For other versions of this document, see http://wikileaks.org/wiki/CRS-RL33755 ------------------------------------------------------------------------------ Order Code RL33755 Federal Income Tax Treatment of the Family Updated January 24, 2008 Jane G. Gravelle Senior Specialist in Economic Policy Government and Finance Division Federal Income Tax Treatment of the Family Summary Individual income tax provisions have shifted over time, first in increasing the burden on larger families, and then in decreasing it. These shifts were caused by changing tax code features: personal exemptions, standard and itemized deductions, rates, the earned income credit, the child credit, and other standard structural aspects of the tax. The distribution of tax burden across income classes has, however, changed relatively little, although burdens at the top and bottom have decreased in recent years. A recent proposal by Chairman Rangel of the Ways and Means Committee, H.R. 3780, proposes some important changes in family tax treatment, including an expansion in the earned income credit for families without children. While several standards may be considered in determining equitable treatment of families over family type and size, a standard approach is based on ability to pay, so that large families with the same income as small ones pay less tax. Based on this standard, the analysis of equity across families suggests that families with children are paying lower rates of tax (or receiving larger negative tax rates) than single individuals and married couples at lower and middle incomes. However, families with children are being taxed more heavily at higher income levels. At the lowest income levels, the EIC provides the largest tax subsidies to families with two or three children. The smallest subsidies go to childless couples. At middle income levels, families with many children will have the most favorable treatment, due to the effect of the child credit, which has a very large effect relative to tax liability. At higher income levels, large families are penalized because the adjustments for children such as personal exemptions and child credits are too small or are phased out, while graduated rates cause larger families that need more income to maintain a given living standard to pay higher taxes. Tax rates are more variable at lower income levels. At all but the lowest and very highest income levels, singles pay higher taxes than married couples. The analysis of the marriage penalty indicates that marriage penalties have largely been eliminated for those without children throughout the middle income range, but this change has inevitably expanded marriage bonuses. Marriage penalties remain at the high and low income levels and could also apply to those with children, where the penalty or bonus is not very well defined. But by and large, the current system is likely to encourage rather than discourage marriage and favors married couples over singles. The analysis of equity across families suggests that increases in earned income tax credits for those without children would lead to more equal treatment based on the ability to pay approach, while full refundability of the child credit would exacerbate inequalities. At the higher end of the scale, eliminating phaseouts of provisions that differentiate across families would probably lead to more equitable treatment, and containing the effect of the alternative minimum tax is important to both reducing the high burden of taxes on families with children at upper middle income levels as well as preventing an increasing level of marriage penalties. This report will not be updated. Contents Development of Current Tax Treatment of the Family . . . . . . . . . . . . . . . . . . . . . 1 Personal Exemptions; Child Credits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 Standard Deduction or Flat Exclusion; Itemized Deductions . . . . . . . . . . . . 3 Rate Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 Earned Income Tax Credit (EIC) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 Child or Dependent Care Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 Alternative Minimum Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 Other Provisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 Equity and Distributional Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 Vertical Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 Horizontal Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 Theories of Equitable Taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 Family Arrangements as Personal Choices . . . . . . . . . . . . . . . . . . . . . 12 Ability to Pay Approaches . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 Targeted Family Assistance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 Applying the Ability-to-Pay Horizontal Equity Standard to Current Law . . . . . . 15 Marriage Penalties and Marriage Bonuses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 List of Tables Table 1. Average Effective Income Tax Rates by Type of Return, Family Size, and Income: Lower and Middle Incomes . . . . . . . . . . . . . . . . 16 Table 2. Average Effective Income Tax Rates by Type of Return, Family Size, and Income: Higher Incomes . . . . . . . . . . . . . . . . . . . . . . . . . 17 Table 3. Average Effective Income Tax Rates for Joint Returns and Unmarried Couples, By Size of Income and Degree of Split: Lower and Middle Incomes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 Table 4. Average Effective Income Tax Rates for Joint Returns and Unmarried Couples, By Size of Income and Degree of Split: Higher Incomes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 Federal Income Tax Treatment of the Family Recent years have been times of significant changes in the income tax treatment of the family. For lower income families, the most important of these have been the expansion of the earned income credit (EIC) in 1990 and 1993. For middle income families, the introduction of the child credit in 1997 and its expansion in 2001-2003, along with the expansion of rate brackets and standard deductions to address the marriage penalty have been important features. For higher income families, the lowering of tax rates in general, and the increasing scope of the alternative minimum tax (AMT) are important changes. Chairman Rangel of the Ways and Means Committee has proposed a reform proposal, H.R. 3970, that would make a number of changes affecting families differently, including repeal of the alternative minimum tax, a surcharge on high income families, and expansion of the earned income credit for families without children.1 While an array of issues might be considered in discussing tax rules and their effects, this paper considers two questions: what is an equitable treatment of families of different sizes, and what are the effects of marriage penalties and bonuses. The first section summarizes the major features of the tax law affecting families and family choices, and how they developed over time, including the relatively recent introduction of large benefits for children at low and moderate income levels, a reversal of a trend in the past that tended to reduce these benefits through the erosion of the real value of the personal exemptions. It also summarizes the origin of the marriage penalty and marriage bonus. The following two sections first discuss general equity issues, and then apply the ability-to-pay standard to examine how tax burdens vary by family size, across the income spectrum. The final section examines the marriage penalties and bonuses. Development of Current Tax Treatment of the Family Current federal income tax law differentiates among families by type and structure in several ways. This differentiation has changed considerably over the years and includes personal exemptions, standard deductions, rate schedules, and various other features such as child care credits, age exemptions, and earned-income credits. 1 See CRS Report RL34249, The Tax Reduction and Reform Act of 2007: An Overview, by Jane G. Gravelle, for an overview of the provisions of H.R. 3970. CRS-2 Personal Exemptions; Child Credits Personal exemptions allow a certain amount per person to be exempt from tax. Combined with standard deductions, which vary by family type, they exclude a minimum level of income from tax. In 1986, these combined amounts were roughly set at the poverty level. Personal exemptions can also play a part in marriage bonuses when only one spouse works: a single individual cannot claim an unmarried companion as a dependent, while a husband can claim a wife (and vice versa). The tax laws have always allowed some relief for family size through exemptions, although the original 1913 act allowed deductions only for the individual taxpayer ($3,000) and spouse ($1,000). These amounts were very large relative to incomes, but the initial income tax was not intended to reach a broad group of individuals. Even when dependent exemptions were allowed in 1917, they were only $200, small relative to the basic exemptions. The practice of allowing an equal exemption for each family member began in the early 1940s. Personal exemptions were reduced in the initial years of the tax, then increased, then reduced again; they were last reduced in the early 1940s. The real value of the exemptions was also affected by inflation. For example, the personal exemption remained constant at $600 from 1948 through 1969, while its real value was heavily eroded through inflation. It was gradually increased over the next ten years to $1,000, where it again remained constant until 1985. From 1948 through 1984 the personal exemption lost 63% of its purchasing power. In large part due to diminution of the real value of personal exemptions, the tax burden had shifted over time to fall more heavily on larger families. In 1986 personal exemptions were increased and indexed, so that today the personal exemption has lost only about 24% of its purchasing power.2 This shift of burden to families with children was changed dramatically by the adoption of the $500 child credits in the Taxpayer Relief Act of 1997 and by the increase in that credit to $1,000 in the Economic Growth and Recovery Act of 2001. In the cases where these credits apply (for children under 17), they caused the personal exemption plus the deduction equivalent of the credit to be 55% larger than its 1948 value with the $500 credit and 133% larger with the $1,000 credit for families in the 15% rate bracket; they are 23% and 70% larger respectively for families in the 25% bracket. The credit is not, however, indexed for inflation, and absent indexation its value will diminish. The $500 increase in the credit is to sunset in 2010 as well, although it may be extended or made permanent. Not all taxpayers received the credit. It was phased out for higher incomes. The credit was not generally refundable and therefore families with no tax liability or insufficient liability to use the full credit would not receive the full benefit. An exception was made for families with three or more children where the credit could offset payroll tax in excess of the earned income tax credit. 