Issue Bulletin #187
January 20, 1994
(Archived document, may contain errors)
January 21, 1994
A GUDE TO TM FAMMEES FMST BHJS MK 3645 AND S. 1576)
For the second time in three years, American taxpayers enter a new year with the pros- pect of giving more of their hard-earned income to the government than they did the year before, thanks to Washington's irresponsible fiscal behavior. In 199 1, as the result of Presi- dent George Bush's 1990 budget deal with the Congress, Americans paid over $20 billion in new taxes, including higher income taxes, higher Medicare payroll taxes, a 5 cents hike in the gasoline tax, and other extra taxes. In 1994, as the result of President Bill Clinton's 1993 budget deal with Congress, taxpayers are paying nearly $35 billion in new taxes, in- cluding higher income taxes, higher Medicare payroll taxes, and the new 4.3 cent-per-gal- Ion gasoline tax, among many other levies. Congress did not have to punish taxpayers to reduce the deficit, however. Congressional Republicans, who recognized that the five-year Clinton plan looked remarkably similar to Bush's unsuccessful 1990 budget deal, but with almost twice the total amount of taxes, pre- sented alternative plans to cut the deficit that relied solely on spending cuts. By all ac- counts, these plans would have made a substantial dent in the federal deficit without the sti- fling effects of a new round of tax hikes. But while these plans were admirable for their avoidance of new taxes and their focus on spending as the real fiscal problem, they would not have corrected the long-term damage due to previous tax increases. What taxpayers and the economy need, in addition to deficit reduction, is a remedy from years of misguided tax increases that were intended to reduce the deficit and yet had the op- posite effect. Those in particular need of tax relief are: Families with childmn, who have seen an ever-larger portion of their income go to Un- cle Sam. During the past four decades, the federal income tax burden on a family of four has increased by over 300 percent as a share of family income.
Senior citizens, who are severely penalized for trying to supplement their Social Secu- rity benefits by working and who now face a punitive surtax on their savings and pen- sions.2 V investors, entrepreneurs, and risk takers, whose incentive to start businesses and cre- ate new jobs is dramatically reduced by excessive taxation of capital and income. For instance, an investor's profits, if any, are reduced by a plethora of taxes, such as cor- porate and personal -income taxes, -the..capital gains tax, the double taxation of divi- dends, and depreciation allowances. Convinced that far more than spending reduction is needed to spur the economy, create jobs, and reverse the rising tax burden on American families, a group of nearly eighty law- makers in the House and twelve in the Senate have proposed a unique alternative eco- nomic plan called the "Family, Investment, Retirement, Savings, and Tax Fairness Act of 1993" (H.R. 3645 and S. 1576). The House members are led by Rod Grains (R-MN) and Tim Hutchinson (R-AR), and the Senate sponsors by Dan Coats (R-IN). The Families First plan, as it is also known, takes a giant step toward undoing the dam- age wrought by Washington's last two budget deals. The Grams-Coats plan channels nearly $200 billion now spent by the federal government back into the economy in tax re- lief over five years: $135 billion for families with children, $26 billion for seniors who work, and $38 billion for entrepreneurs and investors. It stems the tide of Washington's red ink by capping the annual growth of federal spending at two percent, saving $542 bil- lion over five years. Such a growth rate not only affords tax relief, but also puts the budget toward balance by fiscal year 2001. While this plan may not return taxpayers to where they were before Washington steered off course with damaging economic policies, it is an important first step down the road of taking resources back from government and returning them to hardworking families and productive businesses.
