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Backgrounder #752 on Federal Budget

February 9, 1990

The Peace Dividend: It Belongs to the People Not Congress

By


(Archived document, may contain errors)

752 February9,1990 THE PEACEDMD IT BmNGS TO THE PEOPLE, NOT CONGRESS INTRODUCTION As soon as the first holes were punched through the Berlin Wall, and Eastern Europe began its breathtaking rush toward democracy, there was talk in Washington of a Peace Dividend and of ways to spend it. With the Cold War now ending, the argument goes, major cuts can be made in th e United States defense budget, freeing billions of dollars to tackle Americas domestic problems. Indeed, many organizations and lawmakers have held press conferences to outline their views of how this windfall should be spent programs, however, raises two issues that advocates of new spending seem determined to ignore household actually banks the returns on its investments before it spends the money. So far there is no big dividend and there will not be any so long as Eastern-Europe-and-the-Soviet Union-re main in turmoil-and so long as there is no consensus in the U.S. regarding Americas future defense needs. Yet the Peace Dividend lobby blithely urges Congress to commit the federal govern ment to huge new programs.

Escaping Spending Limits. The spending lo bbies, of course, have a strong incentive to declare the dividend to be real and available, and to press for funds to be committed as soon as possible.This would allow escape from the straitjacket of the Gramm-Rudman-Hollings budget ceiling which has held back the natural appetite of lawmakers to spend. And by committing funds now, and creating the agencies and their satellite interest groups, programs The popular notion of a Peace Dividend available for new federal The first is whether there really will b e such a dividend. A prudent can be established which will prove politically impregnable should the Peace Dividend turn out to be a financial mirage mirage. For one thing, the euphoria of late 1989 in Eastern Europe is begin ning to give way to the stark r e ality that democracy is a fragile thing. An un stable Eastern Europe, with the Soviet Union on its doorstep, poses many potential security threats to the West. For another thing, increasing signs of instability within the Soviet Union itself- atnuclear su perpower are deeply worrying. It is hardly time to dismantle Western defenses.

The second issue concerns the way any real Pentagon savings should be treated. The Peace Dividend lobby assumes that the only way to solve any problem is to create a new federal program and spend money. As Senator Phil Gramm, the Republican fromTexas, observes, as the Vietnam War was winding down, the defense budget was cut by $74 billion between 1970 and 19

77. The government spent every penny saved and increased the budget def icit. Yet many of the countrys problems, from young families finding it hard to pay for day care to older workers worried about potential nursing home bills, could be solved by tax law changes that put money back in the pockets of Americans. Several tax r elief strategies, moreover, are partially self-financing, since they generate new employment and thus new taxpayers and new revenue.

If a Peace Dividend materializes, Congress should consider a number of tax relief strategies. Among them 4 4 Roll back the Social Security payroll tax. This tax strangles job crea tion and boosts unemployment and welfare dependency among the unskilled.

Rolling back the tax to lower rates would reduce welfare and unemployment costs and provide new employment opportunities for Americans 4 4 Provide tax relief for the purchase of nursing home insurance. Many Americans wony about crippling long-term nursing home costs. Som e law makers want an expensive new federal program to fund such care. A much sounder policy would be to foster the use of long-term care insurance through tax incentives Signs of Instability. There are good reasons to fear that it may be a 4 4 Increase the personal exemption. The financial pressures on young families with children have prompted calls for federal day care centers and other programs. But the financial pressures stem in large part from the grow ing burden of federal taxation. Increasing the fe d eral tax codes personal ex emption would return money to these families, reducing or eliminating the need for direct services 4 4 Expand the Earned IncomeTax Credit (EITC The liberal estab lishment.continually argues for more welfare programs, despite mou n ting evidence that these do very little to reduce long-term poverty and do very much to increase dependency. An alternative would be to give a strong incen tive for the poor to join the workforce by expanding the EITC, a wage subsidy 2 to low-income worke r s. This would use federal assistance to make work far more attractive to those currently on welfare dress social problems.This is much better than creating new programs to spend taxpayers dollars in ineffective ways.The Peace Dividend debate of fers Congr e ss and the White House the chance to prove that the only way to s.o!ve..any.problei. is nor .to- t and spend. The debate.$g$d highlight the benefits of tax relief strategies These and similar measures return tax dollars to Americans in ways that ad I A ME N U FOR TAX RELIEF For each major new spending program now being offered to deal with American problems, there are tax relief strategies that would be more effec tive. In aggregate, these strategies would cut taxes more than a Peace Dividend would save. Thu s the strategies constitute a menu from which law makers can select. Several of the proposals, such as cutting the capital gains tax, would yield new revenues or spending reductions that would cover all or much of their cost. In other cases, such as an exp a nded Earned IncomeTax Credit, they would trim costs of existing programs. Even without a Peace Dividend, therefore, many of these proposals would improve policies while reducing the deficit lap. Example: The toddler tax credit and the ElTC reform assist s i milar populations of low-income families. If the toddler tax credit were enacted the ElTC expansion could be scaled back without a loss of income to low-in come parents.Thus the cumulative revenue cost of all the proposals, if enacted together, would be w e ll below the cumulative total of the estimates for each program Although treated independently, some of these tax relief proposals do over Among the most important tax-relief strategies lawmakers should consider 1) Roll Back Social Security Payroll Taxes and Return Social Security to Pay-As-You-Go Financing Revenue Reduction 55 billion per year after 1990.

