Presidents Advisory Board Tax Reform Options August 2010

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The P residentsECONOMIC RECOVERY ADVISORY BOARD

The Report on Tax Reform Options:Simplifcation, Compliance, and Corporate Taxation

AUGUST 2010


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The PresidentsEconomic REcovERy AdvisoRy BoARd

The Reprt Tax

Refr opt:Simplifcation, Compliance,

and Corporate Taxation

AUGUST 2010


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The PresidentsEconomic REcovERy AdvisoRy BoARd

Board Members

PaulA.Volcker,Chairman

AnnaBurger JohnDoerr

WilliamH.Donaldson

MartinFeldstein

RogerW.Ferguson

MarkT.Gallogly

JereyR.Immelt

MonicaLozano

JimOwens

CharlesPhillips

PennyPritzker

DavidSwensen

RichardL.Trumka

LauraDAndreaTyson

RobertWolf

AustanGoolsbee,StaDirectorandChiefEconomist


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PREFACEWhatfollowsisareportofthePresidentsEconomicRecoveryAdvisoryBoard(PERAB)onop-

tionsforchangesinthecurrenttaxsystemtoachievethreebroadgoals:simplifyingthetaxsystem,

improvingtaxpayercompliancewithexistingtaxlaws,andreformingthecorporatetaxsystem.

eBoardwasaskedtoconsidervariousoptionsforachievingthesegoalsbutwasaskedtoexclude

optionsthatwouldraisetaxesforfamilieswithincomeslessthan$250,000ayear.Weinterpreted

thismandatenottomeanthateveryoptionweconsideredmustavoidataxincreaseonsuchfami-

lies,butratherthattheoptionstakentogethershouldberevenueneutralforeachincomeclasswith

annualincomeslessthan$250,000.Asimilarprincipleofrevenueneutralitywasusedinthe1986

taxreformlegislationinwhichchangesthatraisedrevenuewerecombinedwithcutsinpersonal

incometaxrates.especicchangesweconsideredcaneitherraiseorlowerrevenue.Werealize

thatrevenueneutralitybyincomeclassmightresultinincreasesordecreasesintaxliabilityforsub-

groupsorindividualtaxpayerswithineachincomeclassthatis,revenueneutralitymightresult

inwinnersandlosers.WehopethattheAdministrationandtheCongresswillselectchangesthataredesirableontheirmeritsandnotworryaboutthedistributionaleectsofeachofthemin-

dividually.eentirepackageofoptionsselectedshouldbeevaluatedbytheTreasuryortheJoint

CommitteeonTaxation(JCT)toseewhatimpactithasontaxliabilitybyincomeclass.If,asseems

likely,thepackageraisestaxesforsomeincomegroupsandlowersthemforothers,thiscouldbe

osetbyadjustmentstothestandarddeduction,taxratesorotherprovisions.Ofcourse,evenif

theratesareadjustedtoberevenueneutralineachincomeclass,therewillbeindividualtaxpayers

whogainandlose.Wedidnottrytoholdalltaxpayersharmlessintheoptionsweevaluated,and

wewerenotaskedtodosobythePresident.Itwouldbeimpossibletodosowithoutsubstantial

costsintermsoflostrevenues.

eBoardgatheredinformationfrombusinessleaders,policymakers,academics,individualciti-zens,laborleaders,andmanyothers.Ourndingsaretheresultofmonthsofinputfrommany

people,andwethankthemfortheiradvice. Inaddition,overtheyearstherehavebeenmany

reportsontax reformoptionsbybothgovernmentagenciesandprivateentities. erehasalso

beensubstantialacademicresearchontheseissues.Wehavebenetedgreatlyfromstudyingthese

previousreportsandmaterials.

eBoardwasnotaskedtorecommendamajoroverarchingtaxreform,suchasthe1986taxre-

form,thetaxplansproposedbythe2005TaxReformPanel,orproposalsforintroducingavalue-

addedtaxinadditiontoorinlieuofthecurrentincometaxsystem. Wereceivedmanysuggestions

forbroadtaxreform,andsomemembersofthePERABbelievethatsuchreformwillbeanessential

componentofastrategytoreducethelong-termdecitofthefederalgovernment. Butconsistent

withourlimitedmandate,wedidnotevaluatecompetingproposalsforoverarchingtaxreformin

thisreport.

Finally,itisimportanttoemphasizeattheoutsetthatthePERABisanoutsideadvisorypaneland

isnotpartoftheObamaAdministration.Wehaveheardtheviewsofexpertsinthegovernment

inthesamewaythatwehaveheardtheviewsofoutsideexpertsandinterestgroups.Wehaveat-

temptedtodistilltheseviewsinthisreporttoprovideanoverviewoftheadvantagesanddisadvan-


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tagesoftaxreformoptionsthatachievethethreegoalsofourmandate:taxsimplication,greater

taxcompliance,andcorporatetaxreform.Ourreportismeanttoprovidehelpfuladvicetothe

Administrationasitconsidersoptionsfortaxreforminthefuture. ereportdoesnotrepresent

Administrationpolicy.


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TABLE OF CONTENTS

I. LIST OF FIGURES AND TABLES. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

II. SIMPLIFICATION OPTIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

a. Option Group A: Simplifcation or Families . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

i. Option 1: Consolidate Family Credits and Simpliy Eligibility Rules . . . . . . . . . . . 6

1. Consolidate Family Benefts into a Work Credit and a Family Credit . . . 8

2. Combine the EITC, Child Tax Credit, and the Child DependentExemption . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

3. Consolidate the Child Tax Credit and Dependent Exemption,and Repeal (or Reduce) Some Education Credits . . . . . . . . . . . . . . . . . . . 10

ii. Option 2: Simpliy and Consolidate Tax Incentives or Education . . . . . . . . . . . . 10

iii. Option 3: Simpliy the Kiddie Tax (Taxation o Dependents). . . . . . . . . . . . . . . . 15

iv. Option 4: Simpliy Rules or Low-Income Credits, Filing Status,and Divorced Parents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

1. Harmonize the EITC and Additional Child Tax Credit. . . . . . . . . . . . . . . . . 17

2. Simpliy Filing Status Determination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

3. Eliminate the Household Maintenance Test orEstranged Spouses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

4. Simpliy the EITC or Childless Workers . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22

5. Clariy Child Waivers in the Event o Divorce or Separation . . . . . . . . . . 22

b. Option Group B: Simpliying Savings and Retirement Incentives. . . . . . . . . . . . . . . . . . . . 23

i. Option 1: Consolidate Retirement Accounts and Harmonize StatutoryRequirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24

ii. Option 2: Integrate IRA and 401(k)-type Contribution Limits and DisallowNondeductible Contributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28

iii. Option 3: Consolidate and Segregate Non-Retirement Savings . . . . . . . . . . . . . 29

iv. Option 4: Clariy and Improve Saving Incentives . . . . . . . . . . . . . . . . . . . . . . . . . . . 29

1. Make the Savers Credit a Match . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

2. Expand Automatic Enrollment in Retirement Savings Plans . . . . . . . . . 31


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v. Option 5: Reduce Retirement Account Leakage . . . . . . . . . . . . . . . . . . . . . . . . . . . 31

vi. Option 6: Simpliy Rules or Employers Sponsoring Plans . . . . . . . . . . . . . . . . . . 32

vii. Option 7: Simpliy Disbursements. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33

viii. Option 8: Simpliy Taxation o Social Security Benefts . . . . . . . . . . . . . . . . . . . . . 34

c. Option Group C: Simpliy Taxation o Capital Gains . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .36

i. Option 1: Harmonize Rules and Tax Rates or Long-Term Capital Gains . . . . . 37

1. Harmonize 25 and 28 Percent Rates on Capital Gains . . . . . . . . . . . . . . 37

2. Simpliy Capital Gains Taxes on Mutual Funds . . . . . . . . . . . . . . . . . . . . . .38

3. Small Business Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38

ii. Option 2: Simpliy Capital Gains Tax Rate Structure . . . . . . . . . . . . . . . . . . . . . . . .39

iii. Option 3: Limit or Repeal Section 1031 Like-Kind Exchanges. . . . . . . . . . . . . . 40iv. Option 4: Capital Gains on Principal Residences . . . . . . . . . . . . . . . . . . . . . . . . . . . 41

d. Option Group D: Simpliying Tax Filing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41

i. Option 1: The Simple Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

ii. Option 2: Data Retrieval. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44

iii. Option 3: Raise the Standard Deduction and Reduce the Benefto Itemized Deductions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45

e. Option Group E: Simplifcation or Small Businesses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .46

i. Option 1: Expand Simplifed Cash Accounting to More Businesses. . . . . . . . . . 48

ii. Option 2: Simplifed Home Ofce Deduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48

iii. Option 3: Simpliy Recordkeeping or Cell Phones, PDAs, andOther Devices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49

. Option Group F: The AMT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49

i. Option 1: Eliminate the AMT. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50

ii. Option 2: Modiy and Simpliy the AMT. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50

III. COMPLIANCE OPTIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53

a. Background on Compliance and the Tax Gap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54

b. General Approaches to Improve Voluntary Compliance and Reduce the Tax Gap . . . . 56


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c. Option 1: Dedicate More Resources to Enorcement and EnhanceEnorcement Tools . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57

d. Option 2: Increase Inormation Reporting and Source Withholding . . . . . . . . . . . . . . . . . 59

e. Option 3: Small Business Bank Account Reporting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60

. Option 4: Clariying the Defnition o a Contractor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .60

g. Option 5: Clariy and Harmonize Employment Tax Rules or Businessesand the Sel-Employed (SECA Conormity) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61

h. Option 6: Voluntary Disclosure Programs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62

i. Option 7: Examine Multiple Tax Years During Certain Audits . . . . . . . . . . . . . . . . . . . . . . . 63

j. Option 8: Extend Holding Period or Capital Gains Exclusion onPrimary Residences. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64

