The Challenge of Individual Income Tax
Reform: An Economic Analysis of Tax Base
Broadening
Jane G. Gravelle
Senior Specialist in Economic Policy
Thomas L. Hungerford
Specialist in Public Finance
March 22, 2012
Congressional Research Service
7-5700
www.crs.gov
R42435
CRS Report for Congress
Pr
epared for Members and Committees of Congress
The Challenge of Individual Income Tax Reform
Summary
Congressional interest in a major reform of the individual income tax that would broaden the base
and use the additional tax revenues to lower rates and/or reduce the deficit has increased. The
President’s Fiscal Commission, for example, proposed an individual income tax reform with three
objectives: to broaden the base and lower the tax rate, to contribute to deficit reduction, and to
maintain or increase the progressivity of the tax system. The Fiscal Commission proposed to
broaden the tax base by eliminating or modifying most tax expenditures. One legislative proposal,
S. 727, introduced by Senators Wyden, Begich, and Coats, would broaden the tax base by
eliminating many tax expenditures and reduce tax rates.
One way to broaden the tax base is to eliminate or reduce tax expenditures, which have been in
the tax code since the passage of the progressive income tax in 1913. An understanding of four
complex issues surrounding tax expenditures is necessary for an informed debate over broadening
the tax base. First, tax expenditures affect the economic behavior of taxpayers (efficiency effects).
Second, changing tax expenditures will change the distribution of tax benefits, and the
distribution of after-tax income (equity effects). Third, changes to tax expenditures could change
the administrative burdens on taxpayers and the Internal Revenue Service (IRS). Lastly, many tax
expenditures are popular among taxpayers and voters. Each one of these issues presents
challenges to broadening the tax base, which could be difficult to overcome.
There are over 200 separate tax expenditures, which are projected to total over $1.1 trillion in
FY2014. The revenue loss of all tax expenditures, however, is highly concentrated in a relatively
small number—the largest 20 tax expenditures account for 90% of the total revenue loss of all tax
expenditures. This amount is equivalent to 74% of the total FY2014 revenue from individual
income taxes. If used for rate reduction alone, eliminating these tax expenditures could allow tax
rates to be reduced by around 43%: for example, the top 39.6% tax rate could be reduced to
approximately 23%.
When evaluating tax expenditures as potential base broadening provisions, it is useful to consider
the general kinds of behaviors they affect or the general objectives in determining the feasibility
of eliminating or modifying specific tax expenditures. Consequently, tax expenditures are divided
into seven major categories: saving, business investment, consumption, owner-occupied housing
(which is a combination of an investment choice and a consumption choice), labor supply,
government programs (which in many cases would have no behavioral effects but are simply
income transfers), and a category termed structural (which provides benefits based on family
circumstances rather than affecting behavior).
The analysis in this report suggests there are impediments to base broadening by eliminating or
reducing tax expenditures, because they are viewed as serving an important purpose, are
important for distributional reasons, are technically difficult to change, or are broadly used by the
public and quite popular. Given the barriers to eliminating or reducing most tax expenditures, it
may prove difficult to gain more than $100 billion to $150 billion in additional tax revenues
through base broadening. This amount could have a significant effect on reducing the FY2014
budget deficit—reducing the projected $345 billion deficit by 30% to 43%. This additional tax
revenue, however, is equivalent to about 6% to 9% of projected FY2014 individual income tax
revenue, and, consequently, would not allow for significant reductions in tax rates (about a one or
two percentage point reduction for each bracket).
Congressional Research Service
The Challenge of Individual Income Tax Reform
Contents
Tax Expenditures and Base Broadening .......................................................................................... 3
Allocational and Efficiency Effects ................................................................................................. 7
Saving........................................................................................................................................ 8
Business................................................................................................................................... 11
Owner-Occupied Housing ....................................................................................................... 12
Consumption............................................................................................................................ 15
Health ................................................................................................................................ 15
Charitable Contributions ................................................................................................... 16
Labor Supply ........................................................................................................................... 18
Government ............................................................................................................................. 18
Exemption of Medicare and Social Security Benefits....................................................... 18
Subsidies for State and Local Governments: Deductions for Income Taxes and
Exclusion of Tax Exempt Bonds.................................................................................... 19
Structural ................................................................................................................................. 20
Other Notable Tax Expenditures ............................................................................................. 20
Distributional Issues ...................................................................................................................... 22
Saving...................................................................................................................................... 23
Housing ................................................................................................................................... 23
Consumption............................................................................................................................ 24
Labor Supply ........................................................................................................................... 25
Government ............................................................................................................................. 25
Structural ................................................................................................................................. 25
Administrative and Technical Challenges...................................................................................... 26
Health Benefits ........................................................................................................................ 26
Pension Benefits ...................................................................................................................... 27
Saving...................................................................................................................................... 27
Other Tax Expenditures ........................................................................................................... 28
Public Attitudes Towards Tax Reform ........................................................................................... 28
Concluding Remarks ..................................................................................................................... 29
Figures
Figure B-1. Concentration Curves: Itemized Deductions.............................................................. 34
Figure B-2. Concentration Curves: Income Exclusions ............................................................... 35
Figure B-3. Concentration Curves: Tax Credits and Preferential Tax Rates.................................. 36
Tables
Table 1. Tax Expenditures by Category of Economic Effect, FY2014............................................ 4
Table 2. The 20 Largest Individual Tax Expenditures, FY2014 ..................................................... 6
Congressional Research Service
The Challenge of Individual Income Tax Reform
Table 3. The 20 Largest Individual Tax Expenditures, FY014, with Expiring Provisions
Extended ....................................................................................................................................... 7
Table 4. Additional Tax Expenditures Not Among the Top 20, With a Cost of $1 Billion
or More, FY2014 ........................................................................................................................ 21
Table 5. Progressivity of Selected Tax Provisions: The Suits Index.............................................. 24
Appendixes
Appendix A. Classification of Tax Expenditures by Category ...................................................... 31
Appendix B. Data and Methods..................................................................................................... 33
Contacts
Author Contact Information........................................................................................................... 37
Congressional Research Service
The Challenge of Individual Income Tax Reform
nterest in a major reform of the individual income tax that would broaden the base and use the
additional tax revenues to lower rates and/or reduce the deficit has increased.1 The President’s
I Fiscal Commission, for example, proposed an individual income tax reform with three
objectives: to broaden the base and lower the rates, to contribute to deficit reduction, and to
maintain or increase the progressivity of the tax system. The Fiscal Commission, a bipartisan
group, proposed a major revision that would eliminate or modify most tax expenditures.2 The
Fiscal Commission also proposed to use revenues to eliminate aspects of the income tax that have
come under criticism, such as the alternative minimum tax. A congressional proposal for income
tax reform and base broadening is S. 727, introduced by Senators Wyden, Begich, and Coats.3
One way to broaden the tax base is to eliminate or reduce tax expenditures, which have been in
the tax code since the passage of the progressive income tax in 1913.4 An understanding of four
complex issues surrounding tax expenditures is necessary for an informed debate over broadening
the tax base.5 First, tax expenditures affect the economic behavior of taxpayers (efficiency
effects). Second, changing tax expenditures will change the distribution of tax benefits and the
distribution of after-tax income (equity effects). Third, changes to tax expenditures could change
the administrative burdens on taxpayers and the Internal Revenue Service (IRS). Lastly, many tax
expenditures are popular among taxpayers and voters. Each one of these issues presents
challenges to broadening the tax base, which could be difficult to overcome.
Proposals have also been made to reform the corporate income tax, and the two reform efforts are
related since changes in provisions measuring business income (such as depreciation rules) would
likely apply in both cases. This report, however, does not focus on corporate tax reform, which is
reviewed in other reports,6 but a brief discussion of individual business-related provisions and
their connection to corporate tax reform is included. There are also proposals for the revision of
other existing taxes (such as the payroll tax or excise taxes), for transformation of the income tax
into a consumption tax, or for new revenue sources, which are discussed in other reports.7
1 Tax reform usually refers to a broad change of the tax system rather than a piecemeal change in law such as changing
tax rates. For a discussion, see C. Eugene Steuerle, “Tax reform, federal,” in The Encyclopedia of Taxation and Tax
Policy, ed. Joseph J. Cordes, Robert D. Ebel, and Jane G. Gravelle, 2nd ed. (Washington: The Urban Institute Press,
2005), pp. 421-424.
2 The National Commission on Fiscal Responsibility and Reform, The Moment of Truth, December 2010,
http://www.fiscalcommission.gov/sites/fiscalcommission.gov/files/documents/TheMomentofTruth12_1_2010.pdf.
3 See CRS Report R41591, Tax Reform: An Overview of Proposals in the 112th Congress, by James M. Bickley; CRS
Report R41970, Addressing the Long-Run Budget Deficit: A Comparison of Approaches, by Jane G. Gravelle; and CRS
Report R41641; Reducing the Budget Deficit: Tax Policy Options, by Molly F. Sherlock. The provisions of the Wyden-
Gregg bill from the 111th Congress, which were identical with one exception to S. 727 (112th), were estimated by the
Joint Committee on Taxation, posted at http://wyden.senate.gov/imo/media/doc/Score.pdf.
4 Tax expenditures are defined under the Congressional Budget and Impoundment Control Act of 1974 (P.L. 93-344) as
“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.”
5 For an introduction to tax expenditures and an explanation on their role in the federal tax system, see CRS Report
RL33641, Tax Expenditures: Trends and Critiques, by Thomas L. Hungerford; CRS Report RL34622, Tax
Expenditures and the Federal Budget, by Thomas L. Hungerford; and CRS Report RL32808, Overview of the Federal
Tax System, by Molly F. Sherlock and Donald J. Marples.
6 See CRS Report RL34229, Corporate Tax Reform: Issues for Congress, by Jane G. Gravelle and Thomas L.
Hungerford; and CRS Report R41743, International Corporate Tax Rate Comparisons and Policy Implications, by
Jane G. Gravelle. For a discussion of revisions focused on the tax treatment of foreign source income, see CRS Report
RL34115, Reform of U.S. International Taxation: Alternatives, by Jane G. Gravelle.
7 CRS Report R41602, Should the United States Levy a Value-Added Tax for Deficit Reduction?, by James M. Bickley;
(continued...)
Congressional Research Service
1
The Challenge of Individual Income Tax Reform
Is it possible to repeal or substantially trim most special tax deductions, credits, exclusions, and
special rates, also known as tax expenditures? If so, the potential for lower rates or additional
revenue would be significant. For FY2014, the year used in analyzing these provisions, individual
income tax expenditures, which account for most of the potential base broadening provisions, are
projected to total over $1.1 trillion. This amount is equivalent to 74% of the total FY2014 revenue
from individual income taxes, and about 7% of GDP.8 If used for rate reduction alone, eliminating
these tax expenditures could allow tax rates to be reduced by around 43%. For example, the top
39.6% tax rate could be reduced to about 23%.9 If the additional revenue were also used to repeal
the alternative minimum tax (which would require about 16% of the revenue),10 tax rates could be
reduced by almost 40%. As developed further in this report, however, it appears unlikely that a
significant fraction of this potential revenue could be realized.
Experience from the last four decades suggests that major individual income tax reform is
difficult to achieve. Prior to the Fiscal Commission study in the current Obama Administration,
major income tax reform was addressed in the Ford, Reagan, and George W. Bush
Administrations.11 Of the three, only the Reagan Administration proposal resulted in legislation,
the Tax Reform Act of 1986. Moreover, although the 1986 act was considered a major tax reform,
and made significant changes in the corporate tax, the base broadening in the individual income
tax was quite limited.12
This report examines large tax expenditures and considers the challenges in achieving significant
base broadening, whether to finance rate reductions or other revisions to the tax code, or to reduce
the deficit. Some special tax benefits may be fulfilling desirable objectives. For example, 30% of
the revenue loss of tax expenditures is from provisions directed at encouraging savings, and many
policy makers and analysts believe that taxes on savings should not be increased. Other tax
expenditures, such as the exclusion of capital gains on owner-occupied housing, have important
economic justifications.
(...continued)
and CRS Report R41591, Tax Reform: An Overview of Proposals in the 112th Congress, by James M. Bickley.
8 Estimates of Tax Expenditures from Joint Committee on Taxation, Estimates Of Federal Tax Expenditures For Fiscal
Years 2011-2015 JCS-1-12, January, 2012, http://www.jct.gov/publications.html?func=startdown&id=4386 with
adjustments to deal with transitory effects such as bonus depreciation and exclusion of negative expenditures. Income
tax revenues in dollar amounts and as a percent of GDP from Congressional Budget Office, The Budget and Economic
Outlook: Fiscal Years 2012-2022, January 2011, http://www.cbo.gov/ftpdocs/126xx/doc12699/01-31-
2012_Outlook.pdf. Adding up tax expenditures only approximates the general cost since there is interaction between
provisions; estimates indicate the totals would be somewhat larger. See Leonard E. Burman, Christopher Geissler, and
Eric J. Toder, “How Big Are Total Individual Tax Expenditures, and Who Benefits From Them,” American Economic
Review, Papers and Proceedings, vol. 98, no. 2 (May 2008), pp. 79-83.
