The Heritage Foundation

Backgrounder #687 on Taxes

January 30, 1989

January 30, 1989 | Backgrounder on Taxes

"Ending the Tax Code's Anti-Family Bias By Increasing the PersonalExemption to $6,300"


(Archived document, may contain errors)

687 January30,1989 ENDI NG THE TAX CODES ANTX-F-Y BIASBY INCREASING THE PERSONAL EXEMPllON TO $6,300 Thomas M. Humbert John M. Olin Fellow INTRODUCTION Every lawmaker claims to be pro-family. Yet the income tax code devised by Congress reflects a different reality. The federal i n come tax system treats children less favorably than a business lunch. Like spending for the movies the costs of raising children are for the most part considered a routine discretionary expense, instead of Americas most important investment in its future.

Reflecting this strange premise, the tax allowance for the costs of nurturing children the personal exemption has been permitted to erode dramatically in value over the years. The result has been a half century of steeply increasing federal income taxes o n Americans who raise children. In 1948, the median-income family of four paid virtually no income taxes, and only $30 a year in direct Social Security taxes (1 percent of income). This year, the equivalent family will pay $2,669 in income taxes and over $ 2,500 7.51 percent of income) in Social Security taxes. Just looking at federal income taxes, this median-income familys tax burden has soared over 2,500 percent from 0.3 percent of income to over 8.0 percent of income in about four decades. Singles and m arried couples without children, by contrast largely have escaped this income tax increase.

Sapping Families Financial Health. As taxes on children have climbed the familys ability to provide for its own needs has been impaired. New government programs are touted as a cure for the familys financial ills. But these congressional remedies are for a problem created by Congress. And new taxes to finance government programs would sap even further the financial ability of the family to stand on it own A far more effective strategy to address the problem would be simply to allow a family with children to keep a greater portion of its own income.

Restoring the personal exemption to the equivalent of its level after World War I1 would allow that family to keep thous ands of dollars more of its own money, making the family less dependent on government, improving access to health care, child care, and education opportunities, and giving the working poor a fighting chance to climb out of poverty Toward A Fair Tax System . As a political strategy, increasing the personal exemption could head off government-provided day care,.mandato,g health care, education subsidies, and similar initiatives that would'prolong the process of first taking away family income and then giving i t back in government-determined services. It could also reduce pressure for a boost in the minimum wage which would cut employment opportunities for the I. poorest and least skilled Americans I In the presidential campaign, George Bush recommended a $1,00 0 tax credit for each child under age four in families earning less than $20,0

00. The Bush proposal would be an important step toward a fair tiix system for the.

American family. Moreover, the Bush plan does not discriminate between traditional families and families where both spouses work; It does not subsidize one life style at the expense of another. Further, the 'tax credit approach gives the same financial assistance to all families, not bigger tax breaks to wealthier families.

Yet this "toddler tax credit" is not enough The real challenge for Congress and the incoming Bush Administration is to empower the family by rolling back the postwar tax increases on children. This strategy will require tax policy to recognize that children are America's most important capital investment and are fundamental to productivity gains. and to future economic growth Reversing 40 Years of Discrimination. As its ultimate' goa1,'the Bush'.

Administration should press Congress to increase the personal exemption to at lea st $6,300 4,300 above where it now stands. At this level, the personal exemption would shield from taxes about the same portion of income as it did in 1948 when the modern income tax first began to take form. This would give the median-income family of fo u r over $25,000 in tax-free income. Combined with the current $5,000 standard deduction, this exemption would eliminate from the income tax rolls those four-person families earning less than $30,200 yearly about one-half of today's' tax returns 2 More impo r tant, with this action, Congress and the Bush Administration would strengthen the family and reverse 40 years of mounting tax discrimination against children HOW THE TAX CODE BECAME ANTI-FAMILY On October 13,1981, senior Treasury official Eugene Steuerle t old a tax conference that perhaps no change in the nations tax laws has been more significant, yet less recognized, than the shift since the late 1940s in the relative tax burdens of households of different size. In the years since Steuerles observation, the anti-family, anti-children bias has remained despite the 1981 and 1986 tax acts.

The 1981 Economic Recovery Tax Act (ERTA) at least has kept matters from getting worse by indexing the tax,system.for, inflation and by providing modest additional tax rel ief. Had ERTA not been enacted, inflation-induced bracket creep and the erosion of the personal exemption would have raised the average income tax on the median-income2 family of four from about 10 percent in 1980 to almost 13 percent by 1986 (see Chart 1 But thanks to ERTA, the median-income familys tax burden actually fell one percentage point to about 9 percent of income.

Families of all sizes experienced similar tax reductions (see Table 1 The 1986 Tax Reform Act was the most pro-family and pro-childre n legislation in 50 years. At last, the income tax threshold was raised above the poverty line, with 5 million poor families taken off the tax rolls al together. Moreover, a dis proportionate share of tax relief was given to larger Average Taxes Paid by a Typical Family. Before and After 1981 Tax Cut 1L 1p 0 g I la n t m e 1980 ma2 ma4 1988 After mi T~XCUI if (0 U.d MadIan Income. married. and 2 dapandanta Harllwa Infochart Chart 1 families, as a result ofdoubling the personal exemption, which will take fu l l effect this year 1 Eugene Steuerle, The Tax Treatment of Households of Different Size, in Rudolph G: Penner, ed Twing the Fumify (Washington, D.C.: American Enterprise Institute, 1983 p. 73 2 Median income is the level of income such that 50 percent of all families are above it, and 50 percent, below.

Median family income is a useful measure for tax purposes because it provides a snapshot of the financial condition of the household in the middle of the income distribution. Average family income is total income divided by number of households, and thus a verage family income could be anywhere in the income distribution of families and is therefore less representative of the typical household 3 #s 4 TAX INCH 8 $8 Neither the 1981 nor the 1986 tax reforms, however, completely removed the decades of accumula t ed tax bias against families. The median-income family of four will have its income taxes cut to 8.0 percent of income in 1989 down from the 1986 level of 9.3 percent. But this tax burden is still far above the level for the median-income family with chil d ren throughout most of the 1940s, 195Os, and 1960s (see Table 1 1 CASES ON THE FAMILY Despite the 1981 and 1986 tax reforms, the American family is still over taxed. Table 1 shows the tax burden on singles, heads of household, and mar percentage of income the income tax burden has risen most dramatically for families with children, with the biggest tax increases hitting the largest families. Single Americans and married couples without children pay about ried couples with no children, two children, and fou r children:.MeaSured..as-a the same portion of their income in taxes as they did in the 1950s The reason for such a tax increase on families has been the erosion of the real value of the per sonal exemption as a result of inflation (see Chart 2 The persona l exemption is $2,000 per person under current law. By comparison, ad justed for inflation the personal exemption in 1948 was worth $3,000 7,00O'in 1940, and around $10,000 in the 1920s and 1930s. Though increased numerous times, the personal ex emption ha s fallen far be hind the amount needed to keep up with inflation Nor has the value of the exemption kept up with increases in income see Chart 3). The ex emptions for a median Value of the Personal Exemption I 84b r-ssf 2 t SO 1819 1820" 1830 1840 1960 188 0 1870 '1880 '1888 Single Married 2 Chlldren 1888 Conrtant Dollarr (Thourandrl I 40 L 1813 1820 1830 1840 1860 1880 1870 1980 1888 81ngla Marrkd 2 Chlldmn 8ourc.: JOIIph A. Paohman. Federal Tax &l/Oy, 61h ad. tmmhlnglon, D.Cr The Bmoklnga Inatltutlon. 1917 DO. ala-

4. Herllaga InlOCharl Chart 2 5 income family of four shielded 75 percent of income from tax in 19

48. The exemptions for the same median income family today would shield less than 25 percent of household income.

The personal exemp tion would h ave to equal about 6,300 per person, or over 25,000 in tax-free in come for a family of four, to shield the same proportion of in Personal Exemption as Percent of Median Family Income isn 100 1 I a I 1 AI p 80 1848 1880 1872 1880 1887 1888 I -8Ingla Yarrl ad 0 P'Chlldnn m4 Chlldmn 1 E.stlmated Harltnga InloChart Chart3 come as in. 19

48. Simp single Americans or couples without children. is ly put, today's family faces heavy tax discrimination compared .with equivalent families in earlier generations, and i ts tax status also has eroded when it is compared to that of Advent of the Income Tax The best standard for judging the current tax code is the immediate postwar period. During that time, the modern income tax emerged as the basic government revenue sourc e. Prior to World War 11 the U.S. government was far different in size and scope. In 1929, for example total government receipts were less than 4 percent of gross national product GNP). But in the years preceding and immediately after World War. 11, the..

U.S. became a modern industrial society and assumed world leadership. To finance these growing domestic and foreign responsibilities, the income tax was extended to a majority of workers; and in 1943.income tax withholding became the backbone of the curre n t system Starting in the postwar years, receipts have tended to average 15 percent to 20 percent of GNP, with the individual income tax accounting for-theoverst whelming proportion of general revenue funds. Thus, making comparisons between the late 1940s a nd late 1980s gives an accurate and valid picture of how the tax burden has changed, given the similar scale of government activity as a feature of national economic activity. 3 THE CASE FOR INCREASING THE PERSONAL EXEMPTION I There is little justificatio n in tax theory for allowing the personal exemption to decrease in real value when measured against income growth or 3 Economic Report of the President, Council of Economic Advisors, February 1988 6 inflation. Nor is there any rationale for shifting the bu r den of taxation more onto families with children, especially for imposing the largest tax increase on those families least able to pay. Admittedly, Congress never legislated the change specifically, least of all did lawmakers explicitly try to justify rai sing taxes on children. Indirectly and unintentionally, however, by not legislating remedies to soften the effects of inflation, Congress has eroded the value of the personal exemption.

Inflation and other factors have, of course, affected various groups. Some might argue, therefore, that there is no particular reason to turn back the clock to aid families rather than other groups. But there are at least six reasons why good tax policy requires restoring the relative value of the personal exemption to what it was in the 1940s Reason #1: There is growing concern about the cost of raising children It is a longstanding principle of taxation that some relief should be given to parents for their financial sacrifice in raising children. In the immediate postwar p e riod, in fact, the median-income family with children was not subject to income taxes at all. But especially during the 1960s and 1970s income taxes on the family soared, even as the costs of raising children also jumped, and education, housing, and healt h expenditures outpaced inflation.

Even moderate-income families today face a severe financial burden in raising children. Increasing the personal exemption would help roll back tax increases and offset some of the higher costs of raising children Reason # 2: Demographic changes are straining the economy and social insurance programs Raising the personal exemption could provide an incentive for Americans to have more children. perican Enterprise Institute Senior Fellow Ben Wattenberg argues that the U.S. wi l l need a higher fertility rate to sustain its growing economy and social benefits. He points out that, in recent years, the fertility rate in the U.S. has fallen significantly below its long-term replacement rate. This poses a number of problems. For one t hing, it means that the economy will face a decline in young workers. For another, it means that such social programs as Social Security will come under increasing financial strain as a rising population of elderly Americans have to be supported by contri b utions from a declining population of workers Reason #3: Raising the exemption would aid the working poor and encourage more Americans to go off welfare It makes no sense to tax low-income:workers so much that government support programs paid for out of t h ose taxes are necessary to give th m a subsistence income. To be sure, the 1986 Tax Reform Act raises the income tax threshold (which includes exemptions plus the standard deduction) slightly above the poverty line for virtually every type of family 7 1 e x cept singles? Yet families significantly above the poverty line have not been given sufficient tax relief to roll back the tax burden accumulated since the 1940s Incentives for the Poor. The working poor are especially vulnerable; they are hit with a high initial tax bracket of 15 percent, together with the equivalent of an additional tax if they lose benefits by leaving the welfare rolls. This combination can easily raise their effective marginal tax rate to higher levels than now are imposed on the rich.

