Chapter 3 Taxation - AARP · PDF fileAARP POLICY BOOK 2011–2012 CHAPTER 3 TAXATION 3-1 AARP PRINCIPLES Five broad principles guide AARP’s evaluation of tax options

TC-1 TAXATION CHAPTER 3 AARP POLICY BOOK 2011–2012

AARP Principles .............................................................................................................3-1

Federal Taxes

Tax Reform .......................................................................................................................3-2

Tax Expenditures and Incentives ...................................................................................3-4

Marriage Penalties ...........................................................................................................3-4

Individual Alternative Minimum Tax ...............................................................................3-5

Capital Gains and Dividends ..........................................................................................3-6

Taxing Medicare and In-Kind Benefits ...........................................................................3-7

Medical Expense Deduction ...........................................................................................3-7

Taxing Employer-Provided Benefits ..............................................................................3-7

Tax-Exempt Interest ........................................................................................................3-8

Earned Income Tax Credit ..............................................................................................3-8

Estate and Gift Taxes ......................................................................................................3-9

Energy and Environmental Taxes ................................................................................ 3-11

State and Local Taxes ............................................................................................... 3-11

Income Taxes................................................................................................................. 3-12

Retail Sales Taxes ......................................................................................................... 3-13

Gross Receipts Taxes ................................................................................................... 3-14

Real Property Taxes ...................................................................................................... 3-14

Other Taxes and Issues

Excise Taxes on Motor Fuels, Tobacco, and Alcohol ................................................ 3-16

User Fees and Asset Sales .......................................................................................... 3-17

Taxpayer Assistance, Compliance, and IRS Administration ..................................... 3-18

Figure 3-1 Estate and Gift Taxes, 2002–2013 ........................................................... 3-10

Chapter 3

Taxation

AARP POLICY BOOK 2011–2012 CHAPTER 3 TAXATION TC-2

Additional references to tax policy:

Chapter 7: Health Principle ............................................................................................................................................... 7-4 Expanding coverage ......................................................................................................................... 7-88 Financing health care ........................................................................................................................ 7-94

Chapter 8: Long-Term Services and Supports Principle ............................................................................................................................................... 8-4 Achieving comprehensive reform ........................................................................................................ 8-6 Support for family caregivers ............................................................................................................. 8-11

Chapter 9: Livable Communities Low-income housing tax credit program ........................................................................................... 9-24 State and local affordable housing issues ......................................................................................... 9-26 Transportation reform, funding and finance ...................................................................................... 9-65

Chapter 10: Utilities: Telecommunications, Energy and Other Services Broadband services ......................................................................................................................... 10-28

AARP POLICY BOOK 2011–2012 CHAPTER 3 TAXATION 3-1

AARP PRINCIPLES

Five broad principles guide AARP’s evaluation of tax options. Proposals to reform the tax code, stimulate the economy, raise additional revenue for any purpose, or modify specific tax provisions should take into account these principles.

Equity—Revenue-raising methods should consider people’s ability to pay and should, to the extent possible, achieve vertical and horizontal equity. Taxation should be progressive, and people with comparable incomes should be taxed at comparable rates. Taxes may also be related to benefits derived from government services.

Economic neutrality—Taxes should be as neutral as possible in their treatment of economic activity and should not unduly encourage behavior undertaken simply to avoid taxation. Often this can be achieved by a combination of a broad taxable base and a low tax rate. In addition taxes should not unduly hinder economic growth, induce inflation, or discourage savings. Taxes may be used to mitigate economic costs imposed on society that were not fully captured through market prices.

Administrative efficiency—Taxes should be simple for taxpayers to understand and comply with, and as easy as possible to administer. The need to collect data on taxpayers and enforce tax laws should be balanced against the protection of individual liberties and privacy.

Revenue—The tax system must produce sufficient revenue to pay for important national, state, and local priorities and maintain fiscal stability. Stable and reliable public policies and programs require adequate and consistent sources of revenue.

Social and other policy goals—A balance must be struck between using the tax system to address social policy goals (through such measures as tax expenditures or earmarking revenue) and raising adequate revenues simply and equitably.

Sometimes the above principles conflict with each other. In these cases AARP may weigh the relative importance of each of the key principles. AARP’s position on tax policies take into account the net fiscal impact of a given policy proposal, not only its tax component.