Offsetting New Revenues 15 billion in income tax and payroll taxes from new jobs.

Ever since the Social Security system was created in 1935, the burden of federal payroll taxes on middle-income families has risen continuously. In 1937, the payroll tax was set at two percent of payroll income under $3,000 by 1980 it was 12.3 percent; and this year it climbed to 15.3 percent of income 1 2 Estimated reduct ion in revenues from the specific tax Estimated new revenues from other taxes, or reduction in outlays, from the policy change 3 under $51,3

00. Half of these taxes are paid directly by the worker and half paid indirectly by the worker as payments by the employer. Counting the employers contribution, in 1990 an American worker will pay up to $7,800 in payroll taxes.

As a result of seven payroll tax hikes in the 198Os, the vast majority of American workers now pay a larger share of their total income in fed eral me! America, creeping Social Security tax increases have eroded all of the income tax relief provided by Congress and Ronald Reagan in 19

81. Moreover, 80 percent of American families now pay more in federal payroll taxes than in federal income taxes.

Worthless IOUs. Todays high payroll tax rates are not necessary to keep the Social Security program in the black for at least the next three decades.

Nor are they being used to build up a Social Security trust fund reserve to pay benefits in the next century when the baby boom generation retires.

Rather, Congress continues to raid the Social Security trust fund to pay for other programs.There is no money in the trust fund; all that is there is a stack of government IOUs. When the baby boomers retire in the next century and demand payment of their retirement benefits, the Social Security trust fund will be holding as much as $12 trillion of worthless IOUs. To redeem them, theTreasury will have to raise taxes, borrow, or print money.

Social Security taxe s should be enough only to finance current outlays a pay-as-you go system.This would allow the payroll tax to be trimmed by about 2.2 percentage points, giving Americans a $62 billion tax cut over the next two years and even more in future years. Senator D aniel Patrick Moynihan, the NewYork Democrat and Chairman of the Senate Finance Subcommittee on Social Security, has proposed such a plan. He correctly em phasizes that such a tax cut would not affect Social Security benefits; it simply would end the fict ion that contributions are being put aside to pay for future benefits.

Fueling Growth. More important, a payroll tax cut would fuel productivity growth, job creation, and higher American living standards. The payroll tax has proved to be one of the most ec onomically destructive ways for the government to raise revenues because it deters businesses from hiring new workers and expanding output. Former U.S. Treasury economists Aldona and Gary Robbins estimate that the 1988 and 1990 payroll tax hik-es rob the American economy of 510,OOO jobs and reduce the nations GNP by $320 bil lion over ten years. By contrast, they argue, every dollar reduction in Social Security taxes would expand economic output by 68 cents.