If the personal exemption were increased to $6,300, the income tax threshold for a family of four would increase to 250 percent of the poverty level, up from 105 percent under current law (see Chart 4 Thus such a fami ly would not begin to pay income tax until it was well clear ofthe poverty level. The benefit of this is that incentives are enhanced for the poor and working groups to save, work, and invest. Families.of other sizes would enjoy similar proportionate increases in tax-free income under such a change.

Moreover, an increase in the personal exemp tion would be very effec tive in directing govern ment financial assistance toward those moderate and low-income workers who suffered the heaviest tax increases over the last 40 years and faced the great est barriers to work effort. In fact, a 6,300 personal exemption ini tially would wipe out at least the federal income tax burden for low-in come and working families Minimum Taxable Levels of Income Under Current Income Tax System and with $6,300 Exempti o n 6 Derrono 4 Demon0 Size of Famiiv 2 Darrono I Ponrty-mI Innom. ulnlmum Tublo ln0ona Undu Curnnl Law Ulnlmm Tombla Inoow Wllh 94900 Eunpllon sdjurtr all tlgurer (or Inllatlm from 1988 lo 1989. urlng Conrumor Price Index Herltrge InhCharl Chart4 Reason #4 : The change would be oEimmediate help to the embattled middle class Middle-income Americans have been hard pressed by escalating taxes on the family. These families today are forced to make heavy financial sacrifices to raise their children. This has enco u raged many middle-income families to press for.new government programs to assist them with such expenditures as child care and college tuition even though these programs limit their 4 Joseph A. Pechman, Federal Tar Policy (Washington, D.C Brooking Institu tion, 1987 pp. 83 and 84 8 discretion as parents and cost tax dollars, imposing a heavier tax burden and a further erosion of their financial situation.

Increasing the personal exemption would allow middle-income families to escape this Catch 22 situation. They would be able to keep more of their income and thus to pay for the costs of raising their children. This would reduce the pressures to seek new programs that could be financed only through tax hikes. The overwhelming portion of the tax benefits from higher exemptions would go to those earning less than $70,000 per year.

When the family is strong, the need for government programs is reduced.

Increasing the personal exemption is a strategy to empower the family strengthen its resources, and liberate i t from reliance on government Reason #5: Raising children should be treated as an investment for tax purposes, not as an item of consumption Economists long have disagreed about the nature of expenditures on children. Some believe that they should be trea t ed as any other item of consumption. Parents, they say, receive pleasure from raising children, so they alone should bear the cost. In this view, there is little reason for giving a special tax preference for children, any more than providing a tax break for purchasing a television set.

This view is disputed by a growing body of economic literature. It considers outlays on such items as health serv ices, housing, and education as an investment in human capital, which leads to higher productivity and future output, much like maintaining or constructing an industrial machine.

Moreover, the prospective returns on investments in education, according to one 1988 British government analysis, could be about 25 percent, much larger than most investments in the British or American economies Investing in People. The distinction between capital and consumption always somewhat arbitrary is particularly difficul t in the case of spending on-human beings. Yet reasonable distinctions are possible. The U.S. tax code allows businesses to deduct their expenditures for the health-or trainirig.of1 their workers, but gives very limited tax benefits to parents investing in their childrens future productivity A higher personal exemption is one practical way of providing some allowance for the outlays in raising children, such as education and health care, which are more in the nature of human capital expenditures 1 I 5 See G a ry S. Becker, Hitman Capifal (Cambridge, Massachusetts: National Bureau of Economic Research 6 Cleve Wolman, A Better Way to Finance Students, Financial ?hies, December 1,1988, p. 17; see also Becker, op. cit 1964 9 Reason #6: The family is the basic unit of taxation, and exemptions should reflect this Most tax theorists regard the family household as the basic unit of taxation.

Thus one goal of tax policy has been to impose equal taxes on families who have command over equal resources. The two-eamer deduc tion, different rate schedules for marital status, and income splitting have been used in the past as rough devices to help adjust taxable income for family circumstances.

The personal exemption is another adjustment for the taxpaying ability of the family.

For example, a single person earning $25,000 enjoys a much higher standard of living than a family with children earning the same amount. The personal exemption is supposed to help account for the greater sacrifices and necessary costs of raising a fam ily, thereby more accurately measuring a family's actual living standard I The current $2,000 personal exemption does not come close to measuring the true sacrifice required by a family to raise a child. A larger exemption would lead to a tax liability mo re in 1ine.with each household's real circumstances COVERING THE REVENUE LOSS FROM INCREASED EXEMPTIONS Raising the exemption to $6,300 for all Americans would reduce the U.S.

Treasury's income tax revenues by about $100 billion to $130 billion? This reven ue loss could be lowered, however, by limiting the increased exemption I' !8 to children claimed as dependents. A%$6,300 children's exemption, for example, would cut income tax revenues by about $30 billion to $50 billion.

If limited further to children u nder five years of age, the tax revenue loss would be less than $12 billion? George Bush'i proposal to give families earning less than 20,000 a $1,000 tax credit for each child under four would cost $2.5 billion.' z Some imaginative proposals, however, wo u ld link increasesin:thepersonal*~l*v exemption with other social policy objectives, potentially leading to less revenue loss for the U.S. Treasury. Under one plan, the personal exemption 7 Estimates based on Internal Revenue Service Individual Income Tax R eturns Stuh3ric.r oflncome, 1984 p 61. Since these estimates are based on numerous simplifying assumptions, they should be viewed as broadly indicative of possible revenue losses, rather than as precise figures. They are also "static and therefore 8 IRS, o p. cit 9 SfutisticalAbsfmct of the Unired Stures, 1987, U.S. Department of Commerce, Bureau of the Census. No phase-out of the exemption is assumed 10 Figures released by Bush campaign staff. unrealistically assume no changes in economic behavior resultin g from the change 10 could be increased in return for further tax reform. The deduction for state and local income and property taxes is used primarily by upper-income families and tends to subsidize highltax states. Eliminating this deduction would raise 15 billion."

Another option would be a floor for itemized deductions of 20 percent of adjusted gross income. Under this plan, only the amount of allowable expenses exceeding 20 percent of income would be deductible from taxes.

This would raise $31 billion While eliminating many tax-induced distortions in the economy, however, a deduction floor would make no distinction between economically efficient and inefficient deductions Relief for the Middle Class. Changes in the homeowner's mortgage interest deduct i on could be viewed as another option to offset an increased personal exemption, as some studies show that the mortgage interest deduction inefficiently shifts resources to the housing stock.and.away from more valuable capital investment.,and saving.!3 Few deductions enjoy more popular and political support and home purchases currently are'regarded as the family's most important capital investment, deserving of special tax treatment. Yet many American families fiercely support the mortgage deduction mainly a s a tax break for the middle class, rather than an objective in itself. They argue that they need the tax relief to help finance other family expenditures. Increasing the personal exemption would give them this relief and could soften their support of the mortgage deduction. And in general increasing the personal exemption would provide more total tax relief to I middle-income families with children than they can obtain from the current deduction for mortgage interest THE DYNAMIC EFFECT OF RAISING THE EXEM P TION In reality, concerns about revenue losses are vastly overstated. Little faith should be put in "static" revenue estimat.es because they'd0 not incorporate any change in economic incentives for work, saving, or investment. In essence, these models ass u me that the economy would be no more productive or robust following the tax cut than before: Suchstaticj 1.2 assumptions were shown to be erroneous in 1981, when they predicted that tax cuts would trigger an economic slowdown and a sharp reduction in tax r evenue. They are just as unrealistic when used to assess the impact of an increase in the exemption Drawing Americans Off Welfare. Exempting,upwards of one-half of all taxpayers from the income tax rolls obviously would have enormous L 11 Pechman, op. cit . , pp. 358-363 12 aid p. 100 13 Patricia H. Hendershott and Sheng-cheng Hu, "The Allocation of Capital Between Residential and Nonresidential Uses: Taxes, Inflation, and Market Constraints Working Paper No. 718 (Cambridge Massachusetts: National Bureau of E conomic Research, 1981 11 consequences for economic incentives and social welfare outlays. Reducing the marginal income tax rate for millions of low paid taxpayers to zero would give poor and working Americans an enormous income boost as well as an incent i ve to work, engage in entrepreneurial activity, and pursue work training or further education. And by making work more rewarding, a higher exemption also would draw people off the welfare rolls and make them less dependent on government support programs, thereby reducing government social welfare spending (see Chart 5 Middle-income Americans also would enjoy lower marginal tax rates.

With higher exemp tions, millions of mid dle-income taxpayers would drop from the 28 percent tax brack et into the 15 percent bracket enjoying almost a 50 percent increase in produc tive incentives.

Thus, by increasing such incentives for economic expansion, a higher exemption would boost the size of the nations Number of Taxpayers in Each Tax Bracket Before and After Personal Exemption? Incr;ease.?.vi Figurea am adjuated for inflation Current 8yatem $8.900 Exemption I 111 Exempt 16% Bracket 28% Bracket 1 L I For 4-peraon funlllma and 88,300 ermpllon lor eaoh permon. Eatlmatem ere broadly Indlcatlw of nusber;ol tan WtumV for e o011 brMU1 rattier thmn pwo~me flgunm 8ource IRB. 1986 8tatlmtlce of Income Chart 5 economy and lead to more tax revenues flowing into the governments cof fers.

A significant portion of the tax cut thus would ultimately be recouped in increased government revenues through faster economic growth CONCLUSION As the foundation of a free society, the incubator of traditional values, and the crucible for instilling good character in future generations, the American family must be the first priority of a free and democratic society. Yet the financial pressures on traditional families raising children are acute.

The governments discriminatory tax treatment of children has undercut the familys financial security and impeded the ability of parents to provide for the health, education,.and welfare of their children. Many point out the bias in the U.S. tax code against saving and investment. They are correct. The greatest bias, however, is that against families with children 12 Tax Relief for Rearing Children. Two path s lie ahead. Down one are more government programs to support weakened families. If high taxation of the family is allowed to continue, families increasingly will be unable to provide for themselves. They will look increasingly to the government for help t o meet the burden of raising children. The prospect of government taking over the functions and choices of parents should alarm most Americans.

The other path leads toward strong families, a more appropriate role for government, and a growing economy. This path begins by giving American families substantial tax relieffor the costs of rearing children. It will require a major, long overdue change in tax policy it will treat.children as an investment in Americas future.

Restoring the personal exemption to where it was, in relative terms;.in-1948 would allow Americas median-income families with two children to keep over $2,500 more of their own incom e to raise and nurture their children. A median-income family with four children would enjoy almost a $4,000 tax cut.

