Phase-out Tax Reform

By: Hailey CzarneckiUniversity of Oregon, School of Law

J.D. Candidate, Class of 2017

December 3, 2015

For: Tax Policy course with Professor Mann

ABSTRACT

This paper examines how our current system of tax-credit phase-out provisions could be

improved by using a simplified version that still achieves the goals of progressivity. To be

eligible for certain tax benefits, a taxpayer needs to have a certain income level to qualify.

Phase-outs are used to limit tax benefits to taxpayers who make under a certain amount of

money. Once a taxpayer’s income exceeds the phase-out range, the taxpayer may no longer

claim a certain benefit. This paper will start by explaining the current system, and showing the

most commonly used tax provisions that contain a phase-out and how the phase-out is used in

each.

Next, the paper will explain why the current system fails to be the most efficient and

effective, illustrating the problems of the phase-out provisions, and show how these phase-outs

complicate this system.

Next, the paper will explore two alternatives to phase-outs. The first alternative

eliminates all phase-outs from the tax code. Many tax policy recommendations encourage

Congress to adopt this method. Adopting this method would simplify many credits and

exemptions, giving taxpayers the ability to fill out their own tax forms and make taxpayers more

willing to comply. However, the downside of this recommendation is that vertical equity is

compromised. The second alternative is adopting a three-tiered system, where phase-outs are

applied at low-, middle-, and high-income thresholds. Because the current system is complex,

and eliminating phase-outs defeats the purpose of phase-outs, the best option is the three-tiered

program. This system will also help reduce the impact of marginal tax rates on each income

level.

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The three-tiered method could simplify the current system, but not make phase-outs as

simple as they could be if they did not exist. This method would also allow the vertical equity

policy of phase-outs to still work. Within this method, each credit that uses a phase-out would

better target the level of income intended by the credit.

The three-tiered system could help the low-income filers become more independent when

filing. This will especially simplify the earned-income tax credit. Low-income taxpayers should

not be spending money on tax preparers just to claim the credits that are supposed to be

favorable to them. The current system forces filers in this range to use paid preparers.

The three-tiered system could help middle-income taxpayers be able to save more on

traditional IRA deductions and education benefits.

The three-tiered system could help middle-income taxpayers avoid rate “cliffs” that drop

exemptions and credits at certain levels of income. The rates at which phase-outs would be

applied at a constant level, which will help reduce the effect of the marginal tax rate for these

taxpayers, who often complain about how marginal rates affect them most. Easing this burden

would make the tax system seem fairer to high-income earners.

Finally, the three-tiered system would ensure that taxpayers who make more than the

$300,000 do not receive any credits or exemptions. This helps the whole system achieve vertical

equity.

The three-tiered system seems like the best system to replace the current system, but

there can be negatives to this system as well. The three-tiered system has the potential of making

the current tax code worse off. By having all phase-outs in one income range happen

simultaneously, marginal tax rates will multiply. For example, if the Earned Income Tax Credit

(EITC) and the Child Care Tax Credit phased out simultaneously, taxpayers who claim both

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would experience an increase in their tax liability for both provisions. Thus, their marginal tax

rates will double. This paper will explain this issue more below. Therefore, for this system to

work, Congress must draft this system in a way that takes this issue into account. Then, each

provision will be able to work the way it was intended.

Once I have explained the proposed system, I will examine the feasibility of

implementing it. This will include the identification of political obstacles and evaluations of the

system from both parties. This paper will conclude that the new three-tiered program could be

the middle ground that creates a less complicated but more progressive tax system.

I. Introduction

The current tax code flourishes with provisions to fit the need of every type of American

that members of Congress could imagine. Each provision has a specific purpose intended for a

specific group of taxpayers. The result of this over-inclusive code is complexity. This

complexity manifests itself in many different ways. Phase-outs produce a peculiar type of

complexity. Phase-outs require a taxpayer to recalculate her income when she elects to use a

specified credit or deduction. Many times, the taxpayer will be required to calculate her income

multiple times in multiple ways to determine what provisions she is eligible for. A taxpayer

must calculate her income to even figure out whether she may not claim a credit. This produces

more work for the taxpayer without any benefit. She can also start to calculate her income for a

provision and realize she may only claim half of it, or thirty-six percent of it, or only two percent

of it. At this point, she probably becomes frustrated with the tax code and seeks help from a tax

preparer, causing her to spend money and waste even more time.

Phase-outs use a lot of tax-specific jargon that must be understood before making any

complicated calculations. A “threshold” is the amount of income listed in a provision that

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determines when a benefit begins to fade, or phase, out. A “rate” is how fast the benefit

disappears. Rates are usually formulated to include a percentage for every dollar amount earned

over a threshold, for example, two percent for every $100 over the $60,000 threshold. The rate it

disappears at is the two per $100. The “method” is the way a benefit is phased out by either

using a cap or a rate. Deductions use a “cap” to determine how much may be deducted when

using certain provisions. The “range” of a phase-out is the difference between when a phase-out

begins (at the threshold) and when the phase-out ends. When a phase-out ends, a taxpayer is no

longer eligible for any part of the benefit. “Income” is defined in a variety of different ways

depending on which provision is used. A “marginal effective tax rate” or “effective marginal

rate” is the percentage of tax imposed on the next dollar a taxpayer earns. A rate “bubble” is a

type of effective marginal rate. A “bubble” is an income range where a low-income filer is taxed

at a higher rate than a high-income filer.1 A bubble makes taxpayers in lower statutory tax

bracket pay a higher tax rate than taxpayers that are in a higher tax bracket. A “tax cliff”

happens when a phase-out abruptly ends. Tax cliffs happen when a provision eliminates fifty or

one hundred percent of a credit once a taxpayer earns one dollar over the limit.

