In Pursuit of Revenues: Federal Income Tax Reform

According to the U.S. Treasury Department, the federal budget reported surpluses averaging $140 billion annually between fiscal years 1998 and 2001. In the next seven years, tie federal budget incurred deficits averaging just over $300 billion annually. The financial meltdown that began in late 2008 resulted in a budget deficit of $1.4 trillion in fiscal year 2009, followed by annual deficits in the $1.3 trillion range through fiscal year 2012. Most economists and the major credit rating agencies agree that the country cannot continue to sustain budget deficits that match the magnitude of recent years or those currently projected by the Congressional Budget Office (CBO) for the near future. In late February, Fitch Ratings announced that the United States "must make credible progress this year" on a long-term deficit-reduction strategy or it would risk losing its top AAA credit rating (Tim Mullaney, "Fitch Wams U.S. Risks Losing AAA Debt Rating," USA Today, Feb. 27,2013). Fitch Ratings further indicated that the key driver of the U.S. credit rating "is the future path of government deficits" and the level of public debt.

On October 15, 2013, Fitch Ratings placed the United States on "Rating Watch Negative" status as a result of the prolonged federal debt ceiling negotiations in Washington. Tellingly, the release also noted that the United States "is the most heavily indebted 'AAA' rated sovereign, with a gross debt ratio equivalent to double that of the 'AAA' median" (Steven Russolillo, "Fitch Puts U.S. Rating on a Negative Watch," Wall Street Journal, http://stream.wsj.com/story/the-fiscalcliffSS-2-87944/SS-2-3 55042/).

Members of Congress continue to debate whether the correct approach to addressing budget shortfalls is to increase revenue, cut spending, or both; however, the fact that income taxes paid by individuals and businesses represent approximately 60% of federal budget receipts (followed by social insurance taxes at 33%) suggests that income tax reform is likely to be a substantial part of any long-term solution to tiie federal budget crisis. Indeed, increased tax rates for high-income individuals were a major portion of the solution to the "fiscal cliff' discussions in late December 2012. In February 2013, the U.S. House Ways and Means Committee held hearings on the merits of maintaining the charitable contributions deduction for individuals.

It also seems likely that increased federal tax revenues will play a significant role in any long-term solution that President Obama signs into law. Limiting or eliminating tax loopholes (i.e., exclusions, deductions, exemptions, credits) might prove to be the chosen path for achieving meaningfully higher revenues. In February 2013, the Joint Committee on Taxation issued the report "Estimates of Federal Tax Expenditures for Fiscal Years 2012-2017" (https://www.jct.gov/publications.html7fimc =startdown&id=4503). The report defines tax expenditures as "revenue losses attributable to provisions of the Federal tax laws which allow a special exclusion, exemption, or deduction from gross income or which provide a special credit, a preferential rate of tax, or a deferral of tax liability" (Congressional Budget and Impoundment Control Act of 1974). Tax expenditures can be thought of as any reduction in income tax liability resulting from a special tax treatment that provides a tax benefit to a particular taxpayer.

The following is a comprehensive overview of the income tax receipts portion of the federal budget and each of the major tax expenditures projected to cost the U.S. Treasury at least $100 billion during the five-year period from 2013 through 2017. Accountants have a duty to contribute to the current federal budget debate in Washington in a nonpartisan manner by bringing their financial expertise to bear on the political conversation.

Home Ownership Deductions

The mortgage interest deduction is designed to encourage home ownership. Home mortgage interest is deductible to individuals who file federal Form 1040, U.S. Individual Federal Income Tax Return, and itemize deductions on Schedule A. Generally, the interest is fully deductible, provided that 1) the taxpayer incurred the mortgage to buy, build, or improve a home, and 2) the total debt equals $1 million or less. Interest is also deductible on second mortgages of $100,000 or less. These limits apply to the combined total debt on a primary residence and a second home (if any). The mortgage interest deduction is expected to cost the federal government an average of $75.8 billion per year between fiscal years 2013 and 2017, a total of $379 billion for the five-year period. (Tax expenditure estimates were taken from the aforementioned Joint Committee on Taxation report.) More than 77% of the mortgage interest deduction benefits individuals who make more than $100,000 per year in modified adjusted gross income (MAGI).

