List of Tables and
Table 1: Heritage Foundation Tax
Table 2: A Family Dedicating the
Entire $500-per-Child Tax Credit for 21 Years Could Pay for Their
Child's Entire Education at an Average Public Univesity or More
Than a Year's Worth at a Typical Private University
Table 3: Estimated Distribution of
Estate Tax Relief in Thousands of Current Dollars
Table 4: Estimated Distribution of
Individual Capital Gains Tax Relief
Chart 1: Estimated Distribution of
Total Tax Relief by Income Group
Chart 2: Families Benefit Most from
Heritage Tax Cut Plan
Chart 3: $500 per-Child Tax Credit
Benefits Middle-Income Families
Tax writers in Congress soon will face the tough task of
crafting a $135 billion tax cut package that meets all the
commitments made in the recent five-year balanced budget agreement
between Congress and President Bill Clinton.1 This agreement promises to deliver a
wide range of tax cuts; specifically, among the things being
- Tax credits for families with children;
- A reduced capital gains tax rate;
- A reformed death tax (estate tax);
- An expansion of individual retirement accounts (IRAs); and
- Tax assistance for educational expenses.
But because the budget deal allots only about 60 percent of the
money needed to fully fund all of these commitments, lawmakers face
a dilemma: Can they craft a tax plan that delivers the maximum
amount of tax relief to the maximum number of Americans without
undermining the integrity of each of the individual measures?
The answer is yes. The result by no means would be the perfect
tax cut plan; but if Congress's tax writers keep in mind a few
simple principles, they can craft tax cuts that work well for
families and for the U.S. economy:
- Taxpayers must see an immediate benefit from the 1997 budget
agreement. The tax cuts should not be phased in over the next
five years in order to reduce their "cost" to the Treasury.
Taxpayers should not have to wait until after the turn of the
century to see the benefits of this deal.
- The tax package must produce good tax policy. It should
not make the current system more complex and thus undermine the
future potential for tax reform.
- The tax cuts must be broad-based and benefit the greatest
number of Americans possible. Lawmakers should avoid
means-testing or other devices that exclude some families to the
benefit of others. Moreover, they should not create special or
targeted tax breaks that benefit a select group of individuals or
industries at the expense of others.
- The tax package must aid in the task of balancing the
budget. The tax cuts should be designed to generate the maximum
amount of jobs and economic growth. Tinkering with some tax cuts
may reduce their "static" cost to the Treasury, but they ultimately
will fail to produce enough economic benefits to help balance the
- The tax cuts must promote good economic actions and not lead
to unintended detrimental consequences. Tax cuts for education,
for example, should promote long-term savings rather than subsidize
college fees or encourage more family debt. Subsidizing college
fees and debt will boost higher education costs, whereas long-term
savings will control higher education costs.
THE HERITAGE TAX CUT PLAN
Based on these simple principles, Heritage Foundation analysts
have crafted a sound tax cut plan that can deliver the
maximum tax relief to aid America's families while promoting job
creation and economic growth. Specifically:
- About 82 percent of the tax cuts in the Heritage plan are
designed specifically to benefit American families.
- The remaining 18 percent of the tax cuts are designed to
generate greater investment and economic growth than possible under
the current policies.
- This new growth would lead to $2,000 in higher disposable
annual income for the average American household and an average of
281,000 more jobs per year over the next five years.
- Some 73 percent of all taxpayers who would benefit from the
Heritage tax cut plan currently have regular2 incomes below $75,000 per year, and 82
percent have regular incomes below $100,000 per year.
As shown in Table 1 and illustrated
in Chart 1 and Chart 2, the central elements of the
Heritage Foundation tax cut plan include:
1. A $500-per-child tax credit for 25 million families
earning up to $110,000 annually and caring for 47 million children
under the age of 18. Over 87 percent of the families eligible
for this credit earn below $75,000 per year, and 97.7 percent earn
below $100,000 per year. For the typical family with two children,
$1,000 in tax relief would pay for one monthly mortgage payment and
a month of groceries. Families could begin taking advantage of this
$500-per child credit in filing their April 1998 tax returns.
Amount of tax relief over
five years: $72.7 billion.