3-2 TAXATION CHAPTER 3 AARP POLICY BOOK 2011–2012

FEDERAL TAXES

Tax Reform

There has been renewed interest in fundamental tax reform in recent years in Congress. This has been

spurred by:

the complexity of the existing income tax code,

inadequate revenue raised by the existing system and the resulting budget deficit,

growing concern about the individual alternative minimum tax,

a belief that the US savings rate is low because of the tax code,

concern for the international competitiveness of the economy’s export sector, and

public dissatisfaction with the existing tax system.

While most of the debate over the federal tax system has revolved around simplifying the income tax and making it more economically neutral, other types of taxes have been proposed as the basis for structural reforms.

Structural reform of the income tax—Some proposals would reform the current income tax (both individual and corporate) by eliminating many tax expenditures to broaden the revenue base while reducing marginal rates or equalizing the treatment of different types of income. This was the approach taken in the 1986 tax reform legislation. Fundamental tax reform proposals, which emerged from the National Commission on Fiscal Responsibility and Reform and other policy groups in 2010, also largely adopt this approach.

Integration of the individual and corporate income taxes—Some analysts have criticized the corporate income tax because some corporate profits are taxed once at the firm level and again through the individual income tax, which requires tax payments on dividends distributed to stockholders. This double taxation is an incentive for businesses to avoid incorporating and paying dividends. Some reform proposals would integrate individual and corporate income taxes.

Consumption taxes—The base of a consumption tax is what people spend or consume in a given period. The fundamental difference between an income tax and a consumption tax is that the former also taxes savings. Shifting from an income tax to a consumption tax has the potential pitfall of taxing

accumulated wealth that has already been taxed under the income tax. There are several types of consumption taxes:

Retail sales tax—The consumption tax most familiar to Americans is the retail sales tax. Retail

establishments collect the tax on behalf of state and local governments but pass the tax burden

directly along to consumers. There have been several proposals in Congress (such as the Fair

Tax) to substitute a national retail sales tax for either the income or payroll tax or both.

Value-added tax—Many countries have adopted a consumption tax known as a value-added tax (VAT). This is a tax on businesses at each stage of production; it is levied on the difference between total sales and total purchases (including capital investment).

Consumed-income (cash-flow) tax—A consumed-income, or cash-flow, tax measures consumption as income minus savings. This approach, like the income tax, requires annual returns by individuals. It can be progressive if exemptions, deductions, and graduated rates like those in the income tax are incorporated, something that neither the retail sales nor VAT taxes can accomplish as easily because they are based on individual transactions.

Flat taxes—Because it does not tax income from savings and investments, the flat tax is in effect a consumption tax. Under a flat tax, only the labor income of individuals and the income—net of costs and investments—of businesses are taxed. Individuals would not pay tax on interest, dividends, and other investment income. Flat taxes have one or two rates and few deductions. A flat tax would eliminate most tax preferences, including the deductibility of mortgage interest, charitable contributions, and state and local taxes.

Fundamental tax reform should be evaluated against the principles listed at the beginning of this chapter.

Equity—Any new tax structure should preserve the progressive nature of the federal income tax. Consumption taxes, which are the centerpiece of many reform proposals, are generally regressive, burdening low-income people disproportionately, because they consume a larger share of their income than higher-income people. To some extent this can be alleviated by providing lump-sum rebates or exempting necessities.


The progressive nature of the overall tax and transfer system also depends on how tax revenue is spent. For example, dedicating VAT revenues to the provision of health care would make the overall effect of the VAT more progressive.

One concern regarding all consumption taxes is that subjecting spending from savings (or wealth) to a new consumption tax would constitute double taxation. Seniors could be taxed twice, once on income during their work years and a second time during retirement, as they spend down their savings to buy goods and services that would be subject to a consumption tax. Because Social Security benefits are indexed to the price of goods, price increases resulting from a VAT would be offset by increases in seniors’ incomes, but income from seniors’ own sources, such as retirement savings, would not increase. Thus retirees would be able to buy less with their savings under a consumption tax.

Economic neutrality—Typically taxes create some inefficiencies by distorting economic choices and thus people’s behavior in the market. One major goal of most tax reform proposals is to reduce these distortions and encourage stronger economic growth. Proponents of consumption taxes note that income taxes encourage consumption over saving. Integrating the individual and corporate income taxes would reduce distortions that influence how businesses are organized and how income is transferred from corporations to shareholders. By eliminating certain tax deductions and other

preferences, fundamental restructuring of the current income tax would also improve the neutrality and efficiency of the tax system.