With this income boost, families would be less reliant on government programs and have access to vastly improved health and education opp ortunities Strengthening the Family. George Bushs proposal for a .toddler tax credit shows that he appreciates the vital role in America of families raising children. But to strengthen that crucial institution, his Administration ultimately must ask Congr e ss to roll backaa. halFcentury-of unfair and 1 discriminatory tax increases on Americas children I 13 No. 687 I The Heritage Foundation 214 Massachusetts Avenue N.E. Washington, D.C. 20002 (202) 546-4400 The Thomas A. Roe Institute for Economic Policy Stu d ies January 30,1989 ENDING THE TAX CODES ANTI-FAMKY BIASBY INCREASING THE PERSONAL -ON TO $6,300 Thomas M. Humbert John M. Olin Fellow INTRODUCTION Every lawmaker claims to be pro-family. Yet the income tax code devised by Congress reflects a different re a lity. The federal income tax system treats children less favorably than a business lunch. Like spending for the movies the costs of raising children are for the most part considered a routine discretionary expense, instead of Americas most important inves tment in its future.

Reflecting this strange premise, the tax allowance for the costs of nurturing children the personal exemption has been permitted to erode dramatically in value over the years. The result has been a half century of steeply increasing fe deral income taxes on Americans who raise children. In 1948, the median-income family of four paid virtually no income taxes, and only $30 a year in direct Social Security taxes (1 percent of income). This year, the equivalent family will pay $2,669 in in c ome taxes and over $2,500 7.51 percent of income) in Social Security taxes. Just looking at federal income taxes, this median-income familys tax burden has soared over 2,500 percent from 0.3 percent of income to over 8.0 percent of income in about four de c ades. Singles and married couples without children, by contrast largely have escaped this income tax increase Sapping Families Financial Health. As taxes on children have climbed the familys ability to provide for its own needs has been impaired. New gove r nment programs are touted as a cure for the familys financial ills. But these congressional remedies are for a problem created by Congress. And Note: Nothing written here is to be construed as necessarily reflecting the views of The Heritage Foundation or as an attempt to aid or hinder the passage of any bill before Congress.new taxes to finance government programs would sap even further the financial ability of the family to stand on it own A far more effective strategy to address the problem would be sim ply to allow a family with children to keep a greater portion of its own income.

Restoring the personal exemption to the equivalent of its level after World War I1 would allow that family to keep thousands of dollars more of its own money, making the famil y less dependent on government, improving access to health care, child care, and education opportunities, and giving the working poor a fighting chance to climb out of poverty Toward A Fair Tax System. As a political strategy, increasing the personal exem p tion could head off government-provided day care, mandatory health care, education subsidies, and similar initiatives that would prolong the process of first taking away family income and then giving it back in government-determined services. It could als o reduce pressure for a boost in the minimum wage which would cut employment opportunities for the poorest and least skilled Americans.

In the presidential campaign, George Bush recommended a $1,000 tax credit for each child under age four in families earning less than $20,0

00. The Bush proposal would be an important step toward a fair tax system for the American family. Moreover, the Bush plan does not discriminate between traditional families and families where both spouses work. It does not subsidize o ne life style at the expense of another. Further, the tax credit approach gives the same financial assistance to all families, not bigger tax breaks to wealthier families.

Yet this toddler tax credit is not enough. The real challenge for Congress and the incoming Bush Administration is to empower the family by rolling back the postwar tax increases on children. This strategy will require tax policy to recognize that children are Americas most important capital investment and are fundamental to productivit y gains and to future economic growth Reversing 40 Years of Discrimination. As its ultimate goal, the Bush Administration should press Congress to increase the personal exemption to at least $6,300 4,300 above where it now stands. At this level, the person a l exemption would shield from taxes about the same portion of income as it did in 1948 when the modern income tax first began to take form. This would give the median-income family of four over $25,000 in tax-free income. Combined with the current $5,000 s tandard deduction, this exemption would eliminate from the income tax rolls those four-person families earning less than $30,200 yearly about one-half of todays tax returns 2 More important, with this action, Congress and the Bush Administration would str e ngthen the family and reverse 40 years of mounting tax discrimination against children. qb (2 f t 0 0 HOW THE TAX CODE BECAME ANTI-FAMILY On October 13,1981, senior Treasury official Eugene Steuerle told a tax conference that perhaps no change in the nati o ns tax laws has been more significant, yet less recognized, than the shift since the late 1940s in the relative tax burdens of households of different size. In the years since Steuerles observation, the anti-family, anti-children bias has remained despite the 1981 and 1986 tax acts.

The 1981 Economic Recovery Tax Act (ERTA) at least has kept matters from getting worse by indexing the tax system for inflation and by providing modest additional tax relief. Had ERTA not been enacted, inflation-induced bracket creep and the erosion of the personal exemption would have raised the average income tax on the median-income2 family of four from about 10 percent in 1980 to almost 13 percent by 1986 (see Chart 1 But thanks to ERTA, the median-income familys tax burden actually fell one percentage point to about 9 percent of income.

Families of all sizes experienced similar tax reductions (see Table 1 The 1986 Tax Reform Act was the most pro-family and pro-children legislation in 50 years. At last, the income tax thresh old was raised above the poverty line, with 5 million poor families taken off the tax rolls al together. Moreover, a dis proportionate share of tax relief was given to larger Average Taxes Paid by a Typical Family. Before and After 1981 Tax Cut 1 le n t m e I 1088 0 1080 ma2 ma4 Afwr (081 hr Cut -If (0 Y*d 48dl811 blcomm. murbd and 2 d8pOndWt8 Hmrl(.g. InfoCh8rl Chart 1 families, as a result of doubling the personal exemption, which will take full effect this year 1 Eugene Steuerle, The Tax Treatment of Ho useholds of Different Size, in Rudolph G. Penner, ed Taxing the Fumily (Washington, D.C American Enterprise Institute, 1983 p. 73 2 Median income is the level of income such that 50 percent of all families are above it, and 50 percent, below.

Median family income is a useful measure for tax purposes because it provides a snapshot of the financial condition of the household in the middle of the income distribution. Average family income is total income divided by number of households, and thus average famil y income could be anywhere in the income distribution of families and is therefore less representative of the typical household 3 e 11 I I I I I I I I I 4 Neither the 1981 nor the 1986 tax reforms, however, completely removed the decades of accumulated tax bias against families. The median-income family of four will have its income taxes cut to 8.0 percent of income in 1989 down from the 1986 level of 9.3 percent. But this tax burden is still far above the level for the median-income family with children th r oughout most of the 1940s, 195Os, and 1960s (see Table 1 TAX INCREASES ON THE FAMILY Despite the 1981 and 1986 tax reforms, the American family is still over taxed. Table 1 shows the tax burden on singles, heads of household, and mar ried couples with no c hildren, two children, and four children. Measured as a percentage of income, the income tax burden has risen most dramatically for families with children, with the biggest tax increases hitting the largest families. Single Americans and married couples w i thout children pay about the same portion of their income in taxes as they did in the 1950s The reason for such a tax increase on families has been the erosion of the real value of the per sonal exemption as a result of inflation (see Chart 2 The personal exemption is $2,000 per person under current law. By comparison, ad justed for inflation, the personal exemption in 1948 was worth $3,000 7,000 in 1940, and around $10,000 in the 1920s and 1930s. Though increased numerous times, the personal ex emption ha s fallen far be hind the amount needed to keep up with inflation.

Nor has the value of the exemption kept up with increases in income see Chart 3). The ex emptions for a median Value of the Personal Exemption Current Dollrrr (thourrnda 4 8 I 1019 1020 1090 lB40 1060 1060 1070 1080 1080 1980 Conatant Dotlrrr (Thouundrl I 1 1 20 1 to z r 0 2 8wmo Jnaaph A. kohlma. Faderel Tea Polfcy. 6th od. (Wmhlngton. 0.G.i lh.

Bmoklngi Inatltutlon. (91

71. DD. am-

4. Hmrltagm InloCharl Chart 2 5 income family of four shielded 75 percent of income from tax in 19

48. The exemptions for the same median income family today would shield less than 25 percent of household income.

The personal exemp tion would have to equ al about 6,300 per person, or over 25,000 in tax-free in come for a family of four, to shield the 120 100 p 00 r c 80 e 40 20 0 Personal Exemption as Percent of Median Family Income I I I I 8lngle mYarrled 00 Chlldnn m4 Cklldnn I Heritmpe inlochart *Eillm ated same proportion of in come as in 19

48. Simp ly put, todays family faces heavy tax discrimination compared with equivalent families in earlier generations, and its tax status also has eroded when it is compared to that of single Americans or couples w ithout children Advent of the Income Tax. The best standard for judging the current tax code is the immediate postwar period. During that time, the modem income tax emerged as the basic government revenue source. Prior to World War IT the U.S. government w as far different in size and scope. In 1929, for example total government receipts were less than 4 percent of gross national product GNP). But in the years preceding and immediately after World War II, the U.S. became a modern industrial society and assu m ed world leadership. To finance these growing domestic and foreign responsibilities, the income tax was extended to a majority of workers; and in 1943 income tax withholding became the backbone of the current system Chart 3 Starting in the postwar years, r eceipts have tended to average 15 percent to 20 percent of GNP, with the individual income tax accounting for the over whelming proportion of general revenue funds. Thus, making comparisons between the late 1940s and late 1980s gives an accurate and valid picture of how the tax burden has changed, given the similar scale of government activity as a feature of national economic activity. 3 THE CASE FOR INCREASING THE PERSONAL EXEMPTION There is little justification in tax theory for allowing the personal ex e mption to decrease in real value when measured against income growth or 3 Economic Report of the President, Council of Economic Advisors, February 1988 6 inflation. Nor is there any rationale for shifting the burden of taxation more onto families with chi l dren, especially for imposing the largest tax increase on those families least able to pay. Admittedly, Congress never legislated the change specifically, least of all did lawmakers explicitly try to justify raising taxes on children. Indirectly and unint entionally, however, by not legislating remedies to soften the effects of inflation, Congress has eroded the value of the personal exemption.

Inflation and other factors have of course, affected various groups. Some might argue, therefore, that there is no particular reason to turn back the clock to aid families rather than other groups. But there are at least six reasons why good tax policy requires restoring the relative value of the personal exemption to what it was in the 1940s Reason #1: There is grow i ng concern about the cost of raising children It is a longstanding principle of taxation that some relief should be given to parents for their financial sacrifice in raising children. In the immediate postwar period, in fact, the median-income family with children was not subject to income taxes at all. But especially during the 1960s and 1970s income taxes on the family soared, even as the costs of raising children also jumped, and education, housing, and health expenditures outpaced inflation.