9 The new rate would be approximately 57% as large as the old rate (1/(1+.74)).
10 Tax Policy Center Table T11-0147, http://taxpolicycenter.org/numbers/displayatab.cfm?DocID=3019&
topic2ID=60&topic3ID=61&DocTypeID=.
11 Blueprints for Basic Tax Reform, U.S. Department of the Treasury, Washington, D.C., January 17, 1977; Tax Reform
for Fairness, Simplicity and Economic Growth, Value Added Tax, Vol. 3, U.S. Department of the Treasury, November,
1984; and Simple, Fair, and Pro-Growth: Proposals to Fix America’s Tax System. The President’s Advisory Panel on
Federal Tax Reform, Washington, D.C. U.S Government Printing Office, November 2005.
12 Most itemized deductions were retained, including deductions for charitable contributions, mortgage interest and
State and local income and property taxes, although the deduction for sales taxes, consumer interest and some
miscellaneous provisions were eliminated. Mortgage interest was capped but at a very high level and the floor under
medical expense deductions was increased. Major employer-based exclusions from income (such as pensions and
exclusions for health insurance) were not addressed. Capital gains were taxed at ordinary rates and individual
retirement accounts significantly limited, but these two changes were subsequently reversed in 1997.
Congressional Research Service
2
The Challenge of Individual Income Tax Reform
In addition, a number of tax expenditures, accounting for about 11% of the total revenue loss,
benefit lower-income individuals, including the exclusion of benefits such as Social Security and
Medicare, the earned income credit, and the child credit. Eliminating these provisions would
increase the tax burden on low- and moderate-income taxpayers. Furthermore, since many of the
recipients of these tax benefits have little or no tax liability, eliminating or reducing these
provisions would reduce the progressivity of the income tax system.
The reform of some tax expenditures, representing about 40% of the total revenue loss, faces
serious administrative and technical barriers largely because they are in-kind benefits that cannot
be easily or fairly valued (e.g., employer-provided health insurance). Furthermore, in the case of
the reduced tax rates on capital gains, current scoring practices incorporate such large predicted
behavioral responses that very little revenue would be projected to be realized.
Among the remaining provisions, possibilities for revision could be limited. For example,
itemized deductions (mortgage interest, state and local taxes, and charitable contributions),
accounting for 20% of the total revenue loss of tax expenditures, are broadly used and are highly
popular provisions; given public attitudes towards these provisions, eliminating or significantly
curtailing them may be difficult. Even narrower provisions may have important constituencies.
The results suggest that most of the revenue that could be gained by eliminating or modifying tax
expenditures, as much as 90%, may be difficult to realize. It may prove difficult to gain more than
$100 billion to $150 billion in additional tax revenues through base broadening. This additional
tax revenue, however, is equivalent to about 6% to 9% of projected FY2014 individual income
tax, and, consequently, would not allow for significant reductions in tax rates (about a one or two
percentage point reduction, thus reducing the top 39.6% tax rate to 37%).
Tax Expenditures and Base Broadening
Most of the provisions that could be considered for expanding the income tax base are on the tax
expenditure list produced by the Joint Committee on Taxation (JCT), which contains over 200
separate tax provisions.13 Tax expenditures are revenue losses attributable to provisions that
provide a special exclusion, exemption, or deduction, or provide for a credit, preferential tax rate,
or deferral of tax liability. These provisions are measured with reference to a “normal structure”
which contains graduated rates, personal exemptions, and standard deductions. There are
provisions that might be considered for base broadening but are not on the list, such as the
deduction for moving expenses and for business entertainment. Similarly, while tax expenditures
include the exclusion of Social Security, Medicare, and cash public assistance from taxation, they
do not include the exclusion of SNAP (formerly food stamps) or Medicaid. Nevertheless, tax
expenditures are a fairly good inventory of potential sources of tax base broadening.
The concept of tax expenditures was developed to highlight the point that these provisions should
be considered as substitutes for direct spending. Consequently, tax expenditures are generally
allocated to the functional budget categories (national defense, international affairs, science and
research, and so forth). With this type of organization, a very large fraction of tax expenditures
(about 40%) falls into the category of housing and commerce, which accounts for less than 1% of
13 U.S. Congress, Joint Committee on Taxation, Estimates of Federal Tax Expenditures for Fiscal Years 2011-2015,
committee print, 112th Cong., 2nd sess., January 17, 2012, JCS-1-12 (Washington: GPO, 2012).
Congressional Research Service
3
The Challenge of Individual Income Tax Reform
direct spending. This organizational approach, however, can cause portions of a tax provision to
appear separately in different functional categories; an example is the deduction for charitable
contributions where separate estimates for contributions to health, education, and all other
recipients are made.
When using the tax expenditure list to organize potential base broadening provisions, it is more
useful to classify the provisions based on the general kinds of economic behaviors they affect or
the general objectives rather than by budget functional categories (see Appendix A). For
example, do tax expenditures reduce taxes on savings or labor earnings? Or do they affect
consumption choices? Table 1, therefore, divides tax expenditures into seven major categories:
saving, business investment, consumption, owner-occupied housing (which is a combination of
an investment choice and a consumption choice), labor supply, government programs (which in
many cases would have no behavioral effects but are simply income transfers), and a category
termed structural (which provides benefits based on family circumstances rather than affecting
behavior). Most of the consumption-related provisions fall into three major categories: health,
education, and charity. JCT’s revenue loss estimates were made under a current law baseline,
which assumes that the Bush tax cuts and the 2009 tax cuts expire as scheduled at the end of
2012.
Table 1. Tax Expenditures by Category of Economic Effect, FY2014
Share with
Provisions
Expiring Before
FY2014 Included
Category
Amount ($billions)
Share of Total (%)
(%)
Saving 347.5
29.1
29.8
Business 23.0
1.9
1.6
Housing: Owner-Occupied
154.3
13.0
12.3
Consumption Al ocation
324.1
27.3
25.5
Health
254.8
21.4
18.9
Education
13.4
1.1
1.9
Charity
50.1
4.2
4.2
Labor Supply
82.8
7.0
7.4
Government Programs
237.1
20.0
18.7
Structural 21.1
1.8
4.6
Source: CRS calculations based on Joint Committee on Taxation revenue estimates.
Notes: The major expiring provisions are the increased child credit (structural), the lower rate for dividends
(savings), elements of the earned income credit (labor supply) and education credits and benefits.
For each category, the estimated revenue loss of the provisions in the category are reported in the
second column of Table 1, followed by the share of the total revenue loss of all tax expenditures.
The last column provides an approximate adjustment for provisions that would be reinstated if the
Bush tax cuts, plus provisions enacted in 2009, were extended, although it does not account for
Congressional Research Service
4
The Challenge of Individual Income Tax Reform
the change in tax rates.14 These calculations add back provisions in four areas: the larger and
largely refundable child credit (structural), education provisions, earned income credit provisions
(labor supply), and lower rates on dividends (saving).15
Allocating provisions to these seven basic categories is not entirely straightforward. For example,
since owner-occupied housing is both an investment and consumption good, owner-occupied
housing subsidies increase the return on investment in housing and reduce the cost of the
consumption of housing. Many of the provisions relating to saving and consumption are in the
form of an exclusion of employer provided benefits (pensions and health insurance) and thus
affect labor supply as well as the return to savings or the cost of health spending. The exclusion of
health insurance, for example, is classified under health rather than labor supply because the
provision primarily changes the amount spent on health. The government programs category
essentially involves moving money from one pocket to another since direct spending by the
government on benefits could replace tax subsidies, although some programs relate to other
categories such as savings (e.g., tax exempt bond interest) and health (e.g., exclusion of
Medicare). However, the property tax deduction is included in owner-occupied housing, which is
consistent with viewing the owner-occupied housing provisions as relating to investment.
Savings and business provisions that reduce the tax on the return to capital add up to almost a
third of cost of tax expenditures. If owner-occupied housing (which could also be viewed as an
investment) is also included, then the share is almost half (44%). Many believe the tax burden on
capital income should be lowered or eliminated, which could present a challenge to an income tax
reform that eliminates or modifies these provisions.
In contrast, provisions that reduce the tax on labor income, without being tied to specific use of
that income, account for a much smaller share of the total, even though overall capital income is
about a third the size of labor income. The earned income credit accounts for about two-thirds of
the labor supply category.
There are over 200 separate tax expenditures, but the cost is highly concentrated in a relatively
small number. Table 2 shows the 20 largest tax expenditures, the category, and the amount and
share of the total.16 Two expenditures, the exclusion of employee health insurance and the
exclusion of pensions contributions and earnings, account for a quarter of the total cost. The top
five, adding the mortgage interest deduction, the exclusion of Medicare, and the lower capital
gains tax rates, account for close to 50% of the total cost, and the top 10 account for 70%. The top
20 expenditures account for almost 90% of the total cost of all tax expenditures.
14 Lower tax rates would cause overall tax expenditures to fall.
15 These changes were based on revenue projections by the Joint Committee on Taxation, Estimated Budget Effects Of
The “Tax Relief, Unemployment Insurance Reauthorization, And Job Creation Act Of 2010,” JCX 54-10, December
10, 2010, http://www.jct.gov/publications.html?func=select&id=48.
16 The revenue loss estimates assume that the tax provisions expiring at the end of 2012 are not extended.
Congressional Research Service
5
The Challenge of Individual Income Tax Reform
Table 2. The 20 Largest Individual Tax Expenditures, FY2014
Share of All
Tax
Amount
Expenditures Cumulative
Provision Category
($billions)
(%)
Share (%)
Exclusion of Employer Health Insurance
Consumption
164.2
13.8
13.8
Exclusion of Employer Pensions
Saving
162.7
13.7
27.5
Mortgage Interest Deduction
Housing
99.8
8.4
35.9
Exclusion of Medicare
Government
76.2
6.4
41.9
Capital Gains Rates
Saving
71.4
6.0
48.3
Earned Income Credit
Labor Supply
58.4
4.9
52.8
Deduction of Income Taxes
Government
54.0
4.5
57.7
Gains: Exclusion at Death/Gift Carryover
Saving
51.9
4.4
62.1
Deduction of Charitable Contributions
Consumption
51.6
4.3
66.4
Employer Benefits under Cafeteria Plans
Consumption
43.8
3.7
70.1
Tax Exempt/Tax Credit Bonds
Government
42.7
3.6
73.7
Exclusion of Social Security Benefits
Government
42.6
3.6
77.3
Exclusion of Inside Buildup, Insurance
Saving
27.7
2.3
79.7
Exclusion of Capital Gains on Housing
Housing
27.2
2.3
82.0
Deduction of Property Taxes
Housing
27.1
2.3
84.2
Deduction of Medical Expenditures
Consumption
16.6
1.4
85.7
Individual Retirement Accounts
Saving
16.0
1.3
87.0
Child Credit
Structural
15.1
1.3
88.3
Accelerated Depreciation
Business
10.3
0.9
89.2
Exclusion of Foreign Earned Income
Labor Supply
8.2
0.7
89.8
Source: CRS calculations based on Joint Committee on Taxation revenue estimates.
Table 3 shows the largest 20 tax expenditures after adding back the provisions of the 2001-2003
Bush tax cuts and the 2009 tax cuts that are expiring at the end of 2012. The child credit (which
would more than double) moves from the 18th largest expenditure to the 9th, with its share rising
from 1.2% to 4.4%. The lower rate for dividends is now the 19th largest expenditure and replaces
the exclusion for income earned abroad.
Congressional Research Service
6
The Challenge of Individual Income Tax Reform
Table 3. The 20 Largest Individual Tax Expenditures, FY014,
with Expiring Provisions Extended
Share of All
Tax
Amount
Expenditures Cumulative
Provision Category
($billions)
(%)
Share (%)
Exclusion of Employer Health Insurance
Consumption
164.2
13.2
13.2
Exclusion of Employer Pensions
Saving
162.7
13.1
26.3
Mortgage Interest Deduction
Housing
99.8
8.1
34.6
Exclusion of Medicare
Government
76.2
6.1
40.4
Capital Gains Rates
Saving
71.4
5.8
46.3
Earned Income Credit
Labor Supply
58.4
4.7
51.0
Deduction of Income Taxes
Government
54.0
4.3
55.3
Gains: Exclusion at Death/Gift Carryover
Saving
51.9
4.2
59.5
Child Credit
Structural
51.7
4.2
63.6
Deduction of Charitable Contributions
Consumption
51.6
4.2
67.8
Cafeteria Plans
Consumption
43.8
3.5
71.3
Tax Exempt/Tax Credit Bonds
Government
42.7
3.5
74.8
Exclusion of Social Security Benefits
Government
42.6
3.5
78.2
Exclusion of Inside Buildup, Insurance
Saving
27.7
2.2
80.2
Exclusion of Capital Gains on Housing
Housing
27.2
2.2
82.2
Deduction of Property Taxes
Housing
27.1
2.2
84.6
Deduction of Medical Expenditures
Consumption
16.6
1.3
86.1
Individual Retirement Accounts
Saving
16.0
1.3
87.4
Lower Rate for Dividends
Savings
14.0
1.1
88.6
Accelerated Depreciation
Business
10.3
0.8
89.4
Source: CRS calculations based on Joint Committee on Taxation revenue estimates.