Administrative efficiency—The degree of administrative complexity depends greatly on the form of the tax. A VAT can have high administrative costs because it increases the number of taxpayers and requires detailed record keeping. But a VAT that replaces the income tax might not be any more costly to administer than the existing tax system. Advocates of flat-rate consumption taxes claim that such schemes are administratively simpler than the income tax, but that is true only if they contain no exemptions or preferences.

Revenue potential—Although consumption may be nearly as broad a base as income, at the rates currently proposed, most consumption tax reform plans would result in a significant loss of revenue.

Social and economic goals—Currently the income tax code contains provisions intended to encourage certain socially desirable goals, such as health insurance coverage, retirement savings, labor-force participation by low-wage workers, and home ownership, among others. The degree to which these provisions achieve their intended goals, however, is subject to some debate and should be considered against the additional complexity and costs they create. A major reform, such as introduction of the consumption tax, could decrease some of these incentives and increase others.

TAX REFORM: Policy

Tax reform FEDERAL STATE

Tax reform should focus on making the income tax more equitable, neutral, and efficient rather than on moving to another type of tax system. Any comprehensive tax reform should:

increase the system’s capacity for raising adequate revenue;

maintain ability to pay as the standard of tax equity—Tax reform should result in a distribution of tax burdens that is no less progressive than the current distribution of burdens under the individual and corporate income taxes;

avoid negative impacts on important social goals such as retirement savings and health insurance coverage;

reduce distortions in the tax code;

reduce the administrative record-keeping burden on American taxpayers;

encourage American competitiveness and job creation; and

provide appropriate transition relief.

AARP supports a progressive income tax as the preferred method of raising revenue at the federal and state levels but recognizes that other sources, such as a consumption tax, may be needed to supplement it.


Tax Expenditures and Incentives

The Congressional Budget Act of 1974 defines “tax expenditures” as “revenue losses attributable to … a special exclusion, exemption, or deduction from gross income or … a special credit, a preferential rate of tax, or a deferral of tax liability.” Such provisions are analogous to direct spending programs as either can be used to accomplish budget policy objectives.

Tax expenditures are often used to encourage certain behaviors that policymakers consider desirable. For example, some tax expenditures are designed to encourage employers to provide health insurance to their workers or encourage workers to save for retirement. However, some tax expenditures may have no real effect because they reward taxpayers for activities they would have undertaken without the incentive. That is, they do not efficiently promote the important policy goals they are designed to achieve; meanwhile other tax expenditures promote activities that contribute little to general economic well-being.

Using tax expenditures to achieve economic or social goals narrows the tax base, so that either revenues are lower than they would have been or tax rates must be

increased to raise the desired level of revenue. This pattern tends to increase economic inefficiencies of taxes. While the Tax Reform Act of 1986 broadened the individual and corporate income tax bases, subsequent changes to the tax code created a large number of new tax expenditures, thus narrowing the tax base and reducing revenues. Tax reform proposals from the National Commission on Fiscal Responsibility and Reform and other policy groups advocate repeal of most tax expenditures.

The tax code can create incentives for people to pursue socially desirable endeavors or to deliver assistance to people with certain types of expenses. For example, the retirement savings contributions (or “saver’s”) credit and a number of tax-free and tax-favored accounts are intended to encourage individuals to save for retirement, either through workplace savings or as individual investments.

For policy on retirement savings, see Chapter 4, Retirement Income; for health insurance tax incentives, see Chapter 7, Health; for long-term care insurance tax incentives and the long-term care tax credit, see Chapter 8, Long-Term Services and Supports; and, for low-income housing tax incentives, see Chapter 9, Livable Communities.

TAX EXPENDITURES AND INCENTIVES: Policy

Tax expenditures FEDERAL

AARP supports efforts to broaden the tax base by limiting tax preferences that do not efficiently achieve important policy goals.

The creation, limitation, or elimination of tax expenditures warrants at least as much scrutiny as direct spending decisions.

The impact of tax expenditures should be monitored carefully to ensure that corporations and upper-income taxpayers bear their fair share of the overall tax burden, in accordance with progressive tax principles.