2 The ratio of prices in 2005 to those in 1948 using the GDP deflator is 7.03, while personal exemptions have increased from $600 to $3200, a ratio of 5.33. CRS-3 When the child credit was doubled under the temporary provisions of the 2001 tax, an additional refundability provision was allowed for all families for income in excess of $10,000 (beginning at 10% and rising to 15%), indexed for inflation. The additional child credit was phased in initially, but accelerated in legislation adopted in 2003 and 2004. The personal exemption is also phased out for higher incomes, although that phase-out is scheduled to expire. Standard Deduction or Flat Exclusion; Itemized Deductions Standard deductions, which vary across the types of returns (single, joint, and head of household), also affect tax burdens across families. Prior to the 2001 tax revision, the standard deductions for singles and heads of household were 60% and 80%, respectively, of the size of the deduction for joint returns. The standard deduction can contribute to a marriage penalty if it is larger than half the deduction for married couples: two singles who both work and marry will have a smaller combined deduction. It can also contribute to a marriage bonus, if there is only one earner in the couple, since the joint deduction is larger than the single deduction. In 2001, joint standard deductions were increased, so as to eliminate the marriage penalty relative to singles without children and reduce it relative to heads of household (where the deduction is 73% as large). These changes increased the marriage bonus. Virtually from its inception, the tax law allowed deductions for taxes, interest, charitable contributions, and certain other personal expenses. In 1944, a standard deduction of 10% of adjusted gross income with a ceiling of $500 was allowed as a substitute for these itemized deductions.3 A major reason for this exemption was to reduce the number of itemizers and make tax filing less complex. In 1964, a minimum standard deduction of $200 plus $100 for each exemption with a $1,000 ceiling was added. Beginning in 1969, these standard deductions were increased substantially. The percentage standard deduction was gradually increased to 16% and the ceiling increased to $2,000. A low-income allowance of $1,100, to be reduced by $50 in each of the next two years, was substituted for the minimum standard deduction. (These reductions were included because of the rise in the personal exemption that was increasing total exempt amounts). The low-income allowance was increased to $1,300 in 1972. In 1975, the low-income allowance was once again differentiated, but based on family type (joint, head of household, single) rather than size. Joint returns received a $2,100 allowance by 1976. The ceiling on the percentage standard deduction was also differentiated by family type, and was raised to $2,800 for joint returns by 1976. In 1977, the low-income allowance and the percentage standard deduction were consolidated into a single flat allowance called the zero-bracket amount, which was set at $3,200 in 1977 and at $3,400 in 1978. This zero-bracket amount was indexed in 1981, so that it would rise with inflation. The Tax Reform Act of 1986 raised the 3 In general, floors and ceilings for standard deductions for joint returns were halved for married couples filing separate returns. CRS-4 flat deduction amount, but continued to differentiate it with respect to family status (but not family size). The 2001 act increased the standard deduction for joint returns to twice that of single returns. In comparing the relative benefits over time, it is important to consider the changes in all flat allowances as well, not just the personal exemption. For example, while the real value of the personal exemption has declined about 24% since 1948, the exempt amount for a family of four (joint return) was very close to the exempt amount had 1948 values been indexed for inflation (using the GDP deflator) prior to the 2001 tax changes. Current levels are about 21% larger than those which would have occurred had the exempt level in 1948 been indexed.4 Ignoring the child credit, smaller families have more generous exempt levels today, while larger ones have less generous levels. For example (again, ignoring the child credit), exempt allowances are larger in real terms today for singles (75% larger), for heads of households with one child or two children (46% and 20% larger respectively) and for joint returns with one to four children (39%, 31%, 11%, and 4% larger respectively). Real levels are about the same as 1948 for heads of household with four family members and smaller for those with more family members (1% for a five-person family, 6% for a six-person family). They are also smaller for joint-return families with five and six family members (2% and 5%, respectively). Heads of household and joint returns with children eligible for the child credit, however, have greater exempt levels. For joint returns, assuming that additional members are eligible children, the credit causes all of them to have increased exempt amount equivalents between 87% and 117% higher than in 1948, with the larger increases for heads of households and large families with joint returns (whose values have tended to more than double). Note, however, that changes in benefits compared to past levels do not necessarily have implications for the appropriate treatment of different families. If past family differentiation was not due to a theory about equitable treatment of differing families, there is no economic reason that current tax treatment should conform to any past standards. Most taxpayers take the standard deduction but about a third itemize, largely at the higher income levels. Itemized deductions tend to keep pace with income levels. They are technically subject to a phase-out but the effect of the phase-out is to increase marginal tax rates, since it is triggered by income and not deductions. Rate Structure Two important aspects of the rate structure are the unit of taxation and the progressivity of the rate structure (that is, how tax rates rise as increments of income increase). Current tax rates are imposed at 10, 15, 25, 28, 33, and 35% under the provisions of the 2001 tax change; if those provisions expire the 10% rate will return 4 In 2005, the personal exemption was $3,200 and the standard deduction $10,000, for a total of $22,800. The exempt allowance in 1948 was $2,667 (600 times 4 divided by 0.9). If the 1948 levels had kept pace with the GDP deflator, the total amount would be $20,177. CRS-5 to 15% and the top four rates will increase to 28, 31, 36, and 39.6%. Taxes are imposed on family units. Married couples cannot use the single rate schedules (although they can file separately with a rate structure that offers no advantage over joint filing). Most taxpayers have income that taxes them at no more than 10% (23% of returns), no more than 15% (41% of returns), and no more than 25% (15% of returns).5 The width of the brackets is greatest for joint returns and smallest for singles, although all types of returns reach the top 35% rate at the same point. For single returns the 10% and 15% brackets are half the width of joint returns, the 25% bracket is 70% as large, and the next two brackets are about 124% as large (longer brackets at the top being necessary to get to the same income for the top bracket). For heads of household the 10% and 15% brackets are 72% and 66% as wide, the next two about the same length and the final bracket 111% as wide.6 There are also phase-outs of itemized deductions, personal exemptions, and child credits at very high income levels.7 However, the higher rates and the phase-outs apply to only a small fraction of taxpayers. Less than 10% of taxpayers had adjusted gross income over $100,000 in 2003 and less than 2% had incomes over $200,000.8 In the original 1913 tax law, a single rate structure was applied to all taxpayers as individuals. In 1948, joint returns were allowed that effectively permitted income splitting. This change had little to do with any theory regarding the tax treatment of the family. Rather, it occurred because married couples in community property states were successfully claiming the right to divide their income evenly for tax purposes. Under a graduated rate structure, this income-splitting reduces the total tax burden by reducing the amount of income subject to higher rates. Income-splitting was adopted to equalize treatment across the states and to forestall a major tax-induced disruption in state property laws. This move created the familiar joint and single returns. Both the community property treatment and the legislated income-splitting resulted in a tax subsidy for marriage. Individuals who married would experience lower tax liabilities due to the rate structure as long as their incomes were unequal. Shortly after, in 1951, a head-of-household schedule for unmarried taxpayers with dependents was introduced which allowed half the benefits from income splitting (i.e., wider tax brackets). This treatment could, in theory, create a marriage penalty for families with children, although this point received virtually no attention. 5 Kyle Mudry and Michael Parisi, Individual Income Tax Rates and Shares, Internal Revenue Service Statistics of Income Bulletin, 2003, posted at [http://www.irs.ustreas.gov/ taxstats/indtaxstats/article/0,,id=129270,00.html#_article]. 6 Details of the tax rates can be found in CRS Report RL30007, Individual Income Tax Rates: 1989 through 2007, by Gregg A. Esenwein. 