all
benefits that exceed (or are not attributable to) the amount of the employee's
contribution are fully taxable.

The proceeds from taxation of Social Security and Tier I Railroad
Retirement benefits at the 50 percent rate are credited to the Social Security
Trust Fund and the National Railroad Retirement Investment Trust,
respectively. Proceeds from taxation of Social Security benefits and Tier I
Railroad Retirement benefits at the 85 percent rate are credited to the Hospital
Insurance Trust Fund (for Medicare).

Impact

The Congressional Budget Office estimates that about 61 percent of Social
Security and Tier I Railroad Retirement recipients pay no tax on their
benefits. The distribution of the tax expenditure is shown below.

Distribution by Income Class of
Tax Expenditure, Untaxed Social Security and
Railroad Retirement Benefits, 2005

Income Class
(in thousands of $)

Percentage
Distribution

Below $10

0.0

$10 to $20

8.6

$20 to $30

11.0

$30 to $40

16.7

$40 to $50

16.4

$50 to $75

33.0

$75 to $100

9.6

$100 to $200

3.5

$200 and over

1.2

Rationale

Until 1984, Social Security benefits were exempt from the federal income
tax. The original exclusion arose from rulings made in 1938 and 1941 by the
then Bureau of Internal Revenue (I.T. 3194, I.T. 3447). The exclusion of
benefits paid under the Railroad Retirement System was enacted in the
Railroad Retirement Act of 1935.

For years many program analysts questioned the basis for the rulings on
Social Security and advocated that the treatment of Social Security benefits
for tax purposes be the same as it is for other pension income. Pension
benefits are now fully taxable except for the proportion of projected lifetime
benefits attributable to the worker's contributions. Financial pressures on the
Social Security program in the early 1980s also increased interest in taxing
benefits. The 1981 National Commission on Social Security Reform
proposed taxing one-half of Social Security benefits received by persons
whose income exceeded certain amounts and crediting the proceeds to the
Social Security Trust Fund. The inclusion of one-half of benefits represented
the employer contribution to the benefits.

In enacting the 1983 Social Security Amendments (P.L. 98-21) in March
1983, Congress essentially adopted the Commission's recommendation, but
modified it to phase in the tax on benefits gradually, as income rose above
threshold amounts. At the same time, it modified the tax treatment of Tier I
Railroad Retirement benefits to conform to the treatment of Social Security
benefits.

In his FY 1994 budget, President Clinton proposed that the taxable propor-
tion of Social Security and Tier I Railroad Retirement benefits be increased to
85 percent effective in 1994, with the proceeds credited to Medicare's
Hospital Insurance (HI) Trust Fund. At that time is was estimated that the
highest paid category of worker would, during the worker's lifetime,
contribute fifteen percent of the value of the Social Security benefits received
by the worker. That is, at least eighty-five percent of the Social Security
benefits received by a retiree could not be attributed to contributions by the
retiree. Congress approved this proposal as part of the Omnibus Budget
Reconciliation Act of 1993 (P.L. 103-66), but limited it to recipients whose
threshold incomes exceed $34,000 (single) or $44,000 (couple). This
introduced the current two levels of taxation.

Assessment

Principles of horizontal equity (equal treatment of those in equal
circumstances) generally support the idea of treating Social Security and Tier
I Railroad Retirement benefits similarly to other sources of retirement income.
Horizontal equity suggests that equal income, regardless of source, represents
equal ability to pay taxes, and therefore should be equally taxed. Just as the
portion of other pension benefits and IRA distributions on which taxes have
never been paid is fully taxable, so too should the portion of Social Security
and Tier I Railroad Retirement benefits not attributable to the individual's
contributions be fully taxed.

In 1993, it was estimated that if Social Security benefits received the same
tax treatment as pensions, on average about 95 percent of benefits would be
included in taxable income, and that the lowest proportion of benefits that
would be taxable for anyone entering the work force that year would be 85
percent of benefits. Because of the administrative complexities involved in
calculating the proportion of each individual's benefits, and because in theory
it would ensure that no one would receive less of an exclusion than entitled to
under other pension plans, a maximum of 85 percent of Social Security
benefits is currently in taxable income.

To the extent that Social Security benefits reflect social welfare payments,
it can be argued that benefits be taxed similar to other general untaxed social
welfare payments and not like other retirement benefits. One exception to
the concept of horizontal equity is social welfare payments - payments
made for the greater good (social welfare). Not all Social Security payments
have a pension or other retirement income component and, unlike other
pensions, more than one person may be entitled to benefits for a single
worker. In addition, Social Security benefits are based on work earnings
history and not contributions, with the formula providing additional benefits
to recipients with lower work earnings histories.

Because the calculation of provisional income (to determine if benefits are
taxable) includes a portion of Social Security benefits and certain otherwise
untaxed income, the provisional income calculation can be compared to the
income resources concept often used for means testing of various social
benefits. Because the taxation increases as the provisional income increases,
the after-tax Social Security benefits will decline as provisional income
increases (but not below 15% of pre-tax benefits). This has resulted in the
taxation of benefits being viewed as a "back-door" means test.

Under the current two level structure, all Social Security beneficiaries have
some untaxed benefits. Taxes are imposed on at least half of the benefits for
middle and upper income beneficiaries, while lower income beneficiaries
have no benefits taxed.

Selected Bibliography

Brannon, Gerard M. "The Strange Precision in the Taxation of Social
Security Benefits," Tax Notes. March 29, 1993.
Fellows, James A., and Haney, J. Edison. "Taxing the Middle Class,"
Taxes. October, 1993.
Scott, Christine, Social Security Benefits: Calculation and History of
Taxing Benefits, Library of Congress, Congressional Research Report
RL32552. Washington, DC.
U.S. Congress, Congressional Budget Office. Reducing the Deficit:
Spending and Revenue Options. March, 1994.
-, Committee on Ways and Means, 2004 Green Book, Background
Material and Data on the Programs Within the Jurisdiction of the Committee
on Ways and Means, WMCP:108-6, March 2004.
-, House of Representatives. Omnibus Budget Reconciliation Act of 1993,
Conference Report No. 103-213. August 4, 1993.
Weiner, David. "Social Security Benefits, Federal Taxation," in The
Encyclopedia of Taxation and Tax Policy, eds. Joseph J. Cordes, Robert O.
Ebel, and Jane G. Gravelle. Washington, DC: Urban Institute Press, 2005.

Veterans' Benefits and Services

EXCLUSION OF VETERANS' BENEFITS AND SERVICES

(1) EXCLUSION OF VETERANS' DISABILITY COMPENSATION
(2) EXCLUSION OF VETERANS' PENSIONS
(3) EXCLUSION OF READJUSTMENT BENEFITS

Estimated Revenue Loss

[in billions of dollars]

Individuals

Fiscal
Year

Veterans
Disability
Compensation

Veterans
Pensions

Readjustment
Benefits

Total

2006

3.6

0.1

0.2

3.9

2007

3.8

0.1

0.3

4.2

2008

3.9

0.1

0.3

4.3

2009

4.0

0.1

0.3

4.4

2010

4.0

0.1

0.3

4.4

Authorization

38 U.S.C. 3101.

Description

All benefits administered by the Department of Veterans Affairs are
exempt from taxation. Such benefits include those for veterans' disability
compensation, veterans' pension payments, and education payments.