IV. CORPORATE TAX REFORM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65

a. Overview o the Corporate System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66

b. Option Group A: Reducing Marginal Corporate Tax Rates. . . . . . . . . . . . . . . . . . . . . . . . . .69

i. Option 1: Reduce the Statutory Corporate Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . .69

ii. Option 2: Increase Incentives or New Investment/Direct Expensing . . . . . . . . 71

c. Option Group B: Broadening the Corporate Tax Base . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72

i. Option 1: Provide More Level Treatment o Debt and Equity Financing . . . . . . 72

ii. Option 2: Review the Boundary Between Corporate andNon-Corporate Taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74

iii. Option 3: Eliminate or Reduce Tax Expenditures . . . . . . . . . . . . . . . . . . . . . . . . . . . 77

1. Eliminating the Domestic Production Deduction. . . . . . . . . . . . . . . . . . . . . 78

2. Eliminate or Reduce Accelerated Depreciation . . . . . . . . . . . . . . . . . . . . . 78

3. Eliminate Other Tax Expenditures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79

A. Special Employee Stock Ownership Plan (ESOP) Rules . . . . . . . . . 79

B. Exemption o Credit Union Income rom Tax . . . . . . . . . . . . . . . . . . . . 79

C. Low-Income Housing Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80


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V. ADDRESSING INTERNATIONAL CORPORATE TAX ISSUES . . . . . . . . . . . . . . . . . . . . . . . . 81

a. The Current U.S. Approach to International Corporate Taxation. . . . . . . . . . . . . . . . . . . . . 82

b. Box 1: The Foreign Tax Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83

c. Economic Eects o the Current U.S. Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85

i. Eects on the Location o the Economic Activities o U.S. Multinationals . . . . 85

ii. Eects on the Costs o U.S. Companies and their Foreign and DomesticCompetitors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86

iii. Erosion o the Business Tax Base through Transer Pricing and ExpenseLocation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87

iv. The Costs o Administering and Complying with the Current U.S. System . . . 88

v. Option 1: Move to a Territorial System. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89

vi. Option 2: Move to a Worldwide System with a Lower Corporate Tax Rate. . . . 91

vii. Option 3: Limit or End Deerral with the Current Corporate Tax Rate . . . . . . . . 93

viii. Option 4: Retain the Current System but Lower the Corporate Tax Rate . . . . 94

VI. ACKNOWLEDGMENTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95

VII. APPENDIX. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96


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I. LIST OF FIGURES AND TABLES

Figure 1: FamilyRelated Tax Credits per Family Taxpayer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

Table 1: Comparison o Provisions Relating to Families with Children . . . . . . . . . . . . . . . . . . . . . . 7

Table 2: Summary o Education Provisions, 2009 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

Figure 2: The Process or Claiming the EITC and Additional Child Credit . . . . . . . . . . . . . . . . . 18

Table 3: Employer-Sponsored Retirement Plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

Figure 3: Retirement Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34

Table 4: Taxation o Social Security Benefts (Single Taxpayer) . . . . . . . . . . . . . . . . . . . . . . . . . . . 35

Table 5: The Gross Tax Gap, by Type o Tax, Tax Year 2001 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53

Table 6: Individual Income Tax Underreporting Gap andNet Misreporting Percentage, by Visibility Groups, Tax Year 2001. . . . . . . . . . . . . . . . . 54

Table 7: Marginal Eective Tax Rates on New Investment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67

Figure 4: Top Statutory Corporate Tax Rates U.S. and OECD . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67

Table 8: Shares o Total Business Returns, Receipts and Net Income, 1980-2007 . . . . . . . . . 74

Table 9: Special Tax Provisions Substantially Narrow the Business Tax Base . . . . . . . . . . . . . . 76


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II. SIMPLIFICATION OPTIONSetaxcodeiscomplex.iscomplexityimposessignicantcostsonaectedtaxpayersandisre-

ectedintheamountoftimeandmoneythatpeoplespendeachyeartoprepareandletheirtaxes.

Taxpayersandbusinessesspend7.6billionhoursandincursignicantout-of-pocketexpenseseach

yearcomplyingwithfederalincometaxlingrequirements. Inmonetaryterms,thesecostsareroughlyequivalenttoatleastonepercentofGDPannually(orabout$140billionin2008).ese

costsaremorethan12timestheIRSbudgetandamounttoabout10centsperdollarofincometax

receipts.eIRSestimatedthatfor2008,taxpayerslingForm1040spentanaverageof21.4hours

onfederaltax-relatedmatters.Mosttaxpayersabout60percentnowpaytaxpreparerstoll

outtheirreturns,andatleast26percentusetaxsoware.Speciallytargetedprovisionsnowrequire

low-incometaxpayers,SocialSecurityrecipients,individualssubjecttotheAlternativeMinimum

Tax(AMT),andmanyothergroupstocalculatetheirincomesmultiplewaysandmultipletimes.

eburdenofthiscomplexityfallsespeciallyheavilyonlower-incomefamiliesandonhouseholds

withcomplicatedlivingarrangements.Familiesclaimingachild-relatedcreditareabout40per-

centmorelikelytouseapaidpreparer,andmorethan70percentoflow-incomerecipientsoftheEarnedIncomeTaxCredit(EITC)usedapaidpreparertodotheirtaxes.Forbusinessesandthe

selfemployed,thecomplianceburdenisparticularlyhigh,andbecausethisburdenhasalargexed

component,thesecostsareregressive.

ecomplexityofthetaxcodeispartlytheresultofthefactthatnewprovisionshavebeenadded

oneatatimetoachieveaparticularpolicygoal,butwithinadequateattentiontohowtheyinteract

withexistingprovisions.isresultsinduplicativeandoverlappingprovisions,multipledeni-

tionsofconceptslikeincomeanddependentchildren,dierencesinphaseouts,anddierences

inthetimingofexpiringprovisions.Between1987and2009,theinstructionbookletssenttotax-

payersfortheForm1040increasedinlengthfrom14pagesto44pagesoftext.etaxcodehas

becomemorecomplexandmoreunstableoverthelasttwodecades,inpartbecauselegislatorshaveincreasinglyusedtargetedtaxprovisionstoachievesocialpolicyobjectivesnormallyachievedby

spendingprograms.erehavebeenmorethan15,000changestothetaxcodesince1986,anda

currentJCTpamphletlists42pagesofexpiringprovisions.

ecomplexityresultsinerrorsandmistakesthatadverselyaecttaxcomplianceandaddtoad-

ministrativeandenforcementcosts.InternalRevenueService(IRS)studiessuggestthatnon-com-

plianceishigheramonglersfacedwithcomplexeligibilityrulesandrecordkeepingrequirements.

Forexample,anIRSstudysuggestedthatbetween23and28percentofEITCpaymentsinscal

year2006wereincorrect.Similarly,theGovernmentAccountabilityOce(GAO)estimatedthat

fortaxyear2005,19 percentofeligibletaxlersfailedtoclaimeitheratuitiondeductionoratax

creditforwhichtheywereeligible.ecomplexityofthesystemalsomakesitharderfortheIRStodoitsjobbyincreasingthedicultyofidentifyingnon-compliantandimproperbehavior.

Beyondthesedirectcoststhatcanbemeasuredintime,money,andrevenuelosttononcompli-

ance,thecomplexityofthetaxsystemisatremendoussourceoffrustrationtoAmericantaxpayers,

reducesthesystemstransparency,andunderminestrustinitsfairness.

etaskforcereceivedmanydierentideasfortaxsimplication.Inthisreport,wegroupthese

ideasintoafewbroadcategories:SimplicationforFamilies;SimplifyingSavingsandRetirement


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Incentives;SimplifyTaxationofCapitalGains;SimplifyTaxFiling;SimplicationforSmallBusi-

nesses;andtheAMT.

a. Option Group A: Simplifcation or Families

Inourpublicmeetings,inconversationswithtaxexperts,andthroughsubmissionsfromindi-vidualtaxpayers,taxprovisionsrelatedtofamiliesandchildrenwereamongthemostcitedsources

ofcomplexityinthetaxcode.etaxcodeprovidesnumerouscreditsanddeductionsthatreduce

taxesforfamilieswithchildrenandforchild-relatedexpenseslikedaycareandeducationcosts.

ereisalsoaspecialratestructureforunmarriedindividualswithfamilyresponsibilities.Cur-

rently,morethan50milliontaxpayerswithchildrenclaimatleastoneofthesechild-relatedtax

benets;mostfamilieswithchildrenreceiveatleasttwoandfrequentlythreeormore.

Eachofthesechild-relatedprovisionshasdierenteligibilityrules,manyofwhicharedicult

tointerpretorenforceandsomeofwhichweheardcriticizedasunfairandarbitrary.Confusion

abouttherulesforthesebenetscontributestomistakesandnoncompliance.Inaddition,having

manydierentbenetsoenrequiresparentstomakemultiplecalculationstocomputeeachcredit

amount,eitherbecausethecreditsaredeterminedonaspecicdenitionofearningsoranalterna-

tivemeasureofincome,orbecauseabenetphasesoutincertainincomeranges.Someprovisions

canbecalculatedinalternativeways,requiringparentstotrydierentcalculationstopickthemost

advantageousone.esystemalsorequireschildren(ortheirparents)tolemillionsofreturns

thatraiselittlerevenue.

Togetanideaofwhythisisaproblem,taketheexampleofamiddle-classfamilywithteenagechil-

drenaged16and19,theeldestastudentwholivesawayatcollegeandissupportedbytheparents.

efamilyhastypicalmiddle-classincome,averybasicfamilystructure,andonlywageincome.

Undercurrentlaw,thefamilyiseligibletoclaimdependentexemptionsforbothchildren,allowingtheparentsadeductionagainsttheirtaxableincome.Becausetheyhaveonechildunder17they

arealsoeligibleforthe$1,000childtaxcredit.ecollegestudentistoooldforthechildcredit,but

theparentsmaybeabletoclaimoneofanumberofeducationcreditsforthestudentdependingon

theamountoftheireducationalexpenditures.