7 The itemized deduction phase-out range, which is indexed for inflation, begins at $145,950 for 2005; the personal exemption phase-out, which is also indexed, varies by type of return, but begins at about $145,950 for singles. The top rate of 35% begins at $326,450 of taxable income. Child credits begin to phase out at about $75,000 for head of household returns and $110,000 for joint returns. 8 Internal Revenue Service, Statistics of Income, posted at [http://www.irs.ustreas.gov/ taxstats/indtaxstats/article/0,,id=96981,00.html#_grp1]. CRS-6 Criticism from singles, arguing that their taxes were too high, led in 1969 to a singles rate schedule with wider brackets. This difference in rate schedules, however, also created a marriage penalty for certain types of families, including those without children. If both spouses worked, tax bills could increase with marriage. Many people were uncomfortable with a tax provision which encouraged couples to live together without benefit of matrimony. Coupled with increasing female labor force participation and a changing social structure, the marriage penalty created considerable concern. For this reason, a capped deduction for the secondary earner in a family was adopted in 1981. The provision allowed 10% of income to be deducted, subject to a cap of $3,000. This deduction was an imperfect device which partly alleviated the problem of the marriage penalty and, for individuals below the cap, reduced the marginal tax rate on the secondary worker. It was repealed in 1986, when the flatter rate structure caused the marriage penalty to be less severe. The marriage penalty was increased for very high income individuals in 1993 with the addition of higher tax rates. These changes affected, however, only a very small fraction of the population. The degree of progression in the rate structure interacts to affect the tax burden that applies to taxpayers in different circumstances. The rate structure has varied significantly over time, but a major revision in the 1986 act reduced the brackets to two (15 and 28%) as well as lowering the top bracket. Certain benefits were phased out. In 1990, the "bubble" due to these phase-outs was eliminated in exchange for adding a new tax rate of 31%. 9 (Capital gains were held to a 28% rate). However, personal exemptions were still phased out. Itemized deductions were also phased out, on a temporary basis, reduced by 3% of adjusted gross income (AGI) above a limit. Since itemized deductions tend to rise with income faster than the reductions due to the phase-out, this phase-out is the equivalent of increasing taxable income by 3%, and an additional percentage point or so in tax. (Each dollar of adjusted gross income taxed leads to a reduction in deductions of $0.03, and if the marginal tax rate is around a third, then the additional tax per dollar of income is around $0.01). In 1993, two marginal tax rates were added at the upper income levels, 36% and 39.6%; this legislation made the itemized deduction and personal exemption phase-outs permanent. The 2001 tax cut, in addition to lowering the top tax rates and introducing a new 10% rate, eliminated the marriage penalty for most taxpayers by increasing the standard deduction, new 10% rate bracket, and the 15% rate bracket to make these values twice as large as for singles, returning to the pre-1969 treatment for most taxpayers. That tax cut also prospectively eliminated the personal exemption phase out (to begin in 2006 and be complete in 2010) and the itemized deduction phase-out (in 2010). 9 Although there were two statutory rate brackets after 1986, 15% and 28%, there was also a surcharge that was designed to phase out the benefits of the 15% rate and the personal exemptions for high income taxpayers. This surcharge effectively increased the tax rate by 5 percentage points, to 33%, and created a bubble: rates were 15%, then 28%, then 33%, and then fell back to 28%. CRS-7 Earned Income Tax Credit (EIC) The earned income tax credit (EIC) is a refundable credit (or negative tax) that provides a wage subsidy for low-income working individuals. The credit is a percentage of earned income which reaches a maximum fixed amount and then is eventually phased out. The credit rates are currently 7.65% for families without children, 34% for families with one child, and 40% for families with two children. The phase-out levels are higher for families with children than for those without children. In 2005, the credit reached its maximum value of $399 for families with no children at an income of $5,220; the credit is phased out at incomes between $6,530 and $11,750 for singles and between $8,530 and $13,750 for joint returns. For families with one child, the maximum credit of $2,662 is reached at $7,830; the credit is phased out between $14,370 and $31,030 for single heads and between $16,370 and $33,030 for married couples. For families with two or more children, the maximum credit of $4,400 is reached at $11,000 and is phased out between $14,370 and $35,363 for single heads and between $16,3790 and $37,263 for married couples. These values are indexed for inflation. Unlike some other provisions, there is no differentiation by family type; rather, the differences depend on the presence of one, two or no children. The EIC plays a role in creating a marriage penalty for lower income families. If individuals with low earnings marry, the couple's higher combined income may phase out more of the earned income tax credit. At the same time, marriage can reduce taxes if a single individual marries someone with children but with little or no income, because he or she becomes eligible for the larger credit for families with children. The earned income tax credit (EIC) was first enacted in 1975. This provision provided a refundable tax credit for 10% of earned income, phased out at a rate of 10% of income over $4,000. Because the credit was refundable, individuals who paid no income tax were nevertheless eligible for a benefit. There were a variety of rationales for the EIC: to provide a work incentive, to offset the social security tax burden, and to provide relief for recent price increases in food and fuel. The credit was, however, only allowed to individuals who maintained a household for dependent children; thus, like the major welfare program of the time, AFDC (Aid to Families with Dependent Children), the EIC as originally enacted was not extended to singles and childless couples. The EIC has been revised in various ways, and in 1990 was differentiated with respect to number of children. In 1993, the credits were increased substantially and a small credit was added for families without children. The 2001 tax cut expanded the phase-out range for married couples which slightly reduced the marriage penalty in the EIC. Child or Dependent Care Credit Another provision allows for credits for paid child care expenses for children under 13 and disabled dependents. A deduction for these costs was first allowed in 1954 and converted to a credit in 1976. The credit is 30% of eligible expenses but is phased down to 20% as income rises from $15,000 to $43,000. Eligible expenses CRS-8 are limited to $3,000 for one child, and $6,000 for two or more children. The credit is available only to single parents or married couples where both parents work and is limited to the smaller earned income. It is not indexed. Alternative Minimum Tax The alternative minimum tax calculates a tax on a broader income base with a large flat exemption (in 2005, $58,000 for married couples and $40,250 for singles) and at rates of 26% and 28%. If this tax is higher than the regular tax, the difference in tax is added to the taxpayer's liability. Currently the AMT does not affect very many taxpayers, but its effects will grow over time unless legislative changes are made, including an increase in the exemption and indexing of the exemptions. Thus far, temporary revisions to limit the scope of the AMT have been enacted. The alternative minimum tax originated in 1969 as an add-on tax on tax preferences and the most important preference was capital gains. At that time, there was an exclusion for a share of capital gains and the excluded share was taxed under the add-on tax. The add-on tax was eventually paired with and then displaced by the alternative minimum tax. In 1986 the capital gains preference was ended and the number of individuals affected by the tax, already small, fell further. Over time, however, the coverage of the AMT began to grow as rates increased and because the exemption was not indexed, while exemptions in the regular tax were. The potential coverage was also increased with the 2001 tax cut which cut regular rates but not AMT rates. The focus of preferences has also changed. The preference for capital gains enacted in 1997 and extended in 2003, and for dividends enacted in 2003 was not included in the AMT. Increasingly the major preference items are personal exemptions and certain itemized deductions. (The child credit was allowed against the AMT after it became clear that failure to do so would push many families onto the tax.) In the middle income classes, large families will increasingly be affected by the AMT, absent change.10 Other Provisions In addition to these basic provisions -- rate structures, personal exemptions, standard allowances, and credits -- several other provisions related to family structure are summarized here. First, there are specific provisions that relate to family structure or characteristics. There are additional standard deductions for elderly and blind taxpayers (provisions that give little benefit to high income individuals who tend to itemize deductions). In addition, there is a 15% tax credit for the elderly and disabled that is phased out; since the base for the credit is offset by social security, it tends to benefit elderly and disabled individuals who do not receive social security. Another explicit family tax provision, adopted in 1986, is the "kiddie tax" which taxes unearned income of children under 14 (now 19) at the parents' tax rate. 10 For a more detailed discussion and history, see CRS Report RL30149, The Alternative Minimum Tax for Individuals, by Gregg A. Esenwein. CRS-9 One might add a variety of exclusions (some social security benefits, welfare payments, in-kind benefits, employer provided child care) and deductions or credits (medical expenses, educational expenses) which benefit families of certain income levels and characteristics. Moreover, since the