Even moder ate-income families today face a severe financial burden in raising children. Increasing the personal exemption would help roll back tax increases and offset some of the higher costs of raising children Reason #2: Demographic changes are straining the eco n omy and social insurance programs Raising the personal exemption could provide an incentive for Americans to have more children. American Enterprise Institute Senior Fellow Ben Wattenberg argues that the U.S. will need a higher fertility rate to sustain i t s growing economy and social benefits. He points out that, in recent years, the fertility rate in the U.S. has fallen significantly below its long-term replacement rate. This poses a number of problems. For one thing, it means that the economy will face a decline in young workers. For another, it means that such social programs as Social Security will come under increasing financial strain as a rising population of elderly Americans have to be supported by contributions from a declining population of worke r s Reason #3: Raising the exemption would aid the working poor and encourage more Americans to go off welfare It makes no sense to tax low-income workers so much that government support programs paid for out of those taxes are necessary to give them a subs i stence income. To be sure, the 1986 Tax Reform Act raises the income tax threshold (which includes exemptions plus the standard deduction) slightly above the poverty line for virtually every type of family, except singles! Yet families significantly above the poverty line have not been given sufficient tax relief to roll back the tax burden accumulated since the 1940s Incentives for the Poor. The working poor are especially vulnerable; they are hit with a high initial tax bracket of 15 percent, together wi t h the equivalent of an additional tax if they lose benefits by leaving the welfare rolls. This combination can easily raise their effective marginal tax rate to higher levels than now are imposed on the rich If the personal exemption were increased to $6, 3 00, the income tax threshold for a family of four would increase to 250 percent of the poverty level, up from 105 percent under current law (see Chart 4 Thus such a fami ly would not begin to pay income tax until it was well clear of the poverty level. Th e benefit of this is that incentives are enhanced for the poor and working groups to save, work, and invest. Families of other sizes would enjoy similar proportionate increases in tax-free income under such a change.

Moreover, an increase in the personal e xemp tion would be very effec tive in directing govern ment financial assistance toward those moderate and low-income workers who suffered the heaviest tax increases over the last 40 years and faced the greatest barriers to work effort. In fact, a $6,300 p ersonal exemption ini tially would wipe out at least the federal income tax burden for low-in come and working families Minimum Taxable Levels of Income Under Current Income Tax System and with $6,300 Exemption 2 pereoni 4 Dereona 8 erro one Size of Famil y hrWty-1 lnoom Ylnlrur Tublo Ylnlmm nublo lnoomo Wllh SO.800 Exmmpllon lnoomo Undr Curnnl Low adJurt. all figure or Inllmtlon from 1988 to 1989. udng Conrumor Price Index Herltrge InfoChart Chart 4 Reason #4: The change would be of immediate help to the e m battled middle class Middle-income Americans-have been hard pressed by escalating taxes on the family. These families today are forced to make heavy financial sacrifices to raise their children. This has encouraged many middle-income families to press for new government programs to assist them with such expenditures as child care and college tuition even though these programs limit their 4 Joseph A. Pechman, Fedeml Tar Policy (Washington, D.C.: Brooking Institution, 1987 pp. 83 and 84 8 discretion as paren ts and cost tax dollars, imposing a heavier tax burden and a further erosion of their financial situation.

Increasing the personal exemption would allow middle-income families to escape this Catch 22 situation. They would be able to keep more of their redu ce the pressures to seek new programs that could be financed only through tax hikes. The overwhelming portion of the tax benefits from higher exemptions would go to those earning less than 70,000 per year. income and thus to pay for the costs of raising t heir children. This would When the family is strong, the need for government programs is reduced.

Increasing the personal exemption is a strategy to empower the family strengthen its resources, and liberate it from reliance on government Reason #5: Raising children should be treated as an investment for tax purposes, not as an item of consumption Economists long have disagreed about the nature of expenditures on children. Some believe that they should be treated as any other item of consumption. Parents, t hey say, receive pleasure from raising children, so they alone should bear the cost. In this view, there is little reason for giving a special tax preference for children, any more than providing a tax break for purchasing a television set.

This view is di sputed by a growing body of economic literature. It considers outlays on such items as health services, housing, and education as 5 an investment in human capital, which leads to higher productivity and future output, much like maintaining or constructing an industrial machine.

Moreover, the prospective returns on investments in education, according to one 1988 British government analysis, could be about 25 percent, much larger than most investments in the British or American economies. 6 Investing in Peop le. The distinction between capital and consumption always somewhat arbitrary is particularly difficult in the case of spending on human beings. Yet reasonable distinctions are possible. The U.S. tax code allows businesses to deduct their expenditures for the health or training of their workers, but gives very limited tax benefits to parents investing in their childrens future productivity A higher personal exemption is one practical way of providing some allowance for the outlays in raising children, such as education and health care, which are more in the nature of human capital expenditures 5 See Gary S. Becker, Huniun Cupiful (Cambridge, Massachusetts: National Bureau of Economic Research 6 Cleve Wolman, A Better Way to Finance Students, Finuncial limes , December 1,1988, p. 17; see also Becker, op. cit 1964 9 Reason #6: The family is the basic unit of taxation, and exemptions should reflect this.

I Most tax theorists regard the family household as the basic unit of taxation.

Thus one goal of tax policy has been to impose equal taxes on families who have command over equal resources. The two-eamer deduction, different rate schedules for marital status, and income splitting have been used in the past as rough devices to help ad just taxable income for family circumstances.

The personal exemption is another adjustment for the taxpaying ability of the family.

For example, a single person earning $25,000 enjoys a much higher standard of living than a family with children earning th e same amount. The personal exemption is supposed to help account for the greater sacrifices and necessary costs of raising a family, thereby more accurately measuring a family's actual living standard The current $2,000 personal exemption does not come c l ose to measuring the true sacrifice required by a family to raise a child. A larger exemption would lead to a tax liability more in line with each household's real circumstances COVERING THE REVENUE LOSS FROM INCREASED EXEMPTIONS Raising the exemption to $6,300 for all Americans would reduce thq U.S.

Treasury's income tax revenues by about $100 billion to $130 billion. This revenue loss could be lowered, however, by limiting the increased exemption to children claimed as dependents. A $6,300 children's exe mption, for example, would cut income tax revenues by about $30 billion to $50 billion8 If limited further to children under five years of age, the tax revenue loss would be less than $12 billion? George Bush's proposal to give families earning less thanl $20,000 a $1,000 tax credit for each child under four would cost $2.5 billion.

Some imaginative proposals, however, would link increases in the personal exemption with other social policy objectives, potentially leading to less revenue loss for the U.S. Tr easury. Under one plan, the personal exemption 7 Estimates based on Internal Revenue Service Individual Income Tax Returns Sraristics of Income, 1984 p 61. Sin& these estimates are based on numerous simpling assumptions, they should be viewed as broadly i n dicative of possible revenue losses, rather than as precise figures. They are also "static and therefore unrealistically assume no changes in economic behavior resulting from the change 8 IRS, op. cit 9 Srarisricul Absrmcr of the United Srares, 1987, U.S. Department of Commerce, Bureau of the Census. No phase-out of the exemption is assumed 10 Figures released by Bush campaign staff 10 could be increased in return for further tax reform. The deduction for state and local income and property taxes is used p rimarily by upper-income families and tends to subsidize high-tax states. Eliminating this deduction would raise 15 billion.

Another option would be a floor for itemized deductions of 20 percent of adjusted gross income. Under this plan, only the amount of allowable expenses exceeding 20 percent of income would be deductible from taxes.

This would raise 31 billion.12 While eliminating many tax-induced distortions in the economy, however, a deduction floor would make no distinction between economically effi cient and inefficient deductions and could soften their support of the mortgage deduction. And in general increasing the personal exemption would provide more total tax relief to middle-income families with children than they can obtain from the current d e duction for mortgage interest THE DYNAMIC EFFECT OF RAISING THE EXEMPTION In reality, concerns about revenue losses are vastly overstated. Little faith should be put in static revenue estimates because they do not incorporate any change in economic incent i ves for work, saving, or investment. In essence, these models assume that the economy would be no more productive or robust following the tax cut than before. Such static assumptions were shown to be erroneous in 1981, when they predicted that tax cuts wo u ld trigger an economic slowdown and a sharp reduction in tax revenue. They are just as unrealistic when used to assess the impact of an increase in the exemption Drawing Americans Off Welfare. Exempting upwards of one-half of all taxpayers from the income tax rolls obviously would have enormous 11 Pechman, op. cit pp. 358-363 12Ibid p. 100 l3 Patricia H. Hendershott and Sheng-cheng Hu, The Allocation of Capital Between Residential and Nonresidential Uses: Taxes, Inflation, and Market Constraints, Working P a per No. 718 (Cambridge Massachusetts: National Bureau of Economic Research, 1981 11 consequences for economic incentives and social welfare outlays. Reducing the marginal income tax rate for millions of low paid taxpayers to zero would give poor and worki n g Americans an enormous income boost as well as an incentive to work, engage in entrepreneurial activity, and pursue work training or further education. And by making work more rewarding a higher exemption also would draw people off the welfare rolls and make them less dependent on government support programs, thereby reducing government social welfare spending (see Chart 5).

Middle-income Americans also would enjoy lower marginal tax rates.

With higher exemp tions, millions of mid dle-income taxpayers would drop from the 28 percent tax brack et into the 15 percent bracket enjoying almost a 50 percent increase in produc tive incentives.

Thus, by increasing such incentives for economic expansion a higher exemption would boost the size of the nations Number of Taxpayers in Each Tax Bracket Before and After Personal Exemption Increase Current Syotem $6.900 Exemption m Exempt 16% BrMk.1 28% Bracket Chart 5 economy and lead to more tax revenues flowing into the governments cof fers. A significant portion of th e tax cut thus would ultimately be recouped in increased government revenues through faster economic growth CONCLUSION As the foundation of a free society, the incubator of traditional values, and the crucible for instilling good character in future genera t ions, the American family must be the first priority of a free and democratic society. Yet the financial pressures on traditional families raising children are acute. The governments discriminatory tax treatment of children has undercut the familys financ i al security and impeded the ability of parents to provide for the health, education, and welfare of their children. Many point out the bias in the U.S. tax code against saving and investment. They are correct. The greatest bias, however, is that against f a milies with children I 12 Tax Relief for Rearing Children. Two paths lie ahead. Down one are more government programs to support weakened families. If high taxation of the family is allowed to continue, families increasingly will be unable to provide for themselves. They will look increasingly to the government for help to meet the burden of raising children. The prospect of government taking over the functions and choices of parents should alarm most Americans.

The other path leads toward strong families, a more appropriate role for government, and a growing economy. This path begins by giving American families substantial tax relief for the costs of rearing children. It will require a major, long overdue change in tax policy it will treat children as an investment in Americas future.

Restoring the personal exemption to where it was, in relative terms, in 1948 would allow Americas median-income families with two children to keep over $2,500 more of their own income to raise and nurture their children. A me dian-income family with four children would enjoy almost a $4,000 tax cut.