Some critics, however, complain that todays high Social Security taxes are needed to keep the retirement program solvent in the next century. But a decade of experience convincingly demonstrates that Congress is unable to avoid the temptation to spend excess Social Security funds. With or without a tax cut, no reserve funds will be accumulated. The best way to ensure the ability of the Social Security system to pay future benefits is through pro growth tax policies today, so that future workers are able to finance future they. did in 19

80. This means t hat for most of-eddle-income 4benefits without heavy taxes. For instance, if real per capita income in the U.S. rises 2 percent per year between now and the year 2030, about the rate during the 198Os, real incomes will be twice what they are today. Cuttin g payroll taxes will make such growth more likely. Allowing recent payroll tax hikes to remain in place will slow down growth flate. the. budget defidt aljo are_ mistaken: Regre$sjye Security taxes were neverintended to finance the budget deficit or any go v ernment pro gram other than Social Security. Moreover, a payroll tax cut would not preclude a balanced budget by 1994.The deficit can be eliminated, without new taxes, by freezing all nonSocia1 Security spending for the next four years. Alternatively, if a ll non-Social Security spending is held to 2 percent growth for four years, the budget deficit will fall to below 2 percent of gross national product in 1994.This would be one-third the level of annual debt ten years earlier and below the deficit rate for most industrialized countries.

Neither of these projections, moreover, assumes the stimulative economic ef fect of the payroll tax cut. Yet a tax cut would spur faster job creation, thereby increasing income tax revenues and redu cing welfare outlays, thus helping to reduce the deficit Those who argue that the payroll tax should not be cut because this will in 2) Reduce the lax Burden on the Elderly by Eliminating the Social Security Earnings lest Revenue Reduction 5 billion per y ear Offsetting New Revenues 2.6 billion per year in taxes from extra work per formed by the elderly.

Federal tax policies are keeping out of the labor pool a group of workers that is growing in number and possesses needed skills Americans over age 65.The f ederal government now slaps the working elderly with so many tax penalties that hundreds of thousands literally find it too expensive to work.

The most onerous of these tax penalties is taxation of Social Security benefits and the earnings test, which red uces Social Security benefits for working senior citizens. These taxes and benefit reductions impose marginal tax rates of 50 percent to 70 percent on many elderly workers. Americans who con tinue to work after age 65, and do not apply for any Social Secu r ity benefits do receive a 3 pereiit incTease in-their monthly Social Security benefits when they eventually retire.This is known as the Delayed Retirement Credit. Yet the credit is insufficient to restore lifetime Social Security benefits to those who con tinue to work after the age of 65.

Today more than 80 percent of all men and 90 percent of all women over age 65 are fully retired, many because they no longer find it worthwhile to work. The federal tax code should not discourage older Americans from work ing and contributing to economic growth.To end this disincentive, the Social Security earnings test for workers between ages 65 and 69 should be eliminated (there is no penalty on those older than 70).The earnings test re 5 q 1 1 d S a a il S P ii s u 0 1 1 F u b C Cl 0 t S E H 3 n P fc ii a h g 0 ti res workers in this age group with earnings over $9,360 to forfeit one dol u of Social Security benefits for every three dollars earned from working his is an effective 33 percent tax on earnings, on top of al l the other federal tate, and local taxes that are deducted.The main effect of this heavy tax is to hive many low- and middle-income senior citizens out of the labor force lome 500,000 moderate income seniors with incomes below $40,000 per year re penalize d by the earnings test. The average Social Security benefit is now bout-.$6O

per-month,~nd.many-retirees who depend ody-on Social Security ncome live at or near the poverty level. Many must work to supplement their locial Security payments to make ends mee t. But today, elderly Americans rith earnings as little as $5.00 an hour can be hit by the earnings test work lenalty.

Freedom to Work Senator William Armstrong, the Colorado Republican ntroduced legislation last session that would raise the income thresh old level a the earnings test gradually so that it affects fewer moderate income elder This would be a desirable reform. Better would be the Older Americans reedom to Work Act, sponsored last year by Representative Dennis Iastert, the Illinois Republican. This bill, with more than 100 cosponsors rould repeal the earnings test entirely.

Some in Congress claim that eliminating the earnings test would increase lenefit payments substantially and thus add to the federal budget deficit.The longressional Budget Of fice has estimated that earnings test repeal would ost Up to $5 billion annually. But these estimates ignore the work incentive f eliminating the tax. Extra work by the elderly means more regular income ax revenue.The additional taxes paid by the elderly w ho increase their hours rorked would recapture about one-half of these costs, according to a study by ltephen Entin of the Washington-based Institute for Research on the konomics of Taxation 1) Index Social Security Benefits for Inflation Revenue Reductio n 430 million per year Offsetting New Revenues: Negligible.