tax law does not apply to certain imputed income, families who prefer owner-occupied homes or in-home provision of goods and services, or the consumption of leisure over other goods, have greater tax benefits. These benefits are, in some cases, associated with family characteristics. For example, families with higher incomes and at certain ages are more likely to live in owner-occupied homes. One-earner married couples benefit from the services provided in the home by the non-working spouse which are not subject to tax.11 Finally, the payroll tax can alter the relative net tax burden between different types of families with consequences that could matter for concerns of equity and efficiency (such as work choice). The social security system may confer a marriage bonus, that can increase the implicit tax on work effort for second earners. Spouses receive a benefit, without necessarily paying any payroll taxes of their own; a second- earner spouse pays additional social security taxes but his or her benefit is only the net of a benefit based on the individual earnings record and the benefit for spouses -- and this amount may not be positive. That is, the spouse's benefit based on the partner's earning record may be better than the benefit a spouse receives on his or her own earnings record, and there is, therefore, no return to payroll taxes paid. Thus, the net tax on a second earner spouse is effectively larger than it would be in the absence of a benefit for spouses, since little or no additional benefits occur as a result of those payments. There are also implicit taxes that affect behavior in the transfer system, where increases in income through work or marriage may cause a reduction in benefits, thereby discouraging these behaviors. Equity and Distributional Issues Tax proposals can be evaluated on many grounds, but one issue is that of fairness. This issue of fairness can involve two elements: vertical equity, or the equity of changes in tax burdens as income rises for an otherwise identical family, and horizontal equity, or how taxes should be fairly differentiated between families of different sizes and structures. This analysis focuses primarily on the issue of horizontal equity, since this is an issue which can be addressed in a more analytical framework. We first, however, briefly discuss the issue of vertical equity. 11 This concept be may unfamiliar, particularly to readers who think of spouses working at home as making a monetary sacrifice, perhaps to stay with their children. While their income is smaller, they save the taxes that would have been paid on outside earnings. However, these spouses do not give up all of their income, since there are cost savings, as in lower child care payments or not having to pay for other services (e.g., dry cleaning, household help). It is this value that provides a benefit to one-earner families and is the imputed income not subject to tax. CRS-10 Vertical Equity The individual income tax is progressive in rate structure and in actual outcomes: higher income taxpayers pay larger shares of their income than do lower income taxpayers, and at the lowest income levels taxpayers received overall subsidies through the EIC. Because the desired degree of redistribution cannot be easily established, issues of vertical equity involve value judgments to a considerable degree.12 By and large, the overall distribution of the tax system has not changed a great deal in the last twenty-three years; all tax rates have fallen and the largest reduction is for the very highest 1% of taxpayers, followed by the middle quintile. At the lower end, the earned income tax credits have more than offset growth in payroll taxes.13 How different tax revisions affect the progressivity of the income tax depends on several factors. First, a significant fraction of taxpayers do not have income tax liability. Positive income taxes do not apply in most cases until individuals are above the poverty line. In the Tax Reform Act of 1986, the combination of standard deductions and personal exemptions were set to roughly approximate the poverty line -- the income levels above which families of different sizes are not considered poor. The allowances for single individuals are below the poverty line and cause some poor single individuals to be taxed. The addition of the child credit means that taxpayers with qualifying children well above the poverty line would not be subject to tax. These taxpayers would not be affected by a tax cut. An exception is when tax cuts are refundable. An expansion of the EIC, which is a refundable credit (or negative tax), would affect low-income individuals. The child credit is also refundable in some circumstances. Certain types of revisions tend to benefit higher income individuals, while others tend to provide little benefit to that group. For example, while lowering the top rates clearly benefitted higher income individuals in 2001, it is also clear that widening the 15% rate bracket for joint returns also benefitted higher income individuals. In 2000, prior to the tax cut, according to the Internal Revenue Service's statistical data, of 129 million returns, approximately 69 million returns paid tax at the 15% rate and another 25 million had no tax liability. Thus the widening of the 15% bracket, which helped only those paying tax above that rate, benefitted approximately the top 25% of taxpayers. Higher income individuals are also more likely to itemize deductions, and changes which increase the standard 12 Progressivity in the tax system is typically based on an equal sacrifice notion and the notion that a dollar to a poor person is much more valuable than a dollar to the wealthy person. These theories do not easily pin down the desired degree of progressivity, however. For a more extensive discussion of distributional issues and of the distribution of the income tax see CRS Report RL32693, Distribution of the Tax Burden Across Individuals: An Overview, by Jane G. Gravelle and Maxim Shvedov. 13 See Congressional Budget Office, Historical Effective Federal Tax Rates: 1979 to 2003, December 2005: [http://www.cbo.gov/ftpdoc.cfm?index=7000&type=1]. CRS-11 deduction will tend to focus more benefits to moderate income taxpayers than high income ones. Similarly, expansions of benefits that are phased out, such as the child credits, would not benefit high income individuals. The 10% bracket also favored lower income families. Horizontal Equity Horizontal equity has to do with equal treatment of equals and is an important focus of this analysis. For the income tax, this standard might mean that families of the same size with the same income should pay the same tax. But, it could also be taken to mean that two individuals with the same income should pay the same tax. In a progressive tax system, these two standards can be incompatible, and, indeed this incompatibility causes marriage penalties and bonuses in a system where the family is the tax unit. Thus, the basic challenge of assessing standards of horizontal equity is to determine how to treat different taxpayers equitably. First, we review the economic principles which could be used in that assessment. Second, we consider in further detail the ability-to-pay concept, which seems most consistent with the equal-sacrifice principles of horizontal equity. As the recent history of the tax law suggests and the following discussion reveals, tax policy has not generally been guided by a consistent theory of fairness or equity across different types of families. Indeed, it is clear that many of the structural changes in the treatment of the family were haphazard. Income splitting, perhaps one of the most important aspects of family tax differentials, was adopted in reaction to a legal situation. Other changes were contemporary reactions to a set of complaints or concerns about behavioral response (such as the singles rate schedule or attempts to fix the marriage penalty). Theories of Equitable Taxation. For taxation purposes, there are two fundamental attributes of families: the type of head (a married couple, or a single individual) and the size. Families can be composed of single persons, single parents with children, childless couples, and married couples with children. And, in turn, there are two important features of the tax system that relate to these differences. First, should the unit of taxation be the individual, or the family? The U.S. tax system imposes taxes on families and differentiates in its rate structure between singles, head of households (single parents with children), and married couples. However, an alternative would be to apply a single rate schedule to each individual on his or her own earnings. While some preference for this view of individual taxation may have to do with philosophical matters, one argument for treating the individual rather than the family as a taxpaying unit has to do with marriage neutrality and efficiency, discussed subsequently. That is, if individuals could be taxed solely on their own earnings, there would be no tax consequences of being married, and the married state would not affect incentives to work via tax differentials. The second issue is how one should adjust for family size, or, in the case of individual taxation, for the number of dependents. Despite the thrust of recent legislation that added substantial tax credits for children, some of the debate over differentiating by taxpayer characteristics has been over whether personal exemptions for dependents should be allowed at all. Under some theories of how the family CRS-12 should be taxed, no differentiation should be allowed for dependents; indeed, arguments are made that individuals should be taxed on their income without regard to their family arrangements. For that matter, individual taxation does not preclude allowances for number of dependents; rather, its focus is on treating working adults, even though married, as separate entities.14 (In practice, such a tax system must always deal with the possibility of income splitting of capital income by transfers of assets within the family, as well as the allocation of deductions.) Clearly the family involves a social and economic unit which differs from unrelated groupings. Although taxation of the family has received limited attention in the economics literature, various principles have been advanced about how to treat family characteristics. Three such approaches