The real estate property tax deduction has the same purpose as the home mortgage interest deduction-to promote home ownership. The real estate property tax deduction is also only available to taxpayers who file Form 1040 and itemize deductions on Schedule A. It is expected to cost the federal government an average of $30.6 billion per year during the 2013-2017 period, a total of $152.9 billion. The primary beneficiaries of this deduction are taxpayers with MAGI in the $100,000-$200,000 range. Federal tax filers in this income range receive 50% of the cumulative benefit of the deduction, whereas taxpayers with a MAGI of at least $200,000 receive 25% of the benefit.

The exclusion of capital gains on sales of principal residences is another tax break related to home ownership. Taxpayers can qualify to exclude up to $250,000 in capital gains ($500,000 if married and filing jointly) when selling their principal residence. To qualify, the taxpayer must have owed and lived in the home as a primary residence for at least two of the five years, ending on the date of sale. This provision was enacted, in part, to provide tax relief to widows and widowers who no longer wish to own a home and to retired persons who wish to downsize to a smaller residence. The tax break has since been expanded to apply to any sale of a primary residence, as long as the use and ownership mies are met. This exclusion is expected to cost the U.S. Treasury $129.8 billion over the 2013-2017 period, an average of $26 billion per year.

Family-Related Credits

Several tax credits in the Internal Revenue Code (IRC) are targeted toward providing relief to families, especially lowand middle-income taxpayers, with dependent children.

Eamed-income credit This credit varies in amount, depending upon taxpayers' level of income and number of dependent children. It is a refundable credit, meaning that it can be larger than the amount of federal income taxes owed by the taxpayer. For tax years 2009 through 2017, the credit increases for working families with three or more dependents. For 2013, the maximum earned income credit is as follows: $6,044 with three or more qualifying children, $5,372 with two qualifying children, $3,250 with one qualifying child, and $487 with no qualifying children. This credit is only available to families earning less than $51,567 (or less, depending upon the number of dependent children) during 2013. This credit is the fifth-largest federal tax expenditure and is expected to cost the federal government an average of $65.2 billion annually during fiscal years 2013-2017, a total of $329.5 billion.

Child tax credit This credit is designed to reduce the tax burden of low- and moderate-income families with dependent children under age 17. The maximum credit is $1,000 per qualifying child. The credit is a nonrefundable credit, which means it is limited to the amount of taxes owed; however, families who do not get the full child tax credit may be eligible for the additional child tax credit. The additional credit is refundable and allows families who do not owe any taxes, or who owe less than the child tax credit amount, to get a refund from the federal government. The child tax credit is estimated to reduce federal revenues by $291.6 billion over the 2013-2017 period, an average annual cost of $58.3 billion. Although this credit is designed to help low- and middle-income families, approximately 53% of the tax benefit goes to families earning $50,000-$200,000 per year.

Education credits. Two education credits exist to help families and students pay for postsecondary education: the American Opportunity Tax Credit (AOTC) and the lifetime Learning Credit (see http://www. irs.gov/uac/Tax-Benefits-for-Education:- Information-Center). Although the AOTC had been set to expire at the end of 2012, the American Taxpayer Relief Act of 2012 (ATRA) extended the credit through 2017. The AOTC allows a maximum credit of up to $2,500 per eligible student enrolled during the first four years of postsecondary education in a degree program or pursuing some other recognized accredited education. Qualifying expenses include tuition, enrollment fees, and course materials. Up to 40% of the credit may be refundable, and the income limits for claiming the AOTC are generous: MAGI of $180,000 for married taxpayers filing jointly and MAGI of $90,000 for single, head of household, and qualifying widow or widower filers.