Despitethesimplicityofthissituation,theprocessforclaimingthebenetsforwhichthisfamily

maybeeligibleis non-trivial. einstructionsforclaimingthedependentexemptionincludea

multi-partchecklistandmorethantwopagesofinstructions.Adependentchildmustnormally

be18oryoungerandresidewiththeparents,butanexceptionappliesforastudentlivingawayat

school.(However,justbecausetheolderchildisacollegestudentforthepurposesofthedepen-

dentexemptiondoesnotnecessarilymakehimeligibleforeducationcredits,whicharegovernedbyothereligibilityandrecordkeepingrequirements.)Beforecalculatingthechildtaxcreditforthe

youngerchild,theparentsmustreadthroughaneligibilitytestintendedtoscreenouttaxpayersin

certainraresituations.Likethevastmajorityoffamilies,thesesituationsdonotapplytothefamily

inthissimpleexample,sotheycanskiptothenext(andforthemnal)step:a10-line,two-page

worksheetneededtocalculatethesizeofthechildtaxcredit.Inthistheyarefortunateafamily

withlessincomeormorechildrenmayneedtocalculateanalternativedenitionofincomeandle


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sionsin2011mayprovideanopportunitytoreviewandconsolidatetheremainingfamilyandde-

pendentprovisionswhileensuringthatthevastmajorityoflower-andmiddle-incomehouseholds

remainatleastaswelloastheywouldbeaertheprovisionsexpired.

Belowweoutlinefouroptionsforsimplifyingthetaxtreatmentoffamilies.Some(butnotall)of

theoptionscompriseseveralproposals.

i. Option 1: Consolidate Family Credits and Simplify Eligibility Rules

Recurrentcriticismsofthepresentfamily-relatedcreditsanddeductionsarethattherearetoomany

dierentcreditsandthatguringouthowtoclaimeachbenetisdicultandtimeconsuming.

Familiesoenreceivemultiplebenetsinasingleyear.In2005,morethan80percentoffamilies

claimingoneoftheEITC,ChildTaxCredit,ordependentexemptionclaimedmorethanoneand

almost30 percentclaimedallthree.Figure1illustratestheaveragenumberofchild-relatedcred-

itsandexemptionsclaimedpertaxpayerwithchildrenatdierentlevelsofincome.Asthegure

shows,taxpayersearningcloseto$25,000receive,onaverage,aboutthreedierentcredits.Asin-

comerisesthesecreditsphaseoutandtaxpayersbecomeineligibleforcertainbenets.Becauseof

theexpansionoftheEITCandthechildtaxcreditundertheAmericanRecoveryandReinvestment

Act(ARRA),thenumberoftaxpayersreceivingmultiplecreditshasincreased.

Figure 1: FamilyRelated Tax Credits per Family Taxpayer

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

0 20 40 60 100 140 180

Dependent Exemption Education CreditsChild Tax Credit EITC

Creditsclaimedpertaxpay

erwithchildren

Adjusted Gross Income ($ thousands)

Source:StatisticsofIncomePublicUseFile(2005).

isisburdensomebecauseeachcreditordeductionisgovernedbyslightlydierenteligibility

rulesandbenetcalculations.Table1providesadescriptionofthelargestchild-relatedbenets

andacomparisonofrulesthatgoverneachone.Asthetableshows,eachbenetisreduced(phased

out)inadierentrangeandatadierentrate.Manyofthecreditsrequiremultiple,sometimes

dozensoflinesofcalculations,andeachdenesaneligiblechildusingadierentcombinationof

age,residency,andrelationshiprequirements.


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Ta

ble1:

ComparisonoP

rovis

ions

Re

lating

toFam

iliesw

ithChildren

DependentExemption

ChildTaxCredit

EarnedIncomeTax

Credit

Childand

Dependent

CareT

axCredit

HeadofHousehold

FilingStatus

EducationCredits

Taxbenet(2009)

D

educ

tiono

$3

,650

oreac

hdepen

den

t.

Cre

dito

$1

,000

perc

hild

.Part

ially

reun

da

ble

.

Cre

ditup

to$3

,043

oronec

hild

,$5

,028

or

twoc

hildren,a

nd

$5

,657ormore

than

twoc

hildren.

Re

un

da

ble

.

Cre

ditoup

to35%

oup

to

$3

,000o

work-rela

tedexpenses

oronech

ild,

$6

,000i

more

thanone.

More

avora

blera

te

sc

he

du

lean

dhigher

stan

dard

de

duc

tion

than

oro

ther

unmarr

iedtaxpayers.

$2

,500or

American

Opportun

ity

Tax

Cre

dit

(AOTC);$2

,000or

Lie

time

Learn

ing

Cre

dit(LLC);an

d

others.A

OTCpart

ially

reun

da

ble

.

Phase-Out

Threshold(Joint

Filers)

Over

$250

,000

Over

$110

,000

Over

$21

,420

Phases-

down

in16

steps

rom

$15

,000to

$43

,000

.

NA

Over

$160

,000or

the

AOTC

.Over

$100

,000

or

LLC

.

Phase-OutRate

(JointFilers)

2.9

7percen

tper

exemp

tion

5percen

t

21

.06percen

t

Cre

dita

llsrom

35

percento

expenses

to20p

ercen

to

expenses

inp

hase-ou

t

ra

nge.

NA

12

.5percen

tper

studen

tor

the

max

imum

AOTCcre

dit

.

10percen

tor

LLC

.

MaximumLinesto

CalculateCredit

10

64

40

34

NA

42

AgeRequirement

Un

der

19orun

der

24

an

das

tuden

t;anyage

ipermanen

tlyan

d

totallydisa

bled

.

Un

der

17.

Un

der

19orun

der

24

an

das

tuden

t;anyage

ipermanen

tlyan

d

totallydisa

bled

.

Un

der1

3;anyage

iuna

ble

tocare

or

himsel

or

herse

l.

Un

der

19orun

der

24

an

das

tuden

t;anyage

ipermanen

tlyan

d

totallydisa

bled

.

Un

der

19orun

der

24an

das

tuden

t;any

age

ipermanen

tly

an

dtotallydisa

bled;

yourse

loryour

spousea

tanyage.

Residency

requirement

Q

ua

liy

ingc

hildmus

t

livew

ithtaxpayer

oroverone

ha

l

otheyear.

Other

n

on-qua

liyingc

hild

relativesmus

tlivew

ith

the

taxpayer

or

the

en

tireyear.

Excep

tion

ors

tuden

tsa

tsc

hoo

l.

Ex

cep

tion

or

divorce

d

paren

ts.

Sameas

depen

den

t

exemp

tion.

Childmus

tlivew

ith

taxpayer

oroverone

ha

lo

theyear.

Mus

tliv

ew

iththe

taxpay

er

or

the

perio

dduringw

hich

theexpenseswere

incurred.

Excep

tion

or

divorce

dparen

ts.

Qua

liy

ingc

hildmus

t

livew

iththe

taxpayer

oroverone

ha

lo

theyear.

Sameas

depen

den

t

exemp

tion.


19/130


Allofthesedierencesrequireparentsto consultpagesof instructions,multiplechecklists,and

occasionallyto turnto alternativepublications to determine whether their child or dependent

qualiesforacreditordeduction. Moreover,becauseeligibilityrulesforcreditsaresimilarbut

notidentical,manyofthesetaxformsandchecklistsaskforsimilaror,insomecases,exactlythe

sameinformation.Forexample,aparentclaimingthedependentexemption,thechildtaxcredit,

EITC,anddependentcarecreditmustreportthesamechildsnameandSocialSecuritynumberfourtimes,andmayhavetocalculateandreporttheirearningsonfourdierentforms.Because

thephase-outsofthesecreditsarealldierent,eachcreditmayneedtobecalculatedseparately.

Incertaincases,thebenetamountmustbecalculatedusingalternativemeasuresofincome.For

example,thedependentexemptionanddependentcarecreditphaseoutasadjustedgrossincome

(AGI)increases,butthechildtaxcreditphasesoutwithamodiedversionofAGI;theEITC,addi-

tionalchildtaxcredit,anddependentandchildcarecreditsuseearningsintheircalculationsand

thedenitionofearningsisnoteventhesamefortheEITCandadditionalchildtaxcredit.

Manyfamilieswillnotreceivethesamesetofbenetsfromyeartoyear.Manyfamilieswithtran-

sitorily lowincomebecauseof unemployment,maternityleave,orillnesswillbe eligibleforthe

EITCforonlyoneyear.Childrenwillageoutofthedependentandchildcarecreditat13andthechildtaxcreditat17.eywillbecomenewlyeligibleforeducationbenetsat18or19butmaynot

receivethesameeducationcreditforeachyearofschool.islackofconsistencyrequiresparents

tolearnnewruleseachyearandreducesthefamiliarityoftaxpayerswiththebenetsforwhich

theyareeligible.

Consolidating taxbenets forfamilieswouldreducethe numberof creditsanddeductionsand

standardizeeligibilityrules,eliminatingmuchofthecomplexity,computationalburden,taxpayer

confusion,anddicultieswithenforcementinthecurrentsystem.Aconsolidationthatreduced

thenumberofcreditsneednotreducetaxbenets;benetamountscouldbeadjustedtomaintain

thecurrentlevelanddistributionofsuchbenets.Asnotedabove,mostparentsreceivemultiple

credits.Moreover,mostofthedierencesineligibilityforfamilyandchildcreditsdependonfam-

ilyincomeandtheagesofchildren,suggestingthatsomecreditscouldbecombinedbyadjusting

ageorincomeeligibilityrules.Consolidatingcreditsmaytakeanynumberofpermutations,but

somegeneralprinciplesapply.issectionprovidesthreeexamplesofconsolidationstoillustrate

potentialoptionswiththeprosandconsofeach.

1. Consolidate Family Benefts into a Work Credit and a Family Credit

Te proposal and its advantages:

eexpertsweheardfromrepeatedlyreferencedanoptionadvocatedbythe2005TaxReformPan-elandmodiedinapolicypaperfromtheCenteronBudgetandPolicyPrioritiesbyJasonFurman.

Inthe2005Panelsoption,thedependentexemption,standarddeduction,andchildtaxcredit

wereconsolidatedintoaFamilyCreditavailabletoalltaxpayers,andtheEITCwasreplacedbya

WorkCredit.edependentcarecreditwaseliminated,andspecictaxbenetsforhigheredu-

cationwerereplacedwithasimilarlygenerousextendedfamilycreditforfulltimestudentsunder

age22.evalueofthesenewcreditswascalibratedtomirrorthelevelanddistributionofbenets

availabletofamiliesundercurrentlaw.