are outlined here: treating living arrangements and children as personal choices that should not be addressed by the tax law, equating post-tax standards of living for families with the same pretax standard of living, and family assistance. This analysis does not consider another alternative principle of taxation, the benefit principle, which would set taxes to reflect the amount of government services received. One could argue that large families, particularly families with children, are greater beneficiaries of public spending, such as education. While some taxes are explicitly formulated as benefit taxes (e.g., the gasoline tax which is used to build roads), the individual income tax has generally been based on other principles, such as the ones described here. Family Arrangements as Personal Choices. People are relatively free to choose whether to marry and have children, and an argument can be made that such choices should not lead to tax relief. From this perspective, if they choose to have children, they are not worse off, since the enjoyment they receive from their children outweighs any cost. Thus, one could think of children as part of the consumption of the parents.15 At a minimum, this approach suggests that no allowance be made for the additional cost of supporting children, treating the choice to have children as a consumption item, no different from the decision to consume food or clothing. Similarly, the choice of a spouse could be seen as a consumption or investment choice, which should not alter the tax paid by the individual, or the combined tax of the two spouses. In this case, the individual should be the tax unit. While the argument that children constitute consumption to their parents may be a defensible one, using this view as a guide to making tax policy is problematic. Even if the adults have made a choice, a troublesome aspect of this treatment of children as consumption is that it considers only the well-being of the parent or 14 See Harvey E. Brazer, "Income Tax Treatment of the Family," and Alicia Munnell, "The Couple vs. The Individual under the Federal Personal Income Tax," both in The Economics of Taxation, ed. Henry J. Aaron and Michael J. Boskin, Washington, DC, Brookings Institution, 1980. 15 The notion of children as consumption can be traced to Henry Simons, Personal Income Taxation, Chicago: University of Chicago Press, 1938. CRS-13 parents. Parents' tastes for children aside, the material level of consumption for children as well as for adults is affected by the number of others in the family. Some theories have suggested that children could be seen as an investment, perhaps for support in old age. There is some justification for this theory of parental motivation, although it must surely be less than universal since many parents leave bequests to their children, rather than being supported by them in old age. If investment were the objective of having children, then there would be some justification for tax relief, since the cost of such an investment should, in theory, be recovered; at the same time, returns (such as help in old age) should be taxed to the parents. Our tax system is not designed along these lines, and, in any case, the children-as-investment theory also suffers from a lack of focus on the well-being of the children. Ability to Pay Approaches. Another approach is simply that of ability to pay, which is the cornerstone of progressive taxation. Applying this ability-to-pay standard of taxation is straightforward in theory if one begins with the proposition that families with equal standards of living before tax should have equal standards of living after tax. If all family members were more or less identical in their needs and if all goods consumed were purely private in nature, this standard would suggest full income splitting of total family income among all members of the family. One could merely divide all family income evenly and then subject each share to an identical rate structure. In a progressive tax system, larger families would pay smaller taxes than smaller families with the same total income. One difficulty with this straightforward prescription is the existence of "club" goods within the family. Some goods are more or less purely private goods, such as food. If one person consumes food, it is not available to anyone else. Other goods have elements of a club nature (one person can consume the good without interfering with another's consumption). Such club goods include housing and some furnishings, reading materials, and the family car. None of these goods are pure shared goods since tastes may not be identical and congestion may occur, but they do provide scale advantages in consumption within a family. These scale advantages in family consumption are recognized in construction of the poverty line, which varies with family size, yet does not increase in full proportion to it. Another problem is that adults and children may differ in the amount of private goods they need or desire. If we knew how to scale ability to pay by family size and characteristics, design of the income tax would be theoretically straightforward. The method would be as follows. Choose a representative family (e.g., a family of two). Devise the tax rate schedule to achieve the desired degree of progression, setting the exempt level at the poverty level or whatever other level is desired. The solution to horizontal equity is then, simply, an averaging approach. For example, consider a larger family which needs 50% more income than the basic reference family. This means that a larger family that has $75,000 of income should have the same average tax rate as a smaller (reference) family with $50,000 of income. We simply apply the basic tax rate schedule to two thirds of the larger family's income, and multiply the resulting tax liability by 1.5. This approach will produce the same effective tax rate for the larger CRS-14 family as for the reference family. (The larger family, which has more income, will still pay more taxes, but the fraction paid will be the same as the smaller family.) The two families will have the same (although smaller) standard of living after tax just as they had the same standard of living before tax. When exempt levels of tax are set roughly at the poverty rate, as was the intent of the 1986 Tax Reform Act, families whose income falls within the first rate bracket (the 15% tax bracket at that point) tend to have equal effective tax rates, if the relative poverty measures across families are correct (ignoring the earned income tax credit). These effects will not hold, however, when higher income families are considered or when other provisions, such as the child credit and the earned income credit, are considered, or with a new small bracket such as the 10% bracket introduced in 2001. Moreover, families with one earner are better off than families with two earners at the same income because of the expenses of working, including child care, and the benefits of home production of the non-working spouse. Thus, credits for child care expenses or allowances for working spouses can move the system towards more equitable treatment, at least vis-a-vis one-earner couples. Targeted Family Assistance. At the opposite end of the spectrum is the notion of targeted family assistance, especially for lower income families, and often targeted towards children. To accomplish this targeting, allowances for family size differentials (e.g., personal allowances) are often made refundable, they take the form of a credit rather than an exemption, and benefits are often phased out as incomes rise. Several of these features, including the EIC and the child credit, have made their way into current law. This view of family allowances differs from the philosophy that personal exemptions, along with other exclusions, should be used to exempt a minimum subsistence amount from the income base, the philosophy underlying the 1986 revisions, and one which is more in line with the ability to pay standard. Similarly, a benefit for child care would be more appropriately made through a deduction, if child care was viewed as one of the costs of working under an ability-to-pay approach. Proposals that are driven by this philosophy are often simultaneously addressing differentiation across family types and a vertical distribution objective. This objective is not necessarily inconsistent with the ability-to-pay objective addressed previously, even though it often appears to be because of the mechanisms chosen, such as credits that are phased out. For a given family size, any degree of vertical equity can be obtained through either exemptions or credits or by arranging the tax rate schedule appropriately. But, the differentiation across families at the same income level (or ability-to-pay) can be achieved only by selecting the sizes of personal exemptions for different family members. An ability-to-pay approach would include differentiation of families of different sizes at either high or low income levels. When a vanishing exemption or credit is chosen in the interest of CRS-15 vertical equity, the actual result is to allow no differentiation for family size at higher income levels.16 Finally, it is important to recognize that the income tax system exists side by side with a welfare system and many conclude that targeted family assistance might better be addressed through the welfare system. Applying the Ability-to-Pay Horizontal Equity Standard to Current Law The ability to pay approach seems the most consistent and, to many, appealing of the three approaches to dealing with tax differentiation based on family size. This method considers the welfare of all in society rather than focusing exclusively on adults or children. A recent study used this approach to estimate effective tax rates in 2005, and how various provisions of the tax law affected these rates, using an equivalency scale similar to the variations in poverty lines across family types.17 Because the tax system has been indexed, the findings of this study remain applicable in 2008 although income levels refer to 2005 values. The remainder of this section reports the results of that study. In defining families that have the same ability to pay, an adjustment based on a research study similar to that adjusting for official poverty levels for different family sizes was used which has a smaller adjustment for children than for adults. Under this standard, a single person requires about 62% of the income of a married couple; a couple with four kids requires about three times the income. Thus, for a married couple with no children with $20,000 of income, an equivalent single person would need slightly over $12,000 and a married couple with four children would need $60,000. Table 1 reports the 2005 effective tax rates for low- and middle-income taxpayers at different levels of income, for family sizes of up to seven individuals, and for the three basic types of returns -- single, joint, and head of household, without considering the child credit. Table 2 reports the tax rates for higher income 16 One argument along these lines is that progressive taxation could be justified by the need to maintain human resources at the bottom of the scale (which justifies some minimum exclusion) and curb the accumulation of power at the top. Since the accumulation of power is undiminished by family size, there should be little differentiation at the top of the scale. See Harold M. Groves, Federal Tax Treatment of the Family, Washington, DC, The Brookings Institution, 1963. 