Allocational and Efficiency Effects
Tax expenditures are sometimes criticized because they are viewed as distorting behavior and
leading to economic inefficiency. If the provision, however, addresses a market failure or is
otherwise justified by meeting economic policy goals, then that is an argument against reducing
or eliminating the provision in income tax reform proposals. Tax expenditures in each of the
seven categories are examined in terms of their effects on economic efficiency.
Congressional Research Service
7
The Challenge of Individual Income Tax Reform
Saving
Three of the five large saving tax expenditures are related to retirement savings. First, employer
contributions to pensions are excluded from income and the earnings of pension assets are
exempt. Employees may also make contributions out of income that has been taxed and tax
deferred savings plans (such as 401(k) plans) allow employee contributions to be deducted. When
pensions are received, they are taxed (although a tax free return of non-deductible employee
contributions is allowed). Pensions may be (1) defined benefit plans where the employee is
provided a pension typically depending on age, years of service, and income, or (2) defined
contribution plans such as 401(k) plans where specific amounts are deposited in an account and
the employee effectively owns the asset. Self-employed individuals are also eligible for pension
benefits. The overall effect of the pension tax treatment when contributions are deductible is
equivalent to a tax exemption if tax rates are constant, or a negative (positive) tax rate if tax rates
are lower (higher) in retirement than during working years. For IRAs with non-deductible
contributions, taxes on investment earnings are deferred until retirement, which basically reduces
the effective rate.
A related provision is the individual retirement account which allows individuals to deduct costs
of contributions to their own plans, whether or not their employer provides a pension plan.
Individuals may also use IRAs to roll over employer retirement plans if they do not want to take
annuities. New contributions to individual retirement accounts are phased out for very high
incomes. Two types of plans are available: traditional IRAs and Roth IRAs. Traditional IRAs,
which account for almost three-quarters of the cost, are treated the same way as pension plans,
with deductions for contributions and taxes on benefits. Roth IRAs are similar to tax exempt
bonds in that the earnings are not taxed, but there is no deduction for the contribution and no tax
on benefits. Both result in an effective zero tax. These benefits are not available for high income
taxpayers, although they can invest in non-deductible IRAs, where tax is deferred until benefits
are received.17 There is also a small savers’ credit, which provides lower-income taxpayers a tax
credit of up to $2,000 for contributions to a retirement plan.
Finally, the inside buildup on life insurance and annuities (the earnings on premiums) is not
subject to tax as it is earned and life insurance paid as a death benefit is not be subject to any tax.
For annuities, the treatment is similar to non-deductible IRAs or contributions to pensions from
after-tax income.
The other two major tax expenditures, under current law, are related to capital gains, which is
subject to a lower rate (currently 15%, but scheduled to rise back to 20% after 2012). In addition,
for assets held until death, the gain accrued during the decedent’s lifetime is not taxed. When
assets are transferred by gift, capital gains tax will eventually apply, but not until the asset is sold.
The revenue loss estimate captures the effect of the 20% maximum tax rate as contrasted with a
39.6% maximum marginal rate. Dividends are currently also subject to a 15% rate but are
scheduled to be taxed as ordinary income after 2012.
If the Bush tax cuts are extended, the capital gains tax rate would remain at 15% and the dividend
rate would also remain at 15% (while the top rate would be 35%). Under this circumstance, the
tax benefit for dividends would be large enough to be included in the top 20 tax expenditures.
17 See CRS Report RL30255, Individual Retirement Accounts (IRAs): Issues and Proposed Expansion, by Thomas L.
Hungerford and Jane G. Gravelle for additional discussion of IRAs.
Congressional Research Service
8
The Challenge of Individual Income Tax Reform
Does exempting or reducing the tax on retirement savings create a distortion, or is it a desirable
feature of a tax system that generally applies to income? Is singling out capital gains (and
possibly dividends) for preferential treatment desirable?
Some economists argue in favor of a tax system that does not tax the return to investment at all,
although most might favor a consumption tax rather than a tax exempting the return to all savings
(i.e., a wage tax).18 If these tax expenditures were eliminated and lower rates substituted, it is
likely that the average tax rate for capital would rise. However, it is not clear that the marginal tax
rate would rise. Pensions and IRAs would be less desirable because the tax benefits are
characterized by ceilings. These ceilings may serve distributional objectives, but the result is that
there is no marginal incentive for those at the ceiling.
Even when effects apply at the margin, the effects on savings of tax reductions are not clear.
Overall, the evidence suggests that tax reductions do not have much effect on savings and
investment whether they are marginal or not.19 One reason for this effect may be the forces of
income and substitution effects: a higher tax rate may make future consumption more costly (the
substitution effect discouraging savings) but it also means one must save more to get to a specific
target (the income effect encouraging savings). The pattern of savings (falling when equity values
are rising, rising in the recent recession when asset values fell) is suggestive of a significant
income effect.
The principal argument made for incentives directed specifically at retirement (even with
contributions capped), is they increase savings because of psychological, “mental accounting,” or
advertising reasons. Individuals may need the attraction of an up-front tax benefit, the segregation
of funds for retirement, and even penalties to prevent raiding their retirement plans. For pension
plans and 401(k) plans, there is evidence that default plan features matter (e.g., that if the
employer automatically signs up new employees, participation in thrift savings plans increases).20
Even if these arguments are correct, the large tax benefits may be a costly way of providing
incentives; moreover, they tend to benefit high income individuals who may be more likely to
have sufficient assets at retirement.
One modification of the defined contribution plans (such as 401(k) plans) that could reduce the
revenue loss is to further limit the total dollar contribution. This proposal could increase national
saving by increasing public saving without reducing private saving because high-income
individuals, who are more likely to save outside these plans, tend to contribute the maximum to
their pension by reducing other saving.21
18 While both a consumption tax and a wage tax exempt the return to new investment, a consumption tax applies to old
capital and allows a deduction for new savings, thereby collecting much more revenue. See Alan J. Auerbach and
Laurence J. Kotlikoff, Dynamic Fiscal Policy (Cambridge: Cambridge University Press, 1987); and Gilbert E. Metcalf,
“Consumption Taxation,” in The Encyclopedia of Taxation and Tax Policy, ed. Joseph J. Cordes, Robert D. Ebel, and
Jane G. Gravelle, 2nd ed. (Washington: Urban Institute Press, 2005), pp. 64-67.
19 CRS Report RL33482, Saving Incentives: What May Work, What May Not, by Thomas L. Hungerford
20 CRS Report RL30255, Individual Retirement Accounts (IRAs): Issues and Proposed Expansion, by Thomas L.
Hungerford and Jane G. Gravelle; and CRS Report RL33482, Saving Incentives: What May Work, What May Not, by
Thomas L. Hungerford.
21 See Congressional Budget Office, Reducing the Deficit: Spending and Revenue Options, March 2011, p. 161.
http://www.cbo.gov/ftpdocs/120xx/doc12085/03-10-ReducingTheDeficit.pdf.
Congressional Research Service
9
The Challenge of Individual Income Tax Reform
A different set of arguments can be made for a reduced capital gains tax rate (where, as will be
seen subsequently, one of the most striking effects is a distributional one, with benefits heavily
concentrated in higher incomes). An argument may be made for providing tax benefits for capital
gains: since gains are taxed only on realization, a lock-in effect causes individuals to delay or
avoid realizations as the tax rate rises, and, consequently, little revenue could be gained. 22 The
revenue loss is based on a static estimate, which assumes that realizations do not change (i.e., no
behavioral effects) when the preferential tax rate is eliminated. But realizations are observed to
decline when the tax rate increases. Using past estimates of the behavioral response from the
1980s, only a small portion of the estimated revenue loss reported in Table 2 (about 7% or $5
billion) would be gained in the long-run by taxing capital gains as ordinary income.23 If the
behavioral response is large, then raising the capital gains tax rate would lead taxpayers to hold
suboptimal investment portfolios and would be undesirable from both an efficiency and
budgetary perspective.
Subsequent research, however, has estimated that the behavioral responses are much smaller.24
Assuming a smaller behavioral response suggests that the revenue gain from eliminating the
preferential capital gains tax rate could be $55 billion (77% of the static estimate).25 But even if
the actual realization response is much smaller, the current scoring assumptions of JCT would
prevent most of the revenue gain from being counted during Congressional debate.26
The second capital gains provision, the exclusion of gains at death, occurs because heirs take as
the basis (the amount subtracted from the sales price in determining capital gains) the value at the
time of death rather than the original purchase price, effectively “resetting” gains to zero. The
opportunity to avoid gains by holding assets until death also contributes to the lock-in effect
during the lifetime. Treating death as a realization event could require the sale of assets to pay the
tax and has never been proposed, although the alternative of retaining the original purchase price
as the basis has been (and was in effect for 2010 as an option with a substantial exemption). This
22 The lock-in effect imposes efficiency losses because investors may be encouraged to hold suboptimal portfolios or
forego investment opportunities with higher pre-tax returns. CRS Report R40411, The Economic Effects of Capital
Gains Taxation, by Thomas L. Hungerford.
23 This issue is discussed in CRS Report R41364, Capital Gains Tax Options: Behavioral Responses and Revenues, by
Jane G. Gravelle. The coefficient in the semi-log function used for this estimate is 3.1, the old and new statutory tax
rates are 0.2 and 0.396, respectively, and realizations are equal to Ae-bt, where A is a constant, e is the natural constant,
b is the coefficient, and t is the tax rate. The effective tax rates are probably lower than the statutory tax rates,
especially for the ordinary income tax rate, but the gains would still be small. The tax expenditure is the tax differential
times the current realizations, whereas the revenue gain would be revenues at the new higher rate compared to current
revenues.
24 See Leonard E. Burman and William C. Randolph, “Measuring Permanent Responses to Capital-Gains Tax Changes
in Panel Data,” American Economic Review, vol. 84, no. 4 (September 1994), pp. 794-809; and CRS Report R40411,
The Economic Effects of Capital Gains Taxation, by Thomas L. Hungerford.
25 The revenue estimating coefficient of 3.1, which is used by JCT, was derived from time series estimates (change in
aggregate capital gains and aggregate tax rates in the economy as a whole). It was chosen because cross section and
panel studies at that time often yielded unreasonable estimates and appeared to be capturing transitory effects.
Moreover, a simulation study indicated that with this response it was easy to project realizations in excess of accruals.
Using state tax variations yielded more reasonable results, and the estimates were around 1 (the $55 billion estimate
uses 1.1). More recent time series data, as well, led to a smaller coefficient of 1.76 used by the Congressional Budget
Office. It would yield a gain of $37 billion. See CRS Report R41364, Capital Gains Tax Options: Behavioral
Responses and Revenues, by Jane G. Gravelle.
26 JCT assumes a revenue estimating coefficient of 3.1, which would yield a long-run revenue gain of about $5 billion
instead of $55 billion. See CRS Report R41364, Capital Gains Tax Options: Behavioral Responses and Revenues, by
Jane G. Gravelle.
Congressional Research Service
10
The Challenge of Individual Income Tax Reform
approach was abandoned when the Bush tax cuts were extended, and would be administratively
problematic if the purchase price is not known.
The realization issue does not arise with beneficial treatment of dividends. Lower rates for
dividends, however, share one argument for capital gains: lower rates reduce the double taxation
of corporate equity income. From this perspective the treatment of capital gains and dividends
might be considered along with corporate tax revisions. If corporate rates are cut substantially
below the rates for individuals, the corporate form would become a tax shelter and that sheltering
option would be more extensive the lower the tax rates are on capital gains and dividends.27 It
should be noted, however, that in advancing this double taxation argument, only about a third of
capital gains arise from corporate stock or capital gains distributions, although another third arises
from pass-through entities that could, in part, reflect corporate stock.28
A disadvantage of differential rates is that it encourages tax sheltering that converts ordinary
income into capital gains. One example of this activity is the carried interest of managers of
investment firms, where what may be viewed as compensation is treated as capital gains. A
proposal to treat this income as ordinary income led to a projected revenue gain of $1.7 billion for
FY2013.29 Another example is borrowing (through a business or a home equity loan) and
deducting the interest, but purchasing assets whose yield is taxed at the lower capital gains and
dividends rate.