The Lifetime Learning Credit is a nonrefiindable credit of up to $2,000 per return. The income limits are less generous for this credit: MAGI of $124,000 for married taxpayers filing jointly and $62,000 for single, head of household, and qualifying widow or widower filers. This credit is available for an unlimited number of years and for all years of postsecondary education (including graduate school) and courses to acquire or improve job skills; being enrolled in a degree program is not required.

The Joint Committee on Taxation projected that these tax credits will cost the federal government about $25.3 billion per year, or $126.4 billion for the 2013-2017 period. Two-thirds of the benefits associated with these credits accrue to families earning an annual MAGI of $50,000-$200,000.

Health Insurance Exclusions

Health insurance serves several purposes. The primary purpose is to reduce the financial burden of healthcare costs on individuals and families. Health insurance is one of the most sought-after benefits offered by employers as a component of fringe benefit packages. Health insurance allows individuals to afford treatment of various illnesses and to engage in preventive care to help avoid major illnesses, such as heart disease and cancer. The federal government allows employers to pay some or all of their employees' health insurance premiums, and the employees are not required to count in their taxable income these payments made on their behalf by their employers; in other words, employer-provided health insurance coverage is not taxable at the individual level. In addition, benefits received under a qualified long-term care policy are generally free of federal income tax because they are considered insurance reimbursements for medical expenses. According to the Joint Committee on Taxation, the exclusion of employer-provided health insurance and long-term care insurance benefits is expected to cost the federal government $760.4 billion over the 2013-2017 period, an average of $152 billion per year. This is easily the single largest tax expenditure in the IRC.

Medicare is a national social insurance program designed to provide health insurance coverage for older Americans, as well as younger people with disabilities. Without the Medicare program, many senior citizens (age 65 and older) would not be able to pay for medical treatments needed to maintain a quality of life. The Medicare Part A program was designed to cover eligible hospital and skilled nursing facility costs. Medicare Parts B, C, and D were designed to help senior citizens afford doctor office visits and prescription drugs. In addition to providing for hospitalization, doctor office visits, and prescription drugs, the benefits, which are low-cost or free to most taxpayers, are excluded from the Medicare beneficiaries' federal taxable income. The exclusion of these benefits is projected to cost the federal government $358 billion in lost tax revenue for the 2013-2017 period. Regardless of the program's social goals, it represents a sizable tax expenditure in the IRC.

Still another healthcare and dependentcare program that reduces federal revenues is the "cafeteria" (or IRC section 125) plan, which allows employees to pay certain qualified expenses on a pretax basis. Premium conversion is the most common use of cafeteria plans; this permits employees to pay their portion of employersponsored group health insurance premiums and term life insurance premiums with pretax dollars through payroll deductions. Cafeteria plans also typically allow employees to use pretax dollars to pay for qualifying dependent-care expenses. In essence, the federal government pays for some of these expenses indirectly by allowing employees to reduce their taxable income through the flexible-spending election amount, up to the legal limit. These plans cost the federal government about $38.5 billion annually, an estimated $192.3 billion from 2013 through 2017.

Preferential Treatment of Investment-Related Income

Second in magnitude only to the exclusion for employer-provided health insurance coverage, the reduced tax rates on qualifying dividends and long-term capital gains is another tax expenditure that might prove too tempting to ignore in a period of record budget deficits. Proponents of these tax incentives believe they encourage investment in American businesses, providing needed employment opportunities and economic growth; however, critics decry the fact that wealthy individuals with income from dividends and capital gains may pay a lower effective tax rate than low- and middle-income individuals who earn a salary. The reduced tax rates on dividends and long-term capital gains are expected to reduce federal revenues by $616.2 billion over the 2013-2017 period, an average of $123.2 billion per year. (Unfortunately, the Joint Committee on Taxation report does not provide a breakdown of the income groups benefitting from this tax expenditure.)