Part II of this paper will describe how our current system uses phase-outs. This section

will describe how phase-outs can affect a taxpayer and why phase-outs are used. Part III will

discuss the reasons why we need a new system and what options are available. This section will

describe the reasons phase-outs are used and make suggestions for how the tax code could

achieve a similar outcome without the complexity that comes with the current phase-out scheme.

Subpart A of this section discusses what the tax code would look like without any phase-outs.

Subpart B discusses how phase-outs could still be used but in a simplified way. Part IV will

1 National Taxpayer Advocate, 2008 Annual Report to Congress, at 9, (Taxpayer Advocate Service, Volume 1, Dec. 31, 2008), https://www.irs.gov/pub/tas/08_tas_arc_intro_toc_msp.pdf.

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explain how the three-tiered program would be administered. This section will then be split into

three subsections to describe the intricacies of each level in the proposed three-tiered system.

Part V will examine the feasibility of implementing a new system. This section will examine the

political pressures Congress faces when creating or changing tax provisions and the entire tax

code. Finally, Part VI will sum up the entire paper in a conclusion that restates the main points

of each section.

II. What are the current phase-out provisions?

The current tax code uses at least one hundred phase-ins and phase-outs among

permanent and sunset provisions that affect individual filers.2 This section will focus on eighteen

of the most commonly used provisions containing phase-outs for individuals. More than half of

taxpayers are affected by a phase-out in at least one, if not multiple, of these common provisions

that they qualify for.3 Income level phase-outs are determined in many different ways. The

purpose for making each phase-out differ so drastically is not clear. At certain levels of income,

the taxpayer’s eligibility is phased out. The purpose for any certain phase-out is to target the

benefits to a certain group of taxpayers believed to have the greatest need.4 This helps achieve

the tax code’s progressivity objective. Provisions are written with a specific purpose and to

target a certain group of taxpayers. The use of phase-outs helps facilitate this goal.

The current system is not efficient. Each provision containing a phase-out determines

how that phase-out is administered. The differences in each provision contribute to the overall

confusion of the tax code and lowers efficiency. Provisions with phase-outs differ in thresholds

and rates to calculate the phase out. While some provisions use the same method such as a rate

2 Id.3 Id.4 President’s Advisory Panel on Federal Tax Reform, Simple, Fair, and Pro-Growth: Proposals to Fix America’s Tax System, at 6, (Jeffrey F. Kupfer, Exec. Director, November 2005), https://www.treasury.gov/resource-center/tax-policy/Documents/Simple-Fair-and-Pro-Growth-Proposals-to-Fix-Americas-Tax-System-11-2005.pdf.

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or a cap, the system as a whole is inconsistent when phase-outs are used together. Many even

use different definitions of income, causing the taxpayer to calculate their income multiple times

in multiple ways to comply with the phase-out rules.5

For example, income for the dependent exemption and the dependent care credit is

evaluated by the amount the Adjusted Gross Income (AGI) increases.6 The child tax credit

evaluates income using Modified AGI (MAGI).7 The additional child tax credit, earned income

tax credit (EITC), and the dependent and child care credits evaluate income based on “earnings,”

but the definition of earnings is inconsistent among each of the benefits.8 9

The current system of phase-outs is not simple. To determine a taxpayer’s liability, a

taxpayer starts with a tax base, which is all income she has received that year. Next, a taxpayer

subtracts above the line deductions, which becomes her Adjusted Gross Income (AGI). Then,

she may subtract exemptions. Some exemptions are limited by phase-outs. This means that the

taxpayer may have to recalculate her income at this step in order to understand what exemptions

she may claim. Next, the taxpayer must calculate her itemized deductions in order to determine

if the standard deduction or itemized deduction applies. If the itemized deductions apply, then

the taxpayer must calculate the deductions again, because some are subject to phase-outs

depending on her income. Her taxable income is then calculated. Then the taxpayer starts

applying credits to her tax liability. Credits, too, require the taxpayer to determine which parts of

her income may be included when calculating her eligibility for a credit.10 Imbedded in all of

5 Id. at 112.6 26 I.R.C. § 21(a)(2) (2012).7 26 I.R.C. § 24(b)(1).8 The President’s Economic Recovery Advisory Board, The Report on Tax Reform Options: Simplification, Compliance, and Corporate Taxation, at 8, (Austan Goolsbee, Staff Director and Chief Economist, August 2010), https://www.whitehouse.gov/sites/default/files/microsites/PERAB_Tax_Reform_Report.pdf.9 26 I.R.C. § 32(a)(2)(A).10 President’s Advisory Panel on Federal Tax Reform, supra note 4, at 24.

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these calculations are different thresholds, percentage rates, methods, and ranges for each phase-

out.