Marriage Penalties

A married couple is generally treated as one tax unit who must pay tax on their total taxable income. A marriage tax penalty is said to exist when the combined tax liability of a married couple filing a joint return is greater than the sum of the tax liabilities the two individuals would incur if they were not married. Marriage tax bonuses also occur for many couples, with the couple paying lower income taxes than they would if they filed as individuals. It is impossible to eliminate these penalties and bonuses in a progressive tax system where the family is the unit of taxation.

While hundreds of provisions may give rise to either marriage tax penalties or bonuses, three elements of the tax structure generated most of them prior to 2001: a standard deduction for joint filers that was less than twice the corresponding amounts for single filers, similarly structured tax-rate brackets, and the phaseout of the earned income tax credit (EITC) as income rises.

The size and likelihood of any marriage penalty or

bonus depended on the split of income between

spouses. Married couples whose income was split

more evenly than a 2-to-1 ratio, which would be the

case for many two-earner couples, generally suffered


a marriage tax penalty under prior law. The penalty is largest when spouses’ incomes are equal. On the other hand, couples with incomes split very unevenly, such as single-earner households, received significant marriage bonuses. The bonus is largest when one spouse receives all of the income. Prior to the 2001 tax legislation, the number of taxpayers with bonuses and penalties were approximately equal.

As a result of 2001 tax legislation, the marriage penalty is partially alleviated between 2002 and 2012 in three ways. First, the standard deduction for a married couple filing a joint return is twice that for an unmarried individual filing a single return. Second, the size of the 10 percent, 15 percent, and 25 percent

income tax brackets for a married couple filing a joint

return is twice the corresponding bracket for an

unmarried individual filing a single return. Third, for

married couples who file a joint return, the EITC is

phased-out more slowly than for unmarried filers. All

of these changes expire at the end of 2012 unless

Congress takes action. These changes not only

reduced marriage penalties, but also significantly

increased marriage bonuses for a large number of

married taxpayers. Because of this policy approach,

the cost of dealing with the marriage penalties is

much higher than the total amounts of the penalties.

In other words, reduction of a marriage penalty by a

dollar costs more than a dollar for the budget.

MARRIAGE PENALTIES: Policy

Marriage penalties FEDERAL

Any further efforts to address the marriage penalty should be targeted to two-earner couples and structured to avoid increasing marriage bonuses.

Individual Alternative Minimum Tax

The individual alternative minimum tax (AMT) is a parallel tax system created in 1969 to prevent high-income taxpayers from shielding themselves from income tax by using a variety of deductions and other tax-avoidance techniques. Taxpayers pay the AMT to the extent it exceeds their regular income tax liability.

Over time the AMT design flaws changed the group of taxpayers primarily affected by the tax. State and local taxes and personal exemptions were the most important triggers of the AMT in recent years, not aggressive tax shelters.

The AMT parameters are not indexed for inflation. Thus, more middle-income taxpayers have become subject to the AMT simply due to the effects of inflation. In 1997, approximately 605,000 taxpayers (about 1 percent of all taxpayers) were subject to the AMT. In 2008, 3.9 million taxpayers (about 2.8 percent) were subject to the AMT. Many taxpayers who do not pay the AMT have to perform special calculations as they file their taxes to make sure they are not subject to it. Since 2001, the number of taxpayers subject to the AMT has been held in check to some extent by temporary increases in the AMT exemption amount. The latest such patch was extended in late 2010 and will apply through 2011. If

this temporary patch is not extended or if the law is

not changed in some other way, the number of

taxpayers subject to the AMT would increase from

over 20 million taxpayers (20 percent) to over 35

million (35 percent) depending on the assumptions

about the future of the tax system. In addition many

more taxpayers will have to calculate both regular tax

liability and the AMT to be certain which they are

required to pay. The projected expansion in the

number of taxpayers affected by the AMT would

occur because it is not indexed for inflation and the

lower tax rates in effect since 2001 reduced regular

income tax liabilities. Married couples, couples with

many children, and residents of states with high

property and income taxes are more likely to become

subject to the AMT.

Preventing this increase in AMT payers would be

expensive. One alternative that would retain the

AMT but prevent a large rise in the number of

middle-income families subject to the tax is to

permanently raise the value of the exemption and

index it for inflation. The cost of this change was

estimated by the Treasury in early 2011 at over $1.5

trillion over ten years.

