Distributional Effects ofAlternative Ways of Limiting Tax Expenditures, Combined with a Constant Percentage Cut in Marginal Tax Rates

We now turn to a comparison of the distributional effects of different ways of limiting tax expenditures. This comparison is most meaningful ifwe compare options with the same effects on federal receipts.

First, however, we show the distributional effects of replacing the AMT and the limitation on itemized deductions with two ways of limiting tax expenditures—the Obama approach of limiting the benefit per dollar of exemption or deduction and the Feldstein et al. approach of limiting the tax saving to a fixed percentage of AGI. The Obama approach with a 28% limit and the tax expenditures we select for inclusion loses revenue and reduces tax burdens on average (table 5.5), while the Feldstein approach with the same tax expenditures limited to 2% of modified adjusted gross income raises revenue.18 The 28% limit option provides the largest net tax cut as a share

The actual Obama budget proposal raised considerable revenue because it retained the AMT and the limitation on itemized deductions and included some tax expenditures (primarily contributions to qualified retirement saving plans) that are not included in our simulations.

Table 5.5 Distributional effects of alternative limits on tax expenditures repeal AMT and the limitation on itemized deductions; limit benefits of tax expenditures: Change in average tax rates, calendar year 2016

Income Group

Limit Benefit

Limit Benefit

Limit Benefit

Limit Benefit of

of Certain Tax

of Certain Tax

of Entire

All Except

Expenditures

Expenditures

Group Except

Charitable and

to 28% Ratea

to 2% of

Charitable

Mortgage Interest

(%)

Modified

to 2% of

to 2% of Modified

AGE (%)

Modified AGI (%)

AGI (%)

Lowest quintile

0.00

0.16

0.16

0.15

Second quintile

0.00

0.56

0.55

0.50

Middle quintile

0.00

1.16

1.13

0.98

Fourth quintile

-0.01

1.63

1.55

1.27

80-90 percentiles

-0.05

1.94

1.82

1.43

90-95 percentiles

-0.16

1.91

1.73

1.19

95-99 percentiles

-0.42

1.58

1.24

0.51

Top 1%

-0.09

1.60

0.71

0.49

All

-0.09

1.48

1.23

0.91

Note: Proposal limits the benefits of all itemized deductions except where otherwise noted and also limits tax benefits from the exclusion for employer-sponsored health benefits, the exclusion of state and local bond interest, education credits, and the deduction for student loan interest. Modified AGI is AGI plus employer-sponsored health benefits plus state and local bond interest income. a Limits the tax saving from selected deductions and exclusions to 28% of amount deducted or excluded, as described in president's budget for fiscal year 2016; b Limits the tax saving from certain tax preferences to 2% of modified AGI, based on proposal by Feldstein, Feenberg, and MacGuineas (2011). Source: Urban- Brookings Tax Policy Center Microsimulation Model (version 0515-2).

of income to taxpayers in the 95-99 percentiles because this group benefits much more than others from elimination of the individual AMT and because the 28% limit does not raise their taxes enough to offset that benefit. The constant percentage ofAGI limit, in contrast, is generally progressive although the average tax increase is somewhat higher for taxpayers in the 80-95 percentiles of the distribution than for those in the top 5%. Tax burdens at the very top, however, fall substantially if the charitable deduction is not subject to the 2% of AGI limit. And if both charitable and mortgage deductions are excluded from the limit, the tax rate increase is largest for taxpayers in the 80-90 percentiles, with both lower and higher income groups experiencing smaller increases in average tax rates.

If revenue from the 2% of modified AGI limit on tax expenditures were used to reduce marginal tax rates, the net distributional effects depend on how rates are cut (table 5.6a). With all selected tax expenditures subject to the limit, using the revenue to reduce marginal tax rates across the board by 12.8% (setting the maximum rate at 34.5% instead of

Table 5.6a Repeal AMT and the limitation on itemized deductions; limit benefits of selected tax expenditures to 2% of modified AGI with alternative revenue offsets: Change in average tax rates, calendar year 2016

Income Group

No Offset (%)

Reduce All Individual Income Tax Rates by 12.8% (%)

Reduce All Individual Income Tax Rates by 2.7 Percentage Points (%)

Reduce 25% and Higher Individual Rates to 24.8% (%)