Veterans' service-connected disability compensation payments are related
to the loss of earnings capacity in civilian occupations resulting from a
service-related wound, injury, or disease. Typically, benefits increase with
the severity of disability. Veterans whose service-connected disabilities are
rated at 30 percent or more are entitled to additional allowances for
dependents. Veterans with a 60- to 90-percent disability may receive
compensation at the 100-percent level if they are unemployable.

Veteran pensions are available to support veterans with a limited income
who had at least one day of military service during a war period and at least
90 days of active duty service. Benefits are paid to veterans over age 65 or to
veterans with disabilities unrelated to their military service.

Pension benefits are based on "countable" income (the larger the income,
the smaller the pension) with no payments made to veterans whose assets may
be used to provide adequate maintenance. For veterans coming on the rolls
after December 31, 1978, countable income includes earnings of the veteran,
spouse, and dependent children, if any. Veterans who were on the rolls prior
to that date may elect coverage under prior law, which excludes from
countable income the income of a spouse, among other items.

Veterans' educational assistance is provided under a number of different
programs for veterans, service persons, and eligible dependents. These
programs have varying eligibility requirements and benefits.

With passage of the Veterans Millennium Health Care Act of 1999,
veterans received expanded long-term care benefits and increased in home
care. The act gave severely disabled veterans and those needing care for
service-connected conditions higher priority access to long-term care benefits
and services. The act also provided higher priority access to veterans
awarded Purple Hearts and certain military retirees. It authorized the VA to
increase co-payments for pharmacy benefits used for treatment of non-
service-connected conditions, and authorized emergency care coverage for
certain veterans without health insurance. Another provision included
surviving spouses of certain totally disabled former prisoners of war as
eligible for health care.

Impact

Beneficiaries of all three major veterans' programs pay less tax than other
taxpayers with the same or smaller economic incomes. Since these exclusions
are not counted as part of income, the tax savings are a percentage of the
amount excluded, depending on the marginal tax bracket of the veteran.
Thus, the exclusion amounts will have greater value for veterans with high
incomes than for those with lower incomes.

Rationale

The rationale for excluding veterans' benefits from taxation is not clear.
The tax exclusion of benefits was adopted in 1917, during World War I.
Many have concluded that the exclusion is in recognition of the extraordinary
sacrifices made by armed forces personnel, especially during periods of war.

Assessment

The exclusion of veterans' benefits alters the distribution of payments and
favors higher-income individuals. It is typically argued that the differential
that exists between veterans' service-connected disability compensation and
the average salary of wage earners reflects the tax-exempt status of their
benefits. Some view veterans' compensation as a career indemnity payment
owed to those disabled to any degree while serving in the nation's armed
forces. If benefits were to become taxable, higher benefit levels would be
required if lost income were replaced. Some disabled veterans would find it
difficult to increase working hours to make up for the loss of expected
compensation payments. Some commentors have noted that if veterans with
new disability ratings below 30 percent were to be made ineligible for
compensation it would concentrate spending on those veterans most impaired.
Further, not only would direct expenditures be reduced, but the indirect tax
expenditure of these payments would be excluded from the tax base.

Selected Bibliography

Cullinane, Danielle. Compensation for Work-Related Injury and Illness.
Santa Monica, CA, RAND, 1992. 60 p. (RAND Publication Series N-3343-
FMP).
Ferris, Nancy. "Serving Those Who Served," Government Executive, v. 30
(January 1998), pp. 18, 20, 22, 24.
Ogloblin, Peter K. Military Compensation Background Papers:
Compensation Elements and Related Manpower Cost Items, Their Purposes
and Legislative Backgrounds. Washington, DC: Department of Defense,
Office of the Secretary of Defense, U.S. Government Printing Office,
November 1991, pp. 633-645.
Poulson, Linda L. and Ananth Seetharaman. "Taxes and the Armed
Forces," The CPA Journal, April 1996, pp. 22-26.
Snook, Dennis William. "Veterans Issues in the 106th Congress," Library
of Congress, Congressional Research Service Report RL30099. Washington,
DC: March 7, 2001. 31 pp.
U.S. Congress, Congressional Budget Office. Disability Compensation:
Current Issues and Options for Change. Washington, DC: U.S. Government
Printing Office, 1982.
-. Budget Options. "End Future Awards of Veterans' Compensation for
Certain Veterans with Low-Rated Disabilities." and "End Future Awards of
Veterans' Disability or Death Compensation When a Disability is Unrelated
to Military Duties." Washington, DC: February 2001, pp. 347-348.
U.S. Congress, General Accounting Office. Major Management
Challenges and Program Risks: Department of Veterans Affairs, GAO
Report GAO-03-110, Washington, DC: U.S. General Accounting Office.
2003. pp. 1-49.

- . Military and Veterans' Benefits: Observations on the Concurrent
Receipt of Military Retirement and VA Disability Compensation, GAO
Report GAO-03-575T, Washington, DC: U.S. Government Printing Office.
2003.
- . Veterans' Benefits: Quality Assurance for Disability Claims and
Appeals Processing Can be Further Improved, Washington, DC: U.S.
Government Printing Office. 2002.
-.Veterans Compensation: Offset of DOD Separation Pay and VA
Disability Compensation; Report to Congressional Committees, GAO Report
GAO/NSIAD-95-123. Washington, DC: U.S. Government Printing Office.
1995.
-. VA Disability Compensation: Comparison of VA Benefits with Those of
Workers' Compensation Programs; Report to the Chairman, Subcommittee
on Benefits, Committee on Veterans' Affairs, House of Representatives, GAO
Report GAO/HEHS-97-5. Washington, DC: U.S. Government Printing
Office. 1997.
-. VA Disability Compensation: Disability Ratings May Not Reflect
Veterans' Economic Losses; Report to the Chairman, Subcommittee on
Compensation, Pension, Insurance and Memorial Affairs, Committee on
Veterans' Affairs, House of Representatives, GAO Report GAO/HEHS-97-9.
Washington, DC: U.S. Government Printing Office. 1997.
U.S. Congress, House Committee on Ways and Means. 2004 Green
Book; Background Material and Data on Programs Within the Jurisdiction
of the Committee on Ways and Means, Committee Print, 108th Congress, 2d
Session. March 2004, pp. 15:135-137.
U.S. Congress, Joint Committee on Veterans' Affairs. Title 38--United
States Code: Veterans' Benefits as Amended Through December 31, 1996
and Related Material. Prepared by the Committee on Veterans' Affairs of the
House of Representatives and U.S. Senate. Washington, DC: March 14,
1997. (S. Prt. 104-75).
U.S. Department of the Treasury, Office of the Secretary. Tax Reform for
Fairness, Simplicity, and Economic Growth; the Treasury Department
Report to the President. Washington, DC: November 1984, pp. 51-57.

Veterans' Benefits and Services

EXCLUSION OF INTEREST
ON STATE AND LOCAL GOVERNMENT BONDS
FOR VETERANS' HOUSING

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

(1)

2007

(1)

2008

(1)

2009

(1)

2010

(1)

(1)Less than $50 million.

Authorization

Sections 103, 141, 143, and 146 of the Internal Revenue Code of 1986.

Description

Veterans' housing bonds are used to provide mortgages at below-market
interest rates on owner-occupied principal residences of homebuyers who are
veterans. These veterans' housing bonds are classified as private-activity
bonds rather than governmental bonds because a substantial portion of their
benefits accrues to individuals rather than to the general public.

Each State with an approved program is subject to an annual volume cap
related to its average veterans' housing bond volume between 1979 and 1985.
For further discussion of the distinction between governmental bonds and
private-activity bonds, see the entry under General Purpose Public
Assistance: Exclusion of Interest on Public Purpose State and Local Debt.