One of Ronald Reagans primary economic policies was to stop govern lent fromnsing inflation to capture an increasing share of each Americans aycheck through the tax code. Reagan successfully urged Congress to index Zderal tax rates, so that inflationary rises in income would not push taxpayers it0 ever higher tax brackets. Indexing taxes for inflation now extends to most spects of the tax code.

Penalizing Senior Citizens. Yet for the elderly, the group generally most armed by inflations erosion of savings, the tax code still explicitly penalizes aim due exclusively to rising prices. The reason: All Social Security benefits ollected by elderly Americans with gross income over $25,000 are treated as aable income at a rate of 50 cents for every additional dollar earned. This 6pushes an elderly worker in, say, the 28 percent tax bracket into an effective 42 percent bracket, and thus destroys work incentives.The income tax threshold level of $25,OOO 32, 0 00 for working couples moreover, is not in dexed to inflation, unlike the rest of the personal income tax code. Hence when incomes are raised to keep up with inflation, a larger number of middle income elderly are subject to the tax, even though their rea l incomes have not risen. Failure to index the tax on Social Security benefits to inflation is Congresss- back-door way of raising taxeson senior: citizens.

Even if congressional supporters of repealing the Social Security earnings test are successful, the beneficial impact of this reform would be reduced be cause of the tax treatment of benefits. Some 300,000 working elderly already are subject to both the earnings test and the Social Security benefits tax.To end this unfair tax penalty on the elderly, Co n gress should index the income threshold level of the benefits tax so that inflation does not reduce real in comes of elderly working Americans 4) Increase the Personal Exemption to $6,300 for Each Child Under Age 18 per child under age 18 would cut income tax revenues by about $40 billion a year Revenue Reduction: Raising the personal exemption from $2,000 to $6,300 Offsetting New Revenues: None The federal income tax burden on American families with children has soared by over 2,500 percent since 1948 fro m 0.3 percent of income to 8 per cent. Four decades ago, a family of four at median family income paid virtual ly no income taxes, and only $60 a year in Social Security taxes (2 percent of income). This year, the equivalent family will pay $2,787 in incom e taxes and over $5,OOO (15.3 percent of income) in employee and employer shares of the Social Security tax. Single individuals and married couples without children have not had their taxes increased to the same extent and today pay about the same portion of their income in income taxes as they did in the 1950s.

The main reason that young families now pay a disproportionate share of taxes is the erosion of the value of the personal exemption. In 1948, the per sonal exemption of $600 equalled 42 percent of average personal per capita income, which was then $1,4

34. Over the following 35 years, the personal ex emption lagged far behind as income rose and inflation soared. While the 1986 tax reform has raised the exemption to $2,000, this only partially offset s the erosion in value since the 1940s. To have the same value relative to in come it held in 1948, todays personal exemption would have to be raised to around $6,300.

Young families are hard-pressed to meet the housing, health, education and day care cos ts of raising children.The financial difficulties experienced by families have led to a call for government assistance in the form of new or 7larger social programs, such as day care, additional health benefits, and help in renting or purchasing a home. I f the tax burden on families were reduced however, most families could meet their childrens needs according to their own priorities and would not need new government programs.

The current $2,000 personal exemption for children under age 18 should be returned to its post-World War Il value; this would be $6,3

00. At this level the personal exemption would shield from taxes about the same portion of in come as it did in 1948.This childrens exemption would allow families to keep more of their income to pay for the costs of raising children and the pressure for new federal programs would be reduced 5) Provide Tax Credits to Households to Cover Medical Expenses and Health Insurance Premiums Revenue Reduction 40.9 billion (in 1991 dollars) when fully enacted.

Offsetting New Revenues 40.9 billion (in 1991 dollars) when fully enacted.

The U.S. spends far more than any other country on health care (over 11 percent of GNP) yet as many as 37 million Americans lack health insurance while inflation plagues the health care system. Prices have been rising rapidly because most Americans receive health care benefits through their employers as tax-free income. Employees tend to view these benefi ts as free and therefore have little concern about the cost of health care services they use. Similarly, health care providers know that their patient is not paying directly for his or her care and so they, too, have little incentive to curb costs.

The tax code, meantime, favors company-based health plans, while in dividuals purchasing their own health insurance generally must pay the full cost for protection, without tax relief.Thus workers in small firms (which do not tend to provide health benefits or w orkers in firms that do not cover de pendents, are discouraged by the tax code from purchasing adequate health insurance.