Lowest quintile

0.16

0.06

-0.05

0.16

Second quintile

0.56

0.13

-0.19

0.56

Middle quintile

1.16

0.25

-0.19

1.15

Fourth quintile

1.63

0.30

-0.10

1.57

80-90 percentiles

1.94

0.27

0.06

1.76

90-95 percentiles

1.91

-0.04

-0.03

1.30

95-99 percentiles

1.58

-0.87

-0.42

-1.06

Top 1%

1.60

-1.45

-0.18

-6.23

All

1.48

-0.21

-0.07

-0.27

Note: Limits the tax saving from certain tax preferences to 2% of modified AGI. Tax preferences subject to limit are all itemized deductions, exclusions for employer-sponsored health benefits and exclusion of state and local bond interest, education credits, and the deduction for student loan interest. Modified AGI is AGI plus employer-sponsored health benefits and state and local bond interest income. Revenue estimates include micro-dynamic responses, but distributional estimates are static. Because revenue- neutral variants of the proposal on balance reduce marginal tax rates and therefore have positive revenue feedback, aggregate tax burdens decline with revenue held constant. Source: Urban-Brookings Tax Policy Center Microsimulation Model (version 0515-2).

39.6% and the bottom rate at 8.7% instead of10%) results in a net tax increase for groups in the bottom 90% of the distribution and a net tax cut for groups in the top 10%, with the biggest tax rate cut going to the top 1% (1.45% ofincome). Ifthe revenue is used to reduce marginal tax rates by 2.7 percentage points (lowering the top rate from 39.6 to 36.9% and the bottom rate from 10% to 7.3%), taxpayers in the bottom four quintiles and the top 10% are net winners, with only tax units in the 80-90 percentiles seeing a very small tax increase. All groups see a tax change of no more than 0.4% of income. Finally, if the revenue is used to reduce all rates that are currently 25% or higher to a maximum rate of 24.8% (with no changes in the lower brackets), then only taxpayers in the top 5% see tax cuts, with the top 1% receiving an average cut in tax burdens of 6.2% of income. Retaining the charitable and mortgage interest deductions does not change the pattern of winners and losers for the scenarios where the revenue is used to cut marginal rates across the board or only reduce the top rate (tables 5.6b and 5.6c), but does change the pattern when marginal rates are reduced by a constant number of percentage points. In that scenario, average tax rates increase in the middle of the distribution, but decline more for the top 5% than when all the selected tax expenditures are included in the limitation.

Table 5.6b Repeal AMT and the limitation on itemized deductions; limit benefits of selected tax expenditures excluding the charitable deduction to 2% of modified AGI with alternative revenue offsets: Change in average tax rates, calendar year 2016

Income Group

No Offset (%)

Reduce All Individual Income Tax Rates by 10.9% (%)

Reduce All Individual Income Tax Rates by 2.2 Percentage Points (%)

Reduce 28% and Higher Individual Rates to 25.9% (%)

Lowest quintile

0.16

0.07

-0.02

0.16

Second quintile

0.55

0.18

-0.08

0.55

Middle quintile

1.13

0.35

0.01

1.13

Fourth quintile

1.55

0.42

0.12

1.53

80-90 percentiles

1.82

0.39

0.26

1.74

90-95 percentiles

1.73

0.07

0.12

1.36

95-99 percentiles

1.24

-0.83

-0.41

-0.86

Top 1%

0.71

-1.79

-0.71

-6.12

All

1.23

-0.19

-0.10

-0.23

Note: Limits the tax saving from certain tax preferences to 2% of modified AGI. Tax preferences subject to limit are all itemized deductions except the deductions for charitable contributions and home mortgage interest, exclusions for employer-sponsored health benefits and exclusion of state and local bond interest, education credits, and the deduction for student loan interest. Modified AGI equals AGI plus employer-sponsored health benefits and state and local interest income. Revenue estimates include micro-dynamic responses, but distributional estimates are static. Because revenue-neutral variants of the proposal on balance reduce marginal tax rates and therefore have positive revenue feedback, aggregate tax burdens decline with revenue held constant. Source: Urban-Brookings Tax Policy Center Microsimulation Model (version 0515-2).

To compare the 2% ofAGI limit with alternative ways oflimiting tax expenditures, we set the parameters of the other tax expenditure limitation approaches so that all three methods would be revenue neutral if combined with elimination of the AMT and the limitation on itemized deductions and a 12.8% across the board cut in marginal tax rates (table 5.7). We substitute a surtax on AGI for high income taxpayers for the Obama limit on the rate at which tax expenditures can be claimed. The base of the surtax is modified AGI, as defined earlier, but excluding long-term capital gains and qualified dividends. The surtax proposal, similar to the other limitations, does not change the marginal tax rate on long-term capital gains and dividends because the rate cuts that the tax expenditure limits finance apply only to ordinary income, not to the preferential rates on gains and dividends.[1]