Presumably, Congress did not include phase-outs to create a complicated tax code that

makes taxpayers hate completing their tax returns. The benefit of this current system is that it

achieves vertical equity for the most part. Phase-outs are usually added to a provision to ensure

that the group intended to benefit may benefit and the group not intended to benefit pays their

taxes. Essentially, phase-outs are used to control progressivity. However, because some

provisions have marginal tax rates, this system does not achieve perfect vertical equity.

The chart below briefly describes each of the commonly used provisions that contain

phase-outs, which are the phase-outs that this paper will cover.

Provision Phase-out method Phase-out threshold End Phase-out

EITC MFJ with three children

21.06 cents taken from

each extra dollar earned

($21.06/$100)

$23,260 $52,427

Child Tax Credit MFJReduce $50 per $1,000

over the threshold$110,000 $130,000

Child and Dependent

Care Credit MFJ

1% for each $2,000 above

threshold down to 20% of

credit

$15,000

Can continue to claim

20% of credit with any

income

American Opportunity Credit MFJ

Full credit allowed for first $2,000

25% of credit for next

$2,000

$160,000 $180,000

Lifetime Learning Credit MFJ

20% of all expenses up to $110,000 $130,000

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$10,000

Education Tuition and Fees Deduction MFJ

$4,000 deducted if under threshold

$2,000 deducted if between threshold

amounts$0 if over

$130,000 $160,000

Adoption Credit

2.9 cents for every dollar

over the threshold

($2.9/$100)

$201,010 $241,010

Personal Exemption MFJ

2% for each $2,500 or

part thereof of AGI above

threshold

$309,900 $432,400

Itemized Deduction MFJ3% of AGI above

threshold, up to 80%

$309,900

Can always claim 20% of

itemized deductions

III. Why does the tax code need to adopt a new system?

However well intended each provision containing a phase out is, phase-outs are overly

burdensome. As the Bush Administration Treasury report stated in 2005, “In any case, the tax

code’s constant phase-ins and phase-outs are a nuisance at best, and a negative force at worst, in

the daily economic lives of American families and businesses.”11 The Obama Administration

Economic Recovery Advisory Board criticizes phase-outs, too. In a report it stated, “The tax

code has become more complex and more unstable over the last two decades, in part because

legislators have increasingly used targeted tax provisions to achieve social policy objectives

normally achieved by spending programs.”12 Congress often does not create new provisions with

old provisions in mind, causing overlap, confusion, and of course, complexity.13

11 Id. at 5.12 The President’s Economic Recovery Advisory Board, supra note 8, at 3.13 Id.

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The first argument for a new system is to increase simplicity. The current provisions each

require their own rulebook. The most complex provisions with phase-outs affect lower income

taxpayers.14 Simplifying the system would allow for only one rulebook or no rulebook at all. A

simplified system would also allow taxpayers to rely less on paid preparers.

Phase-outs can also be so complex that taxpayers fail to apply for credits they are eligible

for. For example, studies have shown that one-fourth of taxpayers eligible for education credits

fail to claim them.15 Rather than intending to be cumbersome, phase-out provisions are meant to

target certain groups and sometimes reward those people for complying with the intended

behavior. Another example of complexity in phase-outs is found in the EITC. The EITC

rewards people for earning an income, especially when they have children to care for. However,

the EITC’s phase out is overly complicated to calculate. The phase out for this credit has eight

different starting points depending on your marital status and how many dependent children you

have.16

Due to the complexity of calculating the credit, taxpayers often seek help filing their tax

returns. A portion of the credit must then be used to pay the tax preparer that filled out the

taxpayer’s form. What use is a provision that rewards an intended behavior if the reward must

be used to claim the provision? The effectiveness of the credit is reduced. The phase-out’s

effect is contradictory to why we have the EITC; the EITC is meant to help low income

taxpayers but it forces them to hire a preparer to help calculate whether they have entered the

phase-out range.17 Because of this, the National Taxpayer Advocate, and many other agencies,

14 Id. at 5.15 President’s Advisory Panel on Federal Tax Reform, supra note 4, at 84.16 ELAINE MAAG AND ADAM CARASSO, TAXATION AND THE FAMILY: WHAT IS THE EARNED INCOME TAX CREDIT?, TAX POLICY CENTER BRIEFING BOOK (February 12, 2014), http://www.taxpolicycenter.org/briefing-book/key-elements/family/eitc.cfm.17 President’s Advisory Panel on Federal Tax Reform, supra note 4, at 84.

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urges Congress to eliminate phase-outs from the tax code or reassess them to achieve their

intended objective.18

The next argument for a new system is efficiency. The current system requires a

taxpayer to calculate his or her income multiple times. A new system would only require one

calculation. This would significantly reduce the amount of time and money wasted on

completing a tax return.

The final argument for a new system is to achieve a better form of equity. Congress

drafts provisions without thought of already existing provisions.19 The unintended effect of this

is that the negative affects on the taxpayer are reduced. The negative affects are reduced because

the taxpayer is not losing out on multiple provisions simultaneously. If thresholds were all

equal, then all credits and deductions would no longer be available to taxpayers who have

reached the phase-out threshold. However, if this were the case, Congress would have no reason

to change the rates each time, the definition of what income qualifies, or the method by which

the phase-out uses. Congress’ only reasonable action to support this intention of reducing the

negative affect is differing thresholds. Nevertheless, the argument is understood in that if the tax

code had a system that caused all provisions to phase-out in the exact same way, the effect could

be very harmful and create rate bubbles.