With this income boost, families would be less reliant on government programs and have access to vastly improved health and education opportunities Strengthening the Family. George Bushs proposal for a toddler tax credit shows that he appreciates the vital role in America of families raising children. But to strengthen that mcial institution, his Administration ultimately must ask Congress to roll back a half century of unfair and d iscriminatory tax increases on Americas children 13 687 January 30,1989 ENDING THE TAX CODES ANTI-FANILY BIASBY INCREASING THE PERSONAL EXEMPTION TO $6,300 Thomas M. Humbert John M. Olin Fellow INTRODUCTION Every lawmaker claims to be pro-family. Yet the i ncome tax code devised by Congress reflects a different reality The federal income tax system treats children less favorably than a business lunch Like spending for the movies the costs of raising children are for the most part considered a routine discre t ionary expense, instead of Americas most important investment in its future I Reflecting this strange premise, the tax allowance for the costs of nurturing children the personal exemption has been permitted to erode dramatically in value over the years. T h e result has been a half century of steeply increasing federal income taxes on Americans who raise children. In 1948, the median-income family of four paid virtually no income taxes, and only $30 a year in direct Social Security taxes (1 percent of income This year, the equivalent family will pay $2,669 in income taxes and over $2,500 7.51 percent of income) in Social Security taxes. Just looking at federal income taxes, this median-income familys tax burden has soared over 2,500 percent from 0.3 percent o f income to over 8.0 percent of income in about four decades. Singles and married couples without children, by contrast largely have escaped this income tax increase Sapping Families Financial Health. As taxes on children have climbed the familys ability t o provide for its own needs has been impaired. New government programs are touted as a cure for the familys financial ills. But these congressional remedies are for a problem created by Congress. And new taxes to finance government programs would sap even further the financial ability of the family to stand on it own A far more effective strategy to address the problem would be simply to allow a family with children to keep a greater portion of its own income.

Restoring the personal exemption to the equivalent of its level after World War I1 would allow that family to keep thousands of dollars more of its own money, making the family less dependent on government, improving access to health care, child care, and education opportunities, and giving the working poor a fighting chance to climb out of poverty Toward A Fair Tax System. As a political strategy, increasing the personal exemption could head off government-provided day care, mandatory health care, educati o n subsidies, and similar initiatives that would prolong the process of first taking away family income and then giving it back in government-determined services. It could also reduce pressure for a boost in the minimum wage which would cut employment oppo rtunities for the poorest and least skilled Americans.

In the presidential campaign, George Bush recommended a $1,000 tax credit for each child under age four in families earning less than $20,0

00. The Bush proposal would be an important step toward a fa ir tax system for the American family. Moreover, the Bush plan does not discriminate between traditional families and families where both spouses work. It does not subsidize one life style at the expense of another. Further, the tax credit approach gives the same financial assistance to all families, not bigger tax breaks to wealthier families.

Yet this toddler tax credit is not enough. The real challenge for Congress and the incoming Bush Administration is to empower the family by rolling back the postwar tax increases on children. This strategy will require tax policy to recognize that children are Americas most important capital investment and are fundamental to productivity gains and to future economic growth Reversing 40 Years of Discrimination. As it s ultimate goal, the Bush Administration should press Congress to increase the personal exemption to at least $6,300 4,300 above where it now stands. At this level, the personal exemption would shield from taxes about the same portion of income as it did i n 1948 when the modern income tax first began to take form. This would give the median-income family of four over $25,000 in tax-free income. Combined with the current $5,000 standard deduction, this exemption would eliminate from the income tax rolls thos e four-person families earning less than $30,200 yearly about one-half of todays tax returns 2 More important, with this action, Congress and the Bush Administration would strengthen the family and reverse 40 years of mounting tax discrimination against ch i ldren HOW THE TAX CODE BECAME ANTI-FAMILY On October 13,1981, senior Treasury official Eugene Steuerle told a tax conference that perhaps no change in the nations tax laws has been more significant, yet less recognized, than the shift since the late 1940s in the relative tax burdens of households of different size. In the years since Steuerles observation, the anti-family, anti-children bias has remained despite the 1981 and 1986 tax acts The 1981 Economic Recovery Tax Act (ERTA) at least has kept matters f rom getting worse by indexing the tax system for inflation and by providing modest additional tax relief. Had ERTA not been enacted, inflation-induced bracket creep and the erosion of the personal exemption would have raised the average income tax on the median-income2 family of four from about 10 percent in 1980 to almost 13 percent by 1986 (see Chart 1 But thanks to ERTA, the median-income familys tax burden actually fell one percentage point to about 9 percent of income.

Families of all sizes experience d similar tax reductions see Table 1 Average Taxes Paid by a Typical Family* Before and After 1981 Tax Cut 12 Og f 4 The 1986 Tax Reform Act was the most pro-family and pro-children legislation in 50 years. At last, the income tax threshold was raised abo v e the poverty line, with 5 million poor families taken off the tax rolls al together. Moreover, a dis proportionate share of tax relief was given to larger families, as a result of doubling the personal exemption, which will take full effect this year e 0 1 I 1880 082 184 1988 After 1981 Tax Cut Median income, married. and 2 dependonle Herllage IntoChart Chart 1 1 Eugene Steuerle, The Tax Treatment of Households of Different Size, in Rudolph G. Penner, ed Tmhg the Family (Washington, D.C American Enterprise Institute, 1983 p. 73 2 Median income is the level of income such that 50 percent of all families are above it, and 50 percent, below.

Median family income is a useful measure for tax purposes because it provides a snapshot of the financial condition of t he household in the middle of the income distribution. Average family income is total income divided by number of households, and thus average family income could be anywhere in the income distribution of families and is therefore less representative of t h e typical household 3 L Ele Ele 4 Neither the 1981 nor the 1986 tax reforms, however, completely removed the decades of accumulated tax bias against families. The median-income family of four will have its income taxes cut to 8.0 percent of income in 1989 down from the 1986 level of 9.3 percent. But this tax burden is still far above the level for the median-income family with children throughout most of the 1940s, 1950s, and 1960s (see Table 1 TAX INCREASES ON THE FAMILY Despite the 1981 and 1986 tax refo r ms, the American family is still over taxed. Table 1 shows the tax burden on singles, heads of household, and mar ried couples with no children, two children, and four children. Measured as a percentage of income, the income tax burden has risen most dram atically for families with children, with the biggest tax increases hitting the largest families. Single Americans and married couples without children pay about the same portion of their income in taxes as they did in the 1950s.

The reason for such a tax increase on families has been the erosion of the real value of the per sonal exemption as a result of inflation (see Chart 2 The personal exemption is 2,000 per person under current law. By comparison, ad justed for inflation, the personal exemption in 19 48 was worth 3,000 7,000 in 1940, and around $10,000 in the 1920s and 1930s. Though increased numerous times, the personal ex emption has fallen far be hind the amount needed to keep up with inflation.

Nor has the value of the exemption kept up with increa ses in income see Chart 3). The ex emptions for a median Value of the Personal Exemption Currant Dollar8 (Thouaanda 101 I 8 8 i 1913 1920 1930 1940 1960 1980 1970 1980 1989 1989 Conatanl Dollar. (Thouaanda 40 1919 1920 1930 1940 1960 1980 1970 1980 1989 I ngle Marrled 2 Chlldren Bourn Joooph A. Peohmon. Federal Tex Flollcy. 6th od. tWaohlnaton, D.Cr Tho Brooklnaa Inotltutlon. 1007 DD. ata-4 5 Chart 2 income faniily of four shielded 75 percent of income from tax in 19

48. The exemptions for the same median income family today would shield less than 25 percent of household income.

The personal exemp tion would have to equal about 6,300 per person, or over 25,000 in tax-free in come for a family of four, to shield the same proportion of in Personal Exemption a s Percent of Median Family Income i an 100 I I e I p 80 r 0 80 e 40 20 0 1848 1860 1872 1860 1867 1888 8tlmated Horltago InfoChart Chart 3 comeas in 19

48. Simp ly put, today's family faces heavy tax discrimination compared with equivalent families in ear lier generations, and its tax status also has eroded when it is compared to that of single Americans or couples without children Advent of the Income Tax. The best standard for judging the current tax code is the immediate postwar period. During that time , the modern income tax emerged as the basic government revenue source. Prior to World War 11 the U.S. government was far different in size and scope. In 1929, for example total government receipts were less than 4 percent of gross national product GNP But in the years preceding and immediately after World War 11, the U.S. became a modern industrial society and assumed world leadership. To finance these growing domestic and foreign responsibilities, the income tax was extended to a majority of workers; and in 1943 income tax withholding became the backbone of the current system.

Starting in the postwar years, receipts have tended to average 15 percent to 20 percent of GNP, with the individual income tax accounting for the over whelming proportion of general revenue funds Thus, making comparisons between the late 1940s and late 1980s gives an accurate and valid picture of how the tax burden has changed, given the similar scale of government activity as a feature of national economic activity THE CASE FOR INCR E ASING THE PERSONAL EXEMPTION There is little justification in tax theory for allowing the personal exemption to decrease in real value when measured against income growth or 3 Economic RepH of the President, Council of Economic Advisors, February 1988 6 i n flation. Nor is there any rationale for shifting the burden of taxation more onto families with children, especially for imposing the largest tax increase on those families least able to pay. Admittedly, Congress never legislated the change specifically, least of all did lawmakers explicitly try to justify raising taxes on children. Indirectly and unintentionally, however, by not legislating remedies to soften the effects of inflation, Congress has eroded the value of the personal exemption.

Inflation and other factors have of course, affected various groups. Some might argue, therefore, that there is no particular reason to turn back the clock to aid families rather than other groups. But there are at least six reasons why good tax policy requires restori n g the relative value of the personal exemption to what it was in the 1940s Reason #1: There is growing concern about the cost of raising children It is a longstanding principle of taxation that some relief should be given to parents for their financial sa c rifice in raising children. In the immediate postwar period, in fact, the median-income family with children was not subject to income taxes at all. But especially during the 1960s and 1970s income taxes on the family soared, even as the costs of raising children also jumped, and education, housing, and health expenditures outpaced inflation.

Even moderate-income fa milies today face a severe financial burden in raising children. Increasing the personal exemption would help roll back tax increases and offset some of the higher costs of raising children Reason #2: Demographic changes are straining the economy and soci a l insurance programs Raising the personal exemption could provide an incentive for Americas to have more children. American Enterprise Institute Senior Fellow Ben Wattenberg argues that the U.S. will need a higher fertility rate to sustain its growing eco n omy and social benefits. He points out that, in recent years, the fertility rate in the U.S. has fallen significantly below its long-term replacement rate. This poses a number of problems. For one thing, it means that the economy'will face a decline in yo u ng workers. For another, it means that such social programs as Social Security will come under increasing financial strain as a rising population of elderly Americans have to be supported by contributions from a declining population of workers Reason #3: R aising the exemption would aid the working poor and encourage more Americans to go off welfare It makes no sense to tax low-income workers so much that government support programs paid for out of those taxes are necessary to give them a subsistence income . To be sure, the 1986 Tax Reform Act raises the income tax threshold (which includes exemptions plus the standard deduction) slightly above the poverty line for virtually every type of family 7 except singles! Yet families significantly above the poverty l ine have not been'given sufficient tax relief to roll back the tax burden accumulated since the 1940s Incentives for the Poor. The working poor are especially vulnerable; they are hit with a high initial tax bracket of 15 percent, together with the equiva l ent of an additional tax if they lose benefits by leaving the welfare rolls. This combination can easily raise their effective marginal tax rate to higher levels than now are imposed on the rich If the personal exemption were increased to $6,300, the inco m e tax threshold for a family of four would increase to 250 percent of the poverty level, up from 105 percent under current law (see Chart 4 Thus such a fami ly would not begin to pay income tax until it was well clear of the poverty level. The benefit of this is that incentives are enhanced for the poor and working groups to save, work, and invest. Families of other sizes would enjoy similar proportionate increases in tax-free income under such a change.