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Advocatesofthissystempointtonumeroussimplications.isoptionreplacesanarrayoftax

benetswithtworelativelysimplecredits,eliminatinganumberofoverlappingprovisions.e

FamilyCreditwouldprovideauniformtaxbenetthatdoesnotphaseoutwithincome,eliminat-

ingthephase-outcalculationsofthepersonalanddependentexemptions,thechildtaxcredit,and

thedependentandchildcarecredit.eWorkCreditwouldreplacetheEITCandtherefundable

portionofthechildtaxcredit,andwouldmaintainworkincentives.Calculatingbenetswouldbesimpliedbecauseduplicativecomputationsofincomeandearningswouldbeeliminated.Replac-

ingmultipleeducationbenetswithaxedbenetforfamilieswithfulltimestudentswouldmain-

tainthesubsidytopursuehighereducation,butwithoutthecomplexitiesassociatedwithclaiming

educationbenetsandrequirementstomaintainrecordsforqualifyingexpenses.Withonlytwo

credits,anumberofstepsinthetaxlingprocesswouldbeeliminated.Additionally,withfewer

credits,theabilityoftaxpayerstogamethesystembyshiingdependentsbetweenunmarriedpar-

entsortootherrelativestoachievelargertaxbenetswouldbereduced,improvingcompliance.

Disadvantages:

Inordertosimplifythecalculationofbenets,theFamilyCreditproposedbythe2005TaxReformPanelwouldnotphaseoutwithincome,asdoesthechildtaxcreditandotherbenetsundercur-

rentlaw. Intheabsenceofphase-outs,theproposalwouldsignicantlyincreasethecostofthe

creditandloserevenuerelativetocurrentlaw.Somenon-standardstudentsolderstudentsor

part-timestudentscouldloseeducationcredits.Inaddition,thevalueoffamily-relatedbenets,

particularlyrefundablecredits like theadditionalchildtax creditand theEITC,haveincreased

since2005,makingthedistributionoffamily-relatedbenetsmorevariableacrossincomegroups.

Withonlyonephase-outofbenetsintheWorkCredit,the2005Panelsrecommendationwould

notreplicatethecurrentprogressivityoffamilybenets.Intheabsenceofotherchangestothetax

system,twooreventhreephase-outswouldbeneededtoapproximatethephase-outsoftheEITC,

thechildtaxcredit,educationbenets,andthepersonalexemption,andachievetheprogressivity

ofthecurrentsystem.

Movingfromsixtypesoffamilybenetstotwowouldalsoreducetheabilitytousethetaxcodeto

targetbenetstospecicgroups.ecurrentsystemreectsadesiretoprovidegreaterbenetsto

youngerchildren,totaxpayerswithhighereducationexpensesorchild-careexpenses,tofamilies

incertainlivingarrangements,andtotaxpayersbasedontheirmaritalstatus.Consolidatingcred-

itswouldresultinthesedierentgroupsfacingmoresimilartaxburdens.

2. Combine the EITC, Child Tax Credit, and the Child Dependent Exemption


esethreeprovisionswouldbecombinedintoasinglefamilybenetwithharmonizedeligibility

requirements,andthecreditwouldberefundablefortaxpayerswith(uniformlydened)earned

income. isoptionwouldreducethecomplexityoffamily-relatedbenetsbyeliminatingtwo

provisions(andtheirassociatedinstructions,checklists,andworksheets).Multiplecomputations

fortheadditionalchildtaxcreditandEITCwouldbeeliminated,andothereligibilityruleswould

beharmonized,streamliningthelingprocess.


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Disadvantages:

Becausethephase-outsforeachofthesecreditsdiersubstantiallyundercurrentlaw,amorecom-

plicatedphase-outschedulewouldberequiredtomaintainthecurrentdistributionofbenets.e

age-eligibilityrulesofthedependentexemptionandchildcreditdier.Hence,extendingtheben-

etsofthechildtaxcredittohigher-incomechildrenwouldeitherreducetaxrevenuesorrequire

areductionintaxbenetsforchildrenunderage17.edependentexemption(orasimilarben-et)wouldberequiredfornon-childdependents,likeelderlyparents,limitingthesimplication

benets.Harmonizingrulesacrossthesecreditscouldraisetaxesforcertaingroupsforexample,

applyingtheEITCeligibilityrulestothecombinedcreditwouldeliminatechild-relatedbenetsfor

non-U.S.residentsandfornon-custodialparents.

3. Consolidate the Child Tax Credit and Dependent Exemption, and Repeal(or Reduce) Some Education Credits


isoptionwouldapplythesameagetestsusedforthedependentexemptiontothechildtax

credit,allowingfamilieswithchildrenunderage24whoarefull-timestudentstoreceivethechild

taxcredit.eeducationcreditsavailabletothisgroupwouldthenbereducedorrepealed,butthe

LifetimeLearningCredit(LLC)wouldbeoeredtotaxpayerswhocannotbeclaimedasdepen-

dents.Inadditiontotheadvantagesofthepreviousoption,additionalsimplicationwouldarise

byreplacingthemultitudeofeducationbenetswithasimpleatcredit,eliminatingthird-party

reportingfromuniversitiesandburdensomerecordkeepingforexpenseslikebooksandsupplies.

Complianceandenforcementofthesecreditswouldimproveandtaxpayerswouldnolongerneed

tomakemultiplecalculationstolearnwhicheducationcredittotake.

Disadvantages:

Again,dependingonthevalueoftheconsolidatedcreditandthequaliedexpensesofstudents,

somefamiliesmayreceivelargerorsmallercredits.

ii. Option 2: Simplify and Consolidate Tax Incentives for Education

etaxsystemincludesatleast18dierentprovisionsbenetingtaxpayerswitheducationalex-

penses(seeTable2).Someprovisionsreducethecostofeducationdirectly,includingtheAmeri-

canOpportunityTaxCredit(AOTC),theLLC,thetuitionandfeesdeduction,andthestudentloan

interestdeduction.Otherprovisionsencouragesavingforfutureexpenseswithsavingsbondsor

throughtax-preferredaccounts(thesearediscussedingreaterdetailinthesectionundersavings

incentives).


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24/130


epurposesofthedierentcreditsandprovisionsdescribedinTable2aretoencourageeduca-

tionalinvestmentandtohelpreducethecostofhighereducation.However,theexpertsweheard

fromarguedthatthecurrentmultiplicityofcreditsis,atbest,aninecientwaytoachievethose

goals.First,thecurrentsystemobscuresthetaxbenetofeducationalinvestmentsuntilaerthey

aremade.isreducesthevisibilityoftheincentivesandmakestheseprovisionslesseectiveat

promotingeducationalinvestment.Moreover,taxcreditshaveuptoa10-monthlagbetweenwhentuitionorothercostsareincurredandwhenthecreditisawarded,somethingthatposesintolerable

nancinghardshipsonthosewithoutsubstantialincomeorotherresources.Asecondconcernis

thatthetaxbenetsforwhichastudentattendingcollegeiseligiblearediculttounderstand.For

example,severaloftheeducationbenetsaremutuallyexclusiveaparent(orstudent)mayclaim

onlyoneofthedeductionfortuitionandfees,theLLC,ortheAOTCforaparticularstudent.

ustaxpayersmustevaluatemultipleprovisionsandmakealternativecalculationsoenwell

aereducationalexpendituresaremadetogureouttheireligibilityfordierenttaxcreditsand

theamountsforwhichtheyareeligible.us,theincentivesinthesecreditsareneithertranspar-

entenoughnortimelyenoughtoencourageeducationformanytaxpayers.Expertscontrasted

thesebenetswiththeprogramofPellGrants,whichtargetlower-incomegroupsandareawardedconcurrentlywithapplicationandadmissiontocollege.ManyarguedthatPellGrantsaremore

helpfultothepoorandtomiddle-incomehouseholdsthanrefundablecredits,andthatincreas-

ingeducationalfundingforthesegroupsmaybebetterdonethroughimprovedPellGrantsthan

throughthetaxsystem.

Anotherconcernisthatthecreditsandotherprovisionsarethemselvescomplexandconfusing,

makingithardfortaxpayerstoclaimthebenetsproperly.epublicationthatdiscusseseduca-

tionbenetsoers11denitionsofaqualifyingexpenseandaqualifyinginstitutionforatotal

of12education-relatedtaxprovisions.Inmanycases,thesealternativedenitionsimplysubstan-

tivedierencesinwhatqualiesforataxbreak:taxpayerscannotclaimmostcreditsforcostsof

roomandboard,butmayusefundsfromaneducationsavingsaccountordeductinterestfromastudentloantopayforthosecosts.Similarly,theAOTCisavailableforastudentpursuingadegree

intherstfouryearsofpost-secondaryeducation,whiletheLLCisavailableforanunlimitednum-

berofyearsandtonon-degreestudents.TaxpayersmaytakemultipleAOTCsformultiplestudents

butonlyoneLCCindependentlyofthenumberofstudents;theymaybeunawarethattheycan

taketheAOTCforonestudentandtheLLCforanother. esystemissucientlycomplicated

thatmanytaxpayersfailtoclaimeducationbenetstowhichtheyareentitled.eGAOreported

that19percentofeligibletaxlersin2005didnotclaimeitheratuitiondeductionorataxcredit

thatcouldhavereducedtaxliabilitybyanaverageof$219,probablyduetothecomplexityofthe

taxprovisions.Taxpayersmayalsoerroneouslyclaimtaxbenetstowhichtheyarenotentitledor

maynotclaimthecreditwhichwouldbemostadvantageoustothem.

Finally,thesystemimposessizablecomplianceandrecordkeepingburdensonstudents,parents,

andeducational institutions. Collegesanduniversities must documentenrollment andtuition,

andtaxpayersmustdocumentandmaintainrecordsofpaymentsforqualiedtuitionandfeesand


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othernon-reportedexpenses,likebooksandsupplies.1Administeringthesebenetsisdicult

becausetheIRScannotevaluatemanyclaimswithoutanintrusiveaudit.

Overall,thesystemofeducationtaxbenetswouldbemoreeectiveiftheincentivesweremore

transparentandtimely,andbenetswereeasiertoclaimandenforce.


