I. Introduction

On Tuesday, July 19, the “Gang of Six” senators who have been negotiating a bipartisan plan to reduce the budget deficit presented their proposal to a closed-door meeting of forty-nine senators.1 The plan was immediately praised by members of both parties and President Obama. The plan borrows heavily from the report issued in December by President Obama’s National Commission on Fiscal Responsibility.2

This memorandum summarizes the tax proposals of the Gang of Six plan and compares the Gang of Six proposals to the analogous proposals made by the Deficit Reduction Commission (and a previous proposal made by the Deficit Reduction Commission’s co-chairs, Senator Alan Simpson and Erskine Bowles).3  

In short, the Gang of Six plan would:  

  • Reduce the number of individual tax brackets from six to three, set the lowest bracket at between 8-12% (from the current 10%), reduce the current 25% and 28% brackets to between 14-22%, and reduce the current 35% bracket to between 23-29%.  
  • Repeal the alternative minimum tax.  
  • Reduce (but not eliminate) the mortgage interest deduction and charitable deduction, and reform other individual “tax expenditures”.
  • Retain the earned income tax credit and the child tax credit (or provide at least the same level of support for qualified beneficiaries).  
  • Reduce the highest marginal corporate tax rate from 35% to between 23-29% and move to a “territorial” tax system for taxing offshore investment.  
  • Maintain – and not raise – the federal gas excise tax.  
  • Maintain or improve the progressivity of the tax code. However, as discussed below, it is possible that the proposal will increase the taxes of some of the lowest-income taxpayers and almost certainly will decrease the taxes of some of the highest-income taxpayers.  
  • The Gang of Six plan indicates that it would “provide $1 trillion in additional revenue” but also provide “net tax relief of approximately $1.5 trillion”.4 This apparent contradiction arises because of the different “baselines” used to measure revenue.5  

Although unstated in its six page summary, the Gang of Six plan also likely would:  

  • Increase the long-term capital gains rate (maximum of 15% under current law) and the qualified dividend rate (maximum of 15% under current law) so that they are the same as the ordinary income rates (i.e., maximum rate between 23-29%).  
  • Repeal the exemption for interest on newly-issued state and municipal bonds.  
  • Eliminate the deduction for miscellaneous itemized deductions and dramatically reduce or eliminate the state and local tax deduction and many other tax credits, deductions, and exclusions for individuals.  
  • Cap tax-deferred contributions to qualified retirement plans at the lower of 20% of annual income and $20,000.
  • Eliminate the domestic production deduction, last-in first-out (LIFO) method of inventory accounting, accelerated depreciation, and all other business tax credits and other tax expenditures.6  

The balance of the memorandum discusses, compares, and contrasts the proposals. Part II discusses the proposals affecting individuals. Part III discusses the corporate income tax proposals.  

II. Proposals Affecting Individuals

A. Introduction

Click here for table

The Gang of Six plan (like the Final Report before it) compresses the number of income tax brackets and reduces the highest marginal tax rates. The reduction in tax rates creates the appearance of a tax cut. However, as discussed in the next section, because the Gang of Six plan appears to repeal or limit a number of deductions, exemptions, and credits (like the Final Report before it), it will likely increase overall taxes for many taxpayers.

B. Overview of the Effect of the Gang of Six Plan on Individuals

In addition to the change in tax rates, the Gang of Six plan proposes to eliminate or significantly reduce many tax credits, deductions, and exemptions. The plan indicates only that it will reduce the number of these tax expenditures, and does not specify which expenditures will be eliminated. The plan does suggest, however, that the home mortgage interest deduction, deduction for charitable giving, exclusion for employer-provided health insurance, and the favorable tax treatment of retirements savings will be reduced. Additionally, the plan indicates that it will retain the earned income tax credit and the child tax credit.

If the plan mirrors the Final Report’s proposals, it will:  

  • Increase the long-term capital gains rate (maximum of 15% under current law) and the qualified dividend rate (maximum of 15% under current law) so that they are the same as the ordinary income rates (i.e., maximum rate between 23-29%).  
  • Repeal the exemption for interest on newly-issued state and municipal bonds.  
  • Eliminate the deduction for miscellaneous itemized deductions.  
  • Replace the mortgage interest deduction with a 12% non-refundable tax credit, available to both itemizers and taxpayers taking the standard deduction. No credit will be given for mortgage interest on second residences or home equity debt.  
  • Cap the exclusion for employer-provided health insurance at the 75th percentile of premium levels, and reduce the excise tax on “Cadillac” health care plans to 12%  
  • Replace the charitable giving deduction with a 12% non-refundable tax credit, available to itemizers and taxpayers taking the standard deduction. The credit will be available only to the extent that charitable giving exceeds 2% of AGI.  
  • Cap tax-preferred contributions to retirement accounts at the lower of 20% of income, and $20,000.  

