The most significant challenge facing the congressional tax-writing committees is to reshape the president's proposal to raise the personal exemption from $1,080 to $2,000. In its current form, it would cause a huge revenue loss, would disproportionately benefit higher-income groups and would discourage work effort.
The proposed increase in the personal exemption would have an important, desirable effect: it would free virtually all Americans below the poverty line from federal taxation and would reduce the relative tax burden of families with children. But the mechanics of the president's proposal make it far more costly than is appropriate or necessary. Although the aim is to reduce or eliminate the tax liabilities for low-income families, the proposed method would raise the personal exemption for all taxpayers. The result is actually a bigger benefit to high-income taxpayers.
The president's plan would give a couple in the top 35 percent tax bracket with no children a bigger tax break than a family with two children in the lowest 15 percent tax bracket. This uneven tax cut happens because the value of the additional exemption increases with the taxpayer's marginal tax rate. For each person in the 35 percent bracket, the increase in the exemption from $1,080 to $2,000 is worth $322 -- since 35 cents in tax would have been paid on each dollar of the $920 increase. A high- income couple therefore sees its tax cut by $644. But for a family of four in the 15 percent bracket, the tax break is only worth $552 -- four times 15 percent of $920. So the high-income couple actually gets $92 more tax reduction than a lower-income family with two children.
The increased exemption for higher-income taxpayers does not have any of the positive incentive effects that result from reductions in marginal tax rates. Indeed, the rise in the personal exemption is a disincentive, since the increase in the taxpayer's total after-tax income reduces the incentive to work.
Another implication of applying the exemption across the board is that it adds up to an enormous revenue loss. The Treasury estimates that the proposed increase in the exemption would cut revenue by $40 billion in 1987, or over 10 percent of projected income tax revenues. And 38 percent of that $40 billion represents a tax cut for the top 17 percent of taxpayers, those with incomes over $40,000.
The right way to help low-income taxpayers without the enormous revenue loss is to target tax relief directly where the need lies.
Perhaps the simplest way would be to increase the personal exemption to $2,000 only for taxpayers in the 15 percent tax bracket -- that is, for couples and families with taxable incomes up to $29,000. Those in the 25 percent tax bracket -- with incomes between $29,000 and $70,000 -- could be given a more modest increase to $1,200. But those with incomes over $70,000 would continue to receive the $1,080 exemption provided under current law.
Targeting the exemption increases in this way would cut the revenue loss in half -- to $20 billion instead of the $40 billion implied by the president's proposal. The targeted exemption increase would nevertheless provide as much relief to low-income families and individuals and would take as many people off the tax rolls as the president's plan.
Another alternative would be to limit the increase to children and not to give any increase to adults. Raising the exemption to $2,000 for all children who are dependents on their parents' tax returns would reduce tax revenue by less than $15 billion. And limiting the increased exemption to children under 6, whose mothers are more likely to be at home and not contributing to family income, would reduce the revenue loss to less than $5 billion.
A quite different way to target tax relief to low-income families would be to replace the exemption with a tax credit. The main difference between the two is that an exemption reduces taxable income and is therefore worth more to a taxpayer in a high tax bracket. In contrast, a tax credit directly reduces the individual's tax liability and is therefore worth the same number of dollars regardless of the individual's tax bracket.
For example, for someone in the 15 percent bracket, a $300 tax credit per person would reduce taxes by as much as a $2,000-per-person exemption. But for taxpayers in the 35 percent bracket, the $300 tax credit would reduce taxes by less than half of the $700 that a $2,000 exemption would bring. By targeting tax relief in this way, the revenue loss would be cut to less than $19 billion.
It is clear that there are several ways to target relief on low-income taxpayers, ways that save tens of billions of dollars and improve incentives to work and to save. An appropriate modification here would make it possible to eliminate or scale back some of the counterproductive increase in business taxation. Rethinking the increased personal exemption should be a top priority for Congress.