Replacing the large number of subsidies that exist to help taxpayers pay forcurrenteducation

expenseswithoneortwoalternativeswouldeliminatemultiple,redundantdenitions,pagesof

instructionsandworksheets,andwouldreducetheneedforindividualstocomputetheirtaxes

multipletimes.Taxpayerswouldknowinadvancewhichcredittheyareeligibleforandwhat

amounttheywouldreceive,increasingthetransparencyofthetaxcodeandthesalienceofincen-

tives. Harmonizingthedenitionof qualiededucationalexpenseswouldhelpfamiliesunder-

standwhichexpensesaredeductibleandwhicharenot.Fromanadministrativeperspective,itis

importanttorecognizethatcomplianceandadministrationareeasierforqualiedexpenseslike

tuitionforwhichthereisgoodthird-partyreporting,andmoredicultforexpensesthatarehard

fortheIRStodocumentlikeexpensesforbooks,orexpensesthatmightbeconsideredabusive,likerentforaluxurycondo.

Someexpertssuggestedmodestchangeslikeallowingthetuitionandfeesdeduction,whichis

redundantformostfamilies,toexpirewhilesimplifyingandnarrowingthedenitionofqualied

expensesforcertainbenets.Amorebroad-reachingreformwouldconsolidateeducationcredits

withotherfamily-andchild-relatedcredits.Forexample,oneproposalwouldextendeligibilityfor

thechildtaxcredittoanytaxpayerclaimingadependentexemptionforafulltimestudentupto

age23,whileeliminatingorreducingcertaineducationcredits.isproposalcouldreplacehard-

to-administerandunderstandeducationcreditswiththerelativelysimplechildtaxcreditrequiring

littlerecordkeepingorcomplianceeort.

eliteratureonbehavioraleconomicsemphasizesthatthepresentationofincentivesoenaects

thechoicesindividualsmake.Recentresearchshowsthatsimplyllingoutfederalstudentaid

formsatthetimetaxpayersletheirreturnswouldinuencethelikelihoodthattheyenrollthem-

selvesortheirchildreninschool.isresearchsuggeststhatabetterintegrationofstudentaidpro-

visionswiththetaxsystemandamorevisiblepreviewofthetaxbenetsavailabletostudentscould

encourageenrollmentwithoutrequiringincreasesinthevalueofgovernment-providedsubsidies.

Disadvantages:

Aconcernwithaconsolidationofcreditsisthatthecurrentvariationincreditsandeligibilityrules

reectsthevariationintypesofstudentsandtypesof educationalinvestments. eAOTCandLLCprovideoverlappingcoveragetomostcollegestudentsandmostchoosetheAOTCbecauseof

itsmoregenerousbenets.However,aconsolidationthateliminatedtheLLCwouldeitherdeprive

about7millionpart-timestudentsfromtheseeducationbenetsorextendmorecostlybenetsto

thislargegroup.Similarly,aproposaltoreplacecertaineducationcreditswithanextendedchild

taxcreditwouldneedtoaddressbenetsforthealmost7millionstudentsovertheageof25.Har-

1 Universitiescanreporteithertuitionbilledortuitionpaid,whichmayleadtoconfusiononthepartofthetax-payeranderrorsintheamountsofdeductionstheyclaim.


26/130


monizingrulesregardingqualiedexpenseswouldalsorequirediculttradeos.Partofthecom-

plexity,recordkeeping,andadministrativeburdenarisesfromhard-to-documentexpensesrelated

tobooks,supplies,androomandboard.Eliminatingtheseexpenseswouldsimplifythecreditand

improvecompliance,butwouldprovideequaltreatmenttotaxpayerswithunequalexpenditures.

iii. Option 3: Simplify the Kiddie Tax (Taxation of Dependents)

Currentlawrequiresapproximately10milliondependentstoletaxeseachyeartoreportrelatively

smallamountsoftax.iskiddietax,enactedtopreventparentsfromreducingtheirfamilystax

liabilitiesbyshiinginvestmentincometotheirchildren,includesrulesthatcanrequireadepen-

denttoleareturnwithaslittleas$950ofinvestmentincome. Ifinvestmentincomeexceedsa

secondthresholdof$1,900,theincomeistaxedatratesthatdependontheincomeofsiblingsand

parents.etaxgenerallyappliestochildrenunderage18,full-timestudentsage19to24whocan

beclaimedasdependentseveniftheyarenotclaimedandtoelderlyordisableddependents.

Abouthalfofkiddietaxlersarecollegestudentsandabout40percentarebetweenage14and 18.

In2005,5.7milliondependentlers(outof9.9million)paidlessthan$50intaxes,andmostofthose5.7millionowednotaxesandledonlytogetarefund.

Inadditiontostringentlingrequirements,thetaxcalculationitselfisparticularlycomplex.Inthe

mostbasiccaseofdependentsreceivingonlyinvestmentincome,therst$950isexemptbasedon

aspecialstandarddeductionfordependentlers,thenext$950istaxedatthedependentstaxrate,

andadditionalincomeistaxedattheparentstaxrate,ifhigher.Ifthedependenthasearnedin-

come,sayfromasummerjob,thestandarddeductionismorecomplexanddependsonthecombi-

nationofearnedandinvestmentincome.Inmostsituations,thedependentsstandarddeductionis

lessthanthestandarddeductionforothersinglelers.Ifaparenthasmorethanonechildsubject

tothekiddietax,anevenmorecomplicatedprovisionrequiresaddinguptheinvestmentincome

ofallthechildrenandtheparentsandthenallocatingtheresultingadditionaltaxamongthechil-drenstaxreturns.Navigatingtheserulesrequiresa28-pageIRSbookletthatincludesworksheets

tocalculatethedependentstaxableincomeandtaxliability.

einterdependencebetweenadependentstaxreturnandthatofsiblingsandparentscancreate

signicant issuesin certainsituations. First,this requirescoordination amongfamilymembers

whenlingtaxes,whichmaybedicultwhenstudentsareawayatcollegeorwhenfamilydisputes

makeitdiculttoobtaintherequiredinformationaboutparentsreturns.Additionally,interde-

pendencerequiresspecialrulestodealwithamendedreturnsandtheAMT.eseprovisionsap-

plytoindividualswhocouldbeclaimedasdependentsofanothertaxpayerregardlessofwhether

theyareactuallyclaimedornot.us,aparentdoesnotescapethecomplexitysimplybynot

claimingadependent.Collegestudentswhocouldbeclaimedasdependentsshouldbelingtheir

returnsasdependentlersandmayneedtocoordinatetheirreturnswiththoseoftheirparentsand

siblingsiftheyaresubjecttothekiddietax.Inmanyinstances,thekiddietaxcouldbeconsidered

tobeataxonafamilyslackofsophistication.atistypicallythesituationwhenfamiliesdonot

understandorusethespecialtaxprovisionsthatprovidefavorabletaxtreatmentforfundssetaside

forthedependentseducation.


27/130


Te proposals and their advantages:

eburdenofthekiddietaxarisesbecauseofthelowlingthresholdthatrequirestaxpayerstole

millionsofreturnsthatgeneratelittlemoney,becauseofthefactthatmillionsmustleforrefunds

despiteowingnotaxes,andbecausethecomputationoftherequiredtaxisitselfcomplicated.e

lingburdencouldbereducedbyraisingthestandarddeductionfordependentsandbyimprov-

ingrulesforwithholdingsothatfewerdependentworkershadtaxeswithheldonsmallamountsofincome.Providingasafeharborwithholdingexemptionforyounglers(lessthanage18,for

example)wherebyindividualsandemployerswerenotpenalizedforimposingzerowithholding

wouldreducethenumberof dependentsrequiredto lejusttoreceivearefund.Becausethese

taxpayersowelittleintaxes,thecomplianceissuesandrevenueconsequenceswouldbesmall.

Similarly,raisingthestandarddeductionfordependentscouldreducetheburdenoflingsigni-

cantlyatarelativelysmallrevenuecost;doublingthe$950standarddeductionto$1,900makesa

singlethresholdatthecurrentkiddietaxlevelandmakes300,000dependentreturnsnon-taxable.

erearealsoseveraladvantagestosimplifyingthetaxcalculationfordependentswhomustle.

First,eliminatinganyinteractioninthecalculationofthetaxratebetweenthedependentsincome

andsiblingsincomewouldreducethenumberofcomputationsrequiredatrelativelysmallrevenue

cost.eadditionalstepofeliminatinginteractionswithaparentstaxratewouldprovidegreater

simplication,butpolicymakerswouldneedtochoosewhichtaxratetoapplytoadependents

investmentincometoensurethatparentswerenotavoidingtaxesbytransferringassetstotheir

children.Oneoptionwouldtaxadependentsordinaryincomeandamodestamountofinvest-

mentincomeatthetaxratefordependentsandthentaxanyremaininginvestmentincomeatthe

maximumrate.Anotheroptionwouldusetheratescheduleforduciaryreturns,whichhasnar-

rowertaxbrackets.

Disadvantages:

Raisingthelingthresholdorincreasingtheamountofincometaxedatthedependentratecouldincreaseparentsincentivetoshelterinvestmentincomeastheirchildrens,sincethetaxratefor

childrenisgenerallylowerthanthatoftheparents.Simplicationthatappliedthetoptaxrateto

thedependentsincomeoverathresholdtodiscouragesuchshelteringcouldraisetaxratesonde-

pendentswithrelativelymodestamountsofincome.Taxinginvestmentincomeofdependentsat

themaximumratecouldbeviewedaspunitiveasitwouldmeantaxingthatincomeataratehigher

thantheparentsrateinmostcases.

iv. Option 4: Simplify Rules for Low-Income Credits, Filing Status,

and Divorced ParentsAnumberofexpertscitedtherulesthatapplytolow-incomeprovisionsliketheEITC,thechildtax

credit,andheadofhouseholdlingstatus,asparticularlycomplex,inconsistent,diculttointer-

pretandtoenforce,andinequitable.eseprovisionsproviderefundablecreditsforlow-income

householdsandreducethetaxburdenforfamilieswithchildren.

SomeofthecomplexityassociatedwithclaimingthesecreditsisillustratedinFigure2,which

showstheactualchecklists,worksheets,andformsalow-incomeparentmustnavigatetoclaimand


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calculatetheEITCandtherefundablechildtaxcredit.Additionalcomplexityarisesfromthevaria-

tionindenitionsandeligibilitycriteriaforthedierentprograms.Becausetheeligibilitycriteria

aectonlyaverysmallsubsetoftaxpayersformanyoftheseprovisions,theadditionalcomplexity

provideslittlebenetintermsofrevenuecollection.