Some of the likely consequences from the reduction of the various credits, deductions, and exemptions include:  

  • A repeal of the deduction for state and local taxes would adversely affect taxpayers in high-tax states, such as New York and California. Legislators from these states would be expected to oppose the proposals for this reason.
  • A repeal of the exemption for interest on state and municipal bonds would dramatically increase the borrowing cost for states and municipalities. Local legislators would be expected to oppose this proposal.  
  • A reduction in the charitable contribution deduction for high-income taxpayers would cause a dramatic increase in charitable giving in the year before the proposal is effective, and would adversely affect charitable giving at the higher-bracket levels after enactment. Religious groups, colleges and universities, and other non-profit groups would be expected to oppose the proposal on these grounds.
  • A significant reduction in mortgage interest deductions would adversely affect residential real estate prices and will have political implications for passage. If existing mortgages are not grandfathered, existing home loans may be unaffordable for many taxpayers.  
  • If the deduction for contributions to 401(k) and other retirement plans is replaced with a 20% refundable tax credit that is capped at $20,000 (as under the Final Report), retirement savings for taxpayers in the higher brackets would be expected to decline, and some taxpayers who contribute pre-tax earnings to retirement plans would be subject to tax without the cash to pay the tax.7  

Many of the highest-income taxpayers would see dramatic tax cuts under the Gang of Six plan. If it is enacted, many of the taxpayers who otherwise would sell their capital gains assets at a 15% rate will defer the gains when the rate is 23-28%.8 (High-income taxpayers with appreciated publiclytraded securities have the ability to hedge their risk and borrow against the securities without recognizing the capital gain.9) Accordingly, many of the highest-income taxpayers will see dramatic tax cuts under the proposals.  

The effect of the plan for a high-income couple can be illustrated with the following example:

High-Income Example. A married couple lives in New York City, has no children, and earns $10 million of ordinary income. The couple pays New York State and City taxes of $1,282,673.10 Under current law, the couple has federal taxable income of $8,709,92711 and a federal income tax liability of $3,018,782.12

If the Gang of Six plan is enacted the top rate would be set at 23%, (and state and local taxes are would no longer be deductible), the couple would have a tax liability of $2,295,630,13 $723,152 less than under current law (a 24% tax cut).14 If the couple lived in Florida (which has no state tax), under current law, the couple’s federal income tax liability is $3,463,658,15 but under the Gang of Six plan, their tax liability would be as low as $2,295,630,16 which is a tax cut of 33.7% ($1,168,028).  

Thus, the couple would always be significantly better off under the Gang of Six plan.

The effect of the plan for a low-income taxpayer can be illustrated with the following example:

Low-Income Example. A married couple has no children and earns $35,400.17 Under current law, their federal tax liability is $1,640,18 leaving them with an after-tax income of $32,321.

If the Gang of Six plan is enacted and the lowest rate is set at 12%, the couple’s tax liability would be $1,968,19 a tax increase of $328 (20%) over current law.20 Even if the lowest rate is set at 8% so that the couple pays $1,312 in federal taxes (a tax reduction of $328 (20%) over current law), their tax cut would be less than the tax cut for the highincome couple.

Thus, in these examples, either the high-income couple would receive a tax cut and the low-income couple would pay more tax, or the high-income couple would receive a much greater tax cut as an absolute amount than the low-income couple. In fact, if the highest marginal rate is cut to 23%, the high-income couple will receive a significantly greater tax cut both in absolute terms and as a percentage of income.

The balance of this Part II discusses the specific elements of the proposals in greater detail.

C. The Earned Income Credit, Child Care Credit, and Other Tax Credit Programs

1. Current Law

Earned Income Credit. Under current law, taxpayers earning up to $43,998 (or $49,078 for married joint filers) are entitled to an earned income tax credit of up to $5,751. The amount of credit depends on the amount of the taxpayer’s earned income and the number of qualifying children.21 For example, if a single taxpayer has earned income of $10,000 and has no children, the taxpayer is entitled to an earned income credit of $263. If the same taxpayer has one child and the same income level, the taxpayer would be entitled to an earned income credit of $3,050; two children, an earned income credit of $4,010; and three or more children, an earned income credit of $4,511.