Impact

Rationale

Veterans' housing bonds were first issued by the States after World War II,
when both State and Federal governments enacted programs to provide
benefits to veterans as a reward for their service to the Nation.

The Omnibus Budget Reconciliation Act of 1980 required that veterans'
housing bonds must be general obligations of the State. The Deficit
Reduction Act of 1984 restricted the issuance of these bonds to the five States
that had qualified programs in existence before June 22, 1984, and limited
issuance to each State's average issuance between 1979 and 1984.

Loans were restricted to veterans who served in active duty any time before
1977 and whose application for the mortgage financing occurred before the
later of 30 years after leaving the service or January 31, 1985, thereby
imposing an effective sunset date for the year 2007. Loans were also
restricted to principal residences.

Assessment

The need for these bonds has been questioned, because veterans are
eligible for numerous other housing subsidies that encourage home ownership
and reduce the cost of their housing. As one of many categories of tax-
exempt private-activity bonds, veterans' housing bonds have been criticized
because they increase the financing costs of bonds issued for public capital
stock and increase the supply of assets available to individuals and
corporations to shelter their income from taxation.

Selected Bibliography

Cooperstein, Richard L. "Economic Policy Analysis of Mortgage Revenue
Bonds." In Mortgage Revenue Bonds: Housing Markets, Home Buyers and
Public Policy, edited by Danny W. Durning, Boston, MA: Kluwer Academic
Publishers, 1992.
-. "The Economics of Mortgage Revenue Bonds: A Still Small Voice." In
Mortgage Revenue Bonds: Housing Markets, Home Buyers and Public
Policy, edited by Danny W. Durning, Boston, MA: Kluwer Academic
Publishers, 1992.
Maguire, Steven. Private Activity Bonds: An Introduction. Library of
Congress, Congressional Research Service Report RL31457. June 9, 2006.
-. Tax-Exempt Bonds: A Description of State and Local Government
Debt. Library of Congress, Congressional Research Service Report
RL30638. March 10, 2006.
U.S. Congress, Joint Committee on Taxation. General Explanation of the
Revenue Provisions of the Deficit Reduction Act of 1984, Committee Print,
98th Congress, 2nd session. December 31, 1984, pp. 903-958.
Zimmerman, Dennis. The Private Use of Tax-Exempt Bonds: Controlling
Public Subsidy of Private Activity. Washington, DC: The Urban Institute
Press, 1991.

General Purpose Fiscal Assistance

EXCLUSION OF INTEREST ON PUBLIC PURPOSE
STATE AND LOCAL GOVERNMENT DEBT

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

18.7

7.3

26.0

2007

20.1

7.8

27.9

2008

21.1

8.2

29.3

2009

22.1

8.6

30.7

2010

23.1

9.0

32.1

Authorization

Sections 103 and 141.

Description

Certain obligations of State and local governments qualify as
"governmental" bonds. The interest income earned by individual and
corporate purchasers of these bonds is excluded from taxable income. This
interest income is not taxed because the bond proceeds generally are used to
build capital facilities that are owned and operated by governmental entities
and serve the general public interest, such as highways, schools, and
government buildings. These bonds can be issued in unlimited amounts,
although State governments do have self-imposed debt limits. The revenue
loss estimates in the above table for general fiscal assistance are based on the
difference between excluded interest income on these governmental bonds
and taxable bonds.

Other obligations of State and local governments are classified as "private-
activity" bonds. The interest income earned by individual and corporate
purchasers of these bonds is included in taxable income. This interest income
is taxed because the bond proceeds are believed to provide substantial
benefits to private businesses and individuals and the bonds are repaid with
revenue generated by the project, e.g., tolls or service charges. Tax
exemption is available for a subset of these otherwise taxable private-activity
bonds if the proceeds are used to finance an activity included on a list of
activities specified in the Code. Unlike governmental bonds, however, these
tax-exempt, private-activity bonds may not be issued in unlimited amounts.
All governmental entities within each State currently are subject to a federally
imposed State volume cap on new issues of these tax-exempt, private-activity
bonds equal to the greater of $80 per resident or $246.6 million in 2006.
Some qualified private activities, such as qualified public educational
facilities, are subject to national caps and are not subject to the State volume
cap. Still other facilities, such as government owned airports, docks, and
wharves, are not capped.

Each activity included in the list of private activities eligible for tax-exempt
financing is discussed elsewhere in this document under the private activity's
related budget function.

Impact

The distributional impact of this interest exclusion can be viewed from two
perspectives: first, the division of tax benefits between State and local
governments and bond purchasers; and second, the division of the tax benefits
among income classes. The direct benefits of the exempt interest income
flow both to State and local governments and to the purchasers of the bonds.
The exclusion of interest income causes the interest rate on State and local
government obligations to be lower than the rate paid on comparable taxable
bonds. In effect, the Federal Government pays part of State and local interest
costs. For example, if the market rate on tax-exempt bonds is 8.5 percent
when the taxable rate is 10 percent, there is a 1.5-percentage-point interest
rate subsidy to State and local governments.

The interest exclusion also raises the after-tax return for some bond
purchasers. A taxpayer facing a 15 percent marginal tax rate is equally well
off purchasing either the 8.5 percent tax-exempt bond or the 10-percent
taxable bond (both yield an 8.5 percent after-tax interest rate). But a taxpayer
facing a 35 percent marginal tax rate is better off buying a tax-exempt bond,
because the after-tax return on the taxable bond is 6.5 percent, and on the tax-
exempt bond, 8.5 percent. These "inframarginal" investors receive what have
been characterized as windfall gains.

The allocation of benefits between the bondholders and State and local
governments (and, implicitly, its taxpayer citizens) depends on the spread in
interest rates between the tax-exempt and taxable bond market, the share of
the tax-exempt bond volume purchased by individuals with marginal tax rates
exceeding the market-clearing marginal tax rate, and the range of the marginal
tax rate structure. The reduction of the top income tax rate of bond
purchasers from the 70 percent individual rate that prevailed prior to 1981 to
the 35 percent individual rate that prevails in 2006 has increased substantially
the share of the tax benefits going to State and local governments.

The table below provides an estimate of the distribution by income class of
tax-exempt interest income (including interest income from both
governmental and private-activity bonds). In 2004, approximately 69 percent
of individuals' tax-exempt interest income is earned by returns with adjusted
gross income in excess of $100,000, although these returns represent only 9.6
percent of all returns. Returns below $30,000 earn only 12.2 percent of tax-
exempt interest income, although they represent 50.5 percent of all returns.

The revenue loss is even more concentrated in the higher income classes
than the interest income because the average marginal tax rate (which
determines the value of the tax benefit from the nontaxed interest income) is
higher for higher-income classes.

Distribution of Tax-Exempt Interest
Income, 2004

Income Class
(in thousands of $)

Percentage
Distribution

Below $10

3.8

$10 to $20

2.9

$20 to $30

3.1

$30 to $40

3.5

$40 to $50

3.1

$50 to $75

7.5

$75 to $100

6.9

$100 to $200

17.5

$200 to $500

16.7

$500 to $1,000

9.8

$1,000 to $1,500

4.7

$1,500 to $2,000

2.9

$2,000 to $5,000

6.9

$5,000 to $10,000

3.9

$200 and over

6.8

Source: IRS, Statistics of Income Division, July 2006

Rationale

This exemption has been in the income tax laws since 1913, and was based
on the belief that state and local interest income had constitutional protection
from Federal Government taxation. The argument in support of this
constitutional protection was rejected by the Supreme Court in 1988, South
Carolina v. Baker (485 U.S. 505, [1988]). In spite of this loss of protection,
many believe the exemption for governmental bonds is still justified on
economic grounds, principally as a means of encouraging State and local
governments to overcome a tendency to underinvest in public capital
formation.