Anadditionalcostofthecomplexityoftheseprovisionsisincreasednoncompliance.According

totheIRS,errorsinclaimingtaxcreditsanddeductionsincludingthosedescribedabovecontrib-

uted$32billiontothetaxgapin2001.InitsmostrecentstudyofEITCnoncompliance,theIRS

estimatedthattheEITCover-claimratewasabout27percent.Whilecomplexityisoencitedasa

reasontaxpayersoverclaimcredits,otherstudiespointoutthatbetween15and25 percentofap-

parentlyeligibleindividualsdonotclaimtheEITC,possiblyduetothecomplexityoftheeligibility

rulesandthecreditcomputation.Hence,thecomplexityoftheseprovisionsalsoresultsintaxpay-

ersforgoingthebenetstheyareprovidedbylaw.

1. Harmonize the EITC and Additional Child Tax Credit

Figure2 showstheactualformsataxpayerclaimingboththeEITCandtheadditionalchildtax

creditmayneedtoletoclaimthesebenets(andthegureexcludesotherformsforotherbenets

suchaparentwouldlikelyclaim).Muchofthecomplexityillustratedinthegurearisesbecause

ofdierencesbetweentheEITCandtheadditionalchildtaxcreditthatrequiretaxpayerstoassess

eligibilityunderdierentrulesandtocalculatebenetsindierentways.Forexample,boththe

EITCandtheChildTaxCreditarepredicatedonearnedincome.However,thedenitionofearned

incomediersbetweenthetwocredits,andfamilieswiththreeormorechildrencanchooseamong

alternativedenitionsofearningsforthechildtaxcredit.islatterprovisionalonerequiresover

onemillionfamiliestocomputetheircreditstwiceinordertomaximizetaxsavings.


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Figure 2: The Process or Claiming the EITC and Additional ChildCredit

Form 1040 Instructions:

Lines 64a and 64b Earned Income Credit (EIC)

(Steps 1-2)


Lines 64a and 64b EIC(Steps 3-4)


Worksheet A EIC Lines64a and 64b

Form 8812 Additional

Child Tax Credit

Pub. 972: 1040 and

1040NR Filers EarnedIncome Worksheet

Form 1040 Instructions: Child Tax

Credit Worksheet Line 51 (Part 1)


30/130



Lines 64a and 64b EIC(Steps 5-6)

Schedule EIC Earned

Income Credit


Worksheet B EIC Lines64a and 64b (Parts 1-4) Form 1040 Instructions:

Worksheet B EIC Lines64a and 64b (Parts 5-7)


Earned Income Chart Line 4a

Pub. 972: Child Tax Credit

Worksheet (Part 1)

Pub 972: Child Tax Credit

Worksheet (Part 2)


31/130


Totargetbenetstotheneedy,theEITCusesinvestmentincomeasaproxyforwealth,andin2010

limitseligibilitytofamilieswithunder$3,100ininvestmentincomefromsourceslikecapitalgains,

propertysales,rents,royalties,andnetincomefrompassiveactivities.istest,whichisnotap-

pliedtotherefundablechildtaxcredit,requiresadditionalinstructionsanda16-lineworksheet.


Harmonizingtherulesgoverningeligibility,thedenitionofearnedincome,andthecalculationof

benetsfortheEITCandthechildtaxcreditwouldeliminatethemultipleschedulesrequiredfor

familieswiththreeormorechildren.iscouldpotentiallyhalvethenumberofcalculationsand

worksheetsneededtogurethesecreditsandeliminatepagesofinstructions.

Inaddition,reducingthescopeofthedenitionofdisqualiedinvestmentincometoonlythemost

commonincomesourcesreportedonthe1040wouldreducethecomplexityoftheinstructions.

Eliminatingthetestentirelywouldprovidefurthersimplication,andwouldreducetheimplicit

taxonsavingandassetaccumulationin workingfamilies. Alternatively,thesametestcouldbe

appliedtoboththeEITCandtheadditionalchildtaxcredit.iswouldbeasimplicationinthe

sensethatfamilieswouldfaceconsistentrequirementsforbothcredits.

Disadvantages:

ecomplexityofthesecreditspartiallyreectsthedesiretotargetbenetstocertaingroups.A

harmonizationofrulesthat adoptedthe EITC denitionofearnings andof qualifyingchildren

wouldreducethesizeoftherefundablechildtaxcreditforcertaingroups,oreliminateitentirely

forsomefamilieswiththreeormorechildren.Forexample,endingmultiplecomputationsforthe

childtaxcreditwouldeliminatethechildtaxcreditforafewhundredthousandfamilieswiththree

ormorechildrenlivinginPuertoRico,whocurrentlylelargelytoreceivethisbenet.

Eliminatingorsimplifyingthedisqualiedincometestwouldexpandeligibilitytofamilieswith

potentiallyconsiderableassetsandwealth;withouttheinvestmentincometest,about500,000tax-payerswouldbecomeeligiblefortheEITC.Asimplication(ratherthanelimination)ofthetest,

however,wouldexpandeligibilitylessandatasmallerrevenuecost.Alternatively,applyingthe

disqualiedincometesttotheadditionalchildtaxcreditwouldreduceeligibilityforthatcreditand

increaserevenues.

2. Simpliy Filing Status Determination

Unmarriedtaxpayerslivingwithdependentsmayqualifytoleasheadofhousehold,alingstatus

thatprovides a largerstandarddeduction andmoregeneroustax brackets. Similarly, taxpayers

whoqualifyassurvivingspousesaerthedeathofaspousemayusethesamestandarddeduc-tionandtaxbracketsappliedtomarriedcouples.Ineithercase,toqualify,a taxpayermustpay

overhalfthecostofmaintainingthehomeinwhichheorsheresideswiththedependentduring

theyear(thehouseholdmaintenancetest).istestisburdensomebecauseitrequirestaxpayers

toproduceandretaindocumentationshowingtheirhouseholdexpenditures,andbecauseofthe

complicateddenitionofwhatisorisnotaqualifyingexpenditure.erecordkeepingrequire-

mentsareafrequentsubjectofenforcementdisputesbecausetheycannotbeveriedintheabsence

ofacumbersomeaudit.


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Eliminatethehouseholdmaintenancetestforunmarriedtaxpayerswhoresidewithandclaima

dependent,andallowthemtoclaimheadofhouseholdlingstatus(orsurvivingspousestatus)

withoutregardtowhethertheymaintainthehomeinwhichtheyreside.Alternatively,eliminate

headofhouseholdlingstatusentirelyandrequirethatunmarriedtaxpayerslereturnsassingle

lers.Eitherofthesechangeswouldeliminatealengthyworksheetanditsinstructions,andreducerecordkeepingformorethan24millionlers.Eliminatingheadofhouseholdlingstatusentirely

wouldremoveaseparateratescheduleandstandarddeduction.

Disadvantages:

isoptionwouldcausemarriagepenaltiestoincreaseunlessspecialruleswereappliedforunmar-

riedparentswhoresidetogether.Asinglehomewithmultiplefamiliescouldpotentiallyinclude

multipleheadsofhousehold.Ifheadofhouseholdlingstatuswereeliminated,thestandardde-

ductionforhouseholdheadswouldshrinkandsometaxpayerswouldbebumpedintohighertax

brackets.e2005TaxReformPaneladvocatedeliminatingheadofhouseholdlingstatus,but

suggestedaddressingthesedistributionalconcernsbyreplacingitwithataxcreditforunmarriedindividualswithfamilyresponsibilities.

3. Eliminate the Household Maintenance Test or Estranged Spouses

MarriedindividualscannotclaimtheEITCunlesstheylejointlyorunlesstheyqualifytoleas

headofhouseholdasanestrangedorabandonedspouse.Toqualifyasanabandonedspouse,a

taxpayermustlivewithhisorherchildapartfromhisorherspouse,andmustalsopassthehouse-

holdmaintenancetestdescribedabove.Becauseofthecomplexityoftheruleandthediculty

ofmaintainingappropriaterecords,thisrulecontributessignicantlytonon-compliance:almost

11percentofEITCoverpaymentsin1999wereduetomarriedtaxpayerslingassingleorheadofhouseholdwhodidnotmeettherequirements.Manyoftheseclaimswouldnotbeerroneous

absentthehouseholdmaintenancetest.


Eliminatingthetestwouldreducetherecordkeepingburdenofthisprovisionandimprovecompli-

ance.(Analternativeproposalwithasimilareectwouldallowmarriedtaxpayerswholesepa-

ratereturnstoclaimtheEITCprovidedtheylivewithachildandapartfromtheirspouse.)is

wouldalsoimproveequitybyextendingthesametreatmenttoabandonedspouseswhomaybe

unabletoprocureadivorceascurrentlyprovidedtodivorcedparentswhoautomaticallyqualifyfor

theEITC.istreatmentwouldmorecloselyreectthetreatmentofotherchild-relatedbenetslikethechildtaxcreditanddependentexemption,whichareavailableindependentlyoflivingar-

rangementsandtomarriedtaxpayerslingseparatereturns.ecurrenttestcontributestoacci-

dentalnoncompliancebecausetaxpayersinthesesituationsappeartoclaimtheEITCerroneously,

notrealizingtheyareineligible.


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Disadvantages:

Eliminatingthetestwouldexpandeligibilitytoabroadergroup.However,therevenuelossislikely

tobemodest,inpartbecausemanyineligibletaxpayersalreadytakeuptheEITCmistakenly.

4. Simpliy the EITC or Childless WorkersTe proposal and its advantages:

erulesthatapplytolow-incomefamiliesincomplicatedlivingsituationsareasourceofaddi-

tionalcomplexitywhenclaimingtheEITC.Aworkerthatliveswithaqualifyingchildbutdoes

notclaimthechildfortheEITCmaynotclaimtheEITCforchildlessworkers.ismeans,forex-

ample,thatanunclethatliveswithhissisterandherchildisnevereligibletoclaimachildlessEITC.