The main problem with phase-outs is the creation of effective marginal tax rates.

Effective marginal tax rates are actual marginal tax rates that cause taxpayers to pay a higher rate

than their statutory rate.20 The example by the Bush administration Treasury’s reform proposal

states:

18 Taxpayer Advocate Service, 2012 Annual Report to Congress: The Complexity of the Tax Code, at 20, (Volume One, 2012) http://www.taxpayeradvocate.irs.gov/2012-Annual-Report/downloads/Most-Serious-Problems-Tax-Code-Complexity.pdf.19 The President’s Economic Recovery Advisory Board, supra note 8, at 3.20 President’s Advisory Panel on Federal Tax Reform, supra note 4, at 27.

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“Consider, for example, a taxpayer in the 28 percent bracket who claims credits that begin to phase out at a rate of $5 for every extra $100 earned. By this measure, each additional $100 earned by the taxpayer increases tax liability by $28, but decreases the value of tax credits by $5. The tax on the additional $100 of earnings is not $28, but $33, and the taxpayer’s marginal tax rate (the rate applied to the last dollar earned by the taxpayer) is not 28 percent ($28/$100), but 33 percent ($33/$100).21

This problem becomes worse when lower income taxpayers begin to pay a higher tax rate

than taxpayers in a higher tax bracket in a rate bubble. Rate bubbles often happen with the

EITC, which phases out at a rate of 21.06 percent. That means that taxpayers that fall within the

phase out range are paying, at a minimum, a marginal rate of 36.06 percent. This is calculated

by using the statutory rate for an income of $23,260, which is when the phase out begins for a

married couple filing jointly with three children. The statutory rate imposed at this income level

is 15 percent. To calculate the marginal rate, the 15 percent is added to the 21.06 percent that the

credit phases out at. Thus, the tax unit is paying 36.06 percent on their next dollar earned over

$23,260. To put things in perspective, taxpayers earning $140,000 to $250,000 a year pay 35

percent.22 A family earning more than $100,000 less is paying a higher tax. This is a rate

bubble. Another example is a taxpayer who earns $10,000 and has two children qualifies for the

EITC and the Child tax Credit. If this taxpayer receives a raise to earn $25,000 a year, she will

be partially phased out from both provisions. Instead of receiving a refund, she will owe taxes.

Her marginal tax rate increased to fifty-eight percent.23 The statutory rate for even the highest

income earners is only 39.6 percent.24

This is evidence that vertical equity, the idea that taxpayers who make more money

should pay higher taxes, is not being achieved. Overall, these effective marginal tax rate issues

21 Id. 22 26 I.R.C. § 1 (2012).23 DANIEL N. SHAVIRO, Effective Marginal Tax Rates on Low Income Households, EMPLOYMENT POLICIES INSTITUTE (February 1999), https://www.epionline.org/studies/r27/.24 26 I.R.C § 1.

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affect one of every five taxpayers.25 These examples happen often with many provisions that

contain phase-outs. The current tax code ‘s use of phase-outs does not work and a new system

must be implemented.

A. All phase-outs should be eliminated from the tax code.

When the Taxpayer Advocate Service (TAS) asked taxpayers for suggestions on how the

tax code should be reformed, an overwhelming number of citizens stated that phase-outs should

be eliminated.26 This prompted TAS to suggest the elimination of all phase-outs.27 Arguably,

Congress can achieve the same distribution of taxes by adjusting marginal tax rates as it does

with phase-outs.28 This means that Congress can change the statutory rates in section 1 of the tax

code to achieve the same distribution that is made through phase-outs. Phase-outs help the

distribution of taxes by targeting provisions to certain income groups. If Congress truly can

achieve the same distribution through changing the tax rates than by using phase-outs, then

phase-outs only create unnecessary complications. The elimination of phase-outs, then, would

make computing taxes less troublesome for taxpayers. So, one of the options available to deal

with the problems of phase-outs is to completely eliminate them from the tax code.

This option could achieve the three goals of taxation better than the current system. The

three goals of taxation are equity, simplicity, and efficiency. First, an action like this would

eliminate rate bubbles due to phase-outs, which would make the tax code more equitable. Next,

many commentators show how this action could also greatly simplify the tax system.29 Finally, a

25 President’s Advisory Panel on Federal Tax Reform, supra note 4, at 27.26 Taxpayer Advocate Service, supra note 18, at 14.27 Id. at 20.28 Id.29 National Taxpayer Advocate, supra note 1, at 342 and National Commission on Restructuring the Internal Revenue Service, Phase-Outs Based on Income Level, (June 25, 1997), http://www.house.gov/natcommirs/aicpa3.htm.

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system with no phase-outs would be more efficient because taxpayers would not have to

calculate their income more than once.

First, eliminating phase-outs would increase equity in the code. Eliminating phase-outs

would reduce rate bubbles, which would be publically friendly.30 Taxpayers who are made

aware of the effect of rate bubbles often feel phase-outs are unfair.31 Thus, eliminating rate

bubbles would make taxpayers feel the tax system is fairer. Rate bubbles threaten vertical

equity. Vertical equity is the idea that higher income individuals pay more in taxes than lower

income individuals. Rate bubbles cause lower income individuals to pay a higher marginal tax

rate than high-income individuals. When phase-outs create rate bubbles, lower income taxpayers

are taxed at a higher rate than higher income taxpayers. Thus, vertical equity is not achieved.

