Copyright (c) 1998 Tax Analysts
JANUARY 5, 1998
DEPARTMENT: Special Reports (SPR)
CITE: 78 Tax Notes 89
HEADLINE: 78 Tax Notes 89 - SIMPLIFICATION: REPLACEMENT OF THE SECTION 68 LIMITATION ON ITEMIZED DEDUCTIONS. (Section 68) (Doc 98-605 (5 pages))
AUTHOR: Johnson, Calvin H.
University of Texas
CODE: Section 68
Professor Calvin H. Johnson wraps up a two-part series on simplifying the tax law by replacing the phase-out taxes of section 68.
Calvin H. Johnson is a professor of law at the University of Texas. The author wishes to thank members of the ABA Tax Structure and Simplification Committee and especially Professors Jim Maule and Reed Shuldiner for helpful comments and discussion. The language and, especially the errors, are the author's sole responsibility and may not be attributed to the ABA or anyone who volunteered to help or critique.
This is the second of a two-part series on simplifying the tax law by replacing the phase-out taxes of section 151(d)(3) and section 68. Part 1, published in Tax Notes, Dec. 22, 1997, p. 1403, discussed the replacement of section 151(d)(3), the personal exemption phase- out. This part discusses the replacement of section 68, the 'overall limitation on itemized deductions.'
Section 68 is, in practice, a tax of 1 percent of adjusted gross income over a threshold amount, now $121,200. While the section 68 adjustments are also in form based on certain disfavored itemized deductions and stop when the taxpayer has lost use of 80 percent of the targeted deductions, in practice, the targeted itemized deductions are so plentiful that the 80-percent itemized-deduction ceiling only rarely comes into play. Tax law would be simpler and more honest if section 68 were replaced with an increase in the explicit tax rates, stated in the section 1 tax brackets. Under one set of revenue estimates, a top rate of 42.1 percent would replace both section 68 and section 151(d)(3).
SIMPLIFICATION: REPLACEMENT OF THE SECTION 68 LIMITATION ON ITEMIZED
by Calvin H. Johnson
TABLE OF CONTENTS
Description of Current Law. . . . . . . . . . . . . . . . . . . . .89
Reasons for Change. . . . . . . . . . . . . . . . . . . . . . . . .92
Explanation of Proposal. . . . . . . . . . . . . . . . . . . . . . 92
Conclusion. . . . . . . . . . . . . . . . . . . . . . . . . . . . .93
1 Simplification of tax law is always said to be a very important goal, but it seems never to be quite as important as other things when specific cases come up. Over time as Congress passes tax acts, tax law gets more complicated. One of the least justifiable complications is section 68 of the Internal Revenue Code, called an 'overall limitation on itemized deductions.' Tax law would be more honest, more comprehensible, and simpler if the revenue from section 68 were replaced with an increase in the explicit tax rates.
2 Section 68, as a practical matter, is a tax of 1 percent, imposed on adjusted gross income over a threshold amount that is now set at $121,200. In form, section 68 reduces certain disfavored itemized deductions and stops when the taxpayer has lost use of 80 percent of the targeted deductions. The targeted deductions are so plentiful, however, that the itemized-deduction limitation only rarely comes into play and section 68 turns out, in effect, to be just a 1 percent tax on adjusted gross income tax. Still, section 68 requires calculations that take up 10 incomprehensible lines of worksheets in the individual tax returns, and the complexity of the section makes the impact of the section hard to understand, even by the country's best tax experts.
3 Tax law would be simpler and more honest if section 68 were replaced with an increase in the explicit tax rates, stated in the section 1 tax brackets. A replacement stated as tax rates would generate the same revenue and have the same distributional effects, but the explicit tax rates would be more legitimate. In a democracy, legitimacy cannot attach to a provision purposely made too convoluted to be understood. Replacing section 68 would also obviate the need for all 10 lines of tax return worksheets now devoted to it.
4 This report describes section 68 and its real impact and the reasons for change. Then, using publicly available data, it estimates what adjustments to the tax rates would be necessary to make replacement of section 68 revenue and distributionally neutral. Under the estimates, both section 68 and section 151(d)(3) could be replaced with a top rate at 42.08.