17 Jane Gravelle and Jennifer Gravelle, "Horizontal Equity and Family Tax Treatment: The Orphan Child of Tax Policy," National Tax Journal, vol 59, September 2006, pp. 631-649. This study calculated stylized effective tax rates reflecting personal exemptions, itemized or standard deductions, the child credit, and the earned income credit The equivalency formula used was (A+0.7K)0.7 based on Constance F. Citro and Robert T. Michael, Measuring Poverty: A New Approach, Washington, DC, National Academy Press, 1995. Using this formula, a single person would need 62% of the income of a married couple without children to achieve the same standard of income. A married couple with one child would need 23% more and a married couple with two children would need 45% more. CRS-16 families. the heading of the column indicates the income level for married couples. Families in each column have the same estimated ability to pay, so that larger families have more income and singles and a head of household with one child have less. The rates across families should be compared by looking down the columns. For example, in Table 1, a married couple with $25,000 in income pays 3.4% of income in taxes, but a married couple with one child with the same ability to pay receives a subsidy of 0.7%, while a single with an equivalent before tax standard of living pays 4.7%. These numbers assume that dependents are children eligible for the child credit and that the families are eligible for the earned income tax credit (a provision not allowed for those over 65 or for those without children under 25). These are illustrative calculations that do not account for any other tax preferences and are designed to show how the basic structural, family-related features of the tax law affect burdens. Tax rates for returns paying the AMT are bolded. Table 1. Average Effective Income Tax Rates by Type of Return, Family Size, and Income: Lower and Middle Incomes (2005 tax law and income levels) Income Level for Married Couple Type-Size $10,000 $15,000 $25,000 $50,000 Single - 1 -6.5% -1.0% 4.7% 9.0% Joint - 2 -2.9 0.0 3.4 8.3 Joint - 3 -23.2 -17.9 -0.7 6.6 Joint - 4 -34.0 -22.4 -2.4 5.3 Joint - 5 -31.4 -18.9 -3.5 4.3 Joint - 6 -27.5 -16.3 -4.8 3.5 Joint - 7 -24.5 -14.3 -6.2 3.0 H/H - 2 -29.8 -22.6 -6.8 6.4 H/H - 3 -39.2 -27.6 -7.9 4.7 H/H - 4 -35.2 -22..7 -5.2 3.7 H/H - 5 -30.8 -18.5 -6.0 4.9 H/H - 6 -26.7 -15.8 -7.4 6.3 H/H - 7 -23.5 -13.7 -8.6 7.4 Source: Gravelle and Gravelle. The dollar amounts refer to the income for a married couple with no children; larger families in each column would have more income and singles and heads of household with 2 family members (one child) would have less income. CRS-17 These tables suggest that the pattern of tax burden by family size varies across the income scale, as it reflects the complications of the earned income tax credit, the child credit, and graduated rates, including phase-out effects. Moreover, the variation across families which have the same ability to pay is substantial. At low incomes, families with children, whether headed by a married couple or a single parent, are favored because of the earned income tax credit. The largest negative tax rates tend to accrue to returns with two children, since the largest EIC credits are available for these returns. Table 2. Average Effective Income Tax Rates by Type of Return, Family Size, and Income: Higher Incomes (2005 tax law and income levels) Income Level for a Married Couple of Two Type-Size $75,000 $100,000 $250,000 $500,000 Single - 1 10.5% 12.8% 17.8% 24.2% Joint - 2 9.5 11.2 19.4 24.8 Joint - 3 8.6 11.9 21.8 24.9 Joint - 4 8.6 12.5 23.4 25.0 Joint - 5 9.0 14.0 24.4 25.1 Joint - 6 10.3 15.5 24.7 25.4 Joint - 7 11.4 16.7 24.8 25.6 H/H - 2 8.9 12.4 21.3 24.6 H/H - 3 9.7 13.6 23.6 24.9 H/H - 4 11.2 15.7 24.3 25.0 H/H - 5 12.6 17.6 24.5 25.3 H/H - 6 13.8 18.9 24.6 25.6 H/H - 7 15.1 19.9 24.7 25.9 Source: Gravelle and Gravelle. The dollar amounts refer to the income for a married couple with no children; larger families in each column would have more income and singles and heads of household with 2 family members (one child) would have less income. As incomes rise, families with children are still favored, but it is the largest families that have the largest subsidies or the smallest tax rates, because of the combination of the personal exemptions and the child credit lower taxes so much for these families. Eventually large families began to be penalized because the value of the child credit and personal exemptions relative to income declines and larger families that require more income are pushed up through the rate brackets. That effect is increased because more families with children are subjected to the AMT. At higher income levels, credits and exemptions begin to be phased out. As incomes reach very high levels, however, the rates converge as the tax becomes large a flat CRS-18 tax. (Note that itemized deductions assumed to be a constant fraction of income, and so is a proportional exclusion). Overall, these calculations suggest (1) that singles are taxed more heavily than childless couples in the middle income ranges but less heavily at very high and very low income levels; (2) when the child credit and EIC are available, families with children tend to be favored over families without children at low and moderate income levels; (3) the number of children in a family sometimes causes more beneficial treatment and sometimes less depending on how the EIC and child credit are being phased out; and (4) the graduated rate structure causes large families at higher income levels to be taxed significantly more, an effect exacerbated by the AMT. These results can be characterized as resulting from the fundamental structural flaws of phase-out provisions and rate brackets. Phase-out points and rate brackets should be based on family size if the ability to pay criterion is being used to determine the tax structure. The flat amount of the child credit and personal exemption also causes them to have little effect on relative tax liabilities at high income levels; phasing them out increases the over-taxation of large families relative to small ones at higher income levels At low income levels, however, the family comparisons are affected by the earned-income tax credit, and differences in tax burdens by family size can be striking. If there were no earned-income tax credit, effective tax rates would be relatively uniform at the lower income levels, at zero or a small positive percentage amount. The EIC introduces disparities. First, the EIC rate is much lower for single taxpayers or two-member joint returns where there are no qualifying children than it is for families with children. Second, if one accepts the ability-to-pay standard, the EIC has an inappropriate adjustment for family size. There is no reason to vary the rate of the EIC by family size; but the base (or maximum creditable wage) and the phase-out levels should be varied according to the ability-to-pay standard. That is, both dollar amounts -- the amount on which the EIC applies and the income at which the phase-out begins -- should be tied to family size according to the ability to pay standard, while the EIC rate should be the same for all families. To make the EIC neutral across families, using the ability-to-pay standard, would require, in addition to allowing it at a common rate for all families, changing the base levels and the phase-out levels for family size. Changing the rate, as was done in 1990 and retained when the EIC was expanded in 1993, does not accomplish equal treatment across families of different sizes, providing too much adjustment for some families and not enough for others. The analysis also considered the effects of other aspects of the tax system. One is the availability of the child care credit. The analysis in that paper indicated that including the child credit (at the maximum) does not have very important effects. The dependent care credit is not effectively available to low income families who do not have sufficient tax liability to use the credit, and is capped and unimportant in a relative sense for high income taxpayers. In the middle income levels, it lowers the tax rate for families with children. CRS-19 Another issue has to do with the treatment of married couples where only one individual works outside the home. These families are better off because the spouse not employed outside the home can perform services at home which result in cost savings, perform household tasks which increase leisure time for the rest of the family, or enjoy leisure. The value of this time, which is not counted in the measured transactions of the economy, is referred to as "imputed income." This imputed income is not taxed, and it would probably be impractical to tax it. Nevertheless, the tax burden as a percent of cash plus imputed income is lower for such a family. Imputed income is not easily valued and this issue is explored in the study by limiting the imputed income to the value of child care using the cap for the expenses eligible for a child care credit and excluding this amount from income. For low income families, this change actually increased taxes by reducing earned income credits. At moderate and middle incomes, it benefitted