2. A "back-ended" HOPE education savings account that would
make the buildup of earnings in all state-based savings plans and
all private savings plans tax-free. This plan would help the
families of 19 million children save for college.
Amount of tax relief over
five years: $5.2 billion.
3. An extension of the $500-per-child tax credit to cover
dependents between the ages of 18 and 21. This part of the
$500-per-child credit would cover the majority of college students
and could be used to pay for any higher education expense,
including room and board, books, or other living expenses. Nearly 8
million college-age students and their families would benefit from
such an extension.
Amount of tax relief over
five years: $16.8 billion.
4. A 50 percent exclusion of individual capital gains
declarations and a 20 percent reduction in the tax rate for
corporate capital gains. Reducing the taxes levied on capital
gains would produce an immediate gain in federal revenues and a
solid, sustainable boost to the general economy. Lower capital
gains taxes encourage large and small investors to move their funds
from less productive to more productive companies, thus freeing an
estimated $7 trillion in assets currently locked up because of high
Amount of net tax relief
over five years: $23.8 billion.
5. Reform of the death tax by increasing to $1 million the
value of estates excluded from taxation and extending the time
taxpayers have to pay the death taxes. Federal law currently
permits estates of $600,000 or less to avoid death taxes.
Increasing to $1 million the threshold at which estates would be
subject to death taxes will take nearly half of all taxable estates
off the tax rolls.
Amount of tax relief over
five years: $10.6 billion.
6. An "American Dream" savings account or IRA. This new
IRA feature would allow workers to put up to $2,000 in after-tax
dollars into a retirement account but be able to withdraw the
buildup tax free once they retired.
Amount of tax relief over
five years: $2 billion.
Heritage economists employed the most current and extensive data
available to estimate the effects of these policy changes. Analysts
constructed each of the revenue estimates shown in Table 1 from data contained in the Bureau
of the Census Current Population Survey, the Internal Revenue
Service (IRS) Public Use File for 1993, or both. The annual Current
Population Survey represents the largest regularly produced
collection of demographic data available to the general policy
community. The IRS Public Use File is the largest machine-readable
sample of individual income tax returns available. Both databases
contain tens of thousands of observations selected by the Census or
the IRS using stratified random sampling techniques, and each
database accurately reflects the true, real world values for
variables used in this Heritage analysis. The dynamic analyses were
conducted using the WEFA Group's Mark 11 economic model.3
TAX CUTS FOR FAMILIES
The $500-Per-Child Tax Credit
There is broad agreement in Washington, D.C., that working
families with children are overtaxed and that tax credits for
children should be included in this year's tax cut package. Members
of Congress and the White House, however, have put forward very
different proposals for delivering tax cuts to families with
The President's plan
Two years ago, Congress passed (as part of the Balanced Budget
Act of 1995, which President Clinton vetoed) a $500-per-child tax
credit for children under age 18 in families earning below $110,000
per year.4 By contrast, Clinton has
proposed a $300-per-child tax credit for dependent children below
the age of 13 in families with annual incomes below $60,000.5 When the President's plan is compared
with Congress's tax credit plan, the age and income restrictions in
the Clinton proposal would deny tax relief to the families of 23
million children.6 Specifically:
- Because roughly 25 percent of all children are over the age of
12, millions of families would be denied a tax cut at precisely the
time in which the cost of raising a child becomes more expensive.
This provision in the President's proposal denies tax relief to the
families of at least 2.8 million children earning under $30,000 per
- Although some 87 percent of all children live in families
earning below $75,000 per year, the Administration's income
restriction would deny $2.6 billion in tax relief to nearly 6
million families with children who are eligible under Congress's
- Worse still, families would have to wait until tax year 2000
for the value of the President's tax credit to increase to $500 per
Congressional tax writers should avoid ploys such as further
means testing the $500-per-child tax credit, lowering the
eligibility age for children, or phasing in the credit as a way to
reduce its five-year cost. Families should not have to wait until
the next century to reap the benefits of the 1997 budget agreement.
Nor should they have to discover that working overtime will make
them ineligible for tax relief or that they would get a tax cut for
one child but not for another.