Description of Current Law
5 Section 68 increases taxable income by 3 percent per dollar of adjusted gross income (AGI) in excess of a threshold, originally set at $100,000. The $100,000 threshold is adjusted for inflation annually and it is now $121,200. /1/ The same threshold applies to both returns for households with many people in the family and to a return for only one, unmarried individual. The threshold is cut in half per return, however, if married couples file separately.
6 The impact of more taxable income in the amount of 3 percent of AGI depends on the tax bracket. The increase in taxable income operates across the 31, 36, and 39.6 percent tax brackets. The product of the 3 percent and the tax bracket is as follows:
3 PERCENT OF AGI ADJUSTMENT CONVERTED TO
TAX RATE ON AGI /2/
Tax bracket 31% 36% 39.6%
Tax rate as percent of AGI 0.93% 1.08% 1.19%
For all the brackets, the tax can be fairly described, rounded, as a 1 percent tax.
7 The base of the 1 percent tax is AGI and not the usual base, taxable income. Such personal deductions as catastrophic casualty losses and medical expenses thus will not reduce the AGI base, even though they are deducted to compute taxable income. Even the standard deduction is not subtracted. Because taxable income is smaller than AGI, moreover, a tax imposed on taxable income would have to have a larger stated rate to generate the same revenue. Thus, for taxpayers with itemized deductions of 25 percent of AGI, /3/ it would take a tax stated to be 1.59 percent of taxable income to give the same revenue as 1.19 percent of AGI tax /4/
8 In form, the section 68 tax is contingent, not just on adjusted gross income, but also on certain itemized deductions. The increase to taxable income is the lesser of two ceilings: (1) 3 percent of AGI, or (2) 80 percent of certain itemized deductions. A taxpayer who has no itemized deductions will have no section 68 tax because of the second ceiling. The 3 percent-of-AGI adjustment will stop when 80 percent of the targeted itemized deductions have been used up or offset. Section 68 has thus been described as a tax that phases out the targeted itemized deductions.
9 Only some specially targeted itemized deductions raise the limit or ceiling of section 68. Deductions for medical expenses (section 213) and for casualty losses (section 165(c)(3)) will not raise the ceiling to allow the 3 percent-of-AGI adjustment to continue to operate. Similarly, gambling losses, allowed initially only to the extent of gambling gains (section 165(d)), and investment interest, allowed only to the extent of investment income (section 163(d)), will not raise the ceiling. If all of the taxpayer's itemized deductions are these listed deductions, section 68 will cause no adjustment.
10 The other targeted itemized deductions do raise the second ceiling and will not stop the 3 percent-of-AGI adjustment. Those targeted itemized deductions all have some considerable risk of giving the taxpayer self-service or consumption. Thus deductions for (a) home mortgage interest, /5/ (b) charitable contributions for local religious services or for opera, /6/ and (c) taxes paid for schools, garbage collection, and fire and police protection /7/ have all been criticized as allowing deductions for amounts that really should be considered part of the taxpayer's standard of living or consumption, and thus should be part of taxable income.
11 While section 68 targets the disfavored deductions in form, the disfavored itemized deductions are so plentiful, in practice, that the 3 percent-of-AGI adjustment rarely stops. Most taxpayers have the targeted itemized deductions in an amount far in excess of the 3 percent of AGI (over the threshold) and thus can never expect the itemized deduction ceiling to come into play. Table 2, following, uses average AGI statistics from IRS tax return data, for taxpayers with different amounts or tiers of AGI, to compare the total adjustment from section 68 (in column 2) and the adjustment that would be expected if section 68 had only a 3 percent-of-AGI ceiling (column 1). As Table 2 shows, the amount collected by section 68 is not materially less than amounts collected if there were nothing in it about itemized deductions. /8/
AVERAGE ADJUSTMENT FROM 3 PERCENT AGI AND TOTAL SECTION 68 COMPARED
(1994 year in thousands,, figures averaged for all taxpayers)
(1) (2) (3)
3% * average %
AGI tier (AGI-exempt) section 68 base difference
>$ 1 mil. $ 76 $ 69 9%
$ 500k-$ 1 mil. $ 17 $ 17 0
$ 200k-$ 500k $ 5 $ 5 0
$ 100k-$ 200k $ 1 $ 1 0
$ 100k->$ 1 mil. $ 3.19 $ 3.14 1.4%
12 According to the data in Table 2, the itemized deduction ceiling does not show up as material on the national statistics. It reduces revenue collected by only 1.4 percent of what would be collected if section 68 did not mention itemized deductions. There is a small benefit from the itemized deduction ceiling for the richest, greater- than-$1-million annual AGI taxpayers, but even there the itemized deduction ceiling reduces tax from section 68 by less than 10 percent. Individual taxpayers who have low or none of the targeted deductions could get a very large benefit from the itemized deduction ceiling, but their benefit does not show up as material on the national statistics. Section 68 is substantially equivalent to a 1 percent tax on adjusted gross income, without regard to itemized deductions.