Incentive to Insure. The problems of escalating health cost and gaps in in surance coverage can be addressed by changing the tax treat ment of medical care and health insurance premiums. Congress gradually should end the tax the value of such plans as a taxable pait of each employees wages. Then, to help employees carry this extra cost, Congress should replace this tax benefit with a new system of tax credits in the personal income tax code to offset the cost of purchasing health insurance or health services directly.This would give the uninsured a tax incentive to purchase adequate insurance, while those currently with insurance would ha ve a greater incentive to question the cost of their medical services and insurance since they would be paying for it directly.

Specifically, a 20 percent federal tax credit should be provided for the pur chase of insurance coverage that meets basic requir ements. In addition, a free fringe benefit status of company-based health plans, thereafter counting 8 credit should be available for out-of-pocket medical expenses. This percent age credit would increase as total medical expenses rise as a percentage of f amily income. By providing a larger credit for out-of-pocket expenses, this reform would encourage families to pay directly for routine, inexpensive ser vices and to reserve insurance for potentially higher costs. This would en courage patients to shop ar ound for routine services and to question costs more aggressively, thereby helping to moderate charges.

The first stage of such a tax incentive for medid insurance is contained in legislation passed last year (S. 5) by the Senate.The measure, introduced by Senator Lloyd Bentsen, theTexas Democrat and Chairman of the Senate Finance Committee, provides a tax credit for insurance to cover children not covered by a company plan. Congress should expand this credit, first to all de pendents and then to all house holds, and offset the revenue loss with a gradual phase-out of the tax-free status of company-provided health plans 6) Provide Tax Incentives for the Purchase of Long-Term Care Insurance Revenue Reduction 560 million per year.

Offsetting New Revenues: None.

Working Americans increasingly are concerned that long-term nursing home costs could wipe out their savings retirement. Some in Congress argue that the way to remove these fears is to create a new federal entitlement pro gram for nursing home care, with the federal government paying for these costs. But such an entitlement would invite a surge in nursing home charges and the prospect of Uncle Sam ultimately paying for care would remove all in centive for todays workers to save for their own potential lo ng-term care costs. Congress shouId recognize instead that the best way to protect savings and other assets from the ravages of nursing home costs is through insurance.

Americans use life insurance and homeowners insurance to protect their as sets from catastrophes. They should be encouraged to purchase long-term care insurance for the same purposes.

Currently very few Americans buy long-term care insurance. To change this, the tax code should encourage working Americans to buy long-term care insurance as a.routine way to protect their assets, just as they routinely buy life insurance. In addition, the government could give todays elderly tax assis tance to pay for nursing home costs.This could be done in several ways. First holders of Individual Retiremen t Accounts (IRAs 401(k) plans, and similar tax-deferred savings plans could be allowed to withdraw funds, tax free, to purchase long-term care insurance. Second, Americans could use the tax credits detailed above for purchases of long-term care insurance a n d nursing home costs. And third, there should be no tax on benefits that insurance companies permit policyholders to draw down from life insurance policies to pay for nursing care during a terminal illness. The Prudential Insurance Com pany of America, an d some other companies, already do offer policyholders 9 tl U tl d 7 E fc n rc P H 0 H a tl tl rc e e d tl tl tl n sl ZI 0 e e tl d a1 tl d h 12 he right to receive benefits before death in certain circumstances. But it is inclear whether these benefits ar e taxable under current 1aw.They should be reated the same as life insurance benefits paid out when the policyholder is leceased, which are not taxable Designate 100 Federal Enterprise Zones to Spur Economic evelopment-in the Inner Citi Revenue Reduction 6 60 million per year.

Offsetting New Revenues: The tax losses would be offset by reductions in zderal outlays thanks to reduced rates of unemployment, lower demand for relfare services, and a long-term tax base broadened by increased employ lent and the cre ation of new businesses.These savings could equal the direct evenue losses of the program.

For decades the federal government has poured billions of dollars into mericas inner cities with little impact on the economic and social condition f these neighborhoods. Indeed, ill-conceived federal projects and increased relfare dependency seem to have hastened the decline of many cities.