Business
Only one individual business provision was large enough to rank in the top 20, accelerated
depreciation.30 This type of change would likely need to be coordinated with corporate tax
reform, and, as indicated in analyses of corporate reform, there is a tradeoff for accelerated
depreciation as an exchange for lowering the rate. Since accelerated depreciation benefits
investment and lower rates benefit the capital stock, reducing the corporate tax rate has a larger
windfall gain than the windfall loss from reducing depreciation. As a result, the effective tax rate
on investment rises. Slowing depreciation also raises more revenue in the short run than in the
long run, which should be taken into account if seeking a long-term revenue neutral change.31
27 Corporate reform options are discussed in CRS Report RL34229, Corporate Tax Reform: Issues for Congress, by
Jane G. Gravelle and Thomas L. Hungerford; and CRS Report R41743, International Corporate Tax Rate Comparisons
and Policy Implications, by Jane G. Gravelle.
28 http://www.irs.gov/taxstats/indtaxstats/article/0,,id=96649,00.html.
29 Joint Committee on Taxation, Estimated Revenue Effects Of The Revenue Provisions Contained In H.R. 4213, The
“American Jobs And Closing Tax Loopholes Act Of 2010,” Scheduled For Consideration By The House Of
Representatives, JCX-30-10, May 28, 2010, http://www.jct.gov/publications.html?func=startdown&id=3685. For a
discussion of carried interest, see CRS Report RS22689, Taxation of Hedge Fund and Private Equity Managers, by
Mark Jickling and Donald J. Marples; and CRS Report RS22717, Taxation of Private Equity and Hedge Fund
Partnerships: Characterization of Carried Interest, by Donald J. Marples.
30 Depreciation allows deductions, over time, for the cost of equipment and structures. Ideally, the deduction in each
year should equal the decline in value of the assets. The tax expenditure is based on the difference between the tax
reduction from the depreciation system and an alternative system. The alternative system allows equal deductions per
year. The current depreciation system accelerates those deductions (allows them more quickly) by concentrating more
deductions in the earlier years and allowing them over a shorter period of time.
31 CRS Report RL34229, Corporate Tax Reform: Issues for Congress, by Jane G. Gravelle and Thomas L. Hungerford;
and CRS Report R41743, International Corporate Tax Rate Comparisons and Policy Implications, by Jane G.
Gravelle. See also Jane G. Gravelle, “Reducing Depreciation Allowances to Finance a Lower Corporate Tax Rate,”
(continued...)
Congressional Research Service
11
The Challenge of Individual Income Tax Reform
Owner-Occupied Housing
All three of the large tax expenditures for owner-occupied housing are in the top 20: the mortgage
interest deduction, the property tax deduction, and the exemption from capital gains taxes on the
sale of a home. The first two provisions are similar in that they reduce the cost of acquiring and
maintaining a home. The exemption from capital gains tax, however, primarily reduces the tax
cost of selling a home. The three provisions together sum to $144.2 billion, about the same size as
the top two expenditures, the exclusion for employer insurance and the exclusions for employee
pensions. The mortgage interest deduction accounts for 65% of the total for owner-occupied
housing incentives, with the capital gains exclusion and the property tax accounting for 17.5%
each.
The mortgage interest deduction and deduction of property taxes are not the only provisions that
reduce the cost of acquiring and maintaining a home. Owner-occupied housing is also subsidized
by the exclusion of net imputed rental income. Imagine two homeowners renting their houses to
each other. They would include the rent received in income but deduct the costs, including
depreciation, insurance, and maintenance as well as mortgage interest and property taxes. Thus,
rather than claiming just deductions for mortgage interest and property taxes they would also
increase their respective incomes by the net rental income. Net imputed rental income is the
estimated value of the net rental income a homeowner “pays” to himself. Thus disallowing the
two deductions would still leave some tax benefit in place. However, taxing imputed rent would
present some administrative and valuation problems.32
The mortgage interest deduction is subject to a limit: interest deductions are limited to those on a
mortgage to acquire or improve a home of $1 million or less, although this high limit affects few
taxpayers. The deduction is not limited to original acquisition indebtedness and so can be used to
borrow funds with interest deductibility to finance other purchases. This type of borrowing is
referred to as home equity loans and homeowners can establish a line of credit for this type of
borrowing. It is subject to a separate limit of interest on $100,000 of principle. The deductions
can also apply to a second, or vacation, home. The deduction for interest other than mortgage
interest was eliminated in the 1986 tax reform act.
In considering the merits of these tax provisions, three questions are addressed. First, should the
government be promoting home ownership? Second, are the tax subsidies effective in achieving
that goal? And, third, if homeownership is desirable, are other alternatives to subsidizing it
better?
(...continued)
National Tax Journal, Vol. 64, December 2011, pp. 1039-1054 and Jane G. Gravelle, Testimony before The
Committee on Finance, United States Senate, March 6, 2012, Tax Reform Options: Incentives for Capital Investment
and Manufacturing.
32 The Department of Treasury classifies the exclusion of net imputed rental income as tax expenditure with an
estimated FY2014 revenue loss of $58.7 billion. The Joint Committee on Taxation does not classify the exclusion as a
tax expenditure, noting that the “measurement of imputed income for tax purposes presents administrative problems
and its exclusion from taxable income may be regarded as an administrative necessity” (U.S. Congress, Joint
Committee on Taxation, Estimates of Federal Tax Expenditures for Fiscal Years 2011-2015, committee print, 112th
Cong., 2nd sess., January 17, 2012, JCS-1-12 (Washington: GPO, 2012), p. 6.).
Congressional Research Service
12
The Challenge of Individual Income Tax Reform
Home ownership is often presumed to be a desirable goal, but subsidies are justified on economic
efficiency grounds only if there is too little housing in private markets.33 Too little housing could
arise from positive externalities (benefits to others that are not priced in the market) or some other
market imperfection. Two justifications are generally advanced for subsidizing homeownership,
relating to external effects and wealth accumulation. The first is that homeowners may make
positive contributions to local neighborhoods by being more stable long-term residents,
maintaining their homes better, or being more involved citizens.34 It has been argued that
homeownership improves the welfare of children, although some recent research suggests this
relationship disappears when controlling for other factors. The second general justification is that
homeownership tends to produce an automatic nest egg that can be used for retirement and there
is evidence that when housing wealth is included, homeowners accumulate more wealth than
renters. If individuals are myopic or for other reasons do not make optimal savings choices, the
purchase of a home could lead to an asset that increases in value with each mortgage payment.35
This effect may be particularly important for moderate income families.
At the same time, home ownership can have negative effects. Homeowners, while producing
positive externalities on neighborhoods, may also join in adopting exclusionary policies (such as
large lot sizes) to protect their property in a way that damages others (by restricting the supply of
housing). Homeowners were more associated with resisting racial integration, for example.36
They may also adopt policies that retard growth and reduce job creation in their areas, making it
more difficult for new entrants.37 Offsetting the wealth accumulation benefit is the problem that
investing too much in a home may lead to less portfolio diversification and greater risk, as has
been demonstrated during the recent (2007-2009) recession. Finally, homeowners’ stability also
leads to labor immobility. While this effect is not a market failure as long as it affects only the
homeowner’s circumstances, the costs can fall on others because of social institutions such as
unemployment insurance. More recently, Glaeser has argued that subsidizing homeownership has
led to moving away from high density housing, causing overconsumption of housing, reducing
33 Numerous articles and studies have been written on the positive and negative external effects of owner-occupied
housing or other market failures and the potential role played by tax and other subsidies, primarily the mortgage
interest deduction. They provide the support for the discussion. See CRS Report R41596, The Mortgage Interest and
Property Tax Deductions: Analysis and Options, by Mark P. Keightley; Edward Coulson and Herman Li, Measuring
the External Benefits of Homeownership, May 2011, http://econ.la.psu.edu/~ecoulson/ownex.pdf; Edward L. Glaeser
and Jesse M. Shapiro, “The Benefits of the Home Mortgage Interest Deduction,” in Tax Policy and the Economy, ed.
James Poterba, January 2003, pp. 37-82; Richard Green, “Homeownership, Social Outcomes, Tenure Choice, and U.S.
Housing Policy,” Cityscape, Vol. 5 No. 2, 2001, pp. 21-29; Zhu Xiao Di, Eric Belsky and Xiaodong Liu, “Do
Homeowners Achieve More Wealth in the Long Run?” Journal of Housing Economics, Vol. 16. 2007, pp. 274-290;
Thomas P. Boehm and Alan Schlottmann, “Wealth Accumulation and Homeownership: Evidence for Low Income
Households,” Cityscape, Vol. 10, No. 2, 2008, pp. 225-256; Christian A. Hilber and Tracy M. Turner, How Sensitive
are Homeownership Decisions to Tax Subsidies, December 2009, http://socrates.berkeley.edu/~raphael/IGERT/
Workshop/turner2010.pdf ; Thomas J. Dohmen, “Housing, Mobility, and Unemployment,” Regional Science and urban
Economics, Vol. 35, 2005, pp. 305-325; and N. Edward Coulson and Lynn M. Fisher, Housing Tenure and Labor
Market Impacts: The Search Goes On, http://buiznt.cob.calpoly.edu/cob/econ/seminars/Coulson.pdf.
34 CRS Report R41596, The Mortgage Interest and Property Tax Deductions: Analysis and Options, by Mark P.
Keightley.
35 CRS Report RL33482, Saving Incentives: What May Work, What May Not, by Thomas L. Hungerford.
36 Ingrid Gould Ellen, Welcome Neighbor? New Evidence on the Possibility of Stable Racial Integration, The
Brookings Institution, Washington, 1997, http://www.brookings.edu/articles/1997/
winter_communitydevelopment_ellen.aspx.
37 William Rohe, Shannon Van Zandt, and George McCarthy, “Social Benefits and Costs of Homeownership,” in Low-
Income Homeownership, ed. Nicolas P. Retsinas and Eric S. Belsky (Washington: Brookings Institution Press, 2002),
pp. 394-396.
Congressional Research Service
13
The Challenge of Individual Income Tax Reform
the vitality of cities, and causing environmental damage.38 The magnitude of these effects have
been difficult to estimate but they do lead to some questions about the desirability of providing
such large benefits for homeownership.
The mortgage interest and property tax deductions have two potential effects: they may increase
the likelihood of homeownership and they may increase the size of homes. It is the tenure choice
(rather than the size of homes) that leads to neighborhood externalities. Evidence, however,
suggests that tenure choice is not affected very much by the tax benefits. For example, the rate of
ownership has not changed although changes in inflation and tax rates have significantly affected
the relative cost of owning versus renting. Similarly, home ownership rates are high in many
countries without these benefits. Those on the margin between renting and owning are likely to be
younger or have lower incomes and thus are less likely to use the tax deductions. Finally, the
major barrier to owning a home is the down payment which is not affected by the subsidy. A
recent temporary tax provision, the first-time homebuyer credit, may have been more targeted to
the down payment issue, but even it required purchasing the house first and then getting a tax
refund.39
The mortgage interest deduction and property tax deduction (as well as the exclusion of imputed
net rent) may cause more expenditures on housing for those who choose owner-occupied housing
and who benefit from the deductions. Since only about 30% of taxpayers (predominately higher-
income taxpayers) itemize deductions while about two-thirds own homes, the deduction tends to
benefit wealthier taxpayers.
In general, the often asserted arguments for subsidizing homeownership are subject to
uncertainty. Moreover, the subsidies are quite large and do not appear to be well targeted.
Eliminating these subsidies could increase tax revenue as could modification of the deductions.
For example, the $1 million ceiling on eligible mortgages could be lowered, home equity loans
could disallowed, and only mortgages on the primary residence could be eligible. CBO estimates
that reducing the combined $1.1 million limit ($1 million for a mortgage and $100,000 for home
equity loans) to $500,000 would raise about $2 billion.40 Property taxes could be subject to a
percentage of income ceiling, or a ceiling might be imposed on all itemized deductions for taxes.
CBO, for example, reports estimates prepared by JCT indicating that limiting the deduction for all
state and local taxes to 2% of adjusted gross income would raise $66 billion in FY2014 compared
to $89 billion if the deduction for all taxes were eliminated.41 Another proposal that would shift
the benefit to more moderate income homeowners is to substitute a credit for the itemized
deduction, which would make it available to all homeowners. This proposal is often made in the
context of a larger reform that would repeal most other itemized deductions or make them subject
to credits.42
38 See Edward L, Glaeser, “Rethinking the Federal Bias Toward Homeownership,” Cityscape, Vol. 13, no. 2, 2011, pp.
5-38. Glaeser argues that ownership is more naturally associated with detached dwellings rather than multi-unit
dwellings which involve shared ownerships of some portions of the dwelling (such as roof, heating system, landscape)
and that subsidizing home ownership indirectly subsidizes larger detached houses.
39 See CRS Report R40153, The First-Time Homebuyer Tax Credit: An Economic Analysis, by Mark P. Keightley.
40 See Congressional Budget Office, Budget Options, Vol. 2, August 2009, http://www.cbo.gov/ftpdocs/102xx/
doc10294/08-06-BudgetOptions.pdf.
41 See Congressional Budget Office, Reducing the Deficit: Spending and Revenue Options, March 2011, p. 148.
http://www.cbo.gov/ftpdocs/120xx/doc12085/03-10-ReducingTheDeficit.pdf.