The Child Tax Credit and Childcare Tax Credit. Taxpayers are entitled to a $1,000 tax credit for every child under 17 years old who lives with the taxpayer. This credit begins to phase out for single filers earning more than $75,000, and for married taxpayers filing jointly at $110,000.22 Taxpayers are also entitled to a child care tax credit of up to 35% of amounts paid for care of “qualifying children” under 13 (and certain other incapacitated dependents) if the amounts paid enable the taxpayer to work. The child care credit is capped at $3,000 for one dependent or $6,000 for two or more, and begins to phase out when the taxpayer’s AGI is above $15,000 (but is always available for 20% of amounts paid) for each qualifying child (or other dependent).23

Education Tax Credits. Three different programs provide education tax credits. The Hope Scholarship tax credit entitles taxpayers to receive a tax credit of up to $1,500 for qualified tuition and related expenses paid by the taxpayer for the taxpayer, the taxpayer’s spouse, or the taxpayer’s dependents to attend a post-secondary school at least half-time.24 The American Opportunity tax credit provides another $1,500 in 2011 and 2012 for qualified tuition and related expenses, but phases out the credit for taxpayers earning more than $80,000 (or $160,000 for married taxpayers filing jointly).25 The Lifetime Learning credit entitles taxpayers with income below $50,000 ($100,000 for married taxpayers filing jointly) to receive an additional tax credit for post-secondary education equal to the lesser of 20% of qualified tuition and related expenses or $20,000.26

Health Coverage Tax Credit. Eligible taxpayers are entitled to a refundable tax credit equal to 65% of premiums paid by the taxpayer on qualified health insurance plans for the taxpayer, the taxpayer’s spouse, and the taxpayer’s dependents.27  

Making Work Pay Tax Credit. Taxpayers are entitled to a credit equal to the lesser of 6.2% of earned income or $400 ($800 for married taxpayers filing jointly). This credit is phased out for single taxpayers with a modified adjusted gross income exceeding $75,000 and for married taxpayers filing jointly with modified adjusted gross income exceeding $150,000.28

2. Overview of the Plan

The Gang of Six proposal retains the earned income tax credit and the child tax credit, and is silent on the other credits. However, the Final Report of the Deficit Commission, which the Gang of Six plan follows closely, would eliminate the other credits.

D. Employer-Provided Health Insurance

1. Current Law

Under current law, employees are not subject to tax on the premiums for their health insurance paid by their employers.29 However, beginning in 2018, there will be an excise tax of 40% imposed on employees who receive so-called “Cadillac plans” (i.e., plans whose annual premiums exceed $27,500 for families and $10,200 for individuals).30

2. Overview of the Plan

The Gang of Six proposal does not offer a specific proposal on the employer-provided health insurance exclusion, but if it follows the Final Report it would cap the exclusion from income of premiums for employer-provided health insurance at the 75th percentile of premium levels in 201431 and reduce the cap beginning in 2018, until 2028, when it would be phased out completely. Thus, by 2028, all employees would report the premiums for health insurance paid by their employers as taxable income.  

The Final Proposal would also reduce the excise tax on Cadillac plans to 12% for years between 2018 and 2038.32

E. The Alternative Minimum Tax

1. Current Law

The alternative minimum tax (“AMT”) is an alternative tax. Each year, taxpayers must pay either their regular income tax or their AMT liability, whichever is greater. The AMT is imposed at a maximum marginal rate of 28% (which is less than the maximum marginal rate of 35% for the regular income tax), but because the AMT denies a number of the exclusions, deductions, and credits permitted under the regular income tax, it may produce a higher tax liability than the regular income tax.33 For example, the AMT has no standard deduction and disallows some itemized deductions.34

Moreover, under the AMT:  

  • state and local income as well as property and sales taxes cannot be deducted (other than property and sales taxes paid on business items);  
  • medical expenses can be deducted only if they exceed 10% of income, as compared to 7.5% under the regular tax;  
  • interest on home-equity loans can be deducted only if the loan proceeds are used for home improvements;  
  • certain miscellaneous itemized deductions, including workers’ unreimbursed job expenses, investment-related expenses, and attorney’s fees paid by winners of taxable damage awards, cannot be claimed;35  
  • the $3,700 per-person exemption for the taxpayer, spouse, and each child is not allowed;  
  • the child-care credit, the Hope Scholarship credit, and the Lifetime Learning credit are not allowed;36
  • tax brackets are not indexed for inflation (unlike the tax brackets for the regular income tax, which are).37  

Because the AMT disallows personal exemptions and the deduction for state and local income taxes, the AMT tends to have a greater effect on taxpayers with many children, taxpayers with high medical expenses, and taxpayers living in high-tax states, such as New York and California.