Another preferential tax treatment is the exclusion of interest income on publicpurpose state and local government bonds, which are securities issued to finance the infrastructure needs of states, counties, and cities. Infrastructure needs vary widely by location but can include schools, streets and highways, bridges, hospitals, public housing, sewer and water systems, public utilities, and various other public projects. In order to encourage individuals to lend money to state and local governments to fund these needs, interest income earned on these bonds is exempt from federal income taxation. This tax expenditure for individuals is projected to reduce federal tax revenues by $191.3 billion during the 2013-2017 period, approximately $38.3 billion per year. (Again, the Joint Committee on Taxation report does not provide a breakdown of the income groups benefitting from this tax expenditure.)

The IRC also provides favorable tax treatment for investment income earned within qualified life insurance and annuity contracts. Generally, investment income earned on qualified life insurance contracts held until death is permanently exempt from federal income tax. Investment income distributed prior to the death of the insured is generally tax deferred; investment income earned on annuities also benefits from tax deferral. This tax expenditure is projected to lower federal tax revenues by $157.6 billion during the 2013-2017 period, an average of $31.5 billion annually. In contrast to the other individual tax expenditures in this discussion, corporations are expected to receive approximately $14 billion of the projected benefit over the five-year period.

Another tax expenditure that will significantly impact federal government tax receipts for the foreseeable future is the net exclusion of pension contributions and earnings. Two types of pension funds are generally used for most individuals: defmed-benefit plans and defmed-contribution plans. These plans generally include an employer contribution that is tax free until it is withdrawn during retirement. Employee contributions to these plans are generally sheltered (deducted pretax). In addition, the earnings that accrue under the plans during employees' working years also accrue tax free until they are withdrawn during their retirement years. These plans undoubtedly encourage retirement savings and contribute to participants' financial future; however, there is a tremendous tax cost to the federal government in allowing the deductibility and tax deferment related to these plans. In fact, this is the third-largest tax expenditure, which is expected to cost the federal government $547.8 billion over the 2013-2017 period, or $109.6 billion annually.

Deductibility of State and Local Taxes

Most states (and some counties and cities) use income taxes, sales taxes, and personal property taxes as means of financing various public projects or activities. For example, states and cities may levy an income tax on their residents' income in order to help fund public education and other similar endeavors. In recognition of this possibility, taxes paid to state and local governments are generally deductible on Form 1040 for those who itemize on Schedule A. The deduction for nonbusiness state and local government income taxes, sales taxes, and personal property taxes (excluding real estate taxes) is anticipated to decrease federal revenues by $277.6 billion over the 2013-2017 period, an average of $55.5 billion per year. Fully 88% of the benefit associated with this tax expenditure accrues to taxpayers with MAGI of at least $100,000.

Miscellaneous Tax Expenditures

Charitable contributions to qualified organizations are deductible by taxpayers who file federal Form 1040 and itemize deductions on Schedule A. Common types of entities that qualify to receive deductible contributions include most nonprofit charitable organizations; churches, temples, synagogues, mosques, and other religious organizations; and most nonprofit educational organizations. The deductibility of charitable contributions is projected to reduce federal tax receipts by $183 billion over the 2013-2017 period, an average of $36.6 billion annually. High-income taxpayers are the primary beneficiaries of this tax expenditure; 57% of the benefit is realized by taxpayers with MAGI of at least $200,000, and 88% of the benefit is realized by taxpayers with MAGI of at least $100,000.

At least a portion of Social Security and railroad retirement benefits is not taxed at the federal level. Given the nature of these systems, the portion of the benefits that is attributable to employer contributions and to earnings on employer and employee contributions conceptually would be subject to income tax. But the IRC may not levy an income tax on all of the benefits that exceed the beneficiary's contributions from previously taxed income. From an actuarial standpoint, previously taxed contributions generally do not exceed 15% of benefits, even for retirees receiving the highest levels of benefits. Thus, up to 85% of recipients' Social Security and tier 1 railroad retirement benefits may be included in a taxpayer's taxable income if the recipient's provisional income exceeds certain base amounts. The untaxed portion of the benefits received by taxpayers who are below these base amounts is counted as a tax expenditure. This is estimated to cost the U.S. Treasury just under $180 billion over the 2013-2017 period, an average of $35.9 billion annually. Unlike many of the other tax expenditures, taxpayers with MAGI of less than $75,000 realize 73% of the benefits of this expenditure.