In the late 197Os, however, several politicians and scholars proposed a new pproach to combat urban blight, known as enterprise zones. In contrast to le traditional strategy of pouring government programs into the inne r cities ne enterprise zone proposal involved reducing government intervention by educing federal regulatory and tax burdens to provide incentives for conomic development. The idea was to remove costly barriers to local ntrepreneurs. The enterprise zone c oncept, pioneered in Britain, was intro uced in the U.S. in 19

79. A majority of states now have some enterprise one programs.There is evidence that the economic activity generated by lese zones in many cases more than compensates for revenue lost through le incentives. A 1988 report commissioned by the New Jersey Department f Commerce, Energy and Economic Development, for instance, finds that le state enterprise zone program has created between 16,000 and 42,000 ew jobs in depressed urban areas and raised between $1.90 and $5.20 in new tate tax revenue for every dollar lost.

Dropping Barriers. The states, however, can only provide partial nterprise are federal. Comprehensive federal enterprise zone legislation ius is needed to complement local versions by reducing the federal tax bur en.

A system of federal zones would mean federal tax and regulatory relief in ddition to state incentives and thus remove more barriers to inner city ven ires. A federal enterprise zone should remove regulatory barriers to eve lopment, ease the transition of new employees to work from welfare, and elp new businesses maintain cash flow and attract investment. Federal legis ition also should offer tax incentives, as proposed last year by Housing and nterprize zone incentives. Man y of the tax burdens stifling inner city 10 1 Urban Development Secretary Jack Kemp, and contained in several congres sional bills, including measures introduced by congressional leaders of both parties.These bills include such incentives as an increase in the earned-in come tax credit to low-income employees, a one-time capital gains tax exemp tion of $lOO,OOO for the owner-operator of a small business, and capital gains tax relief for investments in zone-based businesses I a 8) Reduce the Capital Gains Ta x Revenue Reduction: None Offsetting New Revenues 3.2 billion annual average.

The capital gains tax, which stood at 25 percent through most of the 1950s and 196Os, was increased by the federal government starting in 1968, until it reached a top rate of 34. 13 percent in 1978.The rates then were brought down over the next decade, falling to 20 percent by 1982.Then the 1986 tax reform law brought the rates back up to a maximum of 33 percent.

A tax on gains realized from the sale of such capital assets as stoc ks, bonds and land discourages productive investments, and slows economic growth by discouraging investment. Making matters worse, the current capital gains tax constitutes a triple tax on risk-taking investment.The first tax, the corporate tax, is paid b y the enterprise on its profits. A second tax, on personal income is paid when profits are distributed to shareholders in the enterprise.The third tax, the capital gains tax, is paid on the increased value of the stock when it is sold and part of this is a tax on a mere paper gain because of infla tion.

Spurring Investment. The capital gains tax thus penalizes and discourages productive new investments and movements of capital from less productive to more productive uses. High capital gains taxes also mean less money for the Treasury. Lower rates encourage greater business activity and stock turn over and bring in more tax revenue, as they did in 1979 and 1982 after cuts in the capital gains tax. Harvard economist Lawrence B. Lindsey, now Associate Director for Domestic Economic Policy at the White House, estimates that the federal Treasury will lose between $27 billion and $llO.billion dollars in revenue between 1987 and 1991 due to the 1986 increase in the capital gains tax from 20 percent to 33 percent in 1

86. Lindsey suggests that the rate that will pmduce maximum federal revenue is around 15 percent.

Cutting the capital gains tax from the current 33 percent rate to 15 percent would spur greater productive investment in the U.S creating more jobs and ma king America more competitive. But it would also generate more revenue for the federal government, allowing greater tax cuts in other areas 11 9) Expand the Earned Income Tax Credit Revenue Reduction 12 billion per year if combined with an increase of Off setting New Revenues: None.

The goal of welfare policy should be to strengthen families and encourage selfasufficiency Welfare programs thus should reinforce the efforts of the poor to heip themselves rather than promoting theprolonged dependency that is h armful to the recipient and costly to the taxpayer. Because two-parent families provide a healthier environment for raising children and are less prone to poverty than single parent families, government policy should protect and promote two-parent familie s wherever possible.

Tax Relief. Todays welfare system, however, generally promotes family disintegration and dependency. An exception to this is the Earned Income Tax Credit (EITC The EITC is a tax credit for low-income workers. This tax relief is, in eff ect, an earnings subsidy, obtained from the Treasury, to supple ment the take-home wages of these workers. Moreover, the EITC is refun dable, meaning that if the workers credits exceed his total tax liability he receives the difference in a check from the government.The credit is restricted to low-income employed parents with children. Currently parents can receive a credit equal to 14 percent of their earnings below $7,000 per year. As earnings rise above $7,000, the credit gradually is phased out sistanc e to those in greatest need low-income families with children.