42 The Congressional Budget Office discusses a proposal to limit the value of the deductions to 15%. See Congressional
Budget Office, ibid., p. 151. Note, however, that there are certain itemized deductions that might need to be retained in
(continued...)
Congressional Research Service
14
The Challenge of Individual Income Tax Reform
The potential effect of the housing capital gains exclusion is quite different. As an uncertain tax
benefit in the possibly far future, it is less likely to affect tenure and home size choices. However,
taxing these gains as with other capital gains taxes, would cause a lock-in effect, which, in this
case, affects not only tax revenues and portfolio diversification, but also affects real choices. It
could exacerbate the problem of labor immobility. It can also cause older individuals whose
families have become smaller to forego downsizing or switching to rental housing (thus using
their housing wealth for living expenses) since, if homes are held until death, there would be no
tax.43 Because gains on homes have largely been protected from tax throughout history, there are
little data to provide a guide to the effect of any lock-in on potential revenues from the tax
expenditure, although if the effect is as large as that for ordinary gains it could be significant
(even at the lower elasticities, taxing capital gains at ordinary rates could collect only 60% of the
static revenue gain). Consequently, there appears to potentially be a stronger case for retaining
this tax benefit for owner-occupied housing.
Consumption
Four of the provisions in Table 2 largely affect how individuals allocate their earnings; three
relate to health and one to charitable contributions.
Health
The health market is subject to numerous serious market imperfections, which result in many
individuals without health insurance.44 Those with insurance do not pay the full marginal cost for
a specific episode, leading to over consumption. In the health market, sellers tell customers what
to buy and pricing is generally not transparent.45 Containing costs and achieving universal health
insurance coverage are two goals that have frequently been pursued by public policy.
The single largest health tax expenditure, the exclusion of health benefits provided by employers,
which encourages employer health benefits, has mixed effects. For those eligible, it encourages
the excessive purchase of health insurance and thus leads to more over-consumption and rising
costs of health care. Moreover, while socially optimal insurance would feature limited coverage
for ordinary expenses and more complete coverage for catastrophic expenses, employer plans
typically do not have a high deductible, a situation often thought to be due to the tax subsidy.46 At
(...continued)
deduction form, such as deductions for casualty, theft and gambling losses (important in properly measuring income),
and medical expenses.
43 See CRS Report RL32978, The Exclusion of Capital Gains for Owner-Occupied Housing, by Jane G. Gravelle and
Pamela J. Jackson.
44 Some of this insurance problem arises from a phenomenon known as adverse selection: individuals know more about
their health status than insurance companies and insurance is over-priced for the healthy and underpriced for those in
poor health. As a result, healthy individuals tend to leave the market, driving the price up. Another problem concerns
preexisting conditions so that individuals cannot generally purchase insurance after medical conditions have become
apparent. Thus a private market cannot fulfill social insurance objectives.
45 See CRS Report R40834, The Market Structure of the Health Insurance Industry, by D. Andrew Austin and Thomas
L. Hungerford; CRS Report RL33759, Health Care and Markets, by D. Andrew Austin; and CRS Report RL34101,
Does Price Transparency Improve Market Efficiency? Implications of Empirical Evidence in Other Markets for the
Health Sector, by D. Andrew Austin and Jane G. Gravelle.
46 Socially optimal insurance would cover the care of an individual up to the point where the marginal benefit equals
the marginal cost. See Jonathan Gruber, “The Tax Exclusion for Employer Sponsored Health Insurance,” National Tax
(continued...)
Congressional Research Service
15
The Challenge of Individual Income Tax Reform
the same time, it has played an important role in dealing with market failures that cause
inadequate insurance coverage among the non-elderly population (the elderly population is
covered by mandatory government programs). Therefore, there are justifications for the subsidy,
which should be weighed against the incentives to increase spending on health care.
The health legislation passed in 2010 (the Patient Protection and Affordable Care Act, P.L. 111-
148, and the Health Care and Education Reconciliation Act of 2010, P.L. 111-152) would
mandate health insurance and constrain the range of premiums charged, as well as provide
subsidies for lower-income families not covered by Medicaid, the health coverage program for
those in poverty.47 The justification for encouraging employer health insurance would no longer
apply with such a universal coverage system in place and, on efficiency grounds, the case for
taxing these benefits would be clear. But as discussed below, there are significant technical
challenges to taxing employer health insurance, which, even if eliminating this benefit were
desirable on efficiency grounds, might preclude this provision from being eliminated so as to
raise tax revenues.
The health legislation adopted in 2010 also limited tax benefits for high cost “Cadillac” health
plans by placing an excise tax on high cost employer-sponsored health plans. But it did not
impute income to the employees for these plans; rather, it levied a tax on insurance companies
based on the cost above a ceiling. A possible policy option would be to further lower that ceiling.
A related provision, the exclusion of benefits provided under cafeteria plans, would be much
easier to eliminate.48 A cafeteria plan allows employees to choose a selection of benefits, but the
major use is to cover health insurance premiums paid by employees (hence its inclusion under
health).
The other major health related tax expenditure, the deduction for health expenses, is different. It
is an itemized deduction for to out-of-pocket health expenditures in excess of a percentage of
adjusted gross income. Currently, the deduction is for expenses exceeding 7.5% of income, but
that amount will increase to 10% in 2013. The rationale for this deduction is largely that these
expenses are involuntary ones that reduce the taxpayer’s ability to pay taxes. It may be difficult to
imagine not allowing some allowance for catastrophic medical expenditures, so the principal
issue could be where to set the floor. The 10% floor is high by historical standards (prior to 1986
the floor was either 3% or 5%). It is not clear whether the floor could be increased further while
still achieving the ability-to-pay objective.
Charitable Contributions
A deduction for charitable contributions is an itemized deduction. They are subject to market
failures because of “free-rider” problems: to the extent the contribution increases overall social
welfare, individual taxpayers can benefit from the contributions of others, giving them an
incentive to not contribute; consequently, overall giving is undersupplied. For example, transfers
(...continued)
Journal, Vol. 64, June 2011, Part 2, 511-530.
47 See CRS Report R41331, Individual Mandate and Related Information Requirements under ACA, by Janemarie
Mulvey.
48 Cafeteria plans are an employer benefit that allows employees to choose benefits among various options that include
cash (which is taxable), taxable benefits such as vacation time, and nontaxable benefits such as health care.
Congressional Research Service
16
The Challenge of Individual Income Tax Reform
to relieve poverty can provide a social benefit to donors and to nondonors who are not recipients
if there is a social value, such as reducing crime.
Two issues, however, make the deduction potentially questionable from an economic perspective.
The first is that the individual contributor may be induced to give less to charity than the revenue
loss, so that the government could provide more funds for charitable purposes through grants.
This effect occurs when the elasticity of charitable giving (percentage change in charity
contributions from a 1% change in tax rates) is less than one, which most current research shows.
The second is that the contributors may receive direct benefits, implicit benefits, or their
contributions may go to charities that much of the population does not benefit from (e.g.,
contributors may receive front-row seats at the orchestra or box seats at sporting events, or may
give to Ivy-league schools and art museums that much of the population may not consume). Very
little of charitable giving (less than 8%) goes directly to aid those in poverty.49
One option for charitable contributions is to provide a floor, so that only large contributions
relative to income are eligible, an approach that increases the induced giving per dollar of revenue
loss. It would also increase tax compliance since small donations would no longer be eligible. A
2% of income floor is projected to raise $18.7 billion for FY2013.50 According to the latest data
available, about 14% of contributions would no longer have a marginal incentive with a 2% floor,
although the revenue gain would be 37% of the total tax expenditure.51 The relatively larger gain
in revenue compared to the reduction in incentive is because most of the contributions are made
by taxpayers who would retain a marginal incentive after disallowing contributions up to 2% of
income.
Another option, or perhaps an additional one, is to revise the treatment of appreciated property.
Taxpayers who donate appreciated property can take a deduction for the full value of the property,
without paying capital gains tax on the increase in value. About a quarter of donations are non-
cash, although about 30% are for clothes, autos, and household items that depreciate. Donations
of appreciated property (such as stock, real estate, and art) are heavily concentrated in high
income groups. Revisions could allow deductions only for the minimum of the fair market value
or the basis (which would encourage people to sell the asset), or require tax on the gain.52
49 Counting indirect and in-kind estimates this number may rise to between 25% to 30%, depending on a range of
estimates for religious giving. These numbers encompass items other than direct needs such as scholarships for higher
education. See Patterns of Household Charitable Giving by Income Group, 2005, prepared for Google by the Center on
Philanthropy at Indiana University, Summer 2007 http://www.philanthropy.iupui.edu/Research/
Giving%20focused%20on%20meeting%20needs%20of%20the%20poor%20July%202007.pdf. For further discussion
of charitable contributions issues see CRS Report RL34608, Tax Issues Relating to Charitable Contributions and
Organizations, by Jane G. Gravelle and Molly F. Sherlock and CRS Report R40518, Charitable Contributions: The
Itemized Deduction Cap and Other FY2011 Budget Options, by Jane G. Gravelle and Donald J. Marples . The second
report contains a review of evidence on the elasticity of charitable giving.
50 See Congressional Budget Office, Reducing the Deficit: Spending and Revenue Options, March 2011, p. 150.
http://www.cbo.gov/ftpdocs/120xx/doc12085/03-10-ReducingTheDeficit.pdf.
51 Based on the 2006 Statistics of Income public use file. In that year there were $175.7 billion in contributions, with
$22.3 billion for taxpayers below the floor and $2.3 billion for taxpayers who switch to the standard deduction.
52 For data on non-cash gifts, see Deena Ackerman and Gerald Auten, “Tax Expenditures for Noncash Charitable
Contributions,” National Tax Journal, vol. 64, no. 2, Part 2 (June 2011), pp.651-688.
Congressional Research Service
17
The Challenge of Individual Income Tax Reform
Labor Supply
Two provisions relating to labor supply are in the provisions in Table 2: the earned income tax
credit and the exclusion of fringe benefits. These provisions are tax incentives designed to
encourage work effort.
The earned income credit is a major subsidy for low-income individuals, especially for families
with children, and has helped to offset the stagnation of wages and the burden of the payroll tax at
the lower end of the income spectrum. Unlike other transfer programs aimed at lower-income
individuals, it is related to earnings. In theory, it should increase labor force participation by
single parents, but could reduce hours by those in the work force and second earners because
benefits are phased out and create implicit taxes as earnings rise. Most research suggests that it
encourages labor force participation of single mothers, but has little effect on hours worked. Its
most important justification, however, is distributional, rather than relating to economic
efficiency.53
The other provision is one that excludes a certain amount of income earned abroad from U.S. tax.
Since these individuals are protected from double taxation by a foreign tax credit, this provision
subsidizes the location of employees in low tax jurisdictions abroad, for which there appears to be
no clear economic rationale.
Government
Four of the tax expenditures in Table 2 are tax benefits related to government programs—either
exemptions from taxes on government provided benefits, or benefits granted to states and
localities. These provisions basically subsidize government programs and there are questions as
to whether the goals can best be met through tax provisions or direct spending.54 In this area, the
question is not so much the effect of the tax provision on private behavior (investment and
savings, private consumption choices, and labor supply) but on whether they are desirable as part
of government programs of transfers to individuals or to state and local governments.
Exemption of Medicare and Social Security Benefits
Two of the tax expenditures involve the exemption of Medicare benefits and part of Social
Security benefits from income taxation.55 The reduction of the federal deficit due to taxing these
benefits could also be achieved by directly reducing the benefits by an equivalent amount.
Alternatively, revenues from taxing Social Security and Medicare benefits could be used to
maintain or increase benefit levels (this was the justification for taxing part of Social Security
benefits beginning in 1984).
53 See Nada Eissa and Hilary Hoynes, “Redistribution and Tax Expenditures: The Earned Income Tax Credit,” National
Tax Journal, Vol. 64, No. 2, Part 2, June 2011 pp. 689-730.
54 CRS Report RL33641, Tax Expenditures: Trends and Critiques, by Thomas L. Hungerford.
55 Up to 85% of Social Security benefits are taxable; the percentage that is taxable depends on the amount of other
income received by the taxpayer. See CRS Report RL32552, Social Security: Calculation and History of Taxing
Benefits, by Christine Scott.
Congressional Research Service
18
The Challenge of Individual Income Tax Reform
The recipients affected by taxing Medicare benefits would be largely moderate income taxpayers,
since the Medicare benefit is not tied to income (see below). Although some Social Security
benefits are subject to taxation, low and moderate income taxpayers would bear most of the
increased burden of taxing all Social Security benefits (see below).
The fundamental issues with these tax changes are whether these programs should be cut back,
how the costs and benefits should be distributed, and, in the case of Medicare, whether taxation is
administratively feasible. These same issues apply to taxation of other federal government
benefits, such as the exclusion of certain allowances for military employees and civilian
employees working abroad, and the exclusion of veteran’s benefits.