Bond issues whose debt service is supported by State and local tax bases
have been left largely untouched by Federal legislation, with a few exceptions
such as arbitrage restrictions, denial of Federal guarantee, and registration.
The reason for this is that most of these bonds have been issued for the
construction of public capital stock, such as schools, highways, sewer
systems, and government buildings.

This has not been the case for revenue bonds without tax-base support and
whose debt service is paid from revenue generated by the facilities built with
the bond proceeds. These bonds were the subject of almost continual
legislative scrutiny, beginning with the Revenue and Expenditure Control Act
of 1968 and peaking with a comprehensive overhaul by the Tax Reform Act
of 1986. This legislation focused on curbing issuance of the subset of tax-
exempt revenue bonds used to finance the quasi-public investment activities
of private businesses and individuals that are characterized as "private-
activity" bonds. Each private activity eligible for tax exemption is discussed
elsewhere in this document under the private activity's related budget
function.

Assessment

This tax expenditure subsidizes the provision of State and local public
services. A justification for a Federal subsidy is that it encourages State and
local taxpayers to provide public services that also benefit residents of other
states or localities. The form of the subsidy has been questioned because it
subsidizes one factor of public sector production, capital, and encourages
State and local taxpayers to substitute capital for labor in the public
production process. Critics maintain there is no evidence that any
underconsumption of State and local public services is isolated in capital
facilities and argue that, to the extent a subsidy of State and local public
service provision is needed to obtain the service levels desired by Federal
taxpayers, the subsidy should not be restricted only to capital.

The efficiency of the subsidy, as measured by the Federal revenue loss that
shows up as reduced State and local interest costs rather than as windfall
gains for purchasers of the bonds, has also been the subject of considerable
controversy. The State and local share of the benefits (but not the amount)
depends to a great extent on the number of bond purchasers with marginal tax
rates higher than the marginal tax rate of the purchaser who clears the market.
The share of the subsidy received by State and local governments was
improved considerably during the 1980s as the highest statutory marginal
income tax rate on individuals was reduced from 70 percent to 31 percent and
on corporations from 46 percent to 34 percent. (The highest current rate on
individuals and corporations is now 35 percent.)

The open-ended structure of the subsidy affects Federal control of its
budget and the amount of the Federal revenue loss on governmental bonds is
entirely dependent upon the decisions of State and local officials.

Selected Bibliography

Fortune, Peter. "Tax-Exempt Bonds Really Do Subsidize Municipal
Capital!" National Tax Journal, v. 51, March 1998, pp. 43-54.
-. "The Municipal Bond Market, Part II: Problems and Policies," New
England Economic Review. May/June, 1992, pp. 47-64.
Gordon, Roger H., and Gilbert E. Metcalf. "Do Tax-Exempt bonds Really
Subsidize Municipal Capital?" National Tax Journal, v. 44, December 1991,
pp. 71-79.
Maguire, Steven. Private Activity Bonds: An Introduction. Library of
Congress, Congressional Research Service Report RL31457, June 9, 2006.
-. Tax-Exempt Bonds: A Description of State and Local Government Debt.
Library of Congress, Congressional Research Service Report RL30638,
March 10, 2006.
Ott, David J., and Allan H. Meltzer. Federal Tax Treatment of State and
Local Securities. Washington, DC: The Brookings Institution, 1963.
Poterba, James M. and Andrew A. Samwick. "Taxation and Household
Portfolio Composition: US Evidence from the 1980s and 1990s, Journal of
Public Economics, v. 87, January 2003, pp. 5-38.
Shaul, Marnie. "The Taxable Bond Option for Municipal Bonds."
Columbus, Ohio: Academy for Contemporary Problems, 1977.
Temple, Judy. "Limitations on State and Local Government Borrowing for
Private Purposes." National Tax Journal, v. 46, March 1993, pp. 41-53.
U.S. Congress, Congressional Budget Office. Statement of Donald B.
Marron before the Subcommittee on Select Revenue Measures Committee on
Ways and Means U.S. House of Representatives. "Economic Issues in the
Use of Tax-Preferred Bond Financing," March 16, 2006.
U.S. Congress, Joint Committee on Taxation, Present Law and
Background Related to State and Local Government Bonds, Joint Committee
Print JCX-14-06, March 16, 2006.
U.S. Department of Treasury, Internal Revenue Service. Tax-Exempt
Private Activity Bonds, Publication 4078, June 2004.
Zimmerman, Dennis. The Private Use of Tax-Exempt Bonds: Controlling
Public Subsidy of Private Activity. Washington, DC: The Urban Institute
Press, 1991.
Zimmerman, Dennis. "Tax-Exempt Bonds," in The Encyclopedia of
Taxation and Tax Policy, edited by Joseph J. Cordes, Robert D. Ebel, and
Jane G. Gravelle. Washington, DC: The Urban Institute Press, 2005.

General Purpose Fiscal Assistance

DEDUCTION OF NONBUSINESS
STATE AND LOCAL GOVERNMENT
INCOME, SALES, AND PERSONAL PROPERTY TAXES

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

36.8

2007

27.3

2008

27.3

2009

28.1

2010

28.9

H.R. 6111 (December 2006) increased the loss by $3.0 billion in
FY2007, $2.1 billion in FY2008 and $0.4 billion in FY2009.

Authorization

Section 164.

Description

State and local income, sales, and personal property taxes paid by
individuals are deductible from adjusted gross income. For the 2004 through
2007 tax years, however, taxpayers chose between deducting sales or income
taxes. Business income, sales, and property taxes are deductible as business
expenses, but their deduction is not a tax expenditure because deduction is
necessary for the proper measurement of business economic income.

Impact

The deduction of State and local individual income, sales, and personal
property taxes increases an individual's after-Federal-tax income and reduces
the individual's after-Federal-tax price of the State and local public services
provided with these tax dollars. Some of the benefit goes to the State and
local governments (because individuals are willing to pay higher taxes) and
some goes to the individual taxpayer.

There may be an impact on the structure of state and local tax systems.
Economists have theorized that if a particular state and local tax or revenue
source is favored by deductibility in the federal tax code, then state and local
governments may rely more upon that tax source. In effect, local
governments and taxpayers recognize that residents are only paying part of
the tax, and that the federal government, through federal deductibility, is
paying the remainder.

The distribution of tax expenditures from State and local income, sales, and
personal property tax deductions is concentrated in the higher income classes.
Over 88% of the tax benefits are taken by families with adjusted gross
income in excess of $75,000 in 2005. As with any deduction, it is worth
more as marginal tax rates increase. Personal property tax deductions
(typically for cars and boats) are but a small fraction of state and local taxes
paid deduction, and are less concentrated in higher income classes.