married couples with children, who already tend to be favored. The authors also considered some of the potential changes and whether those would increase horizontal equity or exacerbate it. In the interest of increased horizontal equity, the analysis would support an increase in the earned income credit for those without children; a reduction (or containment) of the AMT which will grow in importance absent change; and elimination of phase-outs for child credits, personal exemptions, and itemized deductions. (2001 tax law changes proposed to eliminate the phase-out of the latter two beginning in 2007.) Making the child credit fully refundable would increase disparities in tax rates at the lower income levels. These calculations should be considered with caution, as they depend on the precision of the family equivalency scales, which do not take into account the heterogeneity of the cost of rearing children, and are aimed at measuring cash needs to attain a given standard of living. Lower income families with younger children who need child care may find their standard of living in material matters lower than other types of families, because of the higher cost of that care relative to their income. In that case, the lower rates due to child care credits or exclusion of imputed income may be appropriate. At higher income levels, child care costs are probably much smaller relative to income, even if more is spent on care. The child care credit, however, has little effect on effective tax rates at these income levels. Marriage Penalties and Marriage Bonuses Concerns about the marriage penalty reflect a reluctance to penalize marriage in a society that upholds such traditions. As the tax law shifts to reduce the marriage penalty, as it did in 2001, it also expands marriage bonuses. These choices have consequences not only for incentives but for equitable treatment of singles and married couples. As shown above in Tables 1 and 2, in the middle income brackets, where the marriage penalty was largely eliminated, singles with the same ability to pay are subject to higher taxes than married couples. Singles benefit at lower income levels because their lower required incomes do not phase them out of the earned income credit. And at very high incomes married couples may pay a larger share of CRS-20 their income because of marriage penalties that remain in the AMT and the upper brackets of the rate structure. This section explores the treatment of married couples and singles in an additional dimension by assuming that singles live together and share the same economies of scale that married couples do. These individuals could be room mates, but they could also be partners who differ from married couples only in that they are not legally married.18 Single individuals who live together in the same fashion as married couples have the same ability to pay with the same income. However, remaining single can alter their tax liability. Remaining single can cause tax liability either to rise or fall, depending on the split of income between the two spouses. If one individual earns most of the income, tax burdens will be higher for two individuals who are not married than for a married couple with the same total income, because the standard deductions are smaller and the rate brackets narrower. If income is evenly split between the two individuals, there can be a benefit from remaining single. Married individuals have to combine their income, and the rate brackets for joint returns at the higher income brackets, while wider than those for single individuals, are not twice as wide. At all levels they are not wider than those for heads of household. The marriage penalty or bonus might, in the context of the measures of household ability-to-pay, also be described as a singles bonus or penalty. In any case, in considering both the incentive and equity dimension to this issue, the tax rates of these families should be compared to the tax rates of other households. Tables 3 and 4 show the effective tax rates for married couples and for unmarried couples with the same combined income, both where income is evenly split and where all income is received by one person. In one case there is no child and in the other a single child. These income splits represent the extremes of the marriage penalty and the marriage bonus. The same reference income classes and equivalency scales in Tables 1 and 2 are used. Note that uneven income splits in the case of a family with a child can yield different results depending on whether the individual with the income can claim the child and therefore receive the benefits of the head of household rate structure, the higher earned income credit, the dependency exemption, and the child credit. If not, that individual files as a single. The tables indicate that both marriage penalties and bonuses persist. In the case of families without children, however, penalties do not exist in the middle income 18 For other discussions of this issue, see Daniel Feenberg, "The Tax Treatment of Married Couples and the 1981 Tax Law," In Taxing the Family, Ed. Rudolph G. Penner, Washington: American Enterprise Institute for Public Policy Research, 1983; Harvey Rosen, "The Marriage Tax is Down But Not Out," National Tax Journal, Vol. 40, December, 1987, pp 567-576; Daniel R. Feenberg and Harvey S. Rosen." Recent Developments in the Marriage Tax." National Tax Journal, Vol. 48, March 1995, pp. 91-101. Rosen, Harvey, "Is It Time to Abandon Joint Filing?" National Tax Journal, Vol. 30 (December 1977): 423-428. U.S. Congressional Budget Office. For Better or for Worse: Marriage and the Federal Income Tax. Washington, DC, June 1997. CRS-21 ranges, only bonuses. In this case, singles who live together and who have uneven incomes would see their tax rates fall if they got married. Both bonuses and penalties exist at the lower income levels because of the earned income tax credit. If income is evenly split, the phase out ranges are not reached as quickly for singles because each of the partners has only half the income. If all of the income is earned by one of the singles in the single partnership, phase out of the credit still occurs and the individual also has a smaller standard deduction, and thus pays a higher tax. The smaller deductions and narrower rate brackets also cause the higher tax rates through the middle income brackets. At very high income levels, marriage penalties can also occur. Some of the penalty is due to not doubling the rate brackets after the 15% bracket, but more of it is due to the marriage penalties in the AMT. If there were no AMT, tax rates for joint returns would be 17.1% and 22.8% for the $250,000 and $500,000 incomes. The regular tax is still responsible for most of the penalty for singles with one partner earning income: the regular rates are 20.9% and 24.1% for the $250,000 and $500,000 incomes. Table 3. Average Effective Income Tax Rates for Joint Returns and Unmarried Couples, By Size of Income and Degree of Split: Lower and Middle Incomes (2005 Levels of Income) Income Level for Married Couple Type-Size $10,000 $15,000 $25,000 $50,000 No Child Joint -2.9 0.0 3.4 8.3 Single 50/50 Split - 7.7 - 4.3 3.4 6.6 Single 100/0 Split 0.5 4.5 8.3 11.2 One Child Joint -23.2 -17.9 -0.7 6.6 50/50 Split (One -19.9 -15.0 -7.9 6.1 Single, One Head of Household 100/0 Split, Single 3.5 6.4 9.0 12.8 Return 100/0 Split, Head of -23.2 -13.6 3.3 8.0 Household Return Source: Congressional Research Service. Note that effective tax rate does not always rise across incomes due to rounding. Matters are more complex for families with one child. At low income levels, and a 50/50 split, one of the singles files a single return with a very limited negative rate because of the small earned income credit for those without children, while the other claims a child and has a much higher negative tax rate than a married couple because there is no phase out of benefits. The result is that there is a marriage bonus. CRS-22 This eventually becomes a marriage penalty because of the favorable head of household standard deduction and rate structure. The penalty continues through all the incomes shown, although it eventually becomes very small at the top. A small part of this penalty is due to the AMT at the $250,000 equivalent incomes: the rates without the AMT for a joint return is 19.7% and the rate for the combined singles 16.8%. Eliminating the AMT would, however, widen the discrepancy between the two at the $500,000 equivalent level: without the AMT the rates would be 23.9% for a joint return and 21.6% for the combined singles. Table 4. Average Effective Income Tax Rates for Joint Returns and Unmarried Couples, By Size of Income and Degree of Split: Higher Incomes (2005 Levels of Income) Income Level for Married Couple Type $75,000 $100,000 $250,000 $500,000 No Child Joint 9.5 % 11.2 % 19.4 % 24.8 % Single 50/50 Split 9.5 11.2 16.7 22.4 Single 100/0 Split 14.0 15.5 22.4 24.8 One Child Joint 8.6 11.9 21.8 24.9 50/50 Split (One 8.5 10.4 17.6 24.2 Single, One Head of Household) 100/0 Split, Single 15.0 16.6 24.2 25.0 Return 100/0 Split, Head of 12.1 14.6 24.2 25.0 Household Return Source: Congressional Research Service. Note that effective tax rate does not always rise across incomes due to rounding. With one of the pair earning all of the income, the results depend on whether the partner with the income can claim the child. If that person cannot, the tax burden is higher throughout the scale (although it reaches roughly the same level at the highest level in part because of the AMT). The discrepancy at the $250,000 level is increased slightly by the AMT (the regular rates are 19.7% for the joint return and 22.1% for the single). If the person with the income can claim the child, joint returns are still favored, but not by nearly as much. Which of these last two assumptions seems more likely depends on the circumstances. When couples divorce, they typically move to different residences and the most usual outcome is that the mother who typically has lower earnings would have the child. According to the Census Bureau, 83% of children who live CRS-23 with one parent live with their mother.19 In that case, the comparisons in Tables 1 and 2 would be appropriate. If the couple divorce but live together, presumably the higher income spouse would claim the child. However, if a couple never married and the child is only related to one