A REAL ALTERNATIVE: THE FAMILIES FIRST PLAN
The Families First Plan (H.R. 3645 and S. 1576) is based in large measure on a proposal developed in February 1993 by the staff of The Heritage Foundation. 3 Families First is based on the principle that prudent fiscal policy should do three things: reduce government spending and borrowing, stimulate new investment through tax incentives, and reverse the growing tax burden on American families. The plan outlined in H.R. 3645 and S. 1576 is a five-year $542 billion package that would: V Cut the deficit to $70 billion by fiscal 1999 and balance the budget by fiscal 200 1; V Grant $135 billion in family tax relief, V Put $26 billion back in the pockets of the working elderly;
V Provide nearly $38 billion in tax incentives for investment to stimulate economic growth and job creation. To achieve these results, H.R. 3645 and S. 1576 contain six major policy components. The measure would:
4 1) Cap the annual growth of total federal spending at two percent. According to recent- Congressional Budget Office-(CB0) estimates made after the pas- sage of Clinton's deficit reduction bill, baseline federal spending growth (assuming no ad- ditional changes in current law) will average 4.5 percent per year over the next five fiscal years, or 1.8 times the projected inflation rate. 5 Federal spending is expected to grow even faster over the long term, averaging 5.0 percent per year through fiscal 2003. This growth rate will push total federal spending to some $2.3 trillion by that year. The Families First plan caps this annual growth rate of federal spending at two percent, beginning in fiscal 1995. This would yield $542 billion in total program savings below the baseline growth rate over five years, and $2.1 trillion through fiscal 2003. The table on the next page displays the annual savings resulting from this cap, as calculated by the CBO. The bill not only states that annual spending shall not grow faster than two percent above the previous year's level, it also puts the dollar amount of the caps in law-much like the federal debt ceiling is specified in law. This means that Congress and the President cannot adjust the caps upward for "technical and economic" reasons, as the discretionary caps in current law permit. Capping total spending at two percent does not mean every program must grow at that rate. It means that, taken together, programs cannot exceed that limit. So if some programs grow faster than two percent, others must grow slower, and others may have to be termi- nated. The two percent cap would be enforced by a sequester. This means there would be automatic across-the-board spending reductions if Congress failed to lower spending on in- dividual programs sufficiently below the targeted spending levels by making cuts in spe- cific programs. However, the plan does exempt Social Security benefits from a sequester. 2) Give every working family in America a $500 tax credit for each child. The plan uses $135 billion of the savings obtained from the spending cap to provide a $500 per child tax credit for every working family. 7be plan indexes the credit to the infla- tion rate, raising its value to roughly $560 after five years. The tax credit is "non-refund- able." This means that the total value of the credits a worker takes cannot exceed the worker's total tax liability, income and payroll taxes combined. If a truck driver with two children, for example, had a combined income and payroll tax liability of $900, this worker could deduct only $900, not $ l,'000, from his taxes.
The parents of some 51 million American children are eligible for such a tax credit. At $500 per child, the fn-st-year revenue loss to the Treasury due to the credit would be about $25.5 billion. By fiscal 1999, indexation would push this revenue loss to an estimated $28.4 billion. This portion of H.R. 3645 and S. 1576 would not increase the deficit how- ever, because the plan more than offsets these lost revenues with reductions in government spending. Family tax relief is the centerpiece of the legislation. Based upon Census Bureau data, Heritage Foundation analysts have calculated the total dollar value of a $500 per child tax
Use One-Third of Capped Savings for Tax Cuts... Eliminate Earnings Test on Social Security" Deficit Reduction $26 Billion $343 Billion Family Tax Relief $135 Billion Economic Growth Tax Cuts $38 Billion Fma-Year 1995 1996 1997 1998 1999 Total Pro-Family TM Cuts 9C $5M per Child Toe Credit $25.5 $263 $27.1 $27.9 $28.7 $135.4 Pro4kvwth Tax Cuts: 9C IRA-Plus Plan (2:7) (1.4) (1.1) 0.3 1.4 (35) OC Neutral Cost Recovery Plan 0.6 (2.7) (5-9) (4.8) 1.2 (11.6) 9C Index Capital Gains and Lower Rau to 15% 0.5 7.5 13.5 15.1 17.1 52-7 Pro-Seniors Employment Incentive 0 Eliminate Earnings Test an Social SecuritV $3.7 $5,6 $5.7 $5.7 $S7 $264 Rewenues Lost from All Tax Changes $26.6 $35.3 $392 $442 $54.1 $199.4 Note: Amounts in parentheses denote incmases in revenuft HerkW DanChart credit for every state and congressional district. The appendix to this paper presents these data. The average congressional district contains about 117,000 children. Thus a $500 tax credit would bring to the average congressional district some $58.7 minion per year in fam- ily tax relief 3) Spur investment and real family wage growth through pro-growth tax cuts. The plan dedicates $38 billion of the savings over five years from the spending cap to fund tax cuts that will generate the new private investment needed to increase the produc- tivity of American workers, and thereby boost real wage growth.