Distribution by Income Class of
Tax Expenditure for State and Local Income and
Personal Property Tax Deductions, 2005

Income Class
(in thousands of $)

Percentage
Distribution

Below $10

0.0

$10 to $20

0.1

$20 to $30

0.4

$30 to $40

0.9

$40 to $50

1.9

$50 to $75

8.3

$75 to $100

10.2

$100 to $200

33.5

$200 and over

44.7

Rationale

Deductibility of State and local taxes was adopted in 1913 to avoid taxing
income that was obligated to expenditures over which the taxpayer had little
or no discretionary control. User charges (such as for sewer and water
services) and special assessments (such as for sidewalk repairs), however,
were not deductible. The Revenue Act of 1964 eliminated deductibility for
motor vehicle operators' licenses, and the Revenue Act of 1978 eliminated
deductibility of the excise tax on gasoline. These decisions represent
congressional concern that differences among States in the legal specification
of taxes allowed differential deductibility treatment for taxes that were
essentially the same in terms of their economic incidence.

The Tax Reform Act of 1986 eliminated deductibility of sales taxes, partly
due to concern that these taxes were estimated and therefore did not perfectly
represent reductions of taxable income, and partly due to concerns that some
portion of the tax reflects discretionary decisions of State and local taxpayers
to consume services through the public sector that might be consumed
through private (nondeductible) purchase. The Omnibus Budget
Reconciliation Act (OBRA) of 1990 curtailed the tax benefit from State and
local income and real property tax deductions for higher income taxpayers
(those whose AGI exceeds the applicable threshold amount--$150,500 for
2006). OBRA 1990 requires that itemized deductions be reduced by a
percentage of the amount by which adjusted gross income exceeds the
threshold amount. The phaseout is scheduled to gradually phase-out
beginning in the 2006 tax year and be completely eliminated beginning with
the 2010 tax year.

In 2004, sales tax deductibility was reinstated for the 2004 and 2005 tax
years by the "American Jobs Creation Act of 2004," (P.L. 108-357). In
contrast to pre-1986 law, State sales and use taxes can only be deducted in
lieu of State income taxes, not in addition to. Taxpayers who itemize and live
in States without a personal income tax will benefit the most from the new
law. The rationale behind the in lieu of is the more equal treatment for
taxpayers in states that do not levy an income tax. In December 2006, H.R.
6111 extended the deduction through 2007.

Assessment

Modern theories of the public sector discount the "don't tax a tax"
justification for State and local tax deductibility, emphasizing instead that
taxes represent citizens' decisions to consume goods and services collectively.
In that sense, State and local taxes are benefit taxes and should be treated the
same as expenditures for private consumption--not deductible against Federal
taxable income.

Deductibility can also be seen as an integral part of the Federal system of
intergovernmental assistance and policy. Modern theories of the public sector
also suggest that:

(1) deductibility does provide indirect financial assistance for the State and
local sector and should result in increased State and local budgets, and

(2) deductibility will influence the choice of State and local tax instruments
if deductibility is not provided uniformly.

In theory, there is an incentive for sub-federal governments to rely upon the
taxes that are deductible from federal income, such as personal property taxes,
because the tax "price" to the taxpayer is lower than the "price" on taxes that
are not deductible.

Selected Bibliography

Feldstein, Martin, and Gilbert Metcalf. "The Effect of Federal Tax
Deductibility on State and Local Taxes and Spending," Journal of Political
Economy. 1987, pp. 710-736.
Gade, Mary and Lee C. Adkins. "Tax Exporting and State Revenue
Structures," National Tax Journal. March 1990, pp. 39-52.
Holtz-Eakin, D. and H. Rosen. "Tax deductibility and Municipal Budget
Structure," National Bureau of Economic Research, Working Paper No.
2224, 1987.
-. "Federal Deductibility and Local Property Tax Rates," Journal of
Urban Economics, v. 27, 1990, pp. 269-284.
Kenyon, Daphne. "Federal Income Tax Deductibility of State and Local
Taxes: What Are Its Effects? Should It Be Modified or Eliminated?"
Strengthening the Federal Revenue System. Advisory Commission on
Intergovernmental Relations Report A-97. 1984, pp. 37-66.
Lindsey, Lawrence B. "Federal Deductibility of State and Local Taxes: A
Test of Public Choice by Representative Government," in Fiscal Federalism:
Quantitative Studies, edited by Harvey Rosen, (Chicago: University of
Chicago Press), pp. 137-176.
Maguire, Steven . "Federal Deductibility of State and Local Taxes,"
Library of Congress, Congressional Research Service Report RL32781.
September 28, 2006.
Noto, Nonna A., and Dennis Zimmerman. "Limiting State-Local Tax
Deductibility: Effects Among the States," National Tax Journal. December
1984, pp. 539-549.
-. Limiting State-Local Tax Deductibility in Exchange for Increased
General Revenue Sharing: An Analysis of the Economic Effects. U.S.
Congress, Subcommittee on Intergovernmental Relations, Committee on
Governmental Affairs, 98th Congress, 1st session, Committee Print S. Prt 98-
77. August 1983.

General Purpose Fiscal Assistance

TAX CREDIT FOR PUERTO RICO AND POSSESSION INCOME
AND PUERTO RICO ECONOMIC ACTIVITY

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

0.3

2007

2008

2009

2010

Authorization

Sections 936, 30A.

Description

In general, corporations chartered in the United States are subject to U.S.
taxes on their worldwide income. However, prior to 2005, the possessions
tax credit provided by section 936 of the Internal Revenue Code and the
Puerto Rican economic activity tax credit provided by section 30A permitted
qualified U.S. corporations that operate in Puerto Rico, the U.S. Virgin
Islands, and other U.S. possessions a tax credit that offset some or all of their
U.S. tax liability on income from business operations and certain types of
financial investment in the possessions. The credits had the effect of
exempting some or all of qualified income from tax at the Federal level. The
possessions enacted their own complementary set of tax incentives. However,
under the terms of the Small Business Job Protection Act of 1996 (Public
Law 104-188), the Federal credits were scheduled to end after 2005, and have
thus expired. A substitute economic development credit has been allowed for
American Samoa for 2006 through 2007.

To qualify for either credit, a firm was required to have derived 80 percent
of its gross from the possessions. Also, 75 percent of a qualified corporation's
income was required to be from the active conduct of a business in a
possession rather than from passive (financial) investment. The amount of
the tax credit was generally equal to a firm's tax liability on possession-source
income, subject to one of two alternative caps enacted in 1993. Under one
cap-that applicable under section 30A's economic activity credit-the credit
was limited to a specified portion of wages and depreciation. The alternative
cap in effect provided a flat 40% tax exemption. The Small Business Job
Protection Act of 1996 also provided for an additional limit that phases the
credit out in the case of Puerto Rico and the U.S. Virgin Islands (but not the
other possessions). Under this additional cap, the amount of income eligible
for the credit was linked to a firm's average possessions earnings during a
base period.

Impact

The most direct effect of the possessions tax credit was to reduce the cost
of qualified investment in Puerto Rico, the Virgin Islands, and the other U.S.
possessions. In addition, changes introduced by the Omnibus Budget
Reconciliation Act of 1993 (OBRA93) reduced the effective cost of qualified
wages paid in the possessions.

The largest user of the credit was the pharmaceuticals industry. In 2001,
for example, it accounted for 49 percent of all credits claimed under sections
936 and 30A. In the long run, however, the burden of the corporate income
tax (and the benefit from reductions in it) probably spreads beyond corporate
stockholders to owners of capital in general. Also--particularly since
enactment of OBRA93 and its caps linked to economic activity in the
possessions--it is likely that part of the benefit of the tax credits was shared by
labor in the possessions.

