The Tax Foundation

October 26, 2007

Rangel’s “Mother of All Tax Reforms” Bill Overshadows Much Bigger Question: What to Do in 2011?

by Gerald Prante

Fiscal Fact No. 110

House Ways and Means Committee Chairman Charlie Rangel has put forth his long-awaited "Mother of All Tax Reforms" bill. It touches on almost every part of the tax code, but the reforms are mostly small relative to the fundamental tax reform that most economists would favor, such as that put forth two years ago by the President's Tax Reform Panel.

The impetus for Rangel's bill is the looming Alternative Minimum Tax (AMT) burden that is scheduled to hit about 20 million new tax filers this year unless something is done within the next few months. But in attempting to provide AMT relief and other tax relief to selected groups of taxpayers, Rangel was also forced to comply with House PAYGO rules, which stipulate that all tax cuts or spending increases must be offset with tax increases or spending cuts. This means that Rangel's proposed tax relief for certain taxpayers would come at the expense of higher taxes on other, high-income individuals. His bill lays out the costs and revenue estimates for each of these major tax cuts and tax hikes on the individual tax side, shown in Table 1.

However, the cost estimates that Rangel included in order to meet the PAYGO requirement over a ten-year budget window all assume that the Bush tax cuts will expire in 2011 as scheduled. Current law is always the baseline in official revenue scoring, but because many of Rangel's provisions interact heavily with that scheduled change in tax law, these revenue estimates can be misleading to the typical layperson, who would likely evaluate Rangel's proposals in light of 2006 tax law rather than in light of the scheduled changes in 2011.

Table 1
Rangel's Tax Plan Cuts Taxes for Some, Raises Taxes for Others

* This amount would not technically be $200,000, but would likely be close to $200,000. (See text below.)

^ Note that corporate provisions may affect some businesses that file in the individual tax code, such as S-Corporations, and take the general business credit.

Source: Tax Reduction and Reform Act of 2007

Tax Cuts for Some in Rangel's Bill
For 2007, Rangel extends the AMT relief that has been given to taxpayers over the past few years—a one-year patch that puts in place the 2006 AMT exemption amounts. But starting in tax year 2008, Rangel's bill would completely repeal the AMT. In total, these AMT relief provisions would cost the treasury about $843 billion over the next 10 years, according to the bill's scoring. This estimate of the cost of AMT relief is much lower for the latter part of the ten-year window because the expiration of the Bush tax cuts would raise regular tax liabilities so much that the AMT would have a much smaller impact relative to the regular individual income tax in tax years 2008 through 2010. Most people would be paying higher taxes as a result of the Bush tax cuts' expiration, but they would not be paying the AMT. On the flip side, if the Bush tax cuts were extended (which depends largely upon the 2008 elections), the cost of repealing the AMT would be much greater.

The other major tax cuts in Rangel's plan are targeted mostly at low-income taxpayers. Most taxpayers who take the standard deduction instead of itemizing are in the 15% tax bracket, so the $850 increase in a married couple's standard deduction would save them 15% of $850, or $127. Similarly, the extra $425 deduction for a single filer would save $64, and the extra $625 deduction for a head-of-household would save $94. For married couples, in 2011, this savings would be totally wiped away because the Bush tax cuts' expiration would reduce the standard deduction by about $2,000 (depending on inflation), thereby bringing back the marriage penalty.

Expanding the standard deduction does nothing for the 43 million tax returns that already pay nothing, so Rangel included some provisions to benefit tax filers at the bottom of the income scale, including an expansion of the Earned Income Tax Credit (EITC) of about $3 billion per year for individuals with no qualifying children. He does not address the issue of the EITC being scaled back in 2011 with the expiration of the Bush tax cuts for married individuals. Specifically, the Bush tax cuts increased by $1,000 the phase-in and phase-out levels of the Earned Income Tax Credit for married couples, thereby expanding the amount of the credit for most married claimants since they tend to have higher incomes than single filers. Overall, the expansion in the EITC as a result of Rangel's plan would be limited by the decrease in the EITC that would come from the expiration of the Bush tax cuts in 2011.