The Heritage Foundation proposal
Congress's $500-per-child tax credit proposal should be the
starting point for this year's debate. The Heritage plan includes a
$500-per-child tax credit for working families earning up to
$110,000 annually with dependents below the age of 18. The credit
would take effect on July 1, 1997, so that families could take
advantage of a prorated amount of the full credit when filing their
tax returns next April 15.
Unlike Congress's proposal, the Heritage plan would include a
Dependent Care Tax Credit (DCTC) bonus option. Under current law,
working families with children in daycare settings can deduct
between 20 percent and 30 percent of a maximum of $2,400 in
professional child care expenses. The average value of the DCTC
claimed by families is $249 per child.7
The Heritage plan would allow these families to take either the
DCTC or the new $500-per-child tax credit--whichever is of greater
value to them--but not both. Most families would choose the new
$500-per-child tax credit because of its greater value and the fact
that it would not be limited to daycare expenses.
This bonus option would lower the five-year cost of the
$500-per-child tax credit plan while still guaranteeing that 25
million families, who care for 47 million children, would be
eligible for the full $500 in tax relief for every child. Over five
years, this plan would deliver $77 billion in tax relief to
families with children.
Among other benefits of the $500-per-child tax credit plan:
- For a typical family of four, $1,000 in tax relief would pay
the mortgage and feed the family for one month, or pay the utility
bills for 11 months, or buy nearly 20 months of clothing for the
- For a family with two children and earning $30,000 per year,
the $1,000 in tax relief would cut their income tax burden by 51
percent. Meanwhile, a family of four earning $40,000 per year would
see their tax burden cut by 30 percent, a family earning $75,000
would see their tax burden reduced by 12 percent, and a family
earning $100,000 per year would receive a tax cut of just 7.4
- As shown in Chart 3, at least 87
percent of the overall benefits of the $500-per-child tax credit
plan would go to families with adjusted gross incomes below $75,000
per year- middle-income families by any standard--and over 98
percent would go to families earning below $100,000 annually.
Helping Families Afford College
The rising cost of higher education is one of the major concerns
facing American families today. Over the past 18 years, the cost of
a college education has increased some 221 percent, while the
general rate of inflation and the average household income have
increased only about 80 percent. Furthermore, the cost of college
is uncertain, making it difficult for families to anticipate just
how much they must put aside or how much debt they or their
children will have to incur to pay for a college education. Both
the uncertainty and the generally high cost of a college education
are matters of concern to Congress and the President.
The President's proposal
Unfortunately, President Clinton's proposed HOPE
scholarship--a $1,500 tax credit for the first two years of
college--is the wrong policy for American families facing steep and
uncertain education bills. In fact, the President's plan would make
matters worse. The reason: The President's HOPE scholarship would
inflate tuition costs,8 ignore the
anxiety families feel when faced with uncertain college costs,
further complicate an already complex federal income tax code, and
create a new and costly middle-class entitlement program.
The Heritage Foundation proposals
Congress can deliver tax relief for higher education but
without the harmful effects of the President's plan. The following
two proposals would help the families of 19 million children save
for college as well as an additional 8 million families with
dependent children already in college. Moreover, these proposals
would reward families who work hard and save for their children's
college rather than subsidize consumption and debt.
- First, lawmakers should create a new "back-ended" HOPE
education savings account (or Super-ESA). This new savings plan
would allow families to deposit after-tax income into a long-term
savings account or a prepaid tuition plan. Families would be able
to meet their children's college costs by withdrawing the buildup
of earnings in these accounts tax-free. Based on Heritage
Foundation estimates, HOPE education savings accounts would provide
the families of some 19 million children with $5.2 billion in tax
relief over five years.