As indicated in the table on the previous page, there are three key components to the eco- nomic growth portion of the plan. Each of these has been "scored" on the basis of a static economic model, the type of model used by federal budget estimators.6 The net revenue loss of these three measures is some $38 billion over five years. But as with the family tax cut, the revenues lost to the Treasury from these tax cuts are offset by an equal reduction in federal spending, making this portion of the plan also deficit neutral. Tax CUt #11: Expand Individual Retirement Accounts in what is called an "IRA-Plus" plan. 7 The Joint Committee on Taxation estimates this element of Families First raises $3.5 billion over five years. Individual Retirement Accounts (IP.As) reduce the tax bias against savings by deferring taxes on income (up to $2,000 per year) placed into these special accounts. However, this income and the interest generated by these savings are taxed when retirees begin to with- draw from their accounts. The prudence of saving for retirement is now being punished even more following the passage of Bill Clinton's massive tax increase. The new tax law contains a provision amending the Internal Revenue Code, Section 86, to create a second bracket for the "elderly surtax" on pensions, IRA withdrawals, interest from municipal bonds, certificates of deposit, and other income. This new second bracket starts at $34,000 ($44,000 for married couples). 8 Although this elderly surtax has been called a tax on Social Security benefits, it is actu- ally a tax on the savings of those Americans who have planned wisely for their retirement by supplementing their Social Security pension, regardless of their level of income during their working years. Since even the maximum Social Security benefit is below the thresh- old ($20,304 for a married couple in 1993 and $13,546 for a single beneficiary), the Social Security pension itself is not actually taxed. The elderly surtax falls on other income from savings, which punishes anyone who has prepared carefully for retirement. The Families First plan offers a way for taxpayers to avoid these punishing taxes in re- tirement by creating a new Individual Retirement Plus Account (IRA-Plus). Contributions to the new IRA-Plus account would be made from post-tax income, but the interest from such savings would not be taxed upon withdrawal if the contributions remained in the ac- count for at least five years. An EKA-Plus account gives workers the incentive to save to- day in order to reap tax savings in retirement. Initially, contributions to the IRA-Plus plan would be limited to $2,000 per taxpayer per year, but this limit would be raised to $3,000 after 1996. In subsequent years, the maxi-
Many experts believe that reducing the tax rate on savings and investment would so stimulate economic growth that overall federal tax revenues would rise. Thus, according to these analysts, tax cuts on investment and savings would help reduce the deficit. However, this view is not shared by the Congressional Budget Office or the Joint Committee on Taxation of the Congress. According to the economic models employed by these organizations, such tax cuts will "lose" money for the Treasury. Thus, these tax cuts must be "paid foe' by either increases in taxes elsewhere or via spending cuts. While Heritage analysts disagree with this latter view, CBO revenue loss estimates are being assumed for the purposes of this plan.