Moreover, an increase in the personal exemp tion wou ld be very effec tive in directing govern ment financial assistance toward those moderate and low-income workers who suffered the heaviest tax increases over the last 40 years and faced the greatest barriers to work effort. In fact, a $6,300 personal exem p tion ini tially would wipe out at least the federal income tax burden for low-in come and working families Minimum Taxable Levels of Income Under Current Income Tax System and with $6,300 Exemption 2 perrona 4 peraone 6 peraona Size of Family I P0nrtp-i i nnoma Ylnlmua Tmubk inooma Undar Cumnt Lmw Ylnlmum mxma inooma With

e,aoo examption dJuate all flgurer for Inflation from 1988 to 1989. ualng Conrumer Price Index Herltage InfoChart Chart 4 I Reason #4: The change would be of immediate help to the embattl ed middle class Middle-income Americans have been hard pressed by escalating taxes on the family. These families today are forced to make heavy financial sacrifices to raise their children. This has encouraged many middle-income families to press for new g overnment programs to assist them with such expenditures as child care and college tuition even though these programs limit their 4 Joseph A. Pechman, Federal Tax Policy (Washington, D.C.: Brooking Institution, 1%7 pp. 83 and 84 8 discretion as parents an d cost tax dollars, imposing a heavier tax burden and a further erosion of their financial situation.

Increasing the personal exemption would allow middle-income families to escape this Catch 22 situation. They would be able to keep more of their income an d thus to pay for the costs of raising their children. This would reduce the pressures to seek new programs that could be financed only through tax hikes. The overwhelming portion of the tax benefits from higher exemptions would go to those earning less t han $70,000 per year.

When the family is strong, the need for government programs is reduced.

Increasing the personal exemption is a strategy to empower the family strengthen its resources, and liberate it from reliance on government Reason #5: Raising ch ildren should be treated as an investment for tax purposes, not as an item of consumption Economists long have disagreed about the nature of expenditures on children. Some believe that they should be treated as any other item of consumption. Parents, they say, receive pleasure from raising children, so they alone should bear the cost. In this view, there is little reason for giving a special tax preference for children, any more than providing a tax break for purchasing a television set.

This view is dispu ted by a growing body of economic literature. It considers outlays on such items as health services, housing, and education as an investment in human capital, which leads to higher productivity and future output, much like maintaining or constructing an i ndustrial machine?

Moreover, the prospective returns on investments in education, according .to one 1988 British government analysis, could be about 25 percent, much larger than most investments in the British or American economies Investing in People. The distinction between capital and consumption always somewhat arbitrary is particularly difficult in the case of spending on human beings. Yet reasonable distinctions are possible. The U.S. tax code allows businesses to deduct their expenditures for the he a lth or training of their workers, but gives very limited tax benefits to parents investing in their childrens future productivity A higher personal exemption is one practical way of providing some allowance for the outlays in raising children, such as edu c ation and health care, which are more in the nature of human capital expenditures 5 See Gary S. Becker, Human Capital (Cambridge, Massachusetts: National Bureau of Economic Research 6 Cleve Wolman, A Better Way to Finance Students, Financial 7imes, Decemb er 1,1988, p. 17; see also Becker, op. cit 1964).

Reason #6: The family is the basic unit of taxation, and exemptions should reflect this Most tax theorists regard the family household as the basic unit of taxation.

Thus one goal of tax policy has been to impose equal taxes on families who have command over equal resources. The two-earner deduction, different rate schedules for marital status, and income splitting have been used in the past as rough devices to help adjust taxable income for family circums tances.

The personal exemption is another adjustment for the taxpaying ability of the family.

For example, a single person earning $25,000 enjoys a much higher standard of living than a family with children earning the same amount. The personal exemption is supposed to help account for the greater sacrifices and necessary costs of raising a family, thereby more accurately measuring a family's actual living standard the true sacrifice required by a family to raise a child. A larger exemption would lead to a tax liability more in line with each household's real circumstances The current $2,000 personal exemption does not come close to measuring COVERING THE REVENUE LOSS FROM INCREASED EXEMPTIONS Raising the exemption to $6,300 for all Americans would reduce the U.S.

Treasury's income tax revenues by about $100 billion to $130 billion? This revenue loss could be lowered, however, by limiting the increased exemption to children claimed as dependents. A $6,300 children's exemption, for example, would cut income tax revenues by about $30 billion to $50 billion?

If limited further to children under five years of age, the tax revenue loss would be less than $12 billion? George Bush's proposal to give families earning less than 20,000 a $1, 000 tax credit for each child under four would cost $2.5 billion.' i Some imaginative proposals, however, would link increases in the personal exemption with other social policy objectives, potentially leading to less revenue loss for the U.S. Treasury. U n der one plan, the personal exemption 7 Estimates based on Internal Revenue Service, "Individual Income Tax Returns Stuhtics of Income, 1984 p 61. Since these estimates are based on numerous simplifying assumptions, they should be viewed as broadly indicat i ve of possible revenue losses, rather than as precise figures. They are also "static and therefore unrealistically assume no changes in economic behavior resulting from the change 8 IRS, op. cit 9 Statistical Abstract of the Uirited States, 1987, U.S. Dep a rtment of Commerce, Bureau of the Census. No phase-out of the exemption is assumed 10 Figures released by Bush campaign staff 10 could be increased in return for further tax reform. The deduction for state and local income and property taxes is used prima rily by upper-income families and tends to subsidize high-tax states. Eliminating this deduction would raise 15 billion.

Another option would be a floor for itemized deductions of 20 percent of adjusted gross income. Under this plan, only the amount of allowable expenses exceeding 20 percent of income would be deductible from taxes.

This would raise 31 billion.12 While eliminating many tax-induced distortions in the economy, however, a deduction floor would make no distinction between economically efficien t and inefficient deductions Relief for the Middle Class. Changes in the homeowners mortgage interest deduction could be viewed as another option to offset an increased personal exemption, as some studies show that the mortgage interest deduction ineffici e ntly shifts resources to the housing stock and away from more valuable capital investment and saving. Few deductions enjoy more popular and political support, and home purchases currently are regarded as the familys most important capital investment, dese r ving of special tax treatment. Yet many American families fiercely support the mortgage deduction mainly as a tax break for the middle class, rather than an objective in itself. They argue that they need the tax relief to help finance other family expendi t ures. Increasing the personal exemption would give them this relief and could soften their support of the mortgage deduction. And in general increasing the personal exemption would provide more total tax relief to middle-income families with children than they can obtain from the current deduction for mortgage interest THE DYNAMIC EFFECT OF RAISING THE EXEMPTION In reality, concerns about revenue losses are vastly overstated. Little faith should be put in static revenue estimates because they do not incorp o rate any change in economic incentives for work, saving or investment. In essence, these models assume that the economy would be no more productive or robust following the tax cut than before. Such static assumptions were shown to be erroneous in 1981, wh e n they predicted that tax cuts would trigger an economic slowdown and a sharp reduction in tax revenue. They are just as unrealistic when used to assess the impact of an increase in the exemption Drawing Americans Off Welfare. Exempting upwards of one-hal f of all taxpayers from the income tax rolls obviously would have enormous 11 Pechman, op. cit pp. 358-363 12 &id, p. 100 13 Patricia H. Hendershott and Sheng-cheng Hu, The Allocation of Capital Between Residential and Nonresidential Uses: Taxes, Inflation , and Market Constraints, Working Paper No. 718 (Cambridge Massachusetts: National Bureau of Economic Research, 1981 11 consequences for economic incentives and social welfare outlays. Reducing the marginal income tax rate for millions of low paid taxpayer s to zero would give poor and working Americans an enormous income boost as well as an incentive to work, engage in entrepreneurial activity, and pursue work training or further education. And by making work more rewarding, a higher exemption also would dr aw people off the welfare rolls and make them less dependent on government support programs, thereby reducing government social welfare spending (see Chart 5 Middle-income Americans also would enjoy lower marginal tax rates.

With higher exemp tions, millions of mid dle-income taxpayers would drop from the 28 percent tax brack et into the 15 percent bracket enjoying almost a 50 percent increase in produc tive incentives.

Thus, by increasing such incentives for economic expansion, a higher exemption would bo ost the size of the nations Number of Taxpayers in Each Tax Bracket Before and After Personal Exemption Increase Figurea are adluatod for Inflation 1 Current Syatem 58.300 Exemption I Exempt 16% Bracket 28% Bracket 1 or 4-ooraon Iamllloa and 86.300 ommoll on (or Oh ooraon Eatlmaka an broadly Indlcatlia 01 nush 01 tax mtuina Oourc IRO. 106S Otatlatlca 01 Income Horllago InfoChart lor Oh bra0L.t rather than pN0l.o lIgUN Chart 5 economy and lead to more tax revenues flowing into the governments cof fers.

A sig nificant portion of the tax cut thus would ultimately be recouped in increased government revenues through faster economic growth CONCLUSION As the foundation of a free society, the incubator of traditional values, and the crucible for instilling good cha r acter in future generations, the American family must be the first priority of a free and democratic society. Yet the financial pressures on traditional families raising children are acute. The governments discriminatory tax treatment of children has unde r cut the familys financial security and impeded the ability of parents to provide for the health, education, and welfare of their children. Many point out the bias in the U.S. tax code against saving and investment. They are correct. The greatest bias, how e ver, is that against families with children 12 Tax Relief for Rearing Children. Two paths lie ahead. Down one are more government programs to support weakened families. If high taxation of the family is allowed to continue, families increasingly will be u nable to provide for themselves. They will look increasingly to the government for help to meet the burden of raising children. The prospect of government taking over the functions and choices of parents should alarm most Americans.

The other path leads to ward strong families, a more appropriate role for government, and a growing economy. This path begins by giving American families substantial tax relief for the costs of rearing children. It will require a major, long overdue change in tax policy it will treat children as an investment in Americas future.

Restoring the personal exemption to where it was, in relative terms, in 1948 would allow Americas median-income families with two children to keep over $2,500 more of their own income to raise and nurture their children. A median-income family with four children would enjoy almost a $4,000 tax cut.

With this income boost, families would be less reliant on government programs and have access to vastly improved health and education opportunities Strengtheni ng the Family. George Bushs proposal for a toddler tax credit shows that he appreciates the vital role in America of families raising children. But to strengthen that crucial institution, his Administration ultimately must ask Congress to roll back a half century of unfair and discriminatory tax increases on Americas children 13 687 January 30,1989 ENDING THE TAX CODES ANII-F-Y BIASBY.

INCREASING THE PERSONAL EXEMPTION TO $6,300 i L hl. Thomas M. Humbert John M. Olin Fellow I INTRODUCTION Every lawmaker cl aims to be pro-family. Yet the income tax code devised by Congress reflects a different reality. The federal income tax system treats children less favorably than a business lunch. Like spending for the movies the costs of raising children are for the mos t part considered a routine discretionary expense, instead of Americas most important investment in its future.

Reflecting this strange premise, the tax allowance for the costs of nurturing children the personal exemption has been permitted to erode dramat ically in value over the years. The result has been a half century of steeply increasing federal income taxes on Americans who raise children.