The Super-ESA is a perfect complement to the $500-per-child tax
credit. The child tax credit would give families the means to save
for higher education, while the Super ESA would give them the tool
to reach that goal. For example, if the parents of a newborn child
chose to invest the entire $500 credit each year in a HOPE account
instead of using the tax relief for immediate needs, they could
expect to have more than $16,000 in their savings account by the
time the child goes to college. As shown in Table 2, this is enough to purchase 5.9
years of education at the typical state university.9 The President's plan, on the other hand,
would provide a maximum of $3,000 in relief. Even without any
inflation in tuition costs, $3,000 would pay for only 1.3 years at
the average state college or for a single semester at the average
- Second, ESAs, however valuable, would not benefit the
families of students currently in college. To help these families,
lawmakers should extend the $500-per-child tax credit to cover all
dependents between the ages of 18 and 21. This extension would
cover most students in college today, and it could be used to pay
for any education-related expense, including books, fees, and room
and board. This extension of the $500-per-child credit would
deliver $2,000 in tax relief to the families of nearly 8 million
students during the course of a four-year college education- often
the most expensive period in raising a child. Moreover, such a
credit would not lead to escalation in tuition costs, as the
Clinton plan would. Over five years, this plan would provide about
$16.8 billion in tax relief to hard-pressed families and
Helping Families Save for Retirement
The Heritage Foundation proposal
The Heritage plan would offer taxpayers a new way to preserve
the value of their retirement savings by creating a new American
Dream Individual Retirement Account (AD IRA), based on the same
proposal passed in the Balanced Budget Act of 1995 but vetoed by
President Clinton. Contributions would be made from post-tax
income, but the interest from such savings would not be taxed upon
withdrawal if contributions had remained in the account for at
least five years and if the retiree has reached age 59 1/2. This is
sometimes referred to as a "back-ended" IRA.
Initially, contributions to the new AD-IRA would be limited to
$2,000 per taxpayer per year ($4,000 for a married couple), but
this amount would be indexed to the rate of inflation in subsequent
years. The plan also allows penalty-free withdrawals for a
first-time home purchase or to pay certain educational or medical
expenses. Over five years, this plan would provide taxpayers with
$2 billion in relief.
Lawmakers should remember that many Americans depend on the
savings they have accumulated in their IRA (or the proposed AD-IRA)
to pay for necessary living expenses during their retirement years,
and allowing penalty-free withdrawals for home purchases or
educational and medical expenses (often expenses that are incurred
earlier in life) may deplete the retirement savings of many
individuals. Therefore, Congress and the President should make sure
that individuals have the opportunity to fully replenish their
retirement accounts after making a substantial withdrawal from
their IRAs. Alternatively, the $2,000-per year limit on
contributions could be increased to allow taxpayers enough of a
buffer to save for retirement and education, health, and home
Helping Family Farms and Businesses
Although federal estate and gift taxes often are considered
another form of capital taxation, their real effect is to penalize
a taxpayer's entire life of productive activity. This part of the
federal tax code stems from the mistaken view that redistributing
income leads to the redistribution of economic power. Nearly a
century of wealth taxation, however, shows that well-to-do
Americans (including a great number of middle-class families)
simply find legal ways to avoid the tax collector.10
Death taxes encourage families to save less and consume more of
their income, thus benefiting from the lower taxes on consumption.
Death taxes also encourage families to make less productive
investments--such as large life insurance policies and substantial
charitable contributions--to reduce the chances that their families
will have to pay a large estate tax upon their deaths. Thus, the
attempt to use the tax code to redistribute economic resources
leads to a distorted distribution of consumption and a less
Taxpayers who are likely to be most affected by estate taxes are
small farmers and minority and female business owners--people who
have worked hard all their lives to plow their earnings back into
their businesses or to accumulate assets they could leave to their
children. Congress has spent the past 80 years promising economic
and social opportunities to these Americans, and it is time it
acted to reform the part of the tax code that directly undermines
their efforts to achieve the American dream.
The Heritage Foundation proposal
Congress should repeal the death tax. Considering the limited
amount of money available for tax cuts this year, however, only
modest reforms are possible. In fact, one third of the Members of
both the House and Senate have co-sponsored legislation to repeal
the death tax. Congress should help maintain the momentum for
repeal by increasing the "unified credit" that estate taxpayers
The Heritage proposal largely adopts the policies set forth in
S. 2. Over seven years, this measure would increase the
threshold at which a family pays death taxes (currently on estates
valued at $600,000 or more) to $1 million. Such an increase would
take nearly 50 percent of all taxpayers off the estate tax rolls,
would provide significant relief for small business owners, and
would focus nearly all tax reduction on the smallest estate.