Subsidies for State and Local Governments: Deductions for Income Taxes and
Exclusion of Tax Exempt Bonds
The other two tax expenditures related to government programs in Table 2 are those that support
state and local governments: the deduction of state and local income taxes, which makes these
taxes effectively smaller for itemizers, and the exclusion of interest on tax exempt bonds.56 (Note
that the property tax deduction was included in housing.)
With any subsidy to state and local governments, whether via a tax subsidy or via direct grants,
one question is whether or not the nation’s taxpayers in general should subsidize activities in
specific states or localities. Some government services provided by state and local governments
do potentially benefit all federal taxpayers to some degree (such as roads) while others do not
(such as residential garbage pick-up). Given the mobility of the population, there are general
benefits to education (which is a recipient of some of the tax benefits of general obligation tax
exempt bonds); similarly, taxpayers may benefit from the awareness that the poor are being cared
for. But overall the spending of state and local governments tends to largely benefit their own
residents.
Furthermore, tax exempt bonds and income tax deductions are blunt instruments to provide
subsidies. Income taxes tend to be the highest for wealthy states that may need aid the least, and a
few states do not have income taxes. Tax exempt bonds are targeted at providing physical assets
(such as buildings). It is unlikely that a system of grants that replaced these benefits would be
targeted in this particular way. For these reasons both have been the targets of reform in the past.
For income tax deductions, an alternative to eliminating the deduction is to cap it, perhaps as a
percentage of income (this change would apply to all taxes, not just income taxes). CBO, for
example, reports estimates prepared by JCT indicting that limiting the deduction for all state and
local taxes to 2% of adjusted gross income would raise $66 billion in FY2014 compared to $89
billion if the deduction were eliminated altogether.57
56 See CRS Report RL32781, Federal Deductibility of State and Local Taxes, by Steven Maguire; CRS Report R41735,
State and Local Government Debt: An Analysis, by Steven Maguire; and CRS Report R40523, Tax Credit Bonds:
Overview and Analysis, by Steven Maguire.
57 See Congressional Budget Office, Reducing the Deficit: Spending and Revenue Options, March 2011, p. 148.
http://www.cbo.gov/ftpdocs/120xx/doc12085/03-10-ReducingTheDeficit.pdf.
Congressional Research Service
19
The Challenge of Individual Income Tax Reform
For tax exempt bonds, two issues arise.58 The first issue is that an exemption of interest is more
costly than a direct subsidy to the states since taxpayers at the highest marginal tax rate get a
windfall. Individuals invest in tax exempt bonds with lower yields because of the tax benefit (and
paying the lower yield is how the state and local governments benefit). For example, if the yield
on a taxable bond is 8% and the yield on a tax exempt bond with the same risk is 6%, a taxpayer
in the 25% marginal tax bracket will be indifferent between the two (since the after-tax return is
the same), but a taxpayer in the 35% tax bracket will receive a higher after-tax return from the tax
exempt bond. If the federal government paid the subsidy directly to the state, this extra return
would be eliminated since state and local bonds would bear the same yield as taxable bonds. An
initiative has already begun in this area with Build America Bonds, although its effects are limited
($2.3 billion of the total cost). Any change in tax exempt bonds would presumably apply only to
new issues of bonds and a shift to direct subsidies would not raise much revenue in the short run.
The CBO budget options study reports JCT estimates indicating a gain of about $3 billion in
FY2013, but rising to $29 billion by FY2021.
The second issue is that about a fifth of the cost of the exemption is not for general obligation
bonds (bonds used to finance government investments such as schools) but for private activity
bonds.59 These funds are borrowed by businesses, and often allow interest to be excluded for
private borrowing. These bonds, however, are capped in some cases and limited to certain
specific uses (sewer facilities, docks, transit); the purpose with the largest revenue cost is
hospitals ($2.5 billion).
Any modification of tax exempt interest would likely need to be coordinated with corporate tax
reform since corporations also purchase these bonds and, at least currently, are taxed at the top
individual rate.
Structural
This category is composed of provisions that don’t provide incentives or affect behavior, but
appear to be associated with distributional or equity issues. The only one appearing in Table 2 is
the child credit, which would be larger if the current higher credit under the Bush tax cuts and the
2009 stimulus are made permanent or extended past 2012 (see Table 3).60
Other Notable Tax Expenditures
By concentrating the discussion on the largest 20 tax expenditures, the analysis has not dealt with
smaller provisions that could be modified or eliminated and together could raise a considerable
amount of tax revenue. Table 4 lists all of the remaining provisions (24) that have revenue effects
of at least $1 billion. In sum, they account for $100 billion or 8% of total tax expenditures.
Compared to category distribution in Table 1, these smaller tax expenditures include no
provisions for owner-occupied housing and only two provisions are related to savings. The largest
category is consumption with health and education accounting for a significant fraction.
58 For a discussion of tax exempt bonds, see CRS Report R42396, The Impact of Budget Proposals on Tax-Exempt
Bonds, by Steven Maguire.
59 CRS Report RL31457, Private Activity Bonds: An Introduction, by Steven Maguire.
60 For a description of the child credit, see CRS Report R41935, The Child Tax Credit: Economic Analysis and Policy
Options, by Margot L. Crandall-Hollick.
Congressional Research Service
20
The Challenge of Individual Income Tax Reform
Table 4. Additional Tax Expenditures Not Among the Top 20, With a Cost of $1
Billion or More, FY2014
Amount
Provision Category
($billions)
Exclusion of Allowances, Military and Foreign Service
Government
7.9
Exclusion of Veteran’s Benefits
Government
7.2
Miscel aneous Employee Fringe Benefits
Labor Supply
7.0
Smal Business Employee Health Insurance Credit
Consumption
6.0
Self Employed Health Insurance Deduction
Consumption
5.9
Employer Provided Non-Health Insurance
Consumption
5.7
Employer Provided Transportation Benefits
Labor Supply
5.7
Tuition Tax Credits
Consumption
5.5
Exclusions of Workers Compensation (Health)
Consumption
5.4
Production Activities Deduction
Business
5.3
Exclusion of Workers Compensation
Government
5.2
Exclusion of Cash Public Assistance
Government
5.0
Exclusion of Health Insurance Military
Consumption
5.0
Additional Standard Deduction, Blind and Elderly
Structural
4.4
Exclusion of Earnings of Voluntary Employees Beneficiary
Labor Supply
4.2
Associations
Exclusion of Scholarships and Fel owships
Consumption
2.7
Deferral of Gain, Non-Dealer Installment Sales
Savings
2.7
Child Care Credit, Employer Care
Labor Supply
2.6
Personal Exemption for Students
Consumption
2.4
Health Savings Accounts
Consumption
2.1
Exclusion of Damages for Injury or Sickness
Structural
1.6
Deferral of Interest on Savings Bonds
Government
1.5
Non-Recognition of Gain on Like Kind Exchanges
Saving
1.3
Exclusion of Employee Meals and Lodging
Labor Supply
1.3
Exclusion of Employee Education Assistance
Consumption
1.0
Source: CRS calculations based on Joint Committee on Taxation revenue estimates.
Most of the health provisions are extensions of employer health exclusions that are listed
separately (for military personnel and retirees, workers compensation, and provisions for the self-
employed) and an alternative employer plan (health savings accounts). The analysis would be
similar to those for exclusions of employer provided health insurance in general.
There were no education subsidies in the top 20 and although these provisions are broadly
available, they have a relatively small revenue loss.61 The largest of these is the tuition tax credit
61 CRS Report RL32507, Higher Education Tax Credits: An Economic Analysis, by Mark P. Keightley.
Congressional Research Service
21
The Challenge of Individual Income Tax Reform
(enacted in 1997), which has been criticized as adding complexity to the tax code when an
apparatus for federal student aid already existed.62
The second largest category of tax expenditures listed in Table 4 is government programs. These
include the exclusion of various military allowances and combat pay for the military as well as
certain allowances for foreign service personnel and exemptions for other federal programs. The
same issues arise with them as with other government programs tax provisions.
Several labor supply provisions are included; most of them relating to the exclusion of various
employee fringe benefits (although some of the transportation subsidies are aimed at encouraging
mass transit or carpooling). The largest is the exclusion of miscellaneous employee fringe
benefits such employee discounts, parking, gyms, and similar provisions. If these were considered
as a group, exclusion of employee benefits would total $18.2 billion and rank 16th on the major
tax expenditures list in Table 2. The exclusion of miscellaneous benefits favors industries where
these benefits are more prevalent (for example, employee discounts may benefit retail sales in
consumer goods). Transportation benefits are, however, aimed at subsidizing mass transit to some
degree. Taxing some or all of these benefits could create administrative problems (see below).
A provision relating to businesses is the production activities deduction. Although this provision
is available for corporations, it would be possible to eliminate it independently. This provision
was introduced in 2004 and was originally aimed at corporate manufacturing, to encourage
operations in the United States, but was later expanded to other industries and unincorporated
businesses. Many of these businesses, particularly unincorporated businesses, are unlikely to
produce abroad, so that this justification does not apply.63
Distributional Issues
Tax expenditures have often been described as having an “upside-down” subsidy feature—that is,
higher-income taxpayers benefit to a greater extent than lower-income taxpayers from tax
expenditures because of the progressive nature of the income tax system.64 The upside-down
subsidy is because a taxpayer in the 35% tax bracket receives a 35 cent tax reduction if their
taxable income is reduced by $1 while a taxpayer in the 15% tax bracket receives only 15 cent tax
reduction. Not all tax expenditures, however, benefit high-income taxpayers; some are explicitly
or implicitly targeted to lower-income taxpayers.65 Since tax expenditures can affect taxpayers in
one part of the income distribution or another, tax expenditures can change the distribution of
after-tax income.66
62 Ibid.
63 CRS Report R41988, The Section 199 Production Activities Deduction: Background and Analysis, by Molly F.
Sherlock.
64 Stanley S. Surrey, “Tax Incentives as a Device for Implementing Government Policy: A Comparison With Direct
Government Expenditures,” Harvard Law Review, vol. 83, no. 4 (February 1970), pp. 705-738.
65 See CRS Report RL33641, Tax Expenditures: Trends and Critiques, by Thomas L. Hungerford; and Thomas L.
Hungerford, “Tax Expenditures: Good, Bad, or Ugly?” Tax Notes, vol. 113, no. 4 (October 23, 2006), pp. 325-324.
66 Thomas L. Hungerford, “The Redistributive Effect of Selected Federal Transfer and Tax Provisions,” Public Finance
Review, vol. 38, no. 4 (July 2010), pp. 450-472.
Congressional Research Service
22
The Challenge of Individual Income Tax Reform
The Suits progressivity index is employed to summarize the progressivity or regressivity of tax
expenditures. The Suits index ranges from −1 to +1.67 The Suits index is negative if the benefits
from a tax provision are received primarily by taxpayers in the upper part of the income
distribution and is said to be regressive. It is positive if the benefits are received primarily by
lower-income taxpayers and is said to be progressive. The tax benefits are proportionately
distributed if the Suits index is zero.
The distributional consequences of tax expenditures can depend on features of the tax code that
are unrelated to the specific provision, such as the tax brackets and tax rates.68 Furthermore, the
nature of the tax expenditure affects the distribution of tax benefits. For example, a provision that
reduces taxable income may have a different effect than one that reduces tax liability directly.
Table 5 reports the Suits index for 14 of the 20 largest individual tax expenditures; the Suits
index for the other six could not be estimated because data are not available.
Saving
The tax expenditures in the saving category are all regressive (though to different extents) since
the Suits index is negative—higher-income taxpayers receive a disproportionate share of the tax
benefits relative to their income. There are two primary reasons for this pattern. First, higher-
income taxpayers are more likely to save and invest in assets than lower-income taxpayers.69
Second, the tax schedule is progressive, so taxpayers in higher tax brackets receive greater tax
benefits from reducing taxable income. For example, if taxpayers in the 35% tax bracket
contribute an additional dollar to their 401(k) plan, they reduce their tax liability by 35 cents.
Conversely, taxpayers in the 15% tax bracket reduce their tax liability by 15 cents if they
contribute an additional dollar to their 401(k) plan. The tax benefits of pension and IRA saving is
less regressive than the other saving tax expenditures because there is an upper limit on annual
contributions and most lower-income taxpayers who do save do so in their 401(k)s and IRAs.
Housing
The two housing provisions are deductions that are only available to taxpayers who itemize
deductions (about one-third of all taxpayers). The Suits index for the deduction for property taxes
and mortgage interest are closer to zero than to −1, suggesting the tax benefits are moderately
regressive. Taxpayers who itemize deductions tend to be spread throughout the income
distribution: almost one-third have income below $50,000 and another third have income over
$100,000.70 However, over half of the total amount deducted is claimed by taxpayers with income
over $100,000 because (1) higher-income taxpayers tend to own more expensive homes with
larger mortgages and higher property taxes, and (2) the progressivity of the tax schedule leads to
the “upside-down” subsidy effect.