It is probable that the end of the tax benefit will reduce investment in
Puerto Rico from what would otherwise occur. This will likely be
accompanied by a decline in labor earnings. However, an alternative (albeit,
less generous) tax benefit remains available for investment in Puerto Rico and
the possessions: the "deferral" benefit under which U.S. firms that operate
abroad through foreign-chartered subsidiaries can indefinitely postpone
federal tax on income reinvested abroad. Since firms chartered in the
possessions are treated as foreign corporations, such firms can defer taxes. In
the years since the possessions tax credit's phase-out began, evidence
indicates that many firms that formerly used the possessions credit continue to
operate in the possessions while using the deferral benefit.

Rationale

A Federal tax exemption for firms earning income in the possessions has
been in effect since the Revenue Act of 1921, although its precise nature has
undergone several changes. However, the credit was not heavily used in
Puerto Rico until the years following World War II, when the Puerto Rican
Government integrated the Federal tax exemption into its "Operation
Bootstrap" development plan; the plan was designed, in part, to attract
investment from the mainland United States.

The Tax Reform Act of 1976 implemented several changes designed to
strengthen the provision's incentive effect and to tie it more closely to the
possessions. The Act also instituted the credit-cum-exemption mechanism
that is currently in place. In keeping the essential elements of the tax
exemption intact, Congress indicated that the provision's purpose was to keep
Puerto Rico and the possessions competitive with low-wage, low-cost foreign
countries as a location for investment.

Changes in the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA)
imposed tighter rules on mainland parent firms that used transfers of
intangible assets (e.g., patents) to possessions subsidiaries as a means of
sheltering mainland-source income from taxes. The Tax Reform Act of 1986
also sought to link the tax credit more tightly to tangible investment in the
possessions by increasing the portion of income that must be from active
business investment. The Omnibus Budget Reconciliation Act of 1993 scaled
back the credit by limiting each firm's maximum credit to a specified portion
of wage and depreciation costs incurred in the credit. While the Act's change
likely reduced the tax benefit for some firms, the cap's link with wages and
depreciation probably increased the incentive for other companies to employ
labor and tangible investment in the possessions, thus focusing the credit
more tightly on the possessions themselves. When repeal was subsequently
proposed, Congress expressed concern about the provision's revenue cost and
stated that the benefit is "enjoyed by only the relatively small number of U.S.
corporations that operate in the possessions" while the revenue costs is "borne
by all U.S. taxpayers."

The possessions tax credit is also intertwined with the issue of Puerto
Rico's political status, and whether Puerto Rico should retain its current
Commonwealth status, become a U.S. State, or become independent. The
link exists because both independence and statehood may require repeal of
the tax credits.

H.R. 6111 (December 2006) provided a substitute economic development
credit for American Samoa for 2006 through 2007.

Assessment

Because it reduced the cost of investment in Puerto Rico and the Virgin
Islands, the possessions tax credit encouraged firms to divert investment from
the mainland and foreign countries to the possessions. The measure probably
played an important role in attracting a large flow of investment to Puerto
Rico in the years following World War II. The investment may have, in turn,
helped transform Puerto Rico's economy from one based on agriculture to one
heavily dependent on manufacturing. The inflow of investment probably also
increased the earnings of Puerto Rican labor by increasing the capital/labor
ratio in Puerto Rico.

The tax credits' supporters maintain that the provision was critical to the
well-being of Puerto Rico's economy. However, the credit's critics have
pointed out that prior to enactment of the credit's wage-related cap in 1993,
the exemption was an incentive to invest rather than a direct incentive to
employ labor, and to the extent it increased employment in Puerto Rico, it did
so only as a by-product of its increase in investment. In addition, some
questioned the measure's cost-effectiveness, arguing that the measure's cost in
terms of foregone tax collections is high compared to the number of jobs the
provision creates in Puerto Rico.

Selected Bibliography

Brumbaugh, David L. The Possessions Tax Credit: Economic Analysis of
the 1993 Revisions. Library of Congress, Congressional Research Service
Report 94-650 E. Washington, DC: 1994.
- . The Puerto Rican Economic Activity Credit: Current Proposals and
Scheduled Phaseout. Library of Congress, Congressional Research Service
Report RS20695. Washington, DC: 2000. October 4, 2000.
-. U.S. Federal Taxes in Puerto Rico. Library of Congress, Congressional
Research Service Report RS20718. Washington, DC: October 20, 2000.
Grubert, Harry, and Joel Slemrod. The Effect of Taxes on Investment and
Income Shifting to Puerto Rico. NBER Working Paper No. 4869.
Cambridge, MA: National Bureau of Economic Research, 1994.
Holick, Daniel S. "U.S. Possessions Corporation Returns, 2003."
Statistics of Income Bulletin 23 (Summer 2006), 113-127.
Martin, Gary D. "Industrial Policy by Accident: the United States in
Puerto Rico." Journal of Hispanic Policy 4 (1989-90), pp. 93-115.
Sierra, Ralph J., Jr. "Puerto Rico Seeks New Incentives Under Section
956." Tax Notes International 22 (June 18, 2001), pp. 3167-3170.
Swanick, Michael F. "Going, Going, Gone: Section 936." Tax
Management International Journal 25 (November 8, 1996), pp. 749-751.
U.S. Congress. Joint Committee on Taxation. An Overview of the Special
Tax Rules Related to Puerto Rico and an Analysis of the Tax and Economic
Policy Implications of Recent Legislative Options. JCX-24-06. Washington:
June 23, 2006.
U.S. Congressional Budget Office. Potential Economic Impacts of
Changes in Puerto Rico's Status under S. 712. Washington, DC: 1990.
U.S. Department of the Treasury. The Operation and Effect of the
Possessions Corporation System of Taxation. Sixth Report. Washington,
DC: 1989.

U.S. General Accounting Office. Fiscal Relations with the Federal
Government and Economic Trends During the Phaseout of the Possessions
Tax Credit. Report GAO-06-541. Washington, DC: May 19, 2006.
U.S. President (1981-1989: Reagan). "Replace Possessions Tax Credit
With a Wage Credit." In The President's Tax Proposals to the Congress for
Fairness, Growth, and Simplicity. Washington, DC: U.S. Government
Printing Office, 1985, pp. 307-312.

Interest

DEFERRAL OF INTEREST ON SAVINGS BONDS

Estimated Revenue Loss

[In billions of dollars]

Fiscal year

Individuals

Corporations

Total

2006

1.1

2007

1.1

2008

1.2

2009

1.2

2010

1.2

Authorization

Section 454(c) of the Internal Revenue Code of 1992.

Description

Owners of U.S. Treasury Series E, Series EE, and Series I savings bonds
have the option of either including interest in taxable income as it accrues or
excluding interest from taxable income until the bond is redeemed.
Furthermore, before September 1, 2004, EE bonds could be exchanged for
current income HH savings bonds with the accrued interest deferred until the
HH bonds are redeemed. As of September 1, 2004, the U.S. Treasury ended
the sale and exchange of HH savings bonds. On September 1, 1998, the
Treasury began issuing Series I bonds, which guarantee the owner a real rate
of return by indexing the yield for changes in the rate of inflation. The
revenue loss shown above is the tax that would be due on the deferred interest
if it were reported and taxed as it accrued.

Impact

The deferral of tax on interest income on savings bonds provides two
advantages. First, payment of tax on the interest is deferred, delivering the
equivalent of an interest-free loan of the amount of the tax. Second, the
taxpayer often is in a lower income bracket when the bonds are redeemed.
This is particularly common when the bonds are purchased while the owner is
working and redeemed after the owner retires.