Second, a code with no phase-outs would be simple. Complexity in the code creates

problems. One problem linked to phase-out complexity is tax fraud. For some provisions, like

the EITC, eliminating phase-outs would decrease the amount of fraudulent claims made. Some

commentators have suggested that the complexity of the EITC creates an opportunity for

taxpayers or their paid preparers to fraudulently claim the credit.32 “Substantial evidence of

misconduct exists, ranging from advising clients to report incorrect income amounts, not

verifying that children claimed for EITC purposes actually lived with the taxpayer for the

requisite period, returns being altered after the client has signed them, and failing to follow basic

due diligence requirements.”33 Overwhelmingly the EITC phase-out level entices individuals to

underreport their income when they approach the phase-out limit. Underreporting is a form of

tax evasion that corrupts the tax system. The complexity of phase-outs opens the door to tax

30 National Taxpayer Advocate, supra note 1, at 411.31 Id.32 Elaine Maag, Earned Income Tax Credit in the Untied States, Urban Institute and Tax Policy Center, at 20, (2015). 33 Id. at 28.

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evasion. By eliminating phase-outs, and simplifying the tax code, less fraudulent claims would

be made.

A simplified system would also increase the effectiveness of provisions. Many

provisions are in place to encourage certain behaviors. For example, the EITC is in place to

encourage taxpayers to earn an income. Phase-outs reduce the effectiveness of tax provisions

like the EITC because it is too complicated. This causes a decrease in taxpayers claiming the

credit.34 For example, in Oregon, many qualifying taxpayers did not claim the EITC, which

resulted in a $124 million not claimed.35

Another aspect of simplicity is transparency. Eliminating phase-outs would make the

code more transparent. Transparency in the tax code means taxpayers can understand how

credits or deductions are applied and better comply with the code.36 Simplicity promotes lower

compliance and administrative costs.37 More compliance leads to less administrative costs. Thus,

eliminating phase-outs would make the tax code less complex and more transparent.

Finally, eliminating phase-outs increase efficiency by lessening the burden of completing

a tax return. With phase-outs, the taxpayer is forced to calculate how accepting a raise in income

or making a decision to work would affect their tax liability or tax return due to entering a phase-

out range.38 If phase-outs didn’t exist, taxpayers could just claim credits or deductions without

any excess calculations.

Although these benefits seem advantageous, taking out all phase-outs would pose some

problems, too. The most notable benefit of having phase-outs is the reduction of cost on tax

34 Id.35 Editorial, $124 million on the table, Registrar Guard, November 7,2015, http://registerguard.com/rg/opinion/33684486-78/124-million-on-the-table.html.csp.36 President’s Advisory Panel on Federal Tax Reform, supra note 4, at 114.37 Congressional Research Service, Tax Reform in the 114th Congress: and Overview of Proposals, at 6, (2015).38 President’s Advisory Panel on Federal Tax Reform, supra note 4, at 114.

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provisions.39 If phase-outs did not exist, provisions would become costly in both the revenues

not raised and the need to refund more to taxpayers.40 Phase-outs also provide some vertical

equity.41 Although phase-outs are complicated, using them allows the tax system to achieve its

goal of increasing the tax burden based on a greater ability to pay.42 As stated above, the

different phase out rates make each provision differ in the vertical equity it creates. Thus, phase-

outs balance simplicity with equity when attempting to achieve tax policy goals.

Because it may not be possible to eliminate all phase-outs, this paper will next discuss the

possibility of an option that simplifies phase-outs by not eliminating them.

B. A three-tiered phase-out system should replace the current system.

Another option could be implementing a three-tiered phase-out system. This three-tiered

phase out system is scarcely mentioned and has never been adopted.43 National Commission on

Restructuring the Internal Revenue Service (National Commission) described this system in

1997. Congress created the National Commission to make suggestions to improve the tax

system. Although this organization has disbanded, and this particular suggestion did not make it

far, it’s worth revisiting the benefits that a system like this could provide. Other organizations

have suggested forms of this system, too. TAS suggested Congress should consolidate like

benefits, such as all education or all retirement savings incentives, so that all definitions of

income, phase out ranges, and thresholds are the same.44 The Tax Policy Center also suggested

Congress coordinate provisions for low-income families and lower the phase-out rate45 or just

39 The President’s Economic Recovery Advisory Board, supra note 8, at 5.40 Id.41 Id.42 Id.43 National Commission on Restructuring the Internal Revenue Service, supra note 29.44 Taxpayer Advocate Service, supra note 18, at 19.45 MAAG AND CARASSO, supra note 16.

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coordinate phase-outs in general.46 The three-tiered phase-out option could achieve the three

goals of taxation—equity, simplicity, and efficiency— better than the current system and balance

the goals better than the elimination of phase-outs option.