In 1948, the median-income family of four paid virtually no income taxes; and only $30 a year in direct Social S ecurity taxes (1 percent of income). This I year, the equivalent family will pay $2,669 in income taxes and over $2,500 7.51 percent of income) in Social Security taxes. Just looking at federal income taxes, this median-income familys tax burden has soare d over 2,500 percent from 0.3 percent of income to over 8.0 percent of income in about four decades. Singles and married couples without children, by contrast largely have escaped this income tax increase S Sapping Families Financial Health. As taxes on ch i ldren have climbed the familys ability to provide for its own needs has been impaired. New government programs are touted as a cure for the familys financial ills. But these congressional remedies are for a problem created by Congress. And I L 1 I new tax e s to finance government programs would sap even further the financial ability of the family to stand on it own A far more effective strategy to address the problem would be simply to allow a family with children to keep a greater portion of its own income .

Restoring the personal exemption to the equivalent of its level after World War I1 would allow that family to keep thousands of dollars more of its own money, making the family less dependent on government, improving access to health care, chiid care, an d education opportunities, and giving the working poor a fighting chance to climb out of poverty Toward A Fair Tax System. As a political strategy, increasing the personal exemption could head off government-provided day care,,mandatory health care, educa t ion subsidies, and similar initiatives that would prolong the process of first taking away family income and then giving it back in government-determined services. It could also. reduce pressure for a boost in the minimum wage which would cut employment o pportunities for the poorest and least skilled Americans In the presidential campaign, George Bush recommended a $1,000 tax. I credit for each child under age four in families earning less than $20,0

00. The Bush proposal would be an important step toward a fair tai system for the American family. Moreover, the Bush plan does not discriminate between traditional families and families where both spouses work. It does not subsidize one life style at the expense of another:Further, the tax credit approach gives the same financial assistance to all families, not bigger tax breaks to wealthier families.

Yet this toddler tax credit is not enough..The real challenge for.Cong5eh and the incoming Bush Administr ation is to empower the family byrollirig back the postwar tax increases on children. This strategy.wil1 require tax policy to recognize that children are Americas most important. capital investment and are fundamental to productivitygains and to future e c onomic growth Reversing 40 Years of Discrimination. As its ultimate goal; the Bush Administration should press Congress to increase the personal exemption to at least $6,300 4,300 above where it now stands. At this level, the personal exemption would shie l d from taxes about the same portion of income as it did in 1948 when the modern income tax first began to take form. This would give the median-income family of four over $25,000 in tax-free income. Combined with the current $5,000 standard deduction, thi s exemption would eliminate from the income tax rolls those four-person families earning less than $30,200 yearly about one-half of todays tax returns 2 More important, with this action, Congress and the Bush Administration would strengthen the family and r everse 40 years of mounting tax discrimination against children HOW THE TAX CODE BECAME ANTI-FAMILY On October 13,1981, senior Treasury official Eugene Steuerle told a tax conference that perhaps no change in the nations tax laws has been more significant , yet less recognized, than the shift since the late 1940s in the relative tax burdens of households of different size. In the years since Steuerles observation, the anti-family, anti-children bias has remained despite the 1981 and 1986 tax acts.

The 1981 Economic Recovery Tax Act (ERTA) at least has kept matters from getting worse by indexing the tax system for. inflation and by providing modest additional tax relief. Had ERTA not been enacted, inflation-induced bracket creep and the erosion of the person a l exemption would havexaised the average income tax on the median-income2 family of four from about 10 percent in 1980 to almost 13 percent by 1986 (see Chart 1 But thanks to ERTA, the median-income familys tax burden actually fell one percentage point to about 9 percent of income.

Families of all sizes experienced similar tax reductions (see Table 1 The 1986 Tax Reform Act was the most pro-family and pro-children legislation in 50 years. At last, the income tax threshold was raised above the poverty line, with 5 million poor families taken off the tax rolls al together. Moreover, a dis proportionate share of tax relief was given to larger Average Taxes Paid by a Typical a Family. Before and After 1981 Tax Cut 09 f m 680 1082 1884 1888 After 1981 Tar cut I 1 18 U.d Median Income. married. and 2 depmdentr Heritage IntoChart Chart 1 families, as a result of doubling the personal exemption, which will take full effect this year 1 Eugene Steuerle, The Tax Treatment of Households of Different Size, in Rudolph G. Penner, ed Taxing the Fumify (Washington, D.C American Enterprise Institute; 1983), p. 73 2 Median income is the level of income such that 50 percent of all families are above it, and 50 percent, below.

Median family income is a useful measure for tax purp oses because it provides a snapshot of the financial condition of the household in the middle of the income distribution. Average family income is total income divided by number of households, and thus average family income could be anywhere in the income distribution of families and is therefore less representative of the typical household 3 2 I 4 9, s t Neither the 1981 nor the 1986 tax reforms, however, completely removed the decades of accumulated tax bias against families. The median-income family of f our will have its income taxes cut to 8.0 percent of income in 1989 down from the 1986 level of 9.3 percent. But this tax burden is still far above the level for the median-income family with children throughout most of the 1940s, 1950s, and 1960s (see Ta b le 1 TAX INCREASES ON THE FAMILY Despite the 1981 and 1986 tax reforms, the American family is still over taxed. Table 1 shows the tax burden on singles, heads of household, and mar ried couples with no children, two children, and four children. Measured a s a percentage of income, the income tax burden has risen most dramatically for families with children, with the biggest tax increases hitting the largest families. Single Americans and married couples without children pay about the same portion of their i ncome in taxes as they did in the 1950s The reason for such a tax increase on families has been the erosion of the real value of the per sonal exemption as a result of inflation (see Chart 2 The personal exemption is $2,000 per person under current law. B y comparison, ad justed for inflation, the personal exemption in 1948 was worth $3,000 7,000 in 1940, and around $10,000 in the 1920s and 1930s. Though increased numerous times, the personal ex emption has fallen far be hind the amount needed to keep up wi t h inflation Nor has the'value of the exemption kept up with increases in income see Chart 3 The ex emptions for a median Value of the Personal Exemption Current Dollara (Thouaanda I I 1 so 1913 1920 1990 1940 1960 1980 1970 1980 1989 I Single Marrled 2 Ch ildren 1 a 1989 Conatant Dollara (Thouaanda 1819 1820 1930 1940 1950 1980 1970 1980 1980 81ngIo Marrled 2 Chlldmn Sourn Joaeph A. Poohman. Federal Tax RpI/oy, Ilh ed. (Waehlngln. D.O The Bmoklnge Inelllullon. 19871. pp. ala-

4. Herllege InfoCherl Chart 2 5 Personal Exemption as Percent of Median Family Income income family of four shielded 75 percent of income from tax in 19

48. The exemptions for the same median income family today would shield less than 25 percent of household income.

The personal exemp tion would have to equal about 6,300 per person, or over 25,000 in tax-free in come for a family of four, to shield the come as in 19

48. Simp ly put, todays family faces heavy tax discrimination compared with equivalent families in earlier generations, and its tax status also has eroded when it is compared to that of same proportion of in Chart 3 single Americans or couples without children I I 100 I I p 80 e -I AI I 1040 1080 1872 1080 1087 1980 Heritage InfoChart Gntlmated il Advent of the Income Tax. The best standard for judging the current tax code is the immediate postwar period. During that time, the modern income tax emerged as the basic government revenue source. Prior to World War 11 the U.S. government was far different in size and scope. In 1 929, for example total government receipts were less than 4 percent of gross national product GNP But in the years preceding and immediately after World. War II, the.

U.S. became a modern industrial society and assumed world leadership. To finance these gr owing domestic and foreign responsibilities, the income tax was extended to a majority of workers; and in 1943 income t& withholding became the backbone of the current system Starting in the postwar years, receipts have tended to average 15 percent to 20 p ercent of GNP, with the individual income tax accounting for.the*over whelming proportion of general revenue funds..Thus, making comparisons between the late 1940s and late 1980s gives an accurate and valid picture of how the tax burden has changed, given the similar scale of government activity as a feature of national economic activity. 3 THE CASE FOR INCREASING THE PERSONAL EXEMPTION I There is little justification in tax theory for allowing the personal exemption to decrease in real value when measured against income growth or 3 Economic Report of the President, Council of Economic Advisors, February 1988 6inflation. Nor is there any rationale for shifting the burden of taxation more onto families with children, especially for imposing the largest tax i n crease ,on those families least able to pay. Admittedly, Congress never legislated the change specifically, least of all did lawmakers explicitly try to justify raising taxes on children. Indirectly and unintentionally, however, by not legislating remedie s to soften the effects of inflation, Congress has eroded the value of the personal exemption.

Inflation and other factors have, of course, affected various groups. Some might argue, therefore, that there is no particular reason to turn back the clock to a id families rather than other groups. But there are at least six reasons why good tax policy requires restoring the relative value of the I personal exemption to what it was in the 1940s I Reason #1: There is growing concern about the cost of raising chil d ren It is a longstanding principle of taxation that some relief should be given to I parents for their financial sacrifice in'raising children:*In-the immediate postwar period, in fact, the median-income family with children was not subject to income'taxe s at all. But especially during the 1960s and 1970s income taxes on the family soared, even as the costs of raising children also jumped, and education, housing, and health expenditures outpaced inflation.

Even moderate-income families today face a severe financial burden in raising children. Increasing the personal exemption would help roll back tax increases and offset some of the higher costs of raising children Reason #2 Demographic changes are straining the economy and social insurance programs.

I Rai sing the personal exemption could provide an incentive for Americans to have more children. American Enterprise InstituteSenior Fellow Ben I Wattenberg argues that the U.S.'will need a higher fertility rate to sustain its growing economy and social benefi t s. He points out that, in recent years, the fertility rate in the U.S. has fallen significantly below its long-term replacement rate. This poses a number of problems. For one thing, it means that the economy will face a decline in young workers: For'anoth e ri it means that such social programs as Social Security will come under increasing financial strain as a rising population of elderly Americans have to be supported by contributions from a declining population of workers Reason #3: Raising the exemption w ould aid the working poor and encourage more Americans to go off welfare It makes no sense to.tax low-income workers so much that government support programs paid for out of those taxes are necessary to give them a subsistence income. To be sure, the 1986 Tax Reform Act raises the income tax threshold (which includes exemptions plus the standard deduction) slightly above the poverty line for virtually every type of family 7 except singles! Yet families significantly above the poverty line have not been giv e n sufficient tax relief to roll back the tax burden accumulated since the 1940s Incentives for the Poor. The working poor are especially vulnerable; they are hit with a high initial tax bracket of 15 percent, together with the equivalent of an additional t ax if they lose benefits by leaving the welfare rolls. This combination can easily raise their effective marginal tax rate to higher levels than now are imposed on the rich I Ponrty-Lmi Inoonm Minimum T~II~BIO W MInImum T.ubia Inoomo Under Curnnl Law Inoo m o Wllh 8e.100 Cumpllon If the personal exemption were increased to $6,300, the income tax threshold for a family of four would increase to 250 percent of the poverty level, up from 105 percent under current law (see Chart 4 Thus such a fami ly would not b e gin to pay income tax until it was well clear of the poverty level. The benefit of this is that incentives are enhanced for the poor and working groups to save, work, and invest. Families of other sizes would enjoy similar proportionate increases in tax-f r ee income under such a change L Moreover, an increase in the personal exemp tion would be very effec tive in directing govern ment financial assistance toward those moderate and low-income workers who suffered the heaviest tax increases over the last 40 y e ars and faced the greatest barriers to work effort. In fact, a $6,300 personal exemption ini tially would wipe out at least the federal income tax burden for low-in come and working families Minimum Taxable Levels of Income Under Current Income Tax System and with $6,300 Exemption 2 pereone 4 pereone 6 pereon8 Size of Family Chart 4 Reason #4: The change would be of immediate help to the embattled middle class Middle-income Americans have been hard pressed by escalating taxes on the family. These families t oday are forced to make heavy financial sacrifices to raise their children. This has encouraged many middle-income families to press for new government programs to assist them with such expenditures as child care and college tuition even though these prog rams limit their 4 Joseph A. Pechman, Fedeml Tar Poky (Washington, D.C Brookings Institution, 1987 pp. 83 and 84 8 discretion as parents and cost tax dollars, imposing a heavier tax burden and a further erosion of their financial situation.