Savings bonds appeal to small savers because of such financial features as
their small denominations, ease of purchase, and safety. Furthermore, there
are currently annual cash purchase limits of $15,000 per person in terms of
issue price for both EE bonds and I bonds (for a total of $30,000 per year).
Because poor families save little and do not pay Federal income taxes, the tax
deferral of interest on savings bonds primarily benefits middle income
taxpayers.

Rationale

Prior to 1951, a cash-basis taxpayer generally reported interest on U.S.
Treasury original issue discount bonds in the year of redemption or maturity,
whichever came first. In 1951, when provision was made to extend Series E
bonds past their dates of original maturity, a provision was enacted to allow
the taxpayer either to report the interest currently, or at the date of
redemption, or upon final maturity. The committee reports indicated that the
provision was adopted to facilitate the extension of maturity dates.

On January 1, 1960, the Treasury permitted owners of E bonds to exchange
these bonds for current income H bonds with the continued deferment of
Federal income taxes on accrued interest until the H bonds were redeemed.
The purpose was to encourage the holding of U.S. bonds. This tax provision
was carried over to EE bonds, HH bonds, and I bonds.

Assessment

The savings bond program was established to provide small savers with a
convenient and safe debt instrument and to lower the cost of borrowing to the
taxpayer. The option to defer taxes on interest increases sales of bonds. But
there is no empirical study that has determined whether or not the cost savings
from increased bond sales more than offset the loss in tax revenue from the
accrual.

Selected Bibliography

U.S. Department of the Treasury. A History of the United States Savings
Bond Program. Washington, DC: September 1984.

-,Treasury Direct,
[http://www.treasurydirect.gov/indiv/products/products.htm], updated
October 6, 2006.
- , Bureau of the Public Debt Online, The Savings Bonds Owner's Manual,
[http://www.publicdebt.treas.gov/mar/marsbomintrogeneral.htm], updated
April 4, 2005.

Appendix A

FORMS OF TAX EXPENDITURES

EXCLUSIONS, EXEMPTIONS, DEDUCTIONS, CREDITS,
PREFERENTIAL RATES, AND DEFERRALS

Tax expenditures may take any of the following forms:

(1) special exclusions, exemptions, and deductions, which reduce taxable
income and, thus, result in a lesser amount of tax;

(2) preferential tax rates, which reduce taxes by applying lower rates to part
or all of a taxpayer's income;

(3) special credits, which are subtracted from taxes as ordinarily computed;
and

(4) deferrals of tax, which result from delayed recognition of income or
from allowing in the current year deductions that are properly attributable to a
future year.

Computing Tax Liabilities

A brief explanation of how tax liability is computed will help illustrate the
relationship between the form of a tax expenditure and the amount of tax
relief it provides.

CORPORATE INCOME TAX

Corporations compute taxable income by determining gross income (net of
any exclusions) and subtracting any deductions (essentially costs of doing
business).

The corporate income tax eventually reaches an average rate of 35 percent
in two steps. Below $10,000,000 taxable income is taxed at graduated rates:
15 percent on the first $50,000, 25 percent on the next $25,000, and 34
percent on the next $25,000. The limited graduation provided in this
structure was intended to furnish tax relief to smaller corporations. The value
of these graduated rates is phased out, via a 5 percent income additional tax,
as income rises above $100,000. Thus the marginal tax rate, the rate on the
last dollar, is 34 percent on income from $75,000 to $100,000, 39 percent on
taxable income from $100,000 to $335,000, and returns to 34 percent on
income from $335,000 to $10,000,000. The rate on taxable income in excess
of $10,000,000 is 35 percent, and there is a second phase-out, of the benefit
of the 34-percent bracket, when taxable income reaches $15,000,000. An
extra tax of three percent of the excess above $15,000,000 is imposed (for a
total of 38 percent) until the benefit is recovered, which occurs at
$18,333,333 taxable income. Above that, income is taxed at a flat 35 percent
rate. Most corporate income is taxed at the 35 percent marginal rate.

Any credits are deducted directly from tax liability. The essentially flat
statutory rate of the corporation income tax means there is very little
difference in marginal tax rates to cause variation in the amount of tax relief
provided by a given tax expenditure to different corporate taxpayers.
However, corporations without current tax liability will benefit from tax
expenditures only if they can carry back or carry forward a net operating loss
or credit.

INDIVIDUAL INCOME TAX

Individual taxpayers compute gross income which is the total of all income
items except exclusions. They then subtract certain deductions (deductions
from gross income or "business" deductions) to arrive at adjusted gross
income. The taxpayer then has the option of "itemizing" personal deductions
or taking the standard deduction. The taxpayer then deducts personal
exemptions to arrive at taxable income. A graduated tax rate structure is
applied to this taxable income to yield tax liability, and any credits are
subtracted to arrive at the net after-credit tax liability.

The graduated tax structure is currently applied at rates of 10, 15, 25, 28,
33, and 35 percent, with brackets varying across types of tax returns. These
rates enacted in the 2001 and 2003 tax bills are technically temporary
(expiring in 2010). At that time the 10% rate will return to the 15% rate and
the four top rates will return to 28, 31, 36, and 39.6 percent, with brackets
varying across types of tax returns. For joint returns, in 2005, rates on taxable
income are 10 percent on the first $14,600, 15 percent for amounts from
$14,600 to $59,400, 25 percent for amounts from $59,400 to $119,950, 28
percent for incomes from $119,950 to $182,800, 33 percent for taxable
incomes of $182,800 to $326,450, and 35 percent for amounts over $326,450.
These amounts are indexed for inflation. There are also phase-outs of
personal exemptions and excess itemized deductions so that marginal tax
rates can be higher at very high income levels. These phase are scheduled to
be eliminated in 2005.

Exclusions, Deductions, and Exemptions

The amount of tax relief per dollar of each exclusion, exemption, and
deduction increases with the taxpayer's marginal tax rate. Thus, the exclusion
of interest from State and local bonds saves $35 in tax for every $100 of
interest for the taxpayer in the 35-percent bracket, whereas for the taxpayer in
the 15-percent bracket the saving is only $15. Similarly, the increased
standard deduction for persons over age 65 or an itemized deduction for
charitable contributions are worth almost twice as much in tax saving to a
taxpayer in the 28-percent bracket as to one in the 15-percent bracket.

In general, the following deductions are itemized, i.e., allowed only if the
standard deduction is not taken: medical expenses, specified State and local
taxes, interest on nonbusiness debt such as home mortgage payments, casualty
losses, certain unreimbursed business expenses of employees, charitable
contributions, expenses of investment income, union dues, costs of tax return
preparation, uniform costs and political contributions. (Certain of these
deductions are subject to floors or ceilings.)

Whether or not a taxpayer minimizes his tax by itemizing deductions
depends on whether the sum of those deductions exceeds the limits on the
standard deduction. Higher income individuals are more likely to itemize be-
cause they are more likely to have larger amounts of itemized deductions
which exceed the standard deduction allowance. Homeowners often itemize
because deductibility of mortgage interest and property taxes leads to larger
deductions than the standard deduction.

Preferential Rates

The amount of tax reduction that results from a preferential tax rate (such
as the reduced rates on the first $75,000 of corporate income) depends on the
difference between the preferential rate and the taxpayer's ordinary marginal
tax rate. The higher the marginal rate that would otherwise apply, the greater
is the tax relief from the preferential rate.