Table 5.6c Repeal AMT and the limitation on itemized deductions; limit benefits of selected tax expenditures excluding the charitable and mortgage interest deductions to 2% of modified AGI with alternative revenue offsets: Change in average tax rates, calendar year 2016

Income Group

No Offset (%)

Reduce All Individual Income Tax Rates by 8.4% (%)

Reduce All Individual Income Tax Rates by 1.7 Percentage Points (%)

Reduce 28% and Higher Individual Rates to 27.9% (%)

Lowest quintile

0.15

0.08

0.02

0.15

Second quintile

0.50

0.22

0.02

0.50

Middle quintile

0.98

0.39

0.12

0.98

Fourth quintile

1.27

0.41

0.17

1.27

80-90 percentiles

1.43

0.34

0.23

1.42

90-95 percentiles

1.19

-0.06

-0.03

1.14

95-99 percentiles

0.51

-1.04

-0.74

-0.70

Top 1%

0.49

-1.42

-0.61

-5.16

All

0.91

-0.17

-0.11

-0.20

Note: Limits the tax saving from certain tax preferences to 2% of modified AGI. Tax preferences subject to the limit are all itemized deductions except the deduction for charitable contributions, exclusions for employer-sponsored health benefits and exclusion of state and local bond interest, education credits, and the deduction for student loan interest. Modified AGI is AGI plus employer-sponsored health benefits and the exclusion of state and local bond interest. Revenue estimates include micro-dynamic responses, but distributional estimates are static. Because revenue-neutral variants of the proposal on balance reduce marginal tax rates and therefore have positive revenue feedback, aggregate tax burdens decline with revenue held constant. Source: Urban-Brookings Tax Policy Center Microsimulation Model (version 0515-2).

Among the three approaches, not surprisingly the most progressive one is the surtax on modified AGI. An 11.4% surtax on modified AGI in excess of the income for the current law 33% rate bracket, combined with a 12.8% cut in marginal tax rates, would raise taxes on average by 2.8% of income for taxpayers in the top 1% of the income distribution, while cutting tax rates for all groups below the top 5%. The least progressive is the percentage of AGI limit; it would reduce tax rates by 1.5% for the top 1%, while raising tax rates for all groups in the bottom 90% of the distribution. The cap on tax expenditures falls in between, it would reduce tax rates slightly in the bottom four quintiles, increase them by an even smaller percentage of income in the 8095 percentiles and cut the average tax rate the most (but even then by less than 0.6% of income) for taxpayers in the 95-99 percentiles. This relatively large (though still modest) tax cut reflects the benefit taxpayers in the 95-99 percentiles receive from elimination of the individual AMT.

Table 5.7 Comparison of alternative revenue-neutral ways of limiting tax expenditures repeal AMT and the limitation on itemized deductions, limit tax expenditures, and reduce all marginal individual income tax rates by 12.8%: Change in average tax rates, calendar year 2016

Income Group

Limit Benefit of Certain Tax Expenditures to 2% of Modified AGIa (%)

Cap Certain Tax Expenditures at $16,300b(%)

Impose 11.4% Surtax on Modified AGI Excluding Capital Gains and Dividendsc (%)

Lowest quintile

0.06

-0.07

-0.07

Second quintile

0.13

-0.29

-0.33

Middle quintile

0.25

-0.36

-0.68

Fourth quintile

0.30

-0.16

-1.03

80-90 percentiles

0.27

0.09

-1.34

90-95 percentiles

-0.04

0.01

-1.49

95-99 percentiles

-0.87

-0.55

0.14

Top 1%

-1.45

-0.26

2.82

All

-0.21

0.01

-0.18

Note: Tax preferences subject to the limit are all itemized deductions, exclusions for employer-sponsored health benefits and state and local bond interest, education credits, and the deduction for student loan interest. a Limit tax saving from selected tax preferences to 2% of AGI plus employer-sponsored health benefits and state and local bond interest; b Limit the sum of the dollar amounts of itemized deductions and selected exclusions to $16,300; c Impose a 11.4% surtax on adjusted gross income plus employer- sponsored health benefits and state and local bond interest, excluding long-term capital gains and qualified dividends. The tax only applies to income in excess of the threshold for the 33% rate under current law. Source: Urban-Brookings Tax Policy Center Microsimulation Model (version 0515-2).

  • [1] All the revenue-neutral tax expenditure limitation proposals, however, indirectly reduce the tax expenditure for capital gains and dividends. By reducing marginal tax rates on ordinary income only, they reducethe differential between the rates on ordinary income and the rates on tax-preferred gains and dividends.
 
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