67 See Daniel B. Suits, “Measurement of Tax Progressivity,” American Economic Review, vol. 67, no. 4 (September
1977), pp. 747-752. See Appendix B for a more detailed explanation of the Suits index and the data used to estimate
the Suits index for the selected tax provisions.
68 See CRS Report RL34622, Tax Expenditures and the Federal Budget, by Thomas L. Hungerford.
69 For example, John Sabelhaus and Jeffrey A. Groen, “Can Permanent-Income Theory Explain Cross-sectional
Consumption Patterns?” Review of Economics and Statistics, vol. 82, no. 3 (August 2000), pp. 431-438 show that
consumption to income ratios decline as income rises.
70 CRS analysis of the 2006 IRS SOI Public Use File.
Congressional Research Service
23
The Challenge of Individual Income Tax Reform
Table 5. Progressivity of Selected Tax Provisions: The Suits Index
Provision Type Suits
Index
Saving
Capital Gains
Preferential Tax Rate
−0.705
Qualified Dividends
Preferential Tax Rate
−0.535
Employer Pensions & IRAs
Deferral of Tax Liability
−0.165
Housing
Property Taxes
Deduction
−0.151
Mortgage Interest
Deduction
−0.115
Consumption
Charitable Contributions
Deduction
−0.352
Medical Expenses
Deduction
0.183
Employer Health Insurance
Exclusion
0.282
Labor Supply
EITC
Tax Credit
0.937
Government
Tax-exempt Interest
Exclusion
−0.559
State & Local Income Taxes
Deduction
−0.405
Medicare
Exclusion
0.478
Social Security
Exclusion
0.499
Structural
Child Tax Credit
Tax Credit
0.536
Source: CRS analysis of the 2006 IRS SOI Public Use File and 2007 Survey of Consumer Finances.
Consumption
The tax provisions in the consumption category show no consistent pattern in the Suits index. The
tax benefit of the charitable contribution deduction is regressive (Suits index of −0.352) for the
same reasons as the mortgage interest deduction—only itemizers can claim the deduction and the
progressivity of the tax schedule.
The tax benefit of the deduction for medical expenses, which an itemized deduction available to
only itemizers, is moderately progressive with a Suits index of +0.183. The reason that the benefit
of the medical expenses deduction is progressive is the income floor—in 2010, medical expenses
above 7.5% of adjusted gross income could be deducted. Lower-income households tend to have
higher medical expenses relative to their income than higher-income households. In 2010, health
care expenditures of the poorest 20% of households were equivalent to 15.4% of their income
compared to 3.1% of income for the richest 20% of households.71
71 CRS calculations based on Bureau of Labor Statistics tabulations from the Consumer Expenditure Survey
(http://www.bls.gov/cex).
Congressional Research Service
24
The Challenge of Individual Income Tax Reform
The tax benefit of the exclusion of employer-provided health insurance is progressively
distributed with a Suits index of +0.282. The exclusion is not limited to just taxpayers who
itemize, so the tax benefit is more widely distributed throughout the income distribution.
Furthermore, the amount excluded often is independent of income.
Labor Supply
The sole labor supply provision is the earned income tax credit (EITC) with progressively
distributed tax benefits.72 The Suits index is close to +1.0. The EITC is available to all taxpayers
who qualify as opposed to just taxpayers who itemize. Furthermore, it does not depend on the
taxpayer’s tax bracket—it is directly subtracted from tax liability. Furthermore, it is a refundable
tax credit and, thus, taxpayers with no tax liability can receive a refund. The EITC is available to
taxpayers with adjusted gross income below a certain level ($48,362 for a married taxpayer filing
a joint return), who have earnings and limited investment income.
Government
The government tax expenditures, which basically subsidize government programs, can be either
progressive or regressive. The exclusion of tax-exempt interest and the deduction of state and
local income taxes are subsidies to state and local governments. The tax benefits of these two tax
expenditures are regressively distributed with Suits indices of −0.559 and −0.405, respectively.
Tax-exempt interest is primarily received by higher-income taxpayers and the tax benefits depend
on the taxpayer’s tax bracket—the progressive tax system leads to the regressive or “upside-
down” tax benefits. The tax benefits of the deduction of state and local income taxes are
regressively distributed because (1) the deduction is limited to itemizers, (2) the benefits depend
on the taxpayer’s tax bracket, and (3) higher-income taxpayers pay higher state and local income
taxes than lower-income taxpayers (i.e., the deduction is larger).
The tax benefits of the exclusions of Medicare and Social Security benefits are progressively
distributed. Although the tax benefits depend on the taxpayer’s tax bracket, which tends to reduce
progressivity, these benefits are received by elderly taxpayers who tend to have lower income
than nonelderly working taxpayers. Furthermore, the proportion of the Social Security benefit that
is excluded depends on the taxpayer’s income—lower-income taxpayers have a larger share of
their Social Security benefit excluded from taxation.
Structural
The last category is structural tax provisions; the only tax provision listed is the child tax credit.
The child tax credit does not depend on the taxpayer’s tax bracket and is not limited to itemizers.
The tax credit is limited to taxpayers with income below a certain level (the credit begins to
phase-out for married taxpayers with AGI over $110,000) and who have qualifying children.
Consequently, the tax benefit is progressively distributed with a Suits index of +0.536.
72 For a description, see CRS Report RL31768, The Earned Income Tax Credit (EITC): An Overview, by Christine
Scott.
Congressional Research Service
25
The Challenge of Individual Income Tax Reform
Administrative and Technical Challenges
Several tax provisions would be easy to change, which could simplify tax administration and
compliance. These provisions include, in general, deductions, credits, and differential rates that
already appear on the tax form. Scaling back deductions (such as by imposing floors) would
require some minor additional computations but present no significant difficulties.
Including certain types of income that do not appear on the tax return (such as certain exclusions)
can present significant technical challenges that could preclude them from consideration in tax
reform proposals. These serious technical problems arise from two separate, but related, issues:
the difficulty of determining the dollar value of certain types of income, and the imposition of
taxes without the actual realization of income. In some cases, there may be potential solutions,
but it others, it may be difficult to imagine how the provision might reasonably be enforced.
These technical challenges apply to five of the provisions in Table 2, including the largest two,
and account for almost 40% of total tax expenditures: the exclusion of employer health insurance,
the exclusion of employer pensions, the exclusion of Medicare benefits, the taxation of capital
gains at death, and the taxation of the inside buildup of annuities. These challenges also apply
about a third of the smaller provisions in Table 4 (accounting for 1% to 2% of total tax
expenditures). It likely would be difficult to reduce or eliminate these tax expenditures because it
would be difficult to administer the tax fairly.
Health Benefits
The principal problem with employer health insurance is determining the value of the insurance
to each taxpayer. When compared to what might be paid in the private market, the value depends
on age, existing health conditions, family size and composition, and cost of medical care in the
particular area. Not only would it be extremely difficult to assign a value, but assigning costs
based on existing health conditions would re-introduce adverse selection issues into the market as
well as result in very large imputed income for those with serious health problems.
An alternative, which was discussed during the 2010 health care debate, would be to allow a fixed
dollar amount per employee, or an amount differentiated by limited characteristics (i.e., family
size and age). But this approach does not eliminate the problem; not only would some employees
then include in income amounts that are in some cases larger than their actual benefits, inequities
between otherwise identical individuals receiving identical benefits could occur because of firm
characteristics. For example, if existing health conditions are not used to differentiate imputations
and some sort of average amount were assigned, then those individuals working in firms,
especially smaller firms, where employees have worse health on average will be assigned more
income than those in other firms. These problems would also occur if age were disregarded.
Another alternative would be to disallow the deduction by the firm but that approach would lead
to other problems (nonprofit and some other firms do not pay taxes, tax rates for employees
would differ from tax rates for firms). The approach taken in the Patient Protection and
Affordable Care Act (P.L. 111-148) was to impose a flat rate tax that the insurer pays, but that too
would face the same problems of a mismatch with employee tax rates.
Modifying the fourth largest tax expenditure, the exclusion of Medicare, confronts the same
problem as the employer exclusion for health care—it would be very difficult to impute the
Congressional Research Service
26
The Challenge of Individual Income Tax Reform
insurance value of the benefit. Moreover, while the value may vary among taxpayers, the
coverage is the same for all individuals regardless of their earnings or the number of years they
were paying taxes (as long as they were vested). Thus not only does the value of the insurance
vary with taxpayer characteristics, the amount that should be included in income varies since the
employee’s portion of the tax that financed Medicare was not originally deductible. That
contribution would need to be recovered tax free, to properly reflect income, and would vary
across taxpayers depending on how long they had been in the system. Social Security benefits are
currently taxed based on a rule of thumb because they are tied, albeit imperfectly, to past
earnings.
Pension Benefits
The modification of the second largest tax expenditure, tax exclusions for employer retirement
plans, confronts certain challenges because of the structure of defined benefit pension plans. With
a defined benefit plan, it is very difficult to determine the annual gain in value of retirement
benefits in any given year because it varies depending on employee circumstances including
future behavior, since retirement benefits plans are generally based on income, age, and years of
service to the firm. Furthermore, an employee is not immediately vested, and if he leaves the firm
before the vesting period is completed (typically five years) there will be no benefit. Changing the
tax treatment of defined contribution plans (e.g., 401(k) plans) would be more straightforward but
would create a disparity in the tax treatment of the two types of pension plans.
Saving
The exclusion from income for gains at death (the eighth largest tax expenditure) could be
difficult to modify because of the uncertainty about the value of the assets (the original cost or
basis may be difficult to determine on long held assets) and the question of whether or not the
estate has the funds to pay the tax. Currently, the capital gains tax is based on the price at which
the asset is sold above the market value at the time of death (rather than the price the decedent
paid).73 Moreover, no subsequent gain is taxed until the asset is sold. In this system, the heir has
the direct information to calculate his gain which is the excess of sales price over the market
value at the time of death. To tax gains currently, the estate administrator would need to know the
basis (from the decedents’ records) and the price for certain assets (such as business assets and
real estate). In many cases, one or both pieces of information may be difficult to obtain. In
addition to valuation problems, the estate might not have enough cash on hand to pay the tax
(especially if this change were in conjunction with taxing capital gains at ordinary rates). Past
proposals and reforms that required the heir to use the original purchase price rather than market
value at death, have ultimately been suspended shortly after or even before they took effect. The
most recent example, enacted in 2001, would have had the capital gains provision taking effect in
2010. It was changed by the Tax Relief, Unemployment Insurance Reauthorization, and Job
Creation Act of 2010 (P.L. 111-312), which allowed heirs of decedents dying in 2010 to elect how
the capital gains would be taxed. The estate could elect no estate tax and use the original purchase
price for gains, or continue step-up in basis and pay an estate tax (with a $5 million exemption).
73 The current method of using the market value at the time of death as the basis is referred to as step-up in basis. Using
the price the decedent paid is referred to as carry-over basis.
Congressional Research Service
27
The Challenge of Individual Income Tax Reform
The thirteenth largest tax expenditure, the exclusion of inside buildup on life insurance and
annuities (the earnings on premiums), is a benefit that can be determined actuarially, but the
individual taxpayer does not actually receive the income. Consequently, changing the tax
treatment would require taxation on an accrual basis rather than on a realization basis. The extent
to which this might cause cash flow difficulties for the investor depends on how large the annuity
appreciation is relative to other income. This problem is a little more tractable, however, since a
withholding tax could be imposed on the insurance company and the taxpayer could take a credit
for it, much as is done with wage withholding. It would add complexity to the tax form, however.
Other Tax Expenditures
Among the smaller tax expenditures, one of the larger ones is miscellaneous fringe benefits,
which has valuation problems as well. Consider the example of an employee discount for clothing
in a retail store. Should the discount be measured relative to the regular price or a sales price?
Does the employee enjoy the full value or do they feel pressured to wear the store’s clothing? To
what extent is the discount a benefit for the store? If the company has a gym, even if the firm can
allocate the cost, some employees don’t use a gym at all, some use it occasionally, and some
intensively. How is this usage to be tracked? Is the benefit of the gym as valuable to the
employees as it costs the firm?
Public Attitudes Towards Tax Reform
Many tax expenditures enjoy strong public support of these provisions. For many large tax
expenditures, survey respondents (from samples of U.S. adults) support maintaining these tax
breaks even if the elimination of the provisions allowed for reducing tax rates. For example, only
30% of survey respondents support eliminating the deduction for State and local taxes in return
for lower tax rates.74 The percentage of respondents supporting the elimination of other tax
provisions in return for lower tax rates are: charitable deductions, 26%;75 exclusion of employer
provided health insurance, 40%;76 child care expenses, 46%;77 and exclusion of 401(k)
contributions, 39%.78
Public support for the mortgage interest deduction, however, is not so straightforward. Overall,
93% of respondents think continuing the mortgage interest deduction is very important (63%) or
somewhat important (30%).79 Furthermore, only one-third of respondents support eliminating or
reducing the deduction in exchange for reducing the deficit.80 However, almost half of the
respondents would exchange the mortgage interest deduction for lower tax rates,81 and 50%
74 Gallup Poll, April 2011, http://www.gallup.com/poll/147125/Americans-Oppose-Eliminating-Income-Tax-
Deductions.aspx.