Table 3 shows the distributional
effects of increasing the unified credit to $1 million. Only 3
percent of the benefit from this credit increase would go to
taxpayers whose incomes exceed $100,000.
TAX CUTS TO UNLEASH ECONOMIC GROWTH
Cutting Capital Gains Taxes
One of the most important things Congress can do this year to
spur job and economic growth is to reduce capital gains taxes.
Lower capital gains taxes stimulate economic growth by reducing the
cost of capital: Taxes make up one part of the cost of capital, and
lowering capital taxes reduces the "price" of capital to all kinds
of borrowers. When borrowing costs fall, entrepreneurs create more
new businesses, managers of existing businesses expand their
factories and buy new machines, and families buy new cars and
homes. All of this expansion in economic activity means more jobs
and higher worker productivity. Productivity gains that stem from
workers using new and improved machines help to increase average
wages, thus returning income benefits even to households that may
never have capital gains income.
Some Members of Congress still believe that lower taxes on
capital gains benefit only rich taxpayers. The data, however, tell
a different story. As Table 4
illustrates, nearly 88 percent of all current taxpayers with
capital gains declarations on their tax returns have incomes from
other sources (such as wages, salaries, self-employment, and
pensions) under $100,000; and 55 percent of all capital gains
dollars are found in households with incomes below $100,000. In
other words, those taxpayers who would benefit from excluding 50
percent of capital gains from taxation are likely to be in the
Just as lawmakers should shun the "tax cuts for the rich"
argument, they should reject the counsel of those tax economists
who suggest that lowering the effective tax rate on capital will
not result in a change in capital gains declarations. History
proves otherwise. Experience with changes in capital gains tax
rates over the past 25 years strongly indicates that rate decreases
(or exclusions) produce more declarations of capital gains and thus
more capital gains taxes. Owners of appreciated assets who face
high tax rates generally hold on to their assets in anticipation of
lower future rates. When rates come down, the amount of capital
gains taxes goes up.
Economists estimate that trillions of dollars in unrealized
capital gains (perhaps as much as $7.5 trillion) exist in the
portfolios of American taxpayers.11
Some economists have estimated that significant capital gains rate
changes could produce substantial economic benefits and create
revenue windfalls for federal and state governments. In a 1994
article for the American Economic Review, Leonard Burman and
William Randolph, two leading tax economists on the staff of the
Congressional Budget Office (CBO), estimated the response of
taxpayers to rate reductions as being on the order of 1 to 6 in the
This means that for every 1 percent drop in the rate (or the
equivalent in exclusions), capital gains realizations would rise by
6 percent.12 In other words, a 50
percent exclusion of capital gains declarations has the potential
of raising declarations by 300 percent. It is from this increase in
declarations that the federal government receives capital gains
revenues above what it would have received without the 50 percent
The Heritage Foundation proposal
For individual taxpayers, the Heritage plan would leave
capital gains tax rates the same as current law but would exclude
50 percent of the net gain on an asset from taxation. For
corporations, the plan would cut the capital gains tax rate from 35
percent to 28 percent.
For individuals, these changes mean that if an asset purchased
for $100 is sold at a price of $200, the seller would pay capital
gains tax on only half of the $100 increased value of the asset. In
this case, the taxpayer would pay a 28 percent tax rate on $50, or
$14 in capital gains tax.
The Heritage proposal is the same as the one contained in S. 2.
Heritage analysts, however, believe that its cost to the federal
Treasury will not be as great as has been calculated by the staff
of the Joint Committee on Taxation (JCT). Even though the
committee's estimate does assume that cutting the effective capital
gains tax rate through a 50 percent exclusion would generate higher
declarations in the first three years after enactment, and thus
higher tax revenue collections than projected under current law, it
is based on the view that for every 1 percent drop in the tax rate,
there will be a 4 percent increase in the capital gains tax
Heritage Foundation analysts have performed the same
calculations assuming a more reasonable 1 to 5 ratio in the first
year, or halfway between the JCT's estimate of new declarations and
the estimate of Burman and Randolph. As a result, Heritage analysts
believe that a 50 percent exclusion of the capital gains tax would
produce roughly $10 billion more in tax revenue collections over
the first five years of the plan. Thus, Heritage analysts believe
the five-year "cost" to the Treasury of this proposal is $23.7
billion, not $33.6 billion as estimated by the JCT.