AllowingrelativeswhoarenotthechildsparenttoclaimtheEITCforchildlessworkersevenifthey

livewithaqualifyingchildwouldequalizethetreatmentofsimilarindividualsregardlessoftheir

livingarrangementsandwouldeliminateanerror-provokingregulation.

Disadvantages:

ExpandingEITCeligibilitywouldreducerevenues.However,themaximumchildlessEITCis$457

and,inpractice,manyindividualsaectedbytheruleprobablyalreadytakethecrediterroneously,

implyingtherevenuelosseswouldbesmall.Someofthetargetingthatmotivatesthecurrentcom-

plexitywouldbelost,andthesimplicationgainswouldbeminimizedbecauserulesprohibiting

co-residentunmarriedparentsfromreceivingthechildlessEITCwouldberequiredtoreducemar-

riagepenalties.

5. Clariy Child Waivers in the Event o Divorce or Separation

erulespertainingtodivorcedandseparatedparentsareparticularlycomplexanddissimilarto

therulesthatapplytootherparents.Divorcedorseparatedparentsareallowedtoexchangetheir

rightsto certainchild-relatedbenetsthe dependentexemptionandthechildcreditbutnot

others,liketheEITC.eserulesburdenalltaxpayerswhoreadinstructionsandllinchecklists.

eyalsoburdendivorcedfamilies,whomayhavetocomputetheirtaxesunderdierentscenarios

tocalculatetheirmaximumtaxsavings.Moreover,thesebenetsareincreasinglylitigatedinchild

supportordivorcesettlements,resultinginapatchworkofrulingsfromstatecourtsthatnowde-

terminewhomayclaimthesefederalbenets.erulealsoreducesEITCcompliancebecause

noncustodialparentswhoclaimthechildtaxcreditandotherbenetsmayalsointentionallyor

erroneouslyclaimtheEITCaswell.Finally,thissituationmayproduceadivorcesubsidybypro-

vidingparentswiththeabilitytolowertaxesbyseparating.


Oneoptiontoaddressthissituationistoeliminatetheabilityofdivorcedorseparatedparentsto

exchangetaxbenets.iswouldsimplifytheinstructionsforalmostallchild-relatedbenetsby

eliminatingthespecialprovisionsfordivorcedparents.iswouldalsoimprovehorizontalequity

bytreatingpeopleinsimilarcustodialandresidentialsituationsthesameway.


34/130


Disadvantages:

Adownsidetothisisthatitcouldincreasecomplexityintheinterimifcurrentagreementswere

grandfathered. Suchachange wouldincreasetaxesonnoncustodialparentscurrentlyclaiming

child-relatedbenetsandwouldreducetaxesoncustodialparents.eeconomiceectofsuch

achangeisuncertain,as parentscouldpresumablyundothisredistributionbymodifyingchild

supportagreements. However,giventhatthedependentexemptionisworthmoretotaxpayersinhighertaxbrackets,theneteectofsuchachangecouldbetoraiserevenuesintheaggregateif

noncustodialparentsareinhigherbrackets.

b. Option Group B: Simpliying Savings and RetirementIncentives

Morethan20provisionsinthetaxcodeprovideincentivestosaveforretirementandforother

purposeslikeeducationandmedicalexpenses.Weheardthatindividualscanbeintimidatedand

confusedbothbythesheernumberofaccountstochoosefromandbythefactthateachaccountisgovernedbyadierentcombinationofrulesregardingeligibility,contributionlimits,andwhen

moneymaybewithdrawn.Weheardconcernsthatthisconfusionreducestake-upofretirement

plansbyworkersandthepropensityofemployerstooerplans,withnegativeeectsonthegoalof

increasingsaving.Giventhatsavingincentiveprovisionsinthetaxcodearethethird-largesttax

expenditurecosting$118billionin2008itisimperativethattheirpublicbenetsjustifytheir

cost.

Weheardthreetypesofcriticismsofthecurrentsystem.First,manyarguedthatthearrayof

optionspresentedtoindividualhouseholds,businesses,andtheiremployeesmakesitdicultto

chooseaplanintherstplaceandthecomplicatedrulesmakeithardtounderstandtheincentives

tosave,underminingtheireectiveness. Asecondgrouppointedoutthatformostworkersthechoiceofanemployer-sponsoredsavingplanwasnotthelargestissuemostemployeesatmedium

andlargeemployersareonlyeligibleforoneplan,forexample,a401(k)iftheyworkforaprivate

employerora403(b)iftheyworkforanon-prot.isgroupsuggestedthatmostofthecosts

ofcomplexityariseatsmalleremployersandforemployeeswithmorecomplicatedemployment

situations. is groupemphasizedadministrativehurdlesforemployers sponsoringaplanand

inequitiescausedbythedierentrules;theysuggestedbehavioralinterventions(likeautomatic

enrollment)toraisesavingswithinthecurrentsystem.Athirdconcernraisedbysomeexpertswas

thatthedistributionofbenetsofthecurrentsetofsavingsincentiveswasnotwellalignedwith

thepublicgoalsofincreasingsavingsamonggroupswithlowsavingsrates;instead mostofthe

benetsofsavings-relatedtaxprovisionsaccruetohigher-incomegroupswhoalreadyhavehighpropensitiestosave.AccordingtotheTaxPolicyCenter,about84 percentofthetaxexpenditure

forretirementsavingsincentivesaccruestotaxpayersearningmorethan$100,000.

Improvingtheeectivenessoftaxpreferencesforretirementsavingcouldbeachievedalongmul-

tipledimensions.Consolidatingaccountsandharmonizingruleswouldsimplifytheretirement

systemformanyworkersandemployers.Otherrules,likethosegoverningwhenandhowmoney

maybewithdrawnfromaccountscouldalsobechangedtoreducetheburdenontaxpayers.Inad-


35/130


dition,incentivestosavecouldbeimprovedwithsimplebehavioralinterventions,likeautomatic

enrollmentandoeringtheSaversCreditasamatchinsteadofacredit.

Wediscusseightoptionsforsimplifyingsavingsandretirementincentives.

i. Option 1: Consolidate Retirement Accounts and HarmonizeStatutory Requirements

etaxcodeoersmorethanadozenvarietiesoftax-favoredretirementsavingaccountsinclud-

ingthe401(k),SavingsIncentiveMatchPlanforEmployees(SIMPLE)401(k),ri,403(b),gov-

ernmental457(b),SalaryReduction SimpliedEmployeePensionPlan(SARSEP),and SIMPLE

IndividualRetirementAccount(IRA)plans.eseaccountsoenhavedierentrulesregarding

eligibility,contributionlimits,andwithdrawals.

Table3belowprovidesdetailsonafewrepresentativeemployer-sponsoredretirementplansand

summarizesmanyofthekeyregulationsgoverningtheplans.2Asthetablemakesclear,thereisa

widevarietyofrulesacrossplans.Mostplanspenalizeearlywithdrawalsfromretirementaccounts,butsomeretirementplansallowearlywithdrawalswithoutpenaltyforhardship(usingdier-

entdenitionsofhardship)orallowforloans;othersallowearlywithdrawalsformedical,home

buying,oreducationalexpenses;andsomeaccountsdeneearlyasbeforeage59andsomeas

anytimebeforeanemployeeleavesarm.erulesforwhenanemployeemayrollovercontri-

butionsfromoneaccounttoanotherhavebeenpartiallyharmonized,buttherearestillcertainac-

countswhichcannotberolledintoothers,orcanonlyberolledoveraerawaitingperiod.Onthe

employerside,dierentplanshavedierentrulesforwhichemployeesmustbecovered,withsome

rulesfocusingonage,someoncompensation,andsomeonmorecomprehensivecoveragetests.

2 etabledoesnotincludeindividualplanslikeTraditional,non-deductible,orRothIRAs,noreducation-relatedaccountslike529plansorCoverdellplans,normedicalexpensesavingsaccountslikeHealthSavingsAccountsorMedicalSavingsAccounts.


36/130


Table3:

Emplo

yer-

Sponsore

dRe

tirem

en

tPlans

Payroll

DeductionIRA

SEP

SIMPLEIRA

Plan

SIMPLE401(k)

SafeHarbo

r

401(k)

Traditional

401(k)

403(b)

457(b)

Sponsor/

Eligible

Employer

Anyem

ployer

Anyemp

loyer

Emp

loyerw

ith

100or

ewer

emp

loyees

an

dnoot

her

qua

life

dp

lan

Emp

loyerw

ith

100or

ewer

emp

loyees

an

dnoo

ther

qua

life

dp

lan

Anyemp

loye

r

other

thana

stateor

loca

l

government

Anyemp

loyer

other

thana

stateor

loca

l

governmen

t

Pu

blic

educa

tion

emp

loyersan

d

tax-exemp

t

501(c)(3)

organ

iza

tions

Statean

dloca

l

governmen

ts;non-

churc

htax-exemp

t

organ

iza

tions

Maximum

Employee

Contribution

$5,0

00

$0

$11

,500

$11

,500

$16

,500

$16

,500

$16

,500

$16

,500

Employer

Contribution

None

Op

tiona

l

Requ

ired

Requ

ire

d

Requ

ire

d

Op

tiona

l

Op

tiona

l

Op

tiona

l

Maximum

Total

Employer+

Employee

Contribution

$5,0

00

Lessero

25

percen

to

compensa

tion

an

d$49

,000

.

$11

,500

by

emp

loyeep

lus

2or

3percen

t

ma

tchup

to

$245

,000

in

compensa

tion.

$49

,000or

100percen

to

compensa

tion.

$49

,000or

100percento

compensa

tion.

$49

,000or

100percen

to

compensa

tion.

$49

,000or

100percen

to

compensa

tion.

$16

,500or

100percen

to

compensa

tion.

Catch-up

Contributions

$1,0

00

$0

$2

,500

$2

,500

$5

,500

$5

,500

$5

,500;

additiona

l

con

tribu

tiono

$3

,000a

llowed

orcerta

in

emp

loyeesw

ith

more

than

15

yearso

serv

ice.

$5

,500;maya

llow

additiona

lca

tch-up

con

tribu

tionsup

to$28

,000three

yearsprior

tothe

yearo

norma

l

retiremen

tage.

Whencan

fundsbe

withdrawn

without

penalty?