The National Commission divided taxpayers into low-, middle-, and high-income classes

that would be indexed for inflation.47 These tiers are not the same as the statutory tax brackets of

Section 1 of the tax code. The statutory rates are separated into seven tax brackets.48 This

system would create only three different brackets and could base the thresholds off the quintile

system. The quintiles are measured by the distribution of household income.49 The lowest and

second quintiles would represent the low-income tier, the middle and fourth quintiles would

represent the middle-income tier, and the highest quintile would represent the high-income tier.

Complexity will be incorporated when taxpayers have to calculate the phase out. Simplicity

must be balanced with fairness, which can be achieved by properly splitting the income tiers.

However, this system is significantly less complex than the system we currently have. As stated

above, the system we have requires taxpayers to calculate their income using different methods,

rates, definitions of income, and threshold.50 The definition of income, the method, and the rate

used for all provisions would be the same. Within each group, then, the same threshold will be

used for all provisions targeted at that group.

First, this system would be more equitable than both other options. Equity is achieved

both vertically and horizontally. Vertical equity would be achieved because provisions would be

46 WILLIAM GALE AND BENJAMIN HARRIS, TAX SIMPLIFICATION: WHAT POLICY REFORMS COULD SIMPLIFY THE TAX CODE?, TAX POLICY CENTER BRIEFING BOOK (December 14, 2007), http://www.taxpolicycenter.org/briefing-book/improve/simplification/policy-reform.cfm.47 National Commission on Restructuring the Internal Revenue Service, supra note 29.48 26 I.R.C. § 1 (2012).49 KEVIN PERRESE, THE DISTRIBUTION OF HOUSEHOLD INCOME AND FEDERAL TAXES, 2011, CONGRESSIONAL BUDGET OFFICE, at 2 (November 2014).50 President’s Advisory Panel on Federal Tax Reform, supra note 4, at 112.

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grouped together to target certain groups on income. When provisions are targeted to certain

income groups, only those income groups will be able to claim a credit or deduction. Vertical

equity is thus achieved because higher income taxpayers will be paying more in taxes than lower

taxpayer who qualify for more provisions. This system would also help with horizontal equity.

The principle behind horizontal equity is that similarly situated people should pay similar taxes.

For example, people who qualify as low-income should pay the same amount in taxes as others

that qualify as low-income, and people who qualify has high-income should pay more than those

who are considered low-income. Horizontal equity would be achieved because this system

would make the tax code more transparent and allow similarly situated taxpayers to claim the

same credits and deductions. Congress could make it easier on taxpayers if the provisions

available for each income group were up front on the income tax return form. One could

imagine it being as easy as simply checking boxes for credits or deductions you may qualify for

and then filling out a form to check how much you have phased out of the available provisions.

The Tax Policy Center stated, “People who cannot understand tax rules may also question the

fairness of the tax system and feel that others are reaping more benefits than they are.”51 With a

check box system administered incorporated in the three-tiered phase-out system, horizontal

equity and fairness could be achieved. People would arguably be less angry with the tax code if

they felt they were reaping the same benefits as others similarly situated to themselves.

Next, simplicity can be achieved. As stated above, the three-tiered phase-out system

would not be as simple as the eliminating phase-outs option, but it strikes a necessary balance

between equity and complexity. Some policymakers argue that simpler taxes also raise

compliance because the rate of inadvertent and intentional nonpayment of taxes or tax evasion is

51 WILLIAM GALE AND BENJAMIN HARRIS, Tax Simplification: What policy reforms could simplify the tax code?, TAX POLICY CENTER BRIEFING BOOK (December 14, 2007), http://www.taxpolicycenter.org/briefing-book/improve/simplification/benefits.cfm.

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reduced.52 These rates are reduced in part because sometimes the reason people do not pay taxes

is because they do not understand the tax law.53 With the three-tiered system, taxpayer can better

understand the code because it would be simple enough to allow taxpayers to complete their

taxes on their own. A simpler system would also make it easier to enforce the law.54

Efficiency could be achieved because this system would still take taxpayers less time to

complete their tax returns than the current system. Again, the current system requires taxpayers

to calculate their income and how much they have been phased out for each provision they wish

to claim. The three-tiered system would allow for taxpayers to calculate their income just once

for all of the provisions they wish to claim. Although this would not be as efficient as

eliminating all phase-outs from the tax code, it too would be striking a balance between equity

and efficiency, specifically, with vertical equity.

Although it would not be as simple as eliminating all phase outs, overall, the system

would achieve the three goals better than the current system and the eliminating phase-outs

option. The goals could only be achieved if the system is implemented with rate bubbles and

marginal tax rates in mind. The three-tiered option can pose problems if not drafted carefully

and can further complicate the tax code if not adopted for all phase-out provisions. But, this

system can also strike the balance that the current tax code needs. The opposing views between

pro-phase-outs and anti-phase=outs challenge each other so much that policymakers fail to find

the middle ground. As stated above, pro-phase-out advocates argue that phase-outs help target

certain income groups through vertical equity55 and lowers the revenue costs of each provision.56

52 Id.53 Id.54 Id. 55 The President’s Economic Recovery Advisory Board, supra note 8, at 5.56 Taxpayer Advocate Service, supra note 18, at 20.