Tax Cut #2: Enact a neutral cost recovery plan for capital investments. The Joint Committee on Taxation estimates this plan will generate $11.6 billion over five years. Under current law, businesses must write off capital investments from their tax liability over a number of years. Equipment purchases, for example, are written off over asset lives of between three and twenty years, and plant or company buildings can be written off over periods as long as 31.5 years. This policy is quite different from all other business ex- penses, which can be deducted in the year of purchase, called "full-expensing." The value of a long-term write-off is less than the original cost of the investment because the amounts deducted in later years lose their value due to inflation and the time value of money. Under current law, for example, a company that writes off a $ 1,000 machine over ten years may recover only 80 percent of the present value of the investment. 9 The Families First plan corrects these penalties in the tax code by indexing the deprecia- tion schedules for business investments to inflation and the time value of money. This ele- ment of Families First is patterned after the Investment Tax Incentive Act of 1993 (H.R. 539), introduced earlier this year by Representative Nick Smith (R-M). Such a change in the tax code would give businesses the present-value equivalent of immediate expensing of any major investment in new plant or equipment. 10 By correcting this flaw in the tax code, Washington would help ehcourage businesses to invest more heavily in America's future economic growth;:
TaxCut#3: Lower the maximum capital gains tax rate to 15 percent and index the original cost of the Investment to the rate of inflation. I I The Joint Committee on Taxation estimates this component of the plan will lose nearly $53 billion over five years. The U.S. tax code unfairly and unwisely punishes capital investment by taxing invest- ment income twice: the first time through corporate and individual income taxes and the second time by taxing the earnings made by after-tax investments. The current tax rate on capital gains is 28 percent and these gains are not indexed to the inflation rate. If in a given year, for example, the normal depreciation deduction for a prior investment was $100 under current law, the new code would give a deduction of $106.6. Ibis figure is equal to the $100 deduction, times the inflation rate [ 1.03], times the real rate of return on the investment [ 1.035]. The legislation is made revenue-neutral by changing the "double declining balance!' (also called 200 percent declining balance) method of depreciation in current law to a 150 percent declining balance method. 11 Wallop-DeLay, op. cit. 12 Entin and Bonilla, op. cit., p. 2. 13 For most of this century, capital gains were treated preferentially at a lower tax rate than ordinary income; though as recently as 1978, the maximum capital gains rate was 48.3 percent. This rate was reduced to 20 percent in 1982, and stayed at this level until 1986. But the 1986 tax reform act removed the preferential contrast, most of America's major economic competitors, such as Japan and Germany, ex- empt capital gains from taxation entirely or tax these gains at a greatly reduced rate while indexing the basis of the gains to inflation. The Families First plan lessens this penalty on investment in two ways. First, it reduces the top capital gains rate to 15 percent for individual and corporate taxpayers. Second, the plan applies this lower rate to the capital gain only after the original cost of the asset has been adjusted for inflation. Ris .widely recognized: that-the. current system unfairly taxes gains without accounting for the effects of inflation on the price of an asset. According to the House Ways and Means Committee: This means that tax may be paid on increase in the value of an asset, even if the real value of the asset has not increased. It is possible that the purchasing power represented by the asset's value may not have increased (if the asset's value and general price inflation are the same). However, when sold, the increase in value could generate taxable income.
By lowering the capital gains tax rate and indexing future gains to inflation, the Families First plan will reward new investment and risk taking. And by unleashing billions of dol- lars of new capital into the market, American businesses will have easier access to re- sources for purchase of better machinery, tools, and equipment for their workers. As a re- sult, workers' productivity will rise, leading to greater real wage gains and increased stand- ards of living for American families. 4) Repeal the earnings test on Social Security recipients ages 65 to 69. As mentioned above, the cuffent tax code penalizes seniors for having the forethought to save and invest for their retirement by forcing them to pay a steep surtax on income from savings and pensions. But the tax code punishes seniors in another way. Seniors between the ages of 65 and 69 who supplement their retirement income by working lose 33 cents in Social Security benefits for every $1 they earn over $10,560. This "earnings test' ' amounts to an additional 33 percent marginal income tax rate. When this rate is added to the 15 per- cent federal income tax rate and the 7.65 payroll tax rate, a working senior faces a 55.6 per- cent tax rate, far in excess of the marginal tax rate paid by the wealthiest Americans. The Families First plan repeals the punitive earnings test, freeing elderly Americans to work without fear of losing their benefits. Because of the peculiar nature of the earnings test - it amounts to a benefit reduction for retirees - its repeal is scored by Washington budgeteers as an increase in spending, not as a tax cut. According to the Joint Committee on Taxation, repealing the earnings test will increase outlays from the Treasury by $26.37 billion over five years. But like the tax cut components of the Families First plan, these added expenditures are fully offset by an equal reduction in federal spending, making them treatment of capital gains and raised the rate to 28 percent, equal to the maximum rate for ordinary income. The recent Clinton tax increase raised the top income tax rate to 39.6 percent, but the capital gains rate remains at 28 percent.
