The Senate agreed yesterday to a fundamental alteration of the income tax system, voting to index tax rates with inflation starting in 1985.
The object would be to offset the tax increases that otherwise occur inexorably each year as incomes rise with inflation, lifting people into higher tax brackets. To neutralize these, the Senate voted for what would amount to automatic annual tax cuts.
The proposal, approved 57 to 40, if it survives the rest of the legislative process, would raise tax brackets, the so-called zero bracket amount or tax threshold and the familiar personal exemption -- now $1,000 per person per year -- by the same percentage the consumer price index rose each year.
It would go into effect the year after the three -- year tax cut now before the Senate. In effect, the Senate thus voted for a permanent tax cut out into the future.
Partly because of its cost, the proposal was not backed by the administration, although Senate Finance Committee Chairman Robert J. Dole (R-Kan.) said he thought there would not be "strenuous objection" from the president.
Congress' Joint Committee on Taxation estimated that the indexation, which is not in the version of the bill now taking shape in the Democratic House, would result in revenue losses of $12.6 billion in 1985, rising to $37.4 billion in 1986.
Congress in the past has regularly cut income taxes on its own to offset inflation, and the fraction of personal income taken by the tax has thus remained remarkably constant over the years, at a little less than one-eighth. But critics have argued that automatic indexation is a bad idea on several grounds. Some say it would help perpetuate inflation by making it less burdensome. Others complain it would restrict Congress' ability to finace government programs. But defenders see this limitation on spending as one of its virtures.
In the meantime, the House Ways and Means Committee completed preliminary action on the basic outline of its version of the tax cut, although the issue of tax breaks for oil producers remained unresolved.
In addition, two key southern backers of the Democratic bill, Rep. EDGAR L. Jenkins (yd-Ga.) and Rep. Ken Holland (D-S.C.), said at a news conference that they would be willing to back a third year of individual tax cuts if the third year were triggered to achievement of President Reagan's targets for reduced inflation and a smaller deficit.
When combined with the acknowledgment of House Speaker Thomas P. (Tip) O'Neill Jr. (D-Mass.) that a third-year tax cut will be hard to beat on the floor, the comments appeared to signal a willingness to compromise with a third-year tax cut if it is tied to a trigger. The administration opposes the trigger.
In another significant tax action, the Senate voted 86 to 10 to partially target one of the most controversial sections of its tax bill -- tax exempt interest from special savings certificates -- to home and farm lending, to allow the certificates to be issued for 15 months ending Dec. 31, 1982, and then to create an entire new interest income exclusion.
The provision would exempt from taxation 15 percent of a taxpayer's interest income, with a ceiling $450 for a single returns and $900 for joint returns. This would replace the straight interest income exclusion of $200 and $400 for single and joint returns.
The effect of this change would be to target the benefits of the exclusion to persons who have large amounts of money earning interest. In order to qualify for a $200 exclusion under current law, a taxpayer has to have $2,000 in an account earning 10 percent interest over one year. The new provision would require the taxpayer to have $13,333 earning 10 percent interest to qualify for the same $200 exclusion.
In the indexing debate, Sen. William Armstrong (R-Colo.), said the amendment would function to benefit the working poor and middle class, who suffer most from bracket creep, and thereby balance the Senate bill's present generosity to the better off and to business.
The vote had a strong partisan edge. Those in favor included 43 Republicans and 14 Democrats while the opposition was made up of 32 Democrats and eight Republicans. Sen. JOHN W. Warner (R-Va.) supported the bill while Sen. Harry F. Byrd Jr. (Ind.-Va.), Paul S. Sarbanes (D-Md.) and Charles McC. Mathias Jr. (R-Md.) voted against the amendment.
Arguing strenuously against the indexing amendment. Sen. John H. Chafee (R-R.I.) said that in order to fight inflation it is "absolutel essential that everyone feels the pain of inflation."
Sen. Russell B. Long (la.), the senior Democrat on the Finance Committee, argued tha the amendment would make inflation worse, by ensuring tax cuts to offset inflation, just when inflation is rising.
The indexation provisions were added to the tax bill that the Senate took up Wednesday; the debate is likely to extend into next week.
In the House, Ways and Means Committee members and House Democratic leaders attempted to determine whether granting a larger tax break to independent oil producers than currently backed by Reagan would produce enough southern Democratic votes to justify the action.
The committee is privately offering southern Democrats from oil states an exemption of up to 1,000 barrels of "new" oil a day from the windfall profits tax in return for their votes for the Democratic tax bill. Sources said that initially only five swing votes among the southern Democrats were willing to commit themselves to the proposition.
In addition to the exemption, Democrats are also offering $3,000 tax credit for oil royalty holders, $500 more than the Reagan administration.
At present, the GOP Senate bill calls for the progressive lowering of the tax on new oil from a 30 percent rate to 15 percent in steps ending in 1986.
The Ways and Means Committee also approved a return to the pre-1976 law governing taxation of employe stock options. Under the amendment, employes could exercise stock options, but would not be taxes until they sold the stock, when the profit would be taxed at capital gains rates. At present employes acquiring stock under favorable options must pay income tax on the difference the market price and the option price in the year the option is exercised.