75 Ibid.
76 Bloomberg Poll, June 2011, http://www.bloomberg.com/news/2011-06-22/americans-worse-now-than-when-obama-
inaugurated-by-44-34-margin-in-poll.html.
77 Ibid.
78 Ibid.
79 CBS News/New York Times Poll, June 2011, http://www.cbsnews.com/8301-503544_162-20075544.html.
80 Gallup Poll, April 2011.
81 Bloomberg Poll, June 2011.
Congressional Research Service
28
The Challenge of Individual Income Tax Reform
support eliminating the mortgage interest deduction for mortgages over $500,000 and for second
homes.82
Less than half of survey respondents (48%) reported they favor eliminating all tax deductions in
return for lower tax rates,83 even though only one-third of taxpayers claims these deductions.
Many of the largest tax expenditures enjoy the support of the majority of the adult population.
The only large tax expenditure that is not supported by a majority is reduced tax rates on capital
gains—54% of survey respondents think it is totally acceptable (17%) or mostly acceptable
(37%) to increase the capital gains tax rate as a way to reduce the federal deficit.84
Concluding Remarks
The analysis in this report suggests there are impediments to base broadening by eliminating or
reducing tax expenditures, because they are viewed as serving an important purpose, are
important for distributional reasons, are technically difficult to change, or are broadly used by the
public and quite popular.
The savings incentives account for almost 30% of the total revenue loss of all tax expenditures
($334 billion), but it may be difficult to repeal or scale back these provisions in any significant
way. Many groups expressing support for tax reform nevertheless believe it is important to avoid
changes that will increase the overall tax on savings. In fact, many would like to move to a
system without any taxation of capital income. Moreover, modification of many of the savings
incentives faces significant technical or administrative barriers. Most of these tax benefits are
associated with unrealized income (pension benefits, including those associated with defined
benefit plans, unrealized gains at death, and inside buildup in insurance plans), which can be
difficult or impossible to value properly. Raising capital gains tax rates on realized capital gains
may not be considered a significant revenue raiser because of current revenue scoring
conventions. Furthermore, since the tax benefits of savings incentives are more concentrated
among higher income individuals, it would be quite difficult to reduce the top rates while
maintaining distributional and revenue neutrality without turning to these provisions.
Some other large tax expenditures, notably the exclusion of employer health insurance and the
exclusion of Medicare, which account for 20% of the total revenue loss of all tax expenditures
($240.4 billion), are also in-kind benefits that are not easily valued. Modifying the health
insurance exclusion was considered during the 2010 debate over health reform but was not
changed (an excise tax on high cost plans was adopted) as it became clear that a fair imputation of
income was probably impossible. Medicare faces even more severe valuation problems and is one
of the provisions most beneficial to lower-income taxpayers. A number of smaller tax
expenditures, relating to fringe benefits, also face difficult measurement problems.
Other tax expenditures that benefit lower-income taxpayers could be difficult to revise. The most
progressively distributed tax provision is the earned income credit with benefits highly
82 ABC News/Washington Post Poll, December 2010, http://abcnews.go.com/story?id=12394216.
83 Bloomberg Poll, September 2011, http://www.bloomberg.com/news/2011-09-14/obama-approval-drops-on-
skepticism-of -jobs-plan.html.
84 NBC News/Wall Street Journal Poll, December 2010, http://online.wsj.com/article/
SB10001424052748704828104576021900230935000.html.
Congressional Research Service
29
The Challenge of Individual Income Tax Reform
concentrated among lower-income individuals. Since individuals with little or no tax liability
receive most of the tax benefits, the earned income credit could not be changed in a way that
maintains both revenue neutrality and distributional neutrality. Taxing Social Security benefits
that are currently not taxed would also fall heavily on lower-income individuals. The floor on the
deduction for medical expenditures, which protects individuals with catastrophic costs, is high by
historical standards and was recently increased. Lastly, there appears to be bipartisan support to
extend the larger tax benefits of the child credit that were enacted by the Bush tax cuts. These
specific tax expenditures account for 11% of the total revenue loss of all tax expenditures ($132.7
billion).
Another tax expenditure that may be difficult to reduce is the capital gains exclusion for owner-
occupied housing ($27.2 billion or 2.3% of the total), which has historically not been subject to
tax and could lead to some significant distortions (e.g., discouraging labor mobility) and
inequities.
These tax expenditures account for over 60% of the revenue loss of all tax expenditures. But even
among the remaining provisions, the scope of revision could be limited. For example, the major
itemized deductions (mortgage interest, state and local taxes, charitable contributions), which
account for a fifth of the total revenue loss of all tax expenditures ($232.5 billion), are broadly
used provisions and it could be difficult to eliminate or significantly curtail them because of
public attitudes towards these provisions.
Given the barriers to eliminating or reducing most tax expenditures, it may prove difficult to gain
more than $100 billion to $150 billion in additional tax revenues through base broadening. This
amount could have a significant effect on reducing the FY2014 budget deficit—reducing the
projected $345 billion deficit by 30% to 43%. This additional tax revenue, however, is equivalent
to about 6% to 9% of projected FY2014 individual income tax, and, consequently, would not
allow for significant reductions in tax rates (about a one or two percentage point reduction for
each bracket).
Congressional Research Service
30
The Challenge of Individual Income Tax Reform
Appendix A. Classification of Tax Expenditures by
Category
This appendix lists the particular tax expenditures classified into categories.85
Savings: Includes capital gains rates, tax treatment at death and by gift, exclusion on small
business stock, deferral for section 1256 contracts, exclusion of investment income on life
insurance and annuities, deferral of tax on non-dealer installment sales, deferral of tax on like-
kind exchanges, the new markets tax credit, tax treatment of employee stock ownership plans and
stock options, exclusion of stock redemptions to pay estate taxes, tax benefits for pensions (both
employer and self employed), and individual retirement accounts. Also includes lower rates for
dividends when considering extension of expiring tax benefits.
Business: Includes expensing of research and development costs, all provision in energy, natural
resources and agriculture except for tax exempt bonds and the residential energy efficiency credit,
provisions relating to rental housing and credits for structures, all provisions in the subcategory
“other business and commerce,” other than capital gains provisions included in savings and tax
exempt bonds, renewal community incentives, and District of Columbia tax incentives. Note that
the research credit expired at the end of 2011, but is negligible for individuals.
Owner-Occupied Housing: Includes mortgage deduction, property tax deduction, exclusion of
capital gains on owner-occupied housing, and residential energy efficiency credits.
Consumption: Classified into three subcategories, with the exception of the employer exclusion
of life and accident insurance.
Health: All of the provisions under the health functional category except for charitable
contributions and tax exempt bonds, plus cafeteria plans which are largely used to pay for the
employee’s share of health plans.
Education: All of the provisions under the education sub-function, except for tax exempt and tax
favored bonds, and charitable contributions.
Charity: Charitable contributions (all three categories: general, education, and health).
Labor Supply: Includes exclusion for income earned abroad, employer transportation benefits,
minister’s housing allowance, fringe benefits, employee awards, income earned by beneficiary
associations, exclusions for child and dependent care, earned income credit.
Government: Includes exclusions of various benefits and payments for the armed services and
federal civilian employees working abroad, all tax exempt bonds (private activity and general
obligation), tax deductions (except property tax), exclusion for transfers under government
programs (Social Security, Medicare, Veteran’s benefits, workers compensation, benefits for
disabled coal miners, cash public assistance), deferral of interest on savings bonds,
85 For a description of each tax expenditure see U.S. Senate, Committee on the Budget, Tax Expenditures:
Compendium of Background Material on Individual Provisions, December 2010, http://www.gpo.gov/fdsys/pkg/
CPRT-111SPRT62799/pdf/CPRT-111SPRT62799.pdf.
Congressional Research Service
31
The Challenge of Individual Income Tax Reform
Structural: Includes disaster relief, child credit, exclusion of damages on account of personal
physical injuries, disaster relief, and the additional standard deduction for the blind and the
elderly.
Congressional Research Service
32
The Challenge of Individual Income Tax Reform
Appendix B. Data and Methods
Two nationally representative data files are used in the analysis to estimate the progressivity of
selected tax expenditures.
2006 Public Use Tax File
The first source of data is the 2006 Internal Revenue Service (IRS) Statistics of Income (SOI)
Public Use File. The Public Use File is a nationally representative sample of tax returns for the
2006 tax year. To protect the identity of individual taxpayers while preserving the character of the
data, the IRS made changes to the data. Consequently, while reliable aggregate information can
be obtained, individual taxpayer records in the data may or may not contain information from just
one tax return. The unit of analysis is the tax return for a taxpayer, and IRS-provided sample
weights are used throughout the analysis. The analysis sample contains information for 130,438
taxpayers (representing 122.7 million taxpayers).
2007 Survey of Consumer Finances
The second source of data is the Federal Reserve Board’s 2007 Survey of Consumer Finances
(SCF). The SCF is a wealth survey, but also includes employment and income information for
households in the sample. The SCF is used to estimate the Suits index for tax benefits of 401(k)-
type pension plans, IRAs, employer provided health insurance, and Medicare benefits. Both
401(k) contributions and account balances as well as IRA account balances are reported in the
SCF. In estimating the tax benefits of 401(k) and IRA earnings, it is assumed that the rate of
return on the account balances is 6%.
Neither the value of Medicare benefits nor the premium for employer provided health insurance is
reported in the SCF. For each person in a household reporting Medicare coverage, the national
expenditure per beneficiary (Part A only) is used as the value of benefits that are not taxed. For
each person in a household covered by employer provided health insurance, the employer paid
premium by firm size and industry is used as the value of the health insurance benefit that is not
taxed. The premium data come from tabulated statistics of the Medical Expenditure Panel Survey
by the Agency for Healthcare Research and Quality.
The Suits Index
The progressivity measure used in the analysis is the Suits index, which was originally developed
to measure tax progressivity.86 The Suits index can be calculated using concentration curves,
which are shown in Figure B-1, Figure B-2, and Figure B-3. The horizontal axis of the
concentration curve measures the cumulative percent of income from poorest to richest. For
example, the first 15% of cumulative income is the income reported by the poorest 50% of
taxpayers in the sample. The vertical axis measures the cumulative percent of tax benefits of a tax
expenditure. If the concentration is above the diagonal line in the figures, then the tax benefits
86 Daniel B. Suits, “Measurement of Tax Progressivity,” American Economic Review, vol. 67, no. 4 (September 1977),
pp. 747-752.
Congressional Research Service
33
The Challenge of Individual Income Tax Reform
tend to accrue to lower-income taxpayers. If the concentration is below the diagonal line, then the
tax benefits tend to accrue to high-income taxpayers.
Define two areas in the figures. The first area is the area below a concentration curve; call this
area A. The second is the area below the diagonal line in the figures; call this area B. The Suits
index is:
A
S = −1+
.
B
The Suits index varies between −1 (a completely regressive tax benefit where area A is zero) to
+1 (a completely progressive tax benefits where area A is twice area B). A Suits index of zero is
for a proportional tax benefits (area A = area B).
Figure B-1. Concentration Curves: Itemized Deductions
100
80
are
60
Medical Expenses
fit Sh
Mortgage Interest
Property Taxes
Charitable Contributions
Bene
State and Local Taxes
40
Tax
20
0
0
20
40
60
80
100
Income Share
Source: CRS analysis of 2006 IRS Statistics of Income Public Use File.
Congressional Research Service
34
The Challenge of Individual Income Tax Reform
Figure B-2. Concentration Curves: Income Exclusions
100
80
are
60
Social Security
fit Sh
Medicare
Health Insurance
Pension & IRAs
Bene
Tax-exempt Interest
40
Tax
20
0
0
10
20
30
40
50
60
70
80
90
100
Income Share
Source: CRS analysis of 2006 IRS Statistics of Income Public Use File and 2007 Survey of Consumer Finances.
Congressional Research Service
35
The Challenge of Individual Income Tax Reform
Figure B-3. Concentration Curves: Tax Credits and Preferential Tax Rates
100
80
are
60
EITC
fit Sh
Child Tax Credit
Qualified Dividends
Bene
Long-term Capital Gains
40
Tax
20
0
0
20
40
60
80
100
Income Share
Source: CRS analysis of 2006 IRS Statistics of Income Public Use File.
Congressional Research Service
36
The Challenge of Individual Income Tax Reform
Author Contact Information
Jane G. Gravelle
Thomas L. Hungerford
Senior Specialist in Economic Policy
Specialist in Public Finance
jgravelle@crs.loc.gov, 7-7829
thungerford@crs.loc.gov, 7-6422
Congressional Research Service
37