Once again, it must be emphasized that these estimates are based upon static economic models that do not account for the potential increase in tax revenues gener- ated by greater numbers of seniors encouraged to reenter the work force. 5) Apply the remaining $343 billion of these total savings to cutting the deficit by two- thirds in fiscal 1999. The plan dedicates the remaining $343 biHion of savings achieved by the spending cap to cut the deficit nearly two-thirds in five years. This means the fiscal 1999 deficit would fall from $223 billion, the current baseline projection, to just $70 billion. Thus the deficit produced by the Families First spending caps will consume less than eight-tenths of one percent of gross domestic product (GDP) in fiscal 1999. By contrast, the deficits produced by the Clinton plan will still consume .2.5 percent of GDP for the remainder of the decade. If the two percent annual spending cap were extended for an additional five years, the federal budget would be balanced by fiscal 2001 and $104 billion in surplus by fiscal 2003. This contrasts with the nearly $360 billion deficit produced by the Clinton plan in that year. 6) Create a bipartisan.commission to identify the specific savings to comply with the two percent cap and enforce the cap with an automatic sequester. A key feature of H.R. 3645 and S. 1576 is that each bill would create a bipartisan com- mission to identify the policy changes necessary to meet the two percent annual spending caps. Though there are some differences in the relative design of each bill's commission, both are largely modeled on the Base Realignment and Closure Commission. Supporters of the Families First plan recognize that few lawmakers are willing to sup- port specific spending cuts even if these cuts lead to reducing the deficit or to tax relief. This is because lawmakers face severe political pressure if they vote for individual spend- ing cuts, particularly if their vote means fewer federal dollars for their state or congres- sional district. This political dynamic was clearly a factor in the recent defeat of the five- year $90 billion spending cut plan forwarded by Representatives Timothy Penny (D-MN) and John Kasich (R-OH). Although this proposal would have cut the growth of federal spending a modest one percent over the next five years, that was sizable enough to gener- ate considerable opposition from Washington's defenders of higher spending, special inter- ests, Appropriations Committee members, and even the White House. Many members were threatened by Committee leaders with the loss of local projects if they voted for the Penny-Kasich plan. For nearly a dozen years, the same forces prevented the closure of obsolete military bases. Congress was unable to close a single obsolete military base from 1977 until the creation of the Base Closing Commission, as it is known, in 1988. But the recommenda- tions, generated by the Commission will lead to the eventual closure or reorganization of over 400 facilities with the minimum amount of political pain. This has been made possi- ble because the Commission is an independent body, largely impervious to political pres- sure, and Congress and the President must either approve or reject the Commission's rec- ommendations in their entirety. Members of Congress thus acquire significant political cover from the fallout accompanying a vote to close a base in their own congressional dis- trict.
The commissions contained in H.R. 3645 and S. 1576 would give similar protection for domestic program cuts. The legislation also would allow sensible, balanced cuts to be achieved, rather than a program of cuts that is distorted by pressure from powerful commit- tees and interest groups. The commission proposed in the House version of Families First would be made up of forty Members of Congress (twenty Representatives and twenty Senators), with an equal number of Democrats and Republicans. The House plan also establishes an advisory coun- cil composed of 150 private citizens to assist commission members. Twenty citizens would be selected at random by the Internal Revenue Service, with the remaining members ap- pointed by the Majority and Minority 1,eaders in each chamber of Congress. The commis- sion would have six months to develop its recommendations, at which point Congress would have seven legislative days to vote up or down on the package, without amendment.