HOW THE HERITAGE PLAN WOULD BENEFIT JOBS AND THE ECONOMY
Within the $135 billion constraint imposed by the 1997 budget
agreement, the Heritage Foundation tax cut plan would deliver the
maximum tax relief to the most Americans while generating the
economic growth needed for the government to stay on course for a
balanced budget. Overall, some 82 percent of the $131.6 billion in
total tax cuts would flow to American families. The remaining 18
percent would be used to reduce the tax penalties on savings and
investment and to reduce the high taxes imposed on families who try
to pass assets down from one generation to the next.
In the final analysis, some 73 percent of all taxpayers
benefiting from the Heritage tax cut plan have regular income below
$75,000 per year, and 82 percent have regular income below $100,000
per year (see Chart 1).
Heritage Foundation economists analyzed the tax cut plan's
impact on jobs and economic growth using the January 1997 U.S.
Macroeconomic Model of the WEFA Group. WEFA economists
reconstructed this January model to embody CBO economic and
budgetary assumptions published in January of this year.13 (It is fair to say that simulations of
policy changes using this specifically adapted model produce
dynamic results based on CBO assumptions.) Next, the elements of
the Heritage tax plan were entered into the model to analyze the
plan's dynamic economic impacts.
The Heritage analysis using the WEFA model indicates that a
balanced package of tax cuts to help families and encourage
investment will result in a stronger, more vigorous general
economy. This analysis suggests that the Heritage tax cut plan
- Increase household income by $2,000. The Heritage tax
plan produces $200 billion in additional, inflation-adjusted
disposable income for households--equal to $2,000 in higher income
for the average American household. The simulation indicates that
real disposable personal income rises above the CBO current law
baseline in each of the five years from 1998 through 2002.
- Spur job creation. The strength of household income is
based in large part on more jobs being created in the private
economy. The Heritage tax plan produces an average of 281,000 more
jobs per year over the five-year period. In fact, in FY 1999, the
simulation shows that the private sector produces 380,000 more
- Expand the tax base. Using mostly "static" estimates
that take only limited account of the tax cut's influence on the
economy's performance, the Heritage tax plan would reduce revenues
to the federal Treasury by $131.6 billion over five years. The more
"dynamic" analysis using the WEFA model, however, suggests that
because the tax cut plan promotes stronger economic growth, the
expanding tax base feeds new tax revenues back into the federal
Treasury. These new tax revenues replace or "feed back" 53 percent
of the expected revenues lost to the Treasury under a static
analysis. In other words, when the tax cut plan's effect on
economic performance is accounted for, the actual "cost" of the
plan to the Treasury is only 53 percent of the purely static
reduction in tax revenues over five years.14
The Heritage Foundation tax cut plan achieves the agreed-upon
budget deal tax target in a way that works best for American
families. It also would boost the economy so that balancing the
budget is still achievable. Not only does the Heritage tax cut plan
help Mainstreet America, but it also generates the kind of economic
growth that benefits every American with higher income and more
Heritage economists follow a two-step procedure in analyzing the
revenue and economic effects of proposed policy changes. First,
estimates are prepared of revenue changes that stem from changes in
the taxpaying population eligible for the tax change, from the base
of taxable income absent any change in the economy and from the tax
rates. These estimates frequently are called "static" estimates,
largely because they are unaffected by changes in the behavior of
taxpayers that stem from tax policy reforms. Second, these static
revenue changes and other important modifications of tax law are
introduced into the WEFA U.S. Macroeconomic Model. The WEFA model
has been designed in part to estimate how the general economy is
reshaped by policy reforms. The results of simulations performed in
the WEFA model produce the "dynamic responses" to policy moves.
These notes describe how Heritage economists prepared the static
estimates described in the paper and how these results and other
assumptions were introduced into the WEFA model.