Su

bject

toIRA

rules;a

terage

591

/2

Su

bjec

ttoIRA

rules;a

terage

591/2

Su

bjec

tto

IRA

rules;a

ter

age

591/2

Su

bjec

tto

401(k)ru

les;

aterage

59

1/2

Su

bjec

tto

401(k)ru

les;

aterage

59

1/2

Su

bjec

tto

401(k)ru

les;

aterage

59

1/2

Aterage

59

1/2

.

Aterseverance

romemp

loymen

t

or

591/2

.

Hardship

Withdrawal

allowed?

No

No

No

Yes,i

distribu

tion

isnecessary

tosa

tis

y

imme

diatean

d

heavy

fnanc

ial

nee

d.

Yes,

i

distribu

tion

isnecessary

tosa

tis

y

imme

diatean

d

heavy

fnancia

l

nee

d.

Yes,i

distribu

tion

isnecessary

tosa

tis

y

imme

diatean

d

heavy

fnanc

ial

nee

d.

Yes,

i

distribu

tion

isnecessary

tosa

tis

y

imme

diateand

heavy

fnanc

ial

nee

d.

Yes,

or

un

oreseea

ble

emergency.

Loans

allowed?

No

No

No

Yes

Yes

Yes

Yes

Yes


37/130


ecurrentsystemalsoprovidesdierentcontributionlimitsandeligibilitylimitstodierentem-

ployees,dependingonwheretheywork,whatretirementoptionstheiremployerchoosestopro-

vide(ifany),andonindividualcharacteristicsliketheemployeesage.Taxpayerswhoseemployers

oeraretirementplanpaylessintaxes(iftheyortheiremployerscontributetoaqualiedretire-

mentplan)thanthosewhoseemployersdo not.In2010,individualemployeesatrmsthatdo

notsponsorretirementaccountsarelimitedtoIRAcontributionsof$5,000(or$6,000if50yearsorolder). Employeesatrmsthatoerretirementaccountsmaychooseto deferup to$16,500

($22,000if50yearsorolder),pluswhatevertheiremployerchoosestocontributeuptoacombined

totalof$49,000.ParticipantsinaSEPmaycontributeupto25percentofcompensationupto

$49,000.Employeesatcertaingovernmentalemployerscancontribute(includingmatches)upto

both403(b)and457plans;theireectivecontributionlimitis$33,000($44,000if50yearsorold-

er).Self-employedindividualsandsmallbusinessownersdirectboththeemployeeandemployer

contributionstotheirownplansandhavediscretiontocontributeupto$49,000.Dierencesin

contributionlimitsandeligibilityrulesleadtoinequitiesintaxburdens.Manyexpertsalsobelieve

thatsuchdierencesunderminetheeciencyofthetaxincentivesforincreasingsavingbecause

themoregenerouslimitsandeligibilityrulesprimarilybenetindividualswhoalreadysavemorethanaverage.us,theseprovisionsmayencouragetheseindividualstoshitheirsavingtotax-

advantagedaccountsratherthantoincreasetheirsaving.However,thecurrentruleswereformed

with competingpolicyobjectives inmind. For example,oering highercontributionlimitsfor

employer-sponsoredplansrelativetoindividualplansprovidesanimportantincentiveforemploy-

erstochoosetosponsoraplan.

Administrativeandcompliancecostshavealsobeencitedasadeterrenttoemployersponsorship

ofretirementplans.Onlyabouthalfofprivateemployersoeradenedcontributionretirement

plantotheirworkers.Forsmallbusinesses,theadministrativecostsareparticularlylargerelative

tothesizeofthebusiness,andlessthan25 percentsponsoranyretirementplan.SIMPLEandsimi-

larplansexistlargelytoreducethesecosts.Nevertheless,facedwithmanychoices,smallbusinessownersmayhavetospendconsiderabletimeandenergychoosingtheoptimalplanforthemselves

andtheirworkers.Smallbusinessownersmayalsodesiretochangethestructureastheirbusiness

grows,creatingfurthercomplications.

emultiplicityofemployer-sponsoredretirementplansmayalsoburdenemployees.Employees

mayberequiredtoevaluatemultipleaccountsandchooseamongalternativeoptions,discouraging

ordelayingparticipation.Inthecurrentsystem,anynumberofcommonlifeeventscandisrupta

workerssavingplan.Marriageordivorce,jobchanges,orchangesinincomeallcanresultinwork-

ersbecomingineligiblefortheirpreviousplanorsuddenlyeligiblefora newplan. Oen,these

changesare notrecognizeduntiltax timetheyear aersavingscontributionsare made;special

(andunfamiliar)taxprovisionslikerecharacterizationsandnondeductibleTraditionalIRAswere

createdtoaddressthesetypesofsurprises.Aworkerwhochangesjobsfrequentlymayhavemul-

tipleretirementaccountsspreadamongpastemployers,eachholdingonlysmallsumsofmoney.

Frequently,workerschangingjobshavetheirretirementcontributionsreturnedtotheminlump-

sumdistributionsratherthanrollingthemoverintoanotheraccount.Suchdistributionsreduce

retirementsavingsandexposeworkerstounexpectedtaxpenalties.


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Te proposals and their advantages:

Experts suggestedconsolidating employer-basedretirement accounts and simplifying eligibility

andcontributionrules. Consolidating plansandsimplifyingruleswouldreducecostsforbusi-

nessesaswellashelpclarifyincentivesandsimplifysavingforworkers.Arststepcouldharmo-

nizerulesandsimplify tax-preferredsavingsaccountsbyimposinguniformrules foreligibility,

contributions,andadministration.Forexampleaconsolidatedsetofrulescouldfollowexistingcontributionlimitsandregulationsfor401(k)plans.Particularareaswhereharmonizationmaybe

desirableincludetherulesforpenaltiesforhardshipwithdrawalsthedenitionofhardshipdif-

fersplan-to-planandsomeaccountsdonotallowhardshipwithdrawalsandrulesallowingloans

againstcertainplanbalances.Simpliedrulesregardingpaperwork,reporting,andlegalliability

couldbeappliedtothesmallestemployerstofurtherreducetheiradministrativecosts.

Certainretirementaccounts appearverysimilarlike 401(k)s,403(b)s,and457plansandare

inmanywaysredundant.eyaredistinctbecausetheywerecreatedtoservedierentemploy-

ersforprots,non-prots,andgovernmentsbuttheyservethesamebasicfunctionforeach.

Consolidating such planscouldeliminateextra accounts,rules, anddocumentation,and would

simplifythenumberandvarietyofaccountsforworkerschangingjobsbetweensectors.Forex-

ample,asmallgroupofworkers(includingstateuniversityprofessors)whoarecurrentlyeligible

forunusuallyhighcontributionswouldbeheldtothesamecontributionlimitaseveryoneelse.

Amoreaggressiveconsolidationwouldeliminatemoresignicantsourcesofcomplexity.Forex-

ample,the2005TaxReformPaneladvancedaplantoconsolidateemployer-baseddenedcon-

tributionplansintoonework-basedaccount(withcurrent-law401(k)limits),allindividualplans

intooneindividualaccount,andallspecialpurposesavingsaccountsintooneaccountforsavings

otherthanforretirement.isconsolidationwouldhavesweptoutrulesforphase-outs,minimum

distributionsandotherprovisions.isplanwasalsopartofabroaderreformintendedtoincrease

opportunitiesfortax-freesavings.Itwouldalsohaveexpandedthesizeofaccountsandeligibilityforaccounts,eliminatingphase-outsandmakingtheaccountsavailabletoalltaxpayers.However,

the2005Panelalsorecommendedreducingtaxesoncapitalgainsatthesametime,makingtax-

preferredaccountslessdesirableandlimitingtherevenuecostofoeringsuchplans.Overall,the

reforms proposedby the2005Panelincreasedopportunities forretirementsavingand reduced

taxesonsavingingeneral,whilemakinguprevenueelsewhere.

Disadvantages:

emultiplicityofplantypespartiallyreectsadesiretooerplanswithreducedadministrative

costs,likeSIMPLEplans,forsmallbusinesses.Consolidationoftheseaccountscouldincreasethe

administrativeburdenonsmallrms.Muchoftheburdensomecomplexityarisesfromprovisions

tolimitthebudgetarycostoftax-preferredvehicles,topromotebroadparticipationinplans(like

coveragetests),andtoensurethattaxsubsidiesavailableforsavingsdonotaccruedisproportion-

atelytohigh-incomegroups(likephase-outsandnondiscriminationrules).Easingtheseprovi-

sionswouldconictwiththegoalstheyaremeanttoachieve.

esimplicationbenetsofconsolidatingcertainaccountscouldultimatelybemodest.ethree

plansdescribedaboveareoeredonlybyemployersintheprivatesector,thenon-protsector,and


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thegovernmentsector,respectively;employeesinthosesectorsoenhavenochoicesandtherules

thatapplyarethesameformostemployeeswithinthosesectors.

Appliedtothecurrenttaxsystem,aplanlikethatinthe2005proposalwouldloseconsiderablerev-

enueandwouldsignicantlyexpandtax-preferredsavingsopportunitiestohigher-incomegroups,

whoalreadydisproportionatelybenetfromthem.erefore,aconsolidationofaccountswould

needtoaddressboththerevenuecostanddistributionalconsequences,forexample,bylimiting

thetaxadvantagesofaccountsforhigher-incomegroupsbyphasingoutthesizeofthededuction

availableforcontributionsorbyapplyingaatcredit(ratherthanadeduction)forcontributions.

ii. Option 2: Integrate IRA and 401(k)-type Contribution Limits and

Disallow Nondeductible Contributions

Undercurrentlaw,deductiblecontributionstoIRAsarephasedoutforhigher-incomegroupswhile

contributionstoemployerplansarenot,andthephase-outrangediersbasedonwhetheranem-

ployeeiscoveredbyanemployer-sponsoredplan.LargelytoallowindividualswhoareineligibletomakedeductibleIRAcontributions(oenduetounexpectedincomeorotherrulesdiscovered

attaxtime)toavoidtheadministrativehassleofhavingtotakeoutexcesscontributionsattheend

oftheyear,individualsareallowedtomakenondeductiblecontribution

Presidents Advisory Board Tax Reform Options August 2010

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Transcript of Presidents Advisory Board Tax Reform Options August 2010