Presidents Advisory Board Tax Reform Options August 2010
Transcript of 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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6T h e R e p o r t o n T a x R e f o rm Op t i o n s : S imp l i f i c a t i o n , C omp l i a n c e , a n d C o r p o r a t e T a x a t i o n
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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7T h e R e p o r t o n T a x R e f o rm Op t i o n s : S imp l i f i c a t i o n , C omp l i a n c e , a n d C o r p o r a t e T a x a t i o n
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.
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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
Te proposal and its advantages:
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
Te proposal and its advantages:
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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13T h e R e p o r t o n T a x R e f o rm Op t i o n s : S imp l i f i c a t i o n , C omp l i a n c e , a n d C o r p o r a t e T a x a t i o n
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.
Te proposal and its advantages:
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.
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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.
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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)
Form 1040 Instructions:
Lines 64a and 64b EIC(Steps 3-4)
Form 1040 Instructions:
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)
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Form 1040 Instructions:
Lines 64a and 64b EIC(Steps 5-6)
Schedule EIC Earned
Income Credit
Form 1040 Instructions:
Worksheet B EIC Lines64a and 64b (Parts 1-4) Form 1040 Instructions:
Worksheet B EIC Lines64a and 64b (Parts 5-7)
Form 8812 Instructions:
Earned Income Chart Line 4a
Pub. 972: Child Tax Credit
Worksheet (Part 1)
Pub 972: Child Tax Credit
Worksheet (Part 2)
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Totargetbenetstotheneedy,theEITCusesinvestmentincomeasaproxyforwealth,andin2010
limitseligibilitytofamilieswithunder$3,100ininvestmentincomefromsourceslikecapitalgains,
propertysales,rents,royalties,andnetincomefrompassiveactivities.istest,whichisnotap-
pliedtotherefundablechildtaxcredit,requiresadditionalinstructionsanda16-lineworksheet.
Te proposal and its advantages:
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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Te proposal and its advantages:
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.
Te proposal and its advantages:
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.
Te proposal and its advantages:
Oneoptiontoaddressthissituationistoeliminatetheabilityofdivorcedorseparatedparentsto
exchangetaxbenets.iswouldsimplifytheinstructionsforalmostallchild-relatedbenetsby
eliminatingthespecialprovisionsfordivorcedparents.iswouldalsoimprovehorizontalequity
bytreatingpeopleinsimilarcustodialandresidentialsituationsthesameway.
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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-
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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.
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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
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26T h e R e p o r t o n T a x R e f o rm Op t i o n s : S imp l i f i c a t i o n , C omp l i a n c e , a n d C o r p o r a t e T a x a t i o n
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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27T h e R e p o r t o n T a x R e f o rm Op t i o n s : S imp l i f i c a t i o n , C omp l i a n c e , a n d C o r p o r a t e T a x a t i o n
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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28T h e R e p o r t o n T a x R e f o rm Op t i o n s : S imp l i f i c a t i o n , C omp l i a n c e , a n d C o r p o r a t e T a x a t i o n
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