Credits

A tax credit (such as the dependent care credit) is subtracted directly from
the tax liability that would accrue otherwise; thus, the amount of tax reduction
is the amount of the credit and is not contingent upon the marginal tax rate. A
credit can (with one exception) only be used to reduce tax liabilities to the
extent a taxpayer has sufficient tax liability to absorb the credit. Most tax
credits can be carried backward and/or forward for fixed periods, so that a
credit which cannot be used in the year in which it first applies can be used to
offset tax liabilities in other prescribed years.

The earned income credit and child credit are the only tax credits which are
now refundable. That is, a qualifying individual will obtain in cash the entire
amount of the refundable credit even if it exceeds tax liability. Child credits
are not fully refundable, however, for certain very low income families.

Deferrals

Deferral can result either from postponing the time when income is
recognized for tax purposes or from accelerating the deduction of expenses.
In the year in which a taxpayer does either of these, his taxable income is
lower than it otherwise would be, and because of the current reduction in his
tax base, his current tax liability is reduced. The reduction in his tax base
may be included in taxable income at some later date. However, the
taxpayer's marginal tax rate in the later year may differ from the current year
rate because either the tax structure or the applicable tax rate has changed.

Furthermore, in some cases the current reduction in the taxpayer's tax base
may never be included in his taxable income. Thus, deferral works to reduce
current taxes, but there is no assurance that all or even any of the deferred tax
will be repaid. On the other hand, the tax repayment may even exceed the
amount deferred.

A deferral of taxes has the effect of an interest-free loan for the taxpayer.
Apart from any difference between the amount of "principal" repaid and the
amount borrowed (that is, the tax deferred), the value of the interest-free loan-
-per dollar of tax deferral--depends on the interest rate at which the taxpayer
would borrow and on the length of the period of deferral. If the deferred
taxes are never paid, the deferral becomes an exemption. This can occur if, in
succeeding years, additional temporary reductions in taxable income are
allowed. Thus, in effect, the interest-free loan is refinanced; the amount of
refinancing depends on the rate at which the taxpayer's income and deductible
expenses grow and can continue in perpetuity.

The tax expenditures for deferrals are estimates of the difference between
tax receipts under the current law and tax receipts if the provisions for
deferral had never been in effect. Thus, the estimated revenue loss is greater
than what would be obtained in the first year of transition from one tax law to
another. The amounts are long run estimates at the level of economic activity
for the year in question.

Appendix B

RELATIONSHIP BETWEEN TAX EXPENDITURES AND
LIMITED TAX BENEFITS SUBJECT TO LINE ITEM VETO

Description

The Line Item Veto Act (P.L. 104-130) enacted in 1996 gave the President
the authority to cancel "limited tax benefits." A limited tax benefit was
defined as either a provision that loses revenue and that provides a credit,
deduction, exclusion or preference to 100 or fewer beneficiaries, or a
provision that provides temporary or permanent transition relief to 10 or fewer
beneficiaries in any fiscal year. The act was found unconstitutional in 1998,
but there have been subsequent proposals to provide veto authority for certain
limited benefits.

Items falling under the revenue losing category did not qualify if the
provision treated in the same manner all persons in the same industry,
engaged in the same activity, owning the same type of property, or issuing
the same type of investment instrument.

A transition provision did not qualify if it simply retained current law for
binding contracts or was a technical correction to a previous law (that had no
revenue effect).

When the beneficiary was a corporation, partnership, association, trust or
estate, the stockholders, partners, association members or beneficiaries of the
trust or estate were not counted as beneficiaries. The beneficiary was the
taxpayer who is the legal, or statutory, recipient of the benefit.

The Joint Committee on Taxation was responsible for identifying limited
tax benefits subject to the line item veto (or indicating that no such benefits
exist in a piece of legislation); if no judgment was made, the President could
identify such a provision.

The line item veto took effect on January 1, 1997.

Similarities to Tax Expenditures

Limited tax benefits resemble tax expenditures in some ways, in that they
refer to a credit, deduction, exclusion or preference that confers some benefit.
Indeed, during the debate about the inclusion of tax provisions in the line
item veto legislation, the term "tax expenditures" was frequently invoked.
The House initially proposed limiting these provisions to a fixed number of
beneficiaries (originally 5, and eventually 100). The Senate bill did not at
first include tax provisions, but then included provisions that provided more
favorable treatment to a taxpayer or a targeted group of taxpayers.

Such provisions would most likely be considered as tax expenditures, at
least conceptually, although they might not be included in the official lists of
tax expenditures because of de minimis rules (that is, some provisions that are
very small are not included in the tax expenditure budget although they would
qualify on conceptual grounds), or they might not be separately identified.
This is particularly true in the case of transition rules.

Differences from Tax Expenditures

Most current tax expenditures would probably not qualify as limited tax
benefits even if they were newly introduced (the line item veto applied only to
newly enacted provisions).

First, many if not most tax expenditures apply to a large number of
taxpayers. Provisions benefitting individuals, in particular, would in many
cases affect millions of individual taxpayers. Most of these tax expenditures
that are large revenue losers are widely used and widely available (e.g.
itemized deductions, fringe benefits, exclusions of income transfers).

Provisions that only affect corporations may be more likely to fall under a
beneficiary limit; even among these, however, the provisions are generally
available for all firms engaged in the same activity.

These observations are consistent with a draft analysis of the Joint
Committee on Taxation during consideration of the legislation which
included examples of provisions already in the law that might have been
classified as limited tax benefits had the line item veto provisions been in
effect. Some of these provisions had at some time been included in the tax
expenditure budget, although they were not currently included: the orphan
drug tax credit, which is very small, and an international provision involving
the allocation of interest, which has since been repealed. ( The orphan drug
tax credit is currently included in the tax expenditure budget.) Some
provisions modifying current tax expenditures might also have been included.
But, in general, tax expenditures, even those that would generally be seen as
narrow provisions focusing on a certain limited activity, would probably not
have been deemed limited tax benefits for purposes of the line item veto.

Bibliographic Reference

U.S. Congress. Joint Committee on Taxation. Draft Analysis of Issues
and Procedures for Implementation of Provisions Contained in the Line Item
Veto Act (Public Law 104-130) Relating to Limited Tax Benefits, (JCX-48-
96), November 12, 1996.
U.S. Congress, Joint Committee on Taxation. Estimates of Federal Tax
Expenditures for Fiscal Years 2006-2010, April 25, 2006. They also include
temporary items that were reinstated during the remainder of 2006.
For a discussion of the conceptual problems involved in defining tax
expenditures and some of the differences between the Administration and Joint
Committee approaches, see The Budget of the United States Government, Fiscal
Year 2005, Analytical Perspectives, "Tax Expenditures," pp. 285-325. See also
Linda Sugin, "What is Happening to the Tax Expenditure Budget?" Tax Notes,
August 16, 2004, pp. 763-766, and Thomas L. Hungerford, Tax Expenditures:
Trends and Critiques, Library of Congress, Congressional Research Service Report
RL33641, September 13, 2006.
See Jane G. Gravelle, Distributional Effects of Taxes on Corporate Profits,
Investment Income, and Estates, Library of Congress, Congressional Research
Service Report RL32517, August 9,2004.
U.S. Congress, Congressional Budget Office. Effective Federal Tax Rates for
1979-2001, April 2004, Table 1B.
These data were released by the Democratic staff of the Ways and
Means Committee, June 7, 2006.
Released by the Democratic staff of the Ways and Means Committee,
June 7, 2006.