Second, it is available to intact two-parent families as well as single parent families, unlike many other welfare benefits.Third, it is linked to work rather than to inactivity. And fourth, it encourages work by providing higher benefits as work effort increases.

Encouraging Self-Sufficiency. Expanding the EITC would increase the in centive for low-income families to take a job and become self sufficient. Cur rently the credit is not adjusted for family size.The value of the credit should be increased, and the credit should rise with the number of children so that families in the greatest need get a large r credit. An additional credit also should be awarded for dependent spouses to encourage the formation and maintenance of intact two parent families up to $9,000 per year for a dependent spouse and each school age child within the family, up to a maximum o f three credits per family. Each pre school child or dependent spouse caring for a pre-school child should receive a credit equal to 12 percent of the familys earned income, up to a maximum of three credits per family.

Under this system a two-parent family with two school age children would receive a maximum credit of 24 percent of family income, or $2,250 a year. A two-parent family with two preschool children would receive a maximum credit of 36 percent of income, or $3,240 per year the personal income t a x exemption for children to $6,300 The EITC promotes family stability and self sufficiency. First, it targets as A restructured EITC should provide a credit equal to8 percent of easngs 12 ..I Escaping Poverty. This EITC expansion would go a long way towar d eliminating poverty among working families. When combined with other wel fare programs such as food stamps, the expanded EITC would give a single working mother with one or two children a family income above the poverty level even if the mother earns onl y the minimum wage. A two-parent family with two children would have an income above the poverty level if the father worked a full year and the mother worked a quarter of the year at the mini mumwage l I How much revenue theTreasury would lose because of a n expanded EITC would depend mainly on the rate at which the credits were phased out for families with incomes above $90

00. Phasing out the EITC gradually is neces sary because losing the credit means the family in effect faces a higher mar ginal tax rate .The more rapid the phase out of the credit: the-higher becomes the familys marginal tax rate. But if an expanded EITC were to be combined with an increase to $6000 of the personal exemption for children in the federal income tax, the proposed EITC credit s could be phased down to zero for families with incomes above $23,000 without imposing unduly high mar ginal tax rates 10) Provide a Toddler Tax Credit Revenue Reduction 10 billion per year.

Offsetting New Revenues: None.

The major problem facing America n families today is overtaxation. In 1950 the median family of four paid just 2 percent of its income to the federal government in taxes.Today that same family pays 24 percent..of its income to the federal government. This overtaxation places severe finan cial pressures on most families, particularly on families with pre-school children. These families either must forego the income of a second parent, so that this parent can care for children in the home, or must pay high costs for non-parental day care.

Th e current child care crisis is caused by this excessive.government taxa tion. Government tax policy is pushing millions of parents-of infant children into the labor force contrary to their wishes; these parents are forced to place their children in paid n on-parental care despite the fact that nearly all parents agree that parental care is best for children.

Over 80 percent of the pre-school children using day care come from two parent two-earner families. Nearly all mothers say that they would prefer to remain at home with their children if they could financially afford to do so.

Day Care Industry. The liberal response to these pressures on the modern family is to tax families even more heavily and create a system of government approved secular day care ce nters. Under this plan, money would be taken from the pockets of families and given to an industry funded by taxpayers to care for Americas children. Polls show, however, that this is the childrearing 13 option parents least prefer.The alternative is to e liminate the original finan cial problem by reducing the tax burden on families with young children.

Parents could use the added take-home pay to allow a parent to stay home to care for pre-school children in the home. Or parents could use the extra in com e to pay for day care that they, not the government, select: care by rela tives, friends, neighbors, and religious day care organizations, for example One.proposal,to reduce.taxes on.families is known as the.toddler tax credit. Under this plan, a tax cred i t equal to 10 percent of earned income would be available to families with an annual income below Sl0,OOO for each pre-school child (up to a maximum of two children per family The credit also would be refundable, meaning that if the available credit excee d ed the familys tax liability, that family would receive the difference in a check from theTreasury. For families with earned incomes between $lO,OOO and $30,000 the credit would equal $l,OOO per child with a maximum limit of $2,OOO per family.The credit w ould be phased down to zero for families with incomes be tween $30,000 and M0,OOO 11) Expand Individual Retirement Account Eligibility Revenue Reduction 4.5 billion per year.