TAX POLICY ASSUMPTIONS
Child Tax Credit
The child tax credit analysis is drawn from tabulations using
the Heritage Matched Database. To be eligible for the credit, a
taxpayer must meet the eligibility criteria described in S. 2.
Under the Heritage tax plan, this credit is extended to taxpayers
with positive tax liabilities who have dependent children under the
age of 22. Both the primary credit and its extension are phased out
according to the threshold criteria set forth in S. 2. The total
amount of the credit is the lowest amount of the full $500 value of
the credit, the remaining portion of the credit had it been phased
down, or the total tax liability of the parent. Under the Heritage
plan, an eligible taxpayer receives either the child tax credit or
the Dependent Care Tax Credit that exists under current law,
whichever is higher.
The year-by-year revenue effects of the child tax credit are
shown in Table 1. Heritage economists used three calculations to
estimate these annual revenue changes. First, the demographic data
drawn from The Heritage Matched Database for 1993 (the base year)
were increased for each fiscal year between 1997 and 2002 by the
population growth rates for people age 22 and under produced by the
Bureau of the Census. Second, Heritage economists forecasted the
number of families with eligible children who fit at or under the
income threshold for each of year of the five-year period. These
forecasts were shaped using the Gross Domestic Deflator forecasts
prepared by the WEFA Group. Third, the population and income
forecasts were combined to determine the annual number of tax
returns with eligible children. The credit then was applied
pursuant to the rules of S. 2 to each eligible return.
Capital Gains Provisions
The Heritage Foundation's estimate of the reduced capital gains
tax revenues from individuals is based on data from the 1993 IRS
Statistics of Income and revenue forecasts from the Heritage
Foundation Individual Income Tax Model. Heritage analysts selected
only those tax returns that contained taxable capital gains in
1993, subtracted the amount of these gains from the taxpayer's
adjusted gross income, and created a new income variable that
summed all of the taxpayer's income except capital gains income.
Forecasts of capital gains declarations under current law were made
that assumed an annual growth in the base of 4 percent and a real
tax rate elasticity of -0.43 percent. These forecasted declarations
and associated capital gains taxes were distributed across the new
These baseline capital gains taxes were reduced by 50 percent
and designated the "purely static" revenue losses under this
provision. To calculate the changes in revenues under an assumption
of "unlocking," Heritage economists assumed a transitory elasticity
of -5.0 percent and 3.0 percent, respectively, for years one and
two of the tax plan; a permanent elasticity of -1.8 percent was
assumed for years after the second year. The application of these
elasticities to the base of capital gains declarations
significantly decreased the purely static revenue losses. The
difference between these purely static revenue losses and the
revenues stemming from "unlocking" were introduced to the WEFA U.S.
Macroeconomic Model as changes in total federal revenues.
Estate and Gift Tax Provisions
Heritage Foundation estimates of the revenue impact of the
increase in the unified credit and the introduction of a
family-owned business exclusion are based on data from the 1993 IRS
Statistics of Income and revenue forecasts from the Heritage
Foundation Estate and Gift Tax Model. Heritage forecasts of estate
tax revenues for fiscal years 1998 2002 were distributed across
adjusted gross income following the techniques described by Daniel
Feenberg, Andrew Mitrusi, and James Poterba in "Distributional
Effects of Adopting a National Retail Sales Tax," Tax Policy and
the Economy, Conference Report, National Bureau of Economic
Research, September 1996, pp. 20-22.
The Heritage Foundation's estimates of the revenue impact of the
IRA provisions in this plan are based directly on the amounts
estimated by the Joint Tax Committee.
MODEL SIMULATION ASSUMPTIONS
Average Effective Tax Rate
The WEFA model contains a variable that measures the total
amount of all federal taxes on individual income as a percentage of
nominal personal income. Heritage adjusted downward this average
effective tax rate for each of the forecast years to reflect the
purely static revenue decreases resulting from adoption of the
Heritage tax plan.
The model assumes that the Federal Reserve Board adopts a
neutral stance with respect to these policy changes. This
assumption was embodied in our simulation by excluding the
stochastic equation for monetary reserves.