Increasing the personal exemption would allow middle-income families to escape this Catch 22 situation. They would be able to keep more of their income and thus to pay for the costs of raising their children. This would reduce the pressures to seek new pr ograms that could be financed only through tax hikes. The overwhelming portion of the tax benefits from higher exemptions would go to those earning less than $70,000 per year.

When the family is strong, the need for government programs is reduced.

Increas ing the personal exemption is a strategy to empower the family strengthen its resources, and liberate it from reliance on government Reason #5: Raising children should be treated as an investment for tax purposes, not as an item of consumption Economists l ong have disagreed about the nature of expenditures on children. Some believe that they should be treated as any other item of consumption. Parents, they say, receive pleasure from raising children, so they alone should bear the cost. In this view, there is little reason for giving a special tax preference for children, any more than providing a tax break for purchasing a television set.

This view is disputed by a growing body of economic literature: It considers outlays on such items as health services, h ousing, and education as an investment in human capital, which leads to higher productivity and 5 future output, much like maintaining or constructing an industrial machine.

Moreover, the prospective returns on investments in education, according $0 one 1 988 British government analysis, could be about 25 percent, much larger than most investments in the British or American economies Investing in People. The distinction between capital and consumption always somewhat arbitrary is particularly difficult in t he case of spending on human beings. Yet reasonable distinctions are possible. The U.S. tax code allows businesses to deduct their expenditures for themhealth or training of their workers, but gives very limited tax benefits to parents investing in their c hildrens future productivity A higher personal exemption is one practical way of providing some allowance for the outlays in raising children, such as education and health care, which are more in the nature of human capital expenditures 5 See Gary S. Beck e r, Huriaara Capital (Cambridge, Massachusetts: National Bureau of Economic Research 6 Cleve Wolman, A Better Way to Finance Students, Financial 7imes, December 1,1988, p. 17; see also Becker, op. cit 1964 9 Reason #6: The family is the basic unit of taxat ion, and exemptions should reflect this Most tax theorists regard the family household as the basic unit of taxation.

Thus one goal of tax policy has been to impose equal taxes on families who have command over equal resources. The two-eamer deduction, dif ferent rate schedules for marital status, and income splitting have been used in the past as rough devices to help adjust taxable income for family circumstances.

The personal exemption is another adjustment for the taxpaying ability of the family.

For e xample, a single person earning $25,000 enjoys a much higher standard of living than a family with children earning the same amount. The personal exemption is supposed to help account for the greater sacrifices and necessary costs of raising a family, the r eby more accurately measuring a family's actual living standard I The current $2,000 personal exemption does not come close to measuring the true sacrifice required by a family to raise a child. A larger exemption would lead to a tax liability more in lin e with each household's real. I circumstances COVERING THE REVENUE LOSS FROM INCREASED EXEMPTIONS Raising the exemption to $6,300 for all Americans would reduce the U.S.

Treasury's income tax revenues by about $100 billion to $130 billion? This revenue los s could be lowered, however, by limiting the increased exemption to children claimed as dependents. A $6,300 children's exemption, for example, would cut income tax revenues by'about $30 billion to $50 billion?

If limited further to children under five ye ars ,of age, the, tax revenue loss would be less than $12 billion? George Bush's proposal to give families earning less than 20,000 a $1,000 tax credit for each.child under four would cost $2.5 billion! d Some imaginative proposals, however, would link in c reases in .the personal exemption with other social policy objectives, potentially leading to less revenue loss for the U.S. Treasury. Under one plan, the personal exemption 7 Estimates based on Internal Revenue Service, "Individual Income Tax Returns Stu t istics oflncome, 1984 p. 61, Since these estimates are based on numerous simplifying assumptions, they should be viewed as broadly indicative of possible revenue losses, rather than as precise figures. They are also "static and therefore unrealistically a s sume no changes in economic behavior resulting from the change 8 IRS, op. cit 9 StutisticufAbstmct ofthe UnitedStutes, 1987, U.S. Department of Commerce, Bureau of the Census. No phase-out of the exemption is assumed 10 Figures released by Bush campaign s taff 10 could be increased in return for further tax reform. The deduction for state and local income and property taxes is used primarily by upper-income families and tends to subsidize high-tax states. Eliminating this deduction would raise 15 billion.

Another option would be a floor for itemized deductions of 20 percent of adjusted gross income. Under this plan, only the amount of allowable expenses exceeding 20 percent of income would be deductible from taxes.

This would raise 31 billion While eliminat ing many tax-induced distortions in the economy, however, a deduction floor would make no distinction between economically efficient and inefficient deductions Relief for the Middle Class. Changes in the homeowner.s mortgage interest deduction could be vi e wed as another option to offset an increased personal exemption, as some studies show that the mortgage interest deduction inefficiently shifts resources to the housing stock and away from more valuable capital investment and saving.13 Few deductions enjo y more popular and political support, and home purchases currently are regarded as the familys most important capital investment, deserving of special tax treatment. Yet many American families fiercely support the mortgage deduction mainly as a tax break f o r the middle class, rather than an objective in itself. They argue that they need the tax relief to help finance other family expenditures. Increasing the personal exemption would give them this relief and could soften their support of the mortgage deduct i on. And in general increasing the personal exemption would provide more total tax relief to middle-income families with children than they can obtain from the current deduction for mortgage interest I THE DYNAMIC EFFECT OF RAISING THEEXEMPTION In reality, concerns about revenue losses are vastly .overstated:.Little faith should be put in static revenue estimates .because they do not incorporate any change in economic incentives for work, saving, or investment. In essence, these models assume that the econo m y would be no more productive or robust following the tax cut than before. Suchstatic assumptions were shown to be erroneous in 1981, when they predicted that tax cuts would trigger an economic slowdown and a sharp reduction in tax revenue. They are just a s unrealistic when used to assess the impact of an increase in the exemption Drawing Americans Off Welfare. Exempting upwards of one-half of all taxpayers from the income tax rolls obviously would have enormous 11 Pechman, op. cit pp. 358-363 12Ibid p. 10 0 13 Patricia H. Hendershott and Sheng-cheng Hu, The Allocation of Capital Between Residential and Nonresidential Uses: Taxes, Inflation, and Market Constraints, Working Paper No. 718 (Cambridge Massachusetts: National Bureau of Economic Research, 1981 11c o nsequences for economic incentives and social welfare outlays. Reducing the marginal income tax rate for millions of low paid taxpayers to zero would give poor and working Americans an enormous income boost as well as an incentive to work, engage in entre p reneurial activity, and pursue work training or further education. And by making work more rewarding, a higher exemption also would draw people off the welfare rolls and make them less dependent on government support programs, thereby reducing government social welfare spending (see Chart 5 Middle-income I Americans also would enjoy lower marginal tax rates.

With higher exemp tions, millions of mid dle-income taxpayers would drop from the 28 percent tax brack et into the 15 percent bracket enjoying almost a 50 percent increase in produc tive incentives Thus, by increasing such incentives for Number of Taxpayers in Each Tax Bracket Before and After Personal Exemption: Increase Figurer are adJueted for inflation Current System 8,900 Exemptlon Exempt 16% Brac ket 28U Braekel For 4-peraon Iamlllaa and 88.800 emmptlon lor emoh paraon.

Eatlmalea are broadly Indlcatlm 01 number ol.tax mturnl or eaoh brmckmt rather than pnolma Ilguna.

Bourc IRE, 1088 Btmtlatlce 01 Income Herltage InloChart economic expansion, I a higher exemption Chart 5 would boost the size of the nations economy and lead to more tax revenues flowing into the governments cof fers. A significant portion of the tax cut t hus would ultimately be recouped in increased government revenues through faster economic growth CONCLUSION As the foundation of a free society, the incubator of traditional values, and the crucible for instilling good character in future generations, the American family must be the first priority of a free and democratic society. Yet the financial pressures on traditional families raising children are acute. The governments discriminatory tax treatment of children has underd the familys financial security and impeded the ability of parents to provide for the health, education, and welfare of their children. Many point out the bias in the U.S. tax code against saving and investment. They are correct. The greatest bias, however, is that against families with children 12 Tax Relief for Rearing Children. Two paths lie ahead. Down one are more government programs to support weakened families. If high taxation of the family is allowed to continue, families increasingly will be unable to provide for themselves. Th ey will look increasingly to the government for help to meet the burden of raising children. The prospect of government taking over the functions and choices of parents should alarm most Americans.

The other path leads toward strong families, a more approp riate role for government, and a growing economy. This path begins by giving American families substantial tax relief for the costs of rearing children. It will require a major, long overdue change in tax policy it will treat children as an investment in Americas future.

Restoring the personal exemption to where it was, in relative terms, in 1948 would allow Americas median-income families with two children to keep over $2,500 more of their own income to raise and nurture.their children. A median-income fa mily with four children would enjoy almost a $4,000 tax cut.

With this income boost, families would be less reliant on government programs and have access to vastly improved health and education opportunities Strengthening the Family. George Bushs proposa l for a toddler tax credit shows that he appreciates the vital role in America of families raising children. But to strengthen that crucial institution, his Administration ultimately must ask Congress to roll back a halfcentury of unfair and I discriminat o ry tax increases on Americas children I 13 687 January 30,1989 I l I Thomas M. Humbert John M. Olin Fellow INTRODUCTION Every lawmaker claims to be pro-family. Yet the income tax code devised by Congress reflects a different reality. The federal income ta x system treats children less favorably than a business lunch. Like spending for the movies the costs of raising children are for the most part considered a routine discretionary expense, instead of America's most important investment in-its future.

Reflec ting this strange premise, the tax allowance forethe costs of nurturing children the personal exemption has been:permitted'to erode dramatically in value over the years. The result has been a half century of steeply increasing federal income taxes on Amer i cans who raise children. In 1948, the median-income family of four paid virtually no income' taxes; and only $30 a year in direct Social Security taxes (1 percent of income This year, the equivalent family will pay $2,669 in income taxes and over $2,500 7 . 51 percent of income) in Social Security taxes. Just looking at federal income taxes, this median-income family's tax burden has soared over 2,500 percent from 0.3 percent of income to over 8.0 percent of income in about four decades. Singles and married c ouples without children, by contrast largely have escaped this income tax increase Sapping Families' Financial Health. As taxes on children have climbed the family's ability to provide for its own needs has been impaired. New government programs are toute d as a cure for the family's financial ills. But these congressional "remedies" are for a problem created by Congress. And

About the Author

Related Issues: Taxes