13 Both section 68 and section 151(d)(3) are often described as twin phase-out taxes, but the impact of the two sections is quite different. Section 151(d)(3) looks like the big tax. It is a surtax of up to 0.83 percent per exemption on AGI between $181,000 and $304,000 /9/ and the cumulative rate can be quite high: for a taxpayer with 10 dependent exemptions, the surtax will be 8.3 percent of added AGI. /10/ Section 68 is always only 1 percent of adjusted gross income tax. Still, because section 68 does not really phase out in practice, it raises more revenue, and most of it from the highest tax bracket. /11/ For section 151(d)(3), the top limit of the range is real, so section 151(d)(3) gets most of its revenue from the second-highest 36 percent bracket taxpayers. Table 3 and Chart 3 illustrate the impact:
CHART 3: TAX DISTRIBUTION SECTION 68 AND
SECTION 151(d)(3) COMPARED (000,000 OMITTED)
DISTRIBUTION OF TAX: SECTION 68 AND SECTION 151(D)(3) COMPARED
Bracket 28% or below 31% 36% 39.6% sum
Section 68 $ 9 mill. $ 1.1 bill. $ 1.2 bill. $ 2.5 bill. $ 4.8 bill.
151(d)(3) 0 0 $ 1.5 bill. $ 0.7 bill. $ 2.3 bill.
14 Section 151(d)(3) raises most of its revenue (65 percent) from the 36 percent bracket. Section 68 raises more revenue overall, and in the top bracket, its revenue yield is 2 times larger. /12/
Reasons for Change
15 Section 68 was justified by its proponents as a disguised tax hike, raising revenue from top-bracket taxpayers without raising the explicit section 1 rates. /13/ The disguise, however, is not without cost. For one thing, there is something objectionable about a purportedly democratic government intentionally confusing its people. In a democracy, the people are the fountain from which all political legitimacy springs, /14/ and the people should not be misled. Section 68 also consumes 10 lines of worksheets on the personal income tax return instructions, /15/ confusing the people. Replacing section 68 with increases in the tax bracket rates in section 1(a)-(d) would simplify tax.
Explanation of Proposal
16 Table 4 estimates what increases in explicit rates are needed to match section 68 both in overall revenue and in distribution of tax. A prior report proposed to replace the section 151(d)(3) personal exemption phase-outs with a roughly 1 percent increase in the top two brackets and Table 4, at the bottom line, shows what rates would be needed to replace both section 68 and section 151(d)(3). The data sources and logic of Table 4 are explained by footnotes.