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Anti-phase-out advocates argue that phase-outs cause complexity in the tax code, create high

marginal tax rates and rate bubbles,57 and encourage taxpayers to report less than they owe.58

The three-tiered system strikes a balance between these two extremes. This system

would be more complex than eliminating all phase-outs from the tax code, but it would also

target income groups through vertical equity. This system would still create marginal rates but

could be drafted in a way to not have rate bubbles. Also, a better system like this has the

possibility of not encouraging taxpayers to falsely report. Finally, this system would also cost

less than eliminating all phase-outs. A tax code with no phase-outs would be expensive. For

example, the EITC cost 65 billion dollars last year and only 26.7 million received it.59 If this

number is multiplied by the 136 million people who file each year,60 the EITC alone would could

cost about 325 billion dollars.

The complexity of this system would help achieve vertical equity because the thresholds

used will target provisions to certain income groups. When provisions are targeted at certain

income groups, taxpayers who make more income than that group will pay taxes instead of

earning a credit. Thus, vertical equity is achieved because taxpayers who have the ability to pay

are paying the tax and taxpayers who make less are benefitted.

The low-income tier would be able to enjoy benefits designed to help their group

specifically. The most common credits targeting this group are the EITC, the Child Tax Credit,

and the Child and Dependent Care Credit. The income level where the phase-outs would begin,

57 Id.58 Maag, supra note 32, at 28.59 EITC CENTRAL, About EITC, INTERNAL REVENUE SERVICE (November 9, 2015), https://www.eitc.irs.gov/EITC-Central/abouteitc.60 SCOTT A. HODGE, Number of Americans Paying Zero Federal Income Tax Grow to 43.4 Million, TAX FOUNDATION (March 30,2006), http://taxfoundation.org/article/number-americans-paying-zero-federal-income-tax-grows-434-million.

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or the threshold, should be around $50,000 for a tax unit that is Married Filing Jointly (MFJ).61

This number is the average of current phase-out starting points for the credits targeted at low-

income taxpayers. If the quintile system is used, the threshold should be around $45,300,

because that is the income amount of the second quintile.62

The most common middle-income provisions are the American Opportunity Credit, the

Lifetime Learning Credit, and the Education Tuition and Fees Deduction, which expired January

1, 2015. These provisions would have a threshold around $120,000 MFJ, or the average of the

thresholds used for these provisions.63 If the quintiles are used, the threshold would be the top of

the forth quintile income amount, which is $97,500.64

The most common high-income provisions are the Adoption Credit, the Personal

Exemption, and the Itemized Deduction.65 These provisions would start phasing out around

$220,000 MFJ, which is the average threshold for these provisions.66 Under the quintile system,

the threshold would be $245,700.67

Phasing-out credits as income increases achieves the goal of vertical equity by targeting

tax benefits to those who really need them, or the idea that taxpayers with a greater ability to pay

should pay more than the taxpayers who have a lesser ability to pay.68 Vertical equity is

achieved because middle- and high-income groups will be ineligible to claim credits or

deductions that are available to the low-income group. Similarly, the high-income tier will not

61 ROBERTON WILLIAMS AND LYDIA AUSTIN, Income Tax Issues: How do phaseouts of tax provisions affect taxpayers?, TAX POLICY CENTER BRIEFING BOOK (March 4,2015), http://www.taxpolicycenter.org/briefing-book/background/issues/phaseouts.cfm.62 PERRESE, supra note 49, at 2.63 WILLIAMS AND AUSTIN, supra note 61.64 PERRESE, supra note 49, at 2.65 WILLIAMS AND AUSTIN, supra note 61.66 Id.67 PERRESE, supra note 49, at 2.68 The President’s Economic Recovery Advisory Board, supra note 8, at 5.

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be able to claim credits or deductions available to the middle-income tier. Because the phase-out

thresholds are set at lower levels, any taxpayer that fits into a higher tier will be completely

phased out and thus ineligible claim credits or deductions targeted at a lower tier. Without

phase-outs, vertical equity could not be achieved.

The next important goal for this system should be keeping marginal tax rates low.

Marginal tax rates increase when provisions reduce deductions.69 The higher the phase out rate,

the more extreme the marginal tax rate, which leads to rate bubbles. When a taxpayer’s income

causes multiple phase-outs to begin at the same time, the negative effects compound.70 This

effect potentially deters taxpayers from earning more money.71 When deductions or credits are

reduced too fast, marginal tax rates increase more.72 The phase out rates in the three-tiered

system should be low enough and gradual enough to not create high marginal tax rates and

especially not create rate bubbles.

The current system creates marginal rates that are too high in many provisions. For

example, in the low-income bracket, the EITC is currently written so that if a tax unit with three

children makes $1 more than the threshold, they will lose 45% of the credit.73 If this family

makes $23,630, which is the threshold of the EITC for a unit filing jointly with three children,

they are in the 15 percent tax bracket.74 The marginal rate created in this situation costs the

family 60 cents on that extra dollar because 15 cents is taken from their tax bracket rate and 45

cents is taken from their credit. This is a rate bubble because this family is now paying a higher

tax than the five other tax brackets above them.

69 WILLIAMS AND AUSTIN, supra note 61.70 Id.71 Margot L. Crandall-Hollick, The Earned Income Tax Credit (EITC): Economic Analysis, at 13, (Congressional Research Service June 2, 2015).72 WILLIAMS AND AUSTIN, supra note 61.73 Id.74 26 I.R.C. § 1 (2012).