parent, that person, more likely the mother and more likely to have low income, would claim the child. If such a couple married and had low incomes, they could obtain the earned income credit and a study of low income families indicates that this latter effect, the bonus, is the most common effect of the EIC.20 Which circumstances are more characteristic of the economy? Note first that, although people refer to the marriage penalty for a particular family situation or the aggregate size of the marriage penalty, it is really not possible, in many cases, to determine the size of the penalty or bonus. The effect of assignment of a child is demonstrated in Tables 3 and 4, but other features matter. Only when a married couple has only earned income, no dependent children, and no itemized deductions or other special characteristics, and only if it is assumed that their behavior would not have been different if their marital status had been different, can one actually measure the size of the marriage penalty or bonus. There is no way to know who would have custody of the children and therefore which of the partners might be eligible for head of household status and for the accompanying personal exemptions and child credits. There is reason to expect that unmarried individuals are penalized in the aggregate. Prior to the 2001 tax cut, which increased bonuses and reduced penalties, using an allocation that reflects typical behavior of married couples with respect to child custody, the Congressional Budget Office (CBO) estimated that 37% of married couples had penalties ($24 billion), 3% were unaffected, and 60% had bonuses ($73 billion). (Itemized deductions and earned income were assigned in proportion to earnings). The net bonus was $49 billion.21 However, in most of its analysis, the CBO study relied on a measure of marriage penalties and bonuses that assumed child custody would be based on a tax-minimizing strategy. For example, if parents of two children had similar individual earnings, each would be assumed to have custody of one of the children so that both would be eligible for head-of-household status. Even using that standard, net bonuses occurred: 43% of married couples had penalties amounting to $32 billion, and 52% had bonuses of $43 billion, for a net bonuses of $11 billion. Nevertheless, a significant proportion of married taxpayers -- between 37% and 43% -- paid marriage penalties. 19 U.S. Census Bureau, Table C2: Household Relationships and Living Arrangements of Children Under 18 [http://www.census.gov/population/www/socdemo/hh-fam/cps2005. html]. 20 See Stacy Dickert-Conlin and Scott Houser. "Taxes and Transfers: A New Look at the Marriage Penalty." National Tax Journal 51, June 1998, pp. 175-217. 21 These and other numbers discussed in this paragraph are from an update of a study by the U.S. Congressional Budget Office, For Better or for Worse: Marriage and the Federal Income Tax. Washington, DC, June 1997. These numbers were updated for 1999 in a memorandum from Bob Williams and David Weiner of CBO dated September 18, 1998. CRS-24 A study using Treasury data and other assumptions produced different measures of the marriage bonus or penalty.22 Using an assumption that divorced parents occupied the same residence, and thus only one could qualify for head of household status, the authors found that 48% had a penalty ($28.3 billion) and 41% had a bonus ($26.7 billion), for a net penalty of $1.6 billion. This study also provided several other ways of measuring penalties and bonuses, including estimating $30.2 billion in singles penalties because these individuals could not use joint return rate schedules. Some of the penalty applied to families with children because of the benefits of head of household status. Without head-of-household status, the Treasury found that 46% of couples have bonuses ($36.6 billion), 43% had penalties ($20.8 billion) and the net effect was a bonus of $15.8 billion. Treasury researchers did a subsequent study using the standard assumption for the effects of the 2001 tax cut and for 2004 income levels.23 As before, they essentially found a penalty (of $3.7 billion) without the 2001 tax cut, but found a $30 billion bonus with 2004 tax law (which included explicit marriage relief provisions and other provisions such as rate reductions). About 60% of couples have bonuses, and 23% have penalties (while some have no effect). The study also warns that penalties will grow substantially if the AMT continues to grow as projected. Given the shift away from penalties and towards bonuses in 2001, it seems clear that the current situation is characterized by bonuses rather than penalties. However, if the AMT is allowed to grow and begins to cover many taxpayers, more significant penalties will return. An alternative measurement is the bonuses and penalties of single individuals who are cohabitating, a much smaller group of people. In 2005, according to the Census Bureau, there were 58 million married households, but only 5 million unmarried couple households (with partners of the opposite sex).24 (There were 77 million households altogether). Thus, assuming that these households were similar to married households, the "single penalties and bonuses" measured by looking at unmarried cohabitating households would be about 9% of the size of "marriage bonuses and penalties" measured by looking at married households. A study has been made of penalties and bonuses for existing co-habiting couples with children, which assign the children to the biological parent, or, if both partners 22 Nicholas Bull, Janet Holtzblatt, James R. Nunns, and Robert Rebelein. Assessing Marriage Penalties and Bonuses. Proceedings of the 91st Annual Conference of the National Tax Association, 1998, pp. 327-340. An updated version of this paper is published as Office of Tax Analysis Paper 82, Defining and Measuring Marriage Penalties and Bonuses, November 1999 [http://www.ustreas.gov/ota/ota82_revised.pdf]. 23 Robert Gillette, Janet Holtzblatt, and Emily Y. Yin, Marriage Penalties and Bonuses: A Longer Term, Proceeding of the National Tax Association, 2004, Washington, DC, National Tax Association, pp. 468-478. 24 [http://www.census.gov/population/www/socdemo/hh-fam/cps2005.html] CRS-25 are biological parents to the higher earner.25 This study found that under 2003 law, 42% of these couples would experience a bonus averaging $1,893 while 50.7% would experience a penalty of $1,497. Under 2003 law, 48.5% receive an average bonus of $2,236 and 44.1% receive a penalty of $1,513. Bonuses are actually more prevalent in low income households because marriage often increases the earned income credit. In general, therefore, the rules tend to indicate that singles who are living together are, on average, being penalized relative to married couples, but this pattern does not hold for all circumstances. The marriage penalty cannot be easily addressed because we cannot simultaneously achieve three apparently desired income tax objectives: a progressive tax, a marriage neutral tax, and equal treatment of couples with the same total incomes, but with different income shares. Moreover, even if one were to chose horizontal equity, the achievement of that system would require information on living arrangements of unmarried individuals that is not available to the tax authorities. The current system, however, appears to lean towards benefitting marriage, as long as the AMT is contained. Conclusion The analysis of equity across families suggests that, based on an ability to pay standard, families with children are paying lower rates of tax (or receiving larger negative tax rates) than single individuals and married couples at lower and middle incomes, while families with children are being taxed more heavily at higher income levels. At the lowest income levels, the EIC provides the largest tax subsidies to single parents with two children, followed by single parents with three children and married couples with two children. The smallest subsidies go to childless couples, but all families with children have much larger subsidies than either childless couples or single individuals. At middle income levels, families with many children will have the most favorable treatment, due to the effect of the child credit which has a very large effect relative to tax liability. At higher income levels, large families are penalized because the adjustments for children such as personal exemptions and child credits are too small or are phased out, while graduated rates cause larger families that need more income to maintain a given living standard to pay higher taxes. Tax rates are more variable at lower income levels. At all but the lowest and very highest income levels, singles pay higher taxes than married couples. After the 2001 tax cut, the vast majority of taxpayers without children receive a marriage bonus rather than a penalty, with penalties occurring only at the bottom and at the top -- the latter due largely to the AMT. The comparison of families with children is less easily defined. Overall, marriage appears to be rewarded, but if the AMT continues to increase its scope (as it will absent legislation) penalties will begin to reach back in the middle income classes. 25 Elaine Maag, "Taxes and Marriage for Cohabiting Parents," Tax Notes, May 23, 2005, p. 1031. CRS-26 H.R. 3970, introduced by Chairman Rangel of the Ways and Means Committee, includes a number of changes that would have effects on relative tax treatment of family types. It would double the size of the earned income tax credit for single individuals without children, which would narrow the differences between family types at the lower income levels. It would also increase the refundability of the child credit, benefitting lower income families with children, although the cost of that change is smaller. It would also slightly increase the standard deduction, with relative increases designed not to increase the marriage penalty, but which would, based on ability to pay, favor married couples. At the higher end of the scale it would restore phase-outs of itemized deductions, which would maintain some uneveness across family types but also would repeal the AMT, which penalizes families with children at higher income levels. ------------------------------------------------------------------------------ For other versions of this document, see http://wikileaks.org/wiki/CRS-RL33755