REVENUE FROM SECTION 68 AND REPLACEMENT /16/
A. Yield of Section 68 (In thousands of dollars)
1. Bracket 28% and below 31% 36%
2. Section 68
income /17/ $ 37,662 $ 4,656,000 $ 3,282,000
3. Tax 2*3 /18/ $ 9,000 $ 1,134,000 $ 1,184,000
28 percent or
below column /20/ $ 1,136,000 $ 1,184,000
B. Yield of Bracket Replacement
5. National tax
by bracket /21/ $ 32,707,948 $ 32,663,917
6. National taxable
income by bracket /22/ $ 105,509,510 $ 90,733,103
7. Less phaseout
elimination /23/ ($ 3,656,789) ($ 3,282,364)
8. Remaining taxable income $ 101,852,721 $ 87,450,739
9. Tax rate increase /24/ 1.12% 1.36%
10. Tax increase 8*9 , $ 1,138,387 $ 1,187,076
11. With bracket shift /25/ ($ 2,194) ($ 3,102)
12. Replacement tax $ 1,136,193 $ 1,183,974
13. Change in tax paid $ 0 $ 0
14. New bracket rates 1+9 32.12% 37.36%
15. Section 151(d)(3) repeal /26/ 1.00%
16. Total new
brackets 14+15 32.12% 38.40%
A. Yield of Section 68 (In thousands of dollars)
1. Bracket 39.6% row sum
2. Section 68 income /17/ $ 6,364,000 $ 13,341,000
3. Tax 2*3 /18/ $ 2,520,000 /19/ $ 4,845,000
28 percent or
below column /20/ $ 2,525,000 $ 4,845,000
B. Yield of Bracket Replacement
5. National tax
by bracket /21/ $ 65,344,257
6. National taxable
income by bracket /22/ $ 165,010,750 $ 361,253,362
7. Less phaseout
elimination /23/ ($ 6,363,847)
8. Remaining taxable income $ 158,646,903
9. Tax rate increase /24/ 1.59%
10. Tax increase 8*9 , $ 2,528,119 $ 4,853,582
11. With bracket shift /25/ ($ 3,532)
12. Replacement tax $ 2,524,588 $ 4,844,755
13. Change in tax paid $ 0 $ 0
14. New bracket rates 1+9 41.19%
15. Section 151(d)(3) repeal /26/ 0.89%
16. Total new brackets 14+15 42.08%
17 Table 4 estimates that revenue and distributional neutrality would be achieved by repealing both section 68 and section 151(d)(3), replacing them with an increase in the top bracket from 39.6 to 42.1 percent. The second highest tax bracket would be increased from 36 to 38.46 percent. The third highest tax bracket would be increased from 31 to 32.12 percent.
18 Table 4 and the calculated rates are logical estimates from published data, but they should be understood as illuminating illustrations and not official revenue estimates. On the issue of calculation of exact rates, the report needs to defer to the professional estimators, who have access to unpublished data -- and perhaps even have better techniques and fewer errors. The exact rates calculated from official revenue estimates will undoubtedly be different.
19 The proposal here abandons any attempt to phase out the itemized deductions that are in form targeted by section 68, without necessarily approving of the deductions. Phaseouts necessarily entail a bubble tax: an increase in the marginal tax per dollar of income over the range the phaseout operates. A bubble tax is regressive because it disappears for higher-income taxpayers once the phaseout is completed. Phase-out taxes cause unnecessarily high marginal rates bubbles, even for benefits that should be reduced. /27/ In practice under section 68, in any event, the itemized deductions are only rarely the operative ceiling.
20 Both section 68 and section 151(d)(3) should be replaced, but the case for replacing section 151(d)(3) is the stronger. Section 151(d)(3) can yield very high marginal rates; a household of 10 dependents can face a surtax of 8.3 percent and a combined real marginal rate of 48 percent. Section 151(d) creates a clear bubble centered on the 36 percent tax bracket and lets the higher-income taxpayers have the lower marginal tax rate. Section 151(d)(3) assumes that bigger families and less well-to-do households should pay tax at higher marginal rates than smaller families and richer households and those assumptions, once stated, cannot stand. Section 68, by contrast, remains a 1 percent of AGI tax and the range of the tax, generally speaking, extends upward until Niagara Falls. The proposed replacement of section 68 would raise the same revenue, distributed in the same way.
21 While section 68 should be replaced, there are replacements that would make matters worse. Complexity is an important consideration, but it is not the only consideration. If, for instance, the $4.8 billion raised by section 68 were redistributed downward in the repeal of section 68 to be collected from poorer taxpayers, the mere shifting of the same tax yield would increase the harm that taxes do. Dollars give ever greater value as the total income of the household decreases. For the poor and near poor, dollars can mean the difference between life and death so that the value of a dollar approaches infinity. As income increases, added dollars add ever less crucial needs to the household. Shifting the burden of tax downward from rich to poor will increase the harm that taxes do. Simplicity is an important value, but it is not as important as avoiding larger harms.