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Although all taxpayers that qualify for this provision are affected similarly, the extreme

outcome makes taxpayers less inclined to work harder because their credit will be reduced.

Another example is the now expired deduction for higher education tuition and fees. When it

was in effect, the deduction drops from $4,000 to $2,000 once a taxpayer earns $1 more than

$65,000.75 Under this provision, a rate cliff affects the taxpayer. This rate cliff causes the

marginal tax rate to increase drastically once the threshold is exceeded. If a taxpayer earned

$65,001, the taxpayer would pay 25 cents for her statutory rate and 50 cents for the lost of the

deduction. The marginal tax rate is 75 cents, which, again, creates a rate bubble because she is

paying a higher tax rate than the four tax brackets above her.

To alter these effects, the three-tiered system should adopt a rate that grows gradually.

For example, the Child and Dependent Care Credit falls at a rate of one percent for every

$2,000.76 This rate allows families to still utilize the credit even if their income only increases by

$1. Only at $2,000 checkpoints do they start to phase out of the credit. For the three-tiered

system to work effectively, it must phase out at gradual rates similarly to the Child and

Dependent Care Credit.

Finally, the three-tiered system will cost less then eliminating phase-outs from the whole

system. The most beneficial use of phase-outs in some policymakers’ opinions is the reduction

of cost on tax provisions.77 If the system had no phase-outs at all, all taxpayers would be able to

claim credits and deductions. As stated above, eliminating phase-outs in the EITC alone would

double the cost of the credit to 130 billion.

Although the three-tiered system appears to solve all the phase-out problems in the tax

code, it has the potential of creating worse problems than our current tax code. When a phase-

75 WILLIAMS AND AUSTIN, supra note 6176 26 I.R.C. § 177 Taxpayer Advocate Service, supra note 18, at 20.

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out is applied to a provision now, a marginal tax rate is created. If multiple provisions are

phased out together, the marginal tax rate is multiplied by each phase out. For example, if the

EITC and the Child Tax Credit both phased out at 10 percent per $100 earned over the threshold

of $50,000, a taxpayer who earned $50,101, would lose 10 cents from the EITC, 10 cents from

the Child Tax credit, and 25 cents from her statutory rate for a total of 45 cents on the extra

dollar earned. The marginal tax rate multiplied because instead of just losing 10 cents per one

credit, she lost 20 cents for two credits. If this system is not carefully drafting, taxpayers may be

hurt immensely. To alleviate this potential hardship, Congress must draft this system with

marginal tax rates in mind. Congress should create a system that does not allow for any rate

bubbles. All credits made available for a certain tier should be drafted together so when they are

combined, the total marginal tax rate does not exceed the next highest statutory tax rate. By

doing this, Congress can ensure the phase-out rates are small enough in the aggregate and the

phase-out range is wide enough to make each provision accomplish its purpose.

In conclusion, the three-tiered system strikes a balance between eliminating all phase-

outs from the tax code to limit some complexity and keeping all phase outs in the system to

achieve vertical equity. Although marginal tax rates will continue in this system, lowering the

effect is possible. With a lower effect, more taxpayers will comply with the system. Finally,

using this system would allow the tax code to not spend as much as it would without any phase-

outs at all.

IV. Conclusion

Although the three-tiered phase-out option seems like the best route to take, our tax code

has a long way to go before this problem is solved. The feasibility of implementing a new

system is small. In an interview with Nina Olson, who is an IRS National Taxpayer Advocate,

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she stated that any tax reform is unlikely until Congress believes there is a true crisis. Martin

Lobel, chair of Tax Analysts’, similarly believes that tax reform is unlikely to happen in the near

future.78

Democratic politics often refer to provisions that favor certain behaviors as loopholes.

The word loophole has a negative connotation. Democrats would prefer a tax code that did not

have any loophole-like provisions.79 The only positive of these provisions, according to

Democrats, is the use of phase-outs. Phase-outs can be beneficial with loophole provisions

because at least the highest income taxpayers have to pay their taxes.

Republican politicians fight for a more fair tax system. To Republicans, fair means that

every taxpayer may qualify for every provision of the tax code. Republicans believe phase-outs

are targeted at high-income earners.80 Republicans see helpful provisions as reasonable

deductions that encourage certain behaviors.81

This battle between whether phase-outs are good or bad will likely go unresolved unless a

policymaker can see the benefits of meeting in the middle of the two. The three-tiered system

can be this middle ground. It provides phase-outs to help with vertical equity and progressivity,

but also limits the confusion and coordinates phase-outs to make it fair. There are many issues

that can be resolved in the tax codes. For the benefits of all, the three-tiered system should be

implemented.

78 Martin Lobel, A Cynic’s View of Tax Reform, Tax Notes, June 8, 2015.79 Gabriella Levy, GOP Contenders Call for Closing Carried Interest Loophole, U.S. News, September 17,2015, http://www.usnews.com/news/articles/2015/09/17/gop-contenders-call-for-closing-carried-interest-loophole.80 Id.81 Kyle Pomerleau, The Pease Limitation on Itemized Deductions is Really a Surtax, Tax Foundation, October 16, 2014, http://taxfoundation.org/blog/pease-limitation-itemized-deductions-really-surtax.

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