Offsetting New Revenues: Negligible.

By historical standards, Americans do not s ave enough. An Individual Retirement Account is an excellent vehicle to encourage savings. With an IRA, a taxpayer can obtain a tax deduction for deposits made into such ac counts with both interest and profits on such deposits accumulating tax free until they are drawn out upon retirement. TheTax Reform Act of 1986 sharp ly restricted IRAs.

Before this IRAs were the only vehicle available to virtually all workers in all circumstances. IRAs avoid all vesting problems, since funds paid into an IRA immediate ly belong to the worker. The accounts avoid all portability problems, since the IRA funds are under the workers ownership and control wherever she or he goes. Other pension plans usually are not fully available to a worker unless she or he remains for sev eral years with a particular com pany. Thus IRAs offer workers greater freedom and control than Social Security or work pensions.

Expansion of IRA eligibility also would help raise Americas savings rate by eliminating some of the discrimination in the tax code against savings. The current tax system discourages savings by effectively taxing it twice: first when it is accumulated through earnings and again when the savings generate inter est. In effect, the tax code makes it twice as costly to save as to co n sume.The IRA deduction reduces the impact of this double taxation by allowing Americans to defer taxes until retirement 14 Stimulating Savings. The evidence suggests strongly that IRAs stimulate private saving. A study by economists David Wise of Harvard a nd Steven Venti of Dartmouth finds that 45 percent to 55 percent of IRA contributions are new savings by individuals, 35 percent constitutes money that would have been taxed had it not been deposited in an IRA, and only 10 percent to 20 percent represents money that would have been saved anyway and is merely shifted to an IRA from some other form of savings Other countries provide various tax incentives to stimulate saving. Japan for example, effectively exempts interest income from taxes it also enjoys on e of the highest personal savings in the world. Canada gives tax relief on up to $l,OOO of investment income each year on Canadian investments.

To encourage savings and to help Americans better plan for their retire ment, IRA elig ibility should be restored to all individuals, whether they are under private pension plans or not. Further, the amount that can be deposited in an IRA for a non-working spouse should be raised from $250 to 2,000. a CONCLUSION The headlong rush in Washing t on to spend the anticipated Peace Dividend is symptomatic of two instincts of Congress: to use any excuse to create a new program; and to create a spending program rather than to reduce taxes, since a new program suggests that lawmakers are "doing somethi ng" to solve a problem. New programs create a constituency of providers and service recipients who are inclined to be grateful at election time.

But the range of problems now facing Congress, from concerns about day care to worries about the cost of nursin g home care, are examples of how returning money to Americans, through carefully-crafted tax cuts, would be far better than taking dollars from Americans and then giving them services to offset their lack of personal resources.The prospect of a Peace Divi d end is like a new jar of honey for the interest groups in Washington and lawmakers who have an electoral interest in serving these constituencies. It has given new vigor to a Congress that has been constrained for years by the need to keep within Gramm-Ru dman-Hollings guidelines for reducing the deficit.

Suddenly lawmakers can claim that billions of dollars are now available for new -programs 3 Steven Venti and David Wise, Tax-Deferred Accounts, Constrained Choice and Estimation of Individual Saving Review of Economic Sntdes, August 1986, pp. 5794

01. See also StevenVenti and David Wise Have IRAs Increased US. Saving Evidence From Consumer Expenditures Surveys National Bureau of Economic Research Working Paper No. 2217, April 1987, and R. Glenn Hubbard Do IRAs and Keoghs Increase Savings National Tar Journal, March 1984, pp. 43-54 15 Dividend for Taxpayers. Americans should be skeptical about the Peace Dividend. They should insist on seeing real defense savings materialize before those savings are committe d to new programs. And they should remind their representatives in Congress that dividends normally are paid to investors, not kept by the corporation.To the extent that there is a Peace Dividend, it should be returned to taxpayers in ways that address the problems faced by ordinary Americans, and not kept in Washington to ea ~Qngressiona1:s~ending spree The Heritage Foundation Domestic Policy Studies Staff Stuart M. Butler, Ph.D editor I 16

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