The ATRA increased the estate-tax exemption for 2013 to $5.25 million and indexed it to the rate of inflation going forward. As a result, a taxpayer may die with substantial untaxed capital gains associated with assets left in his estate. Because the estate's heirs benefit from a steppedup basis in most inherited assets, the exclusion of capital gains at death is considered a tax expenditure, one that is projected to reduce federal tax revenues by $258 billion over the 2013-2017 period, or $51.6 billion annually. (The Joint Committee on Taxation report does not provide a breakdown of the benefit of this tax expenditure by income levels.)

Deferral of Income from Controlled Foreign Corporations

The only significant tax expenditure related to businesses included in the Joint Committee on Taxation report is the deferral of active income of controlled foreign corporations (CFC), defined by the 1RS as "any foreign corporation in which more than 50 percent of the total combined voting power of all classes of stock entitled to vote is owned directly, indirectly, or constructively by U.S. shareholders on any day during the taxable year of such foreign corporation or more than 50% of the total value of the stock is owned directly, indirectly or constructively by U.S. shareholders on any day during the taxable year of the corporation." A CFC's current earnings may be deferred from U.S. income tax if they are not actually distributed to the U.S. shareholder. Because many billions of dollars of earnings of CFCs are never repatriated, those funds remain offshore and untaxed by the U.S. government. This provision is expected to cost the federal government $265.7 billion over the 2013-2017 period, an average of $53.1 billion per year.

Exhibit 1 provides a summary of the 10 tax expenditures that are projected to have the largest effects on federal tax revenues for the next five fiscal years, per the Joint Committee on Taxation report.

Federal Income Tax Burden by Income

In light of the fact that high-income taxpayers tend to enjoy a substantial majority of the benefits associated with many of the individual tax expenditures discussed above, it might also be helpful to briefly review 1RS data relating to the proportion of total individual income taxes paid by taxpayers of different income levels. Exhibit 2 summarizes the relevant data for 2010, the latest year for which the information is available.

Based on this information, the top 1% of taxpayers, reporting an AGI of at least $369,691, accounted for 18.9% of total AGI and paid 37.4% of total income taxes. That income group paid an average tax rate of 23.39%. The top 5% of taxpayers, reporting AGIs of at least $161,579, accounted for 33.8% of total AGI and paid 59.1% of total income taxes. Interestingly, the top 50% of taxpayers accounted for 88.3% of total AGI and paid 97.6% of total income taxes.

Reducing the Federal Deficit

Solving the dramatic imbalance between federal revenues and expenditures could include any or all of the following proposals: increasing income tax rates, limiting or eliminating income tax expenditures, reducing federal spending, or relying on a strengthening economy to boost tax receipts. As indicated by the public pronouncements by Fitch Ratings, the credit ratings agencies are looking to Congress and the administration to make credible progress toward addressing the country's recurring budget deficits. The primary deficit-reduction mechanism in the ATRA was to raise income tax rates on upper-income individuals. Furthermore, the Patient Protection and Affordable Care Act of 2010 included a 3.8% tax on the investment income of some high-income individuals-one of the more significant tax expenditures detailed here. Neither political party appears to willing to cut federal spending in any meaningful manner; thus, the tax expenditures outlined in this discussion might very well prove too tempting for the country's elected leaders as they struggle to reduce the federal budget deficit. ?

Gregory L. Prescott, CPA, CGMA, CMA, CFM, is a senior instructor, and James R. Hardin, CPA, PhD, is a professor and chair of the department of accounting, both at the Mitchell College of Business, University of South Alabama, Mobile, Ala.