22 Section 68 is complicated and the complexity seems to have been intended to disguise its effect as a tax raiser. Replacing section 68 with an adjustment to the explicit tax rates of section 1 would be more honest and legitimate and simpler.
/1/ Rev. Proc. 96-59, 1996-53 IRB 17 section 2.06 (applicable to 1997 tax year).
/2/ The formula for Table 1 is 3 percent adjustment times tax bracket rate.
/3/ Internal Revenue Service, Individual Income Tax Returns 1994 (1997) (hereinafter SOI 1994), Table 2.1 taxable income, col. (47), divided by AGI, col. (1) shows that taxable income was 76 percent of AGI for the $100,000-$200,000 tier.
(1) 1.19% * AGI = x % * (AGI - 25% * AGI) Revenue equality
(2) x % = 1/75% * 1.19% = 1.59%
Solving equation (1) for x percent.
/5/ Home mortgage interest is a cost of providing shelter and the primary beneficiary of the shelter is the household itself. Interest would be a deductible cost if we taxed the return from houses, but the primary return from the investment in a house is the opportunity to live in it, which is not taxed. We allow a deduction for the primary costs of a house (interest and property taxes) and exclude the primary revenue (use and sale gain). Tax thus adds value to the house beyond what it would be worth in absence of tax. Individuals divert their capital from productive investments into their own shelter beyond what they would do in absence of tax. The tax benefit is largely capitalized, and the benefit is bracket dependent. Thus the subsidies will gross up the market price of houses (assuming 40 percent tax) in the well-to-do neighborhoods by up to 167 percent (1/1-40 percent) of pretax value, thereby excluding start up and less well-to-do buyers. The subsidy has no effect in poorer neighborhoods, where the standard deduction replaces the home mortgage interest deduction. It is hard to find a justification besides the crassest political explanation that homeowners do not like to pay tax and they vote.
/6/ See, e.g., Mark Gergen, 'The Case for a Charitable Contributions Deduction,' 74 Va. L. Rev. 1393 (1988) (doubting that charitable contributions primarily serve other than the taxpayer).
/7/ Dep't. Treasury, Tax Reform for Fairness, Simplicity and Economic Growth: The Treasury Department Report to the President 78 (1984) (arguing that state and local taxes provide benefits primarily for residents of the taxing jurisdiction); Office of President Ronald Reagan , The President's Tax Proposals to the Congress for Fairness, Growth and Simplicity 63 (1985) (state and local taxpayers receive important personal benefits in return for their taxes, such as public education, water and sewer services, and municipal garbage removal).
/8/ For column (1) of Table 2, average AGI is from SOI 1994, table 2.1 col. (2) divided by col. (1) for the various AGI tiers. The exemption amount ($111,800 in 1994. Rev. Proc. 93-49,1993-2 C.B. 580) is subtracted from the average and column (1) is 3 percent of the remainder. Col. (2) is drawn from SOI 1994, table 2.4 col. (49) divided by col. (1).
/9/ Rev. Proc. 96-59, 1996-53 IRB 17 section 2.09 (2) (applicable to 1997 tax year).
/10/ See Calvin H. Johnson, 'Simplification: Replace the Personal Exemptions Phase-out Bubble,' Tax Notes, Dec. 22, 1997, p. 1402.
/11/ Data for distribution of section 68 adjustments is given for AGI tiers, rather than brackets. SOI 1994, Table 2.1 col. (49). For row 1 of Table 3 of text, section 68 income is reattributed to brackets so that tax can be computed, using SOI 1994, table 3.5 col. (18), (21), and (24) to find what percentage of each AGI tier fell within each bracket.
/12/ Section 68 is not purely progressive, however, because of the small 9 percent drop in the tax in the highest, greater than $1 million AGI tier. See, supra, Table 2.
/13/ Tim Gray, 'Tax Negotiations Feature New Bubble, More Deduction Caps,' Tax Notes, Oct. 29, 1990, p. 495 (supporter argues that intent of itemized deduction bubble tax is to raise taxes on wealthiest through the back door); Andrew J. Hoerner, ''Pease Plan' Emerges as Key Issue in Debate Over Tax Progressivity,' Tax Notes, Oct. 29, 1990. p. 498 (proposer of phase-out of itemized deductions preferred simple rate hike and proposed phase outs only as indirect tax hike).