Furthermore, Rangel proposes expanding the refundable child tax credit by about $1 billion per year. This is targeted mostly at the same group as the Earned Income Tax Credit: parents and workers who pay no income taxes as a result of the tax policies of Presidents Bush and Clinton over the past decade.

In fact, tax code provisions designed to benefit low-income individuals have increased much faster than the traditional welfare program, Temporary Assistance for Needy Families, and most other anti-poverty spending. In total, EITC and the child tax credits grew by 43 percent from 2000 to 2005 in real terms (adjusted for inflation). (See Figure 1.) While many would not consider a tax credit of $1,000 per child given to a couple earning $80,000 to be the equivalent of "welfare," economically, there is little difference.

Figure 1
EITC and Child Tax Credit from 1998 to 2005

Source: Internal Revenue Service

Tax Hikes for Others in Rangel's Bill
In order to pay for all these tax cuts, especially the AMT repeal, Rangel has proposed a large tax hike on wealthy Americans. He has not chosen the AGI amount for the tax hike arbitrarily. As policymakers too often do, Rangel has decided to make the tax code more complicated than is necessary. This is how he describes the income level at which the surtax would kick in: "The amount to be set by the Treasury shall be determined by selecting an income level above which ninety percent of all married taxpayers would otherwise be subject to tax under the AMT, but in no event less than $200,000." The rate applied to the income earned between this amount and $500,000 would be subjected to an additional tax of 4 percent. All income in excess of $500,000 for a married couple ($250,000 for singles) would be subject to a 4.6 percent rate. This surtax is projected to raise taxes by $832 billion on high-income earners over the next ten years relative to current law.

The bigger question associated with this tax hike is: What happens in 2011 when the Bush tax cuts expire? The top marginal taxable income bracket would be 39.6 percent on top of this 4.6 percent surtax. That means somebody currently earning $500,000 would have government taking about half of his next dollar of income (when state income taxes are included). Such high rates on high-income earners can have significant effects on individual labor-leisure decisions, i.e. whether people choose to spend more or less time working. High-income earners tend to be the most sensitive to high marginal tax rates for two reasons: (1) diminishing marginal utility of income and (2) their greater ability to control their own labor supply relative to the typical worker, who has essentially a binary choice of working 40 hours a week or not working at all. The economic losses associated with such a rate hike should move lawmakers to instead pursue fundamental tax reform that lowers marginal tax rates by removing many of the deductions and distortions in the individual tax code. Unfortunately, Rangel's so-called "tax reform" largely ignores these deductions and distortions, except for his reinstating the limitations on itemized deductions and personal exemptions, which is another tax-raising component of the plan to pay for tax cuts elsewhere.

Finally, Rangel estimates that his plan will raise about $55 billion over a ten-year period—a little over $5 billion per year—due to his proposed tax law changes for carried interest, hedge fund managers, and employees of service S-corporations. However, these changes raise difficult questions about the definition of income. Lawyers and economists don't always agree with each other or even amongst themselves on the correct definition of income, and Rangel's proposed tax law changes are likely to be met with fierce resistance by the small group of taxpayers who would be affected.

Conclusion
Rangel's tax plan contains two major provisions: AMT relief and a surtax on high-income taxpayers, with additional provisions added to benefit low-income individuals at the expense of higher taxes on selected groups. While Rangel may consider this a significant tax reform package, on the individual side of the tax code, it is not truly what most tax experts would consider tax reform. Most true tax reform consists of broadening the tax base in order to lower rates. Rangel is doing this in principle on the corporate side (see Tax Foundation Fiscal Fact No. 108, "Congress Finally Considers Lower Corporate Tax Rate but Underestimates International Tax Competition"). Overall, the scheduled expiration of the Bush tax cuts is the 800-pound guerilla in the room, as the tax cuts interact heavily with the main parts of Rangel's bill. In fact, almost all of the 90 million taxpayers whom Rangel claims would pay less under his tax plan would still end up paying more to Uncle Sam in 2011 as a result of the tax cuts' expiring.

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  by Gerald Prante
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