The Senate bill's proposed commission is a modification of a deficit reduction cornmis- sion outlined in S. 119 1, sponsored by Senator Connie Mack (R-FL), and H.R. 2953, spon- sored by Representative Kasich. The commission would be composed of seven members appointed by the President. Four of these members would be chosen from a list submitted by the Speaker of the House and the Senate Majority Leader, and the remaining three mem- bers would be chosen from a list submitted by the House and Senate Minority Leaders. The -Senale sponsors offanfilies First want 1he commission to -be a body of outsiders. In Title 5, Sec. 503 of the bill, they state, "No current Member of Congress, employee of the executive branch, or current or former registered lobbyist may serve on the commission." The goal of this provision is to make the commission as independent of the political proc- ess as possible, untainted by special interest pressures. Unlike the commission designed in the House version, which has a fixed lifetime of six months to determine the needed spending cuts, the Senate bill creates an on-going commis- sion, charged with submitting spending cut recominendations each year. The original Mack-Kasich bill charged the commission with submitting $65 billion in spending cuts per year until the budget is balanced. This mission statement is modified slightly in Families First. It requires the commission to: review all Federal spending, including entitlement programs, in order to identify and recommend specific reduction in any Federal project, program, or activity to assure that aggregate Federal spending does not grow at a rate in excess of 2 percent per annum for any fiscal year beginning after 1 4.15 Each bill contains a fail-safe device if Congress failed to approve the commission's rec- ommendations, or to take any other actions that would keep spending within the cap limita- tions. In such a circumstance, an across-the-board sequester would take effect to lower spending to the required level. Social Security benefits, however, would be exempt from the sequester.
CONCLUSION The Family, Investment, Retirement, Savings, and Tax Fairness Act of 1993 (H.R. 3645 and S. 1576), or Families First bill, charts a new course in Washington's fiscal affairs by re- warding Americans with tax cuts, jobs, and economic growth for the inconvenience of lower federal spending growth. By contrast, the Clinton tax biU passed last summer "re- warded" families, seniors, and the business community with the pain of higher taxes, fewer jobs, and lower economic growth for accepting the "pain" of deficit reduction.
15 S. 1576, Tide V, Sec. 502. p. 48. 16 Also excluded, of course, are prior obligations of the government such as interest payments on the federal debt.
Families First is a solid first step toward undoing the devastating effects of the largest tax increase in American history. H.R. 3645 and S. 1576 offer taxpayers the prospect of real long-term deficit reduction, tax relief rather than tax hikes, and economic growth rather than economic stagnation.
Scott A. Hodge Grover M., Hermann Fellow in Federal Budgetary Affairs
APPENDIX Based on Census Bureau data, Heritage Foundation scholars have calculated the total value of a $500 per-child tax credit for each state and congressional district. Nationally, there are nearly 51 million children eligible-for such a credit. Thus in the first year of the plan, nearly $25.5 billion would be returned to American families. These results are summarized in the first table in this appendix. While the number of children in each congressional district varies greatly, the average district has 117,000 children. At $500 per child, this means the average district will receive some $58.7 million in family tax relief each year. The second table lists the congressional districts by state. Included in the table are: the number of eligible children in the district, the total amount of money the district will receive in family tax relief, and the name of the member representing the district. Heritage analysts also have calculated the value of a $500 per-child tax credit for every county in the U.S. These data are available upon request.
1 Robert Rector, "How to Strengthen America's Crumbling Families," Heritage Foundation Backgrounder No. 894, April 28, 1992, p. 1
.2 Joe Cobb and Scott A. Hodge, "Me Clinton Surtax on the Elderly's Savings:' Heritage Foundation FYI, August 18,1993.
3 Scott A. Hodge, "Putting Families First: A Deficit Reduction and Tax Relief Strategy," Heritage Foundation Backgrounder No. 927, February 16, 1993.
4 Total federal spending is defined hem as excluding deposit insurance. Ibis means that the highly unpredictable outlays and future offsetting receipts of the savings and loan bailout are not counted under the cap. S Congressional Budget Office, The Economic and Budget Outlook, September 1993, p. 26. Average inflation rate based on the projected implicit GDP deflator, see p. 18.
7 Ibis component is similar to the provision in the Economic Growth and Jobs Creation Act of 1991, crafted by Senator Malcolm Wallop (R-WY) and RepresentativeTom DeLay (R-TX).
8 Cobb and Hodge, op. cit mum amount would be indexed to the annual rate of inflation. The plan also allows penalty- free withdrawals for a first-time home purchase or to pay certain educational or medical ex- penses.
9 Stephen J. Entin and Carlos Bonilla, "A Rational Tax Package for Near-Tam Recovery and Long-Term Growth," Institute for Research on the Economics of Taxation, December 23, 199 1. p. 4.
1014 Committee on Ways and Means, U.S. House of Representatives, Committee Print, Overview of the Federal Tar System, 1993 Edition, June 14, 1993, p. 60.