/14/ See, e.g., Benjamin Franklin, Debates in the Federal Convention (Aug. 7, 1787) in 2 Records of the Federal Constitution of 1787, 204 (Max Farrand ed., rev. ed. 1937) (also praising the virtue of our common people, whose public spirit contributed principally to the winning of the Revolution).
/15/ Forms and Instructions 1040 (1996) at A.5 (Instructions for Schedule. A, line 28).
/16/ Table 4 is based on data published in SOI 1994,which is the most recent, publicly available data. The Table 1 figures are 'static' revenue estimates that ignore taxpayer responses to the changes, but since the changes are projected to be revenue neutral and the proposals yield substantially the same real marginal rates without regard to industry or investment vehicle, it can be assumed that taxpayer responses will not be material.
/17/ The sum column is from SOI 1994, Table 2.1 col.(49) row 2 of text reattributes the section 68 adjustments from column (49) from AGI tiers, given in (49), to tax brackets according to what percentage of each AGI tier falls into each tax bracket, calculated from the data found in SOI 1994, Table 3.5 col. (18, 21, and 24).
/18/ Row 3 is the product of row 2 data times the row 1 tax bracket for the column. The weighted average rate for section 68 as a whole is 36.32 percent.
/19/ If the 'deep structure' of section 68 is to impose a 1 percent tax on adjusted gross income, then the revenue collected from the 39.6 percent bracket is too low, by about 9 percent. See, supra, Table 2. The yield to be matched should be augmented by returning tax benefits of the itemized deduction ceiling back into the tax yield. The table reflects the judgment, however, that tax yield to be matched should be determined by looking at actual yield and not an idealized yield, at least if the tax rate is not allowed to drop in the highest brackets.
/20/ Row 4 represents a judgment that tax collected by section 68 from 28 percent brackets and below does not need to be replaced by an explicit increase in the lower tax brackets. The section 68 threshold was originally set at $100,000 well above the original $89,150 top of the 28 percent bracket, so it seems that lower bracket taxpayers were not the explicit target. Row 4 reattributes the modest $9 mil. revenue from lower brackets according to the percent of section 68 adjustments shown in row 2. The modest revenue also means that the issue is not material.
/21/ SOI 1994, Table 3.5 col. (19, 22, and 25)
/22/ SOI 1994, Table 3.5 col. (18, 21, and 24)
/23/ Elimination of section 68 will cause national taxable income to shrink by the amount of row 2.
/24/ Row 9 is the derived figure, showing what explicit tax rate increase for a bracket is necessary to keep the tax paid within the bracket (row 12) the same after replacement of section 68, i.e., row 13 = 0.
/25/ The 3 percent shrinkage in taxable income because of the repeal of section 68 (row 7) will drop some income into lower tax brackets. Most of the 3 percent shrinkage will have no effect on bracket and the row 7 adjustment is sufficient, but for taxpayers with income that is just (3 percent or less) over a new bracket the shrinkage will drop some of the excess income into the just lower bracket. On the simplifying assumption that income is spread equally across the 3 percent, the drop will move 1.5 percent of the excess income into the lower bracket. That will drop the tax rate, e.g., from 42.1 percent to 38.4 percent, that is, by 3.7 percent. The column 39.6 percent row 11 figure is thus 3.7 percent * 1.5 percent times row 7 figure. The other columns use a different drop in tax rate, but the logic is the same.
/26/ The rates to replace section 151(d) (3) are from Johnson, supra note 10, at 1406.
/27/ An opponent of welfare would favor rapid phaseout of the welfare benefits as soon as the recipient reaches a very modest standard of living. And yet, necessarily, the phaseout of the welfare creates a high marginal tax rate on income above whatever threshold is set in the form of loss of benefits. Ironically, the high marginal tax rate will give rational recipients a strong incentive not to make enough income to get off welfare. The phenomenon may be unfortunate, but is also logically unavoidable The best that can happen is a long phase-out range that keeps the bubble tax as low as possible. Phaseouts are not, in sum, the best way to limit benefits.