2. Overview of the Plan

The Gang of Six proposal would repeal the AMT.38 Although the Gang of Six plan would repeal the AMT, it ironically has the effect of turning the regular income tax into a version of the AMT, because it would reduce the regular income tax rate to a rate that approximates the AMT and deny or limit deductions, exemptions, and credits much in the same way as the AMT does. Thus, the Gang of Six plan will adversely affect taxpayers in high-tax states or with high medical expenses, much in the same way that the AMT does, but will not adversely affect taxpayers with many children.  

F. Dividend and Capital Gains Rates

1. Current Law

For 2011, the maximum marginal rate for long-term capital gains and “qualified dividend income” is 15%.39 In 2013, the rates will increase to 20% for long-term capital gains and 39.6% for dividends unless Congress extends the lower rates. Under current law, capital losses may offset only $3,000 of ordinary income each year.40 Reduced rates for capital gains have been justified (i) to promote capital investment and (ii) to correct for the “lock-in effect” of our realization system (which discourages sales of capital assets). The preference has been criticized on grounds of neutrality (growth stocks are favored over income stocks), equality (investors are favored over wage-earners), and distributional grounds (wealthy taxpayers earn a disproportionate amount of capital gains).41

Reduced rates for dividend income partially ameliorates the double taxation of corporate earnings and therefore minimizes the bias against investment in corporations.

2. Overview of the Plan

The Gang of Six proposal would apparently tax capital gains and dividends at the same rate as ordinary income. It is unclear whether the plan would change the rule that capital losses can offset only $3,000 of ordinary income each year.  

3. Commentary

By taxing capital gains at the same rate as ordinary income, the Gang of Six plan effectively increases the highest marginal tax rate for capital gains by between 53%-93%. The increase in rates for capital gains will tend to increase the “lock-in effect”; that is, taxpayers will be less likely to sell their appreciated assets and will be more likely to hedge their appreciated assets and borrow against (or “monetize”) them. The increase in the tax rate on dividends will discourage taxpayers from investing in dividend-paying corporations and increase the tax bias towards investment in “growth companies” that do not pay dividends.

III. Proposals Affecting Corporations

A. Current Law

Corporations are taxable at a maximum marginal rate of 35%, which is the highest marginal rate imposed by all developed countries.42 However, the United States’ corporate tax revenues are only slightly higher than the OECD average.43 This phenomena is attributed principally to the tax credits, deductions, and exclusions available to corporations. For example, various corporations are permitted (i) a 9% deduction equal to the income from manufacturing, construction, and certain other domestic production activities,44 (ii) research and experimentation tax credits, (iii) accelerated depreciation deductions for certain property, (iv) unlimited deferral for the active business income earned by their foreign subsidiaries, (v) the last-in-first-out (or “LIFO”) method of accounting, which tends to defer taxation of economic income, (vi) tax credits for producing fuels from nonconventional sources, and (vii) investment tax credits for investment in renewable energy property and the rehabilitation of certain real property.45

B. Overview of the Plan

The Gang of Six proposal would reduce the maximum marginal rate to between 23-29% and, if it mirrors the Final Report, it would eliminate the domestic production deduction, LIFO method of inventory accounting, energy tax preferences, accelerated depreciation rules, and other tax credits. It would also convert the U.S. international tax system to a “territorial system” under which active foreign income would be exempt from tax (rather than only deferred as under current law) and passive foreign-source income would be subject to tax immediately (as under current law).  

C. Commentary

The reduction of the corporation income tax coupled with the repeal of a great number of deductions, exclusions, and credits will produce winners and losers. Multi-national corporations will generally win under the Gang of Six plan because their deferral of U.S. tax on active business income will be made permanent. However, if the subpart F regime is overhauled in the process, U.S. multinationals may become losers. Moreover, because the plan generally raises revenues, there are likely to be more losers than winners.