Labor Force Participation
A small adjustment of 0.06 index points was made in the model's
labor force participation rate to account for the dynamic effects
of reforming the estate and gift tax. This adjustment in the labor
force participation rate is explained more fully in William W.
Beach, "The Case for Repealing the Estate Tax," Heritage Foundation
Backgrounder No. 1091, August 21, 1996, pp. 24-26.
Declarations of Capital Gains
Heritage economists adjusted federal tax collections to reflect
a higher level of capital gains declarations. The base was
increased to reflect estimated elasticities associated with
significant capital gains rate reductions. See Leonard Burman and
William Randolph, "Measuring Permanent Responses to Capital-Gains
Tax Changes in Panel Data," American Economic Review, Vol.
84, No. 4 (September 1994).
Corporate AAA Bond Rates
Heritage economists decreased the corporate AAA bond rate by 60
basis points to reflect the drop in taxes on capital stemming from
capital gains and estate tax reform. This variable is a component
in a large WEFA equation that calculates the cost of capital.
1 The "net" size of
the tax cut package will shrink to $85 billion after $50 billion in
proposed tax increases are deducted.
2 "Regular" income
includes income from all other sources except capital gains.
3 The WEFA Group's
Mark 11 U.S. Macroeconomic Model was developed in the late 1960s by
Nobel Prize winning economist Lawrence Klein and several of his
colleagues at the University of Pennsylvania's Wharton School of
Business. It is widely used by Fortune 500 companies and by
prominent federal agencies and economic forecasting
4 For taxpayers
filing jointly with incomes above $110,000, the credit phases out
at a rate of $25 for each $1,000 above the threshold (a range of
$20,000), thus fully phasing out at $130,000 in income. For single
filers, the credit begins to phase out at $75,000 in income.
Administration's $300-per-child credit begins phasing out for
families with incomes above $60,000 and reaches zero at $75,000 in
family income. The credit increases in value to $500 per child in
tax year 2000.
6 For a complete
analysis of these differences, see Scott A. Hodge, "Balanced Budget
Talking Points #5: Clinton's $300-Per-Child Tax Cut Plan Denies Tax
Relief to 23 Million Children," Heritage Foundation F.Y.I.
No. 78, December 11, 1995.
7 The Heritage
Foundation analysis was based on 1993 IRS Public Use Files.
8 For an
explanation of how the President's HOPE scholarship plan would
inflate tuition, see John S. Barry, "Higher Education Tax
Proposals: The Right and Wrong Ways to Take the Anxiety out of
Paying for College," Heritage Foundation Backgrounder No.
1118, May 22, 1997.
9 These figures
assume an 8 percent nominal return on savings and a 3 percent
inflation rate, adjusted to 1996 dollars. School costs are based on
1996-1997 figures obtained from CollegeNET,
10 The death tax
is only one of many federal taxes that place a multiple tax on
income. Double taxation raises numerous ethical and economic
issues. See Daniel J. Mitchell, "Taxes, Deficits, and Economic
Growth," Heritage Lecture No. 565, 1996.
11 See, for
example, Jude Wanniski's March 15, 1995, testimony before the
Senate Finance Committee as cited in Stephen Moore and John Silvia,
"The ABCs of the Capital Gains Tax," Cato Institute Policy
Analysis No. 242, October 4, 1995.
12 Leonard E.
Burman and William C. Randolph, "Measuring Permanent Responses to
Capital-Gains Tax Changes in Panel Data," American Economic
Review, Vol. 84, No. 4 (September 1994), p. 803.
Congressional Budget Office, The Economic and Budget Outlook:
Fiscal Years 1998-2002 (Washington D.C.: U.S. Government
Printing Office, 1997). See also the accompanying Technical
Appendix for a description of The Heritage Foundation's use of the
WEFA Model and various steps incorporated to simulate the budget
resolution. It should be noted that the methodologies, assumptions,
conclusions, and opinions herein are entirely those of Heritage
Foundation economists and have not been endorsed by, and do not
necessarily reflect the views of, the owners of the WEFA Mark 11
14 The accounting
cost of the tax package is some $175 billion over five years. The
"feedback" effect of higher economic growth, however, combined with
the increased revenues generated by higher capital gains
declarations, reduces this amount by 53 percent.