AMT reform could have an almost neutral effect on

total tax revenues. Various reform packages have

been proposed that would accomplish this.


INDIVIDUAL ALTERNATIVE MINIMUM TAX: Policy

Individual alternative

minimum tax (AMT)

FEDERAL

Congress should reform the AMT to prevent the number of AMT filers from increasing solely as the result of inflation and to simplify filing for many taxpayers; however, the large revenue loss should be offset by other equitable tax changes.

Capital Gains and Dividends

A capital gain occurs when an investor sells an asset for more than its purchase price (or “basis”). Capital gains on assets held one year or longer are taxed at lower rates than ordinary income, such as wages or interest. The top tax rate on capital gains was reduced in 2003 from 20 percent to 15 percent. For taxpayers in the lowest income tax brackets (10 percent and 15 percent), it dropped to zero in 2008. In 2013 all capital gains tax rates revert to higher 2002 levels unless Congress extends current policy.

Beginning in 2003, most dividends are taxed at the same rate as capital gains. Prior to that, they were treated as ordinary income. This preferential tax rate is also set to expire in 2013.

High-income taxpayers receive a disproportionately large share of capital gains and dividends, therefore these tax preferences heavily benefit higher earners and provide little benefit to lower- and middle-income taxpayers. Moreover, reduced tax rates on capital gains and dividends have a high budgetary cost.

Expiration of the 2003 tax rates would cause significant change. According to the Congressional Budget Office, the federal government would raise an additional $40 billion per year if the capital gains tax rates reverted to 2002 levels.

Maintaining the parity between tax rates on capital gains and dividends may be important because it may reduce, although not completely eliminate, tax advantages of capital gains over dividends. Realizing capital gains or receiving dividends are two alternative ways in which shareholders receive a return on their investments. Yet the advantageous treatment of capital gains may violate the principle of neutrality. In practice, it may lead firms to lower dividend payouts from the levels they would have chosen in the absence of taxes.

Capital gains also receive preferential treatment in the form of deferred taxation. Taxes are assessed and paid when the capital gains are realized, i.e., when

assets are sold, rather than as gains accrue. As a result investors may time capital gains realizations to reduce their tax liability. On the other hand investors typically have no control over timing of dividend payouts, which virtually eliminates deferment and tax shielding opportunities.

Individuals can also exclude from taxable income up to $250,000 of gain ($500,000 for married couples filing a joint return) realized on the sale or exchange of a principal residence. Among other rules, the taxpayers must have owned and used the property as their principal residence for at least two years during the five-year period ending on the date of sale or exchange.

The capital gains rate differential complicates tax-code compliance. It induces taxpayers to recharacterize ordinary income as capital gains income. The most affluent are usually in the best position to engage in such tax avoidance strategies.

One reason to treat capital gains differently than other types of income is that some of the appreciation reflected in a higher selling price is the result of inflation and therefore does not reflect a true increase in value. Thus, capital gains could be indexed for inflation, requiring investors to pay taxes only on the amount of inflation-adjusted gain.

Under present law property transferred at a person’s death receives a basis equal to fair-market value at the time of death (known as a “stepped-up” basis). This means that heirs pay capital gains tax only on the appreciation that occurs after they inherit the asset. Appreciation occurring while the decedent owned the asset may never be taxed. Requiring heirs to assume the decedent’s basis rather than a stepped-up basis would treat different types of income more equally and improve tax fairness.

One difficulty with taxing deferred capital gains generally and eliminating the step-up in basis specifically is that investors need to keep records of their basis for long periods of time. Beginning with stock acquired in 2011 or later, mutual fund holdings acquired in or after 2012, and certain other securities


acquired in 2013 or later, securities brokers will be required to provide this basis information to taxpayers and the Internal Revenue Service (IRS) when securities are sold. (Currently, only the sales

price is reported to the seller and the IRS.) This additional reporting will make it easier for taxpayers to track their basis in stock holdings and other securities and for the IRS to monitor tax compliance.

CAPITAL GAINS AND DIVIDENDS: Policy

Tax treatment FEDERAL

AARP supports the taxation of capital gains and dividends at the same rate.

The taxation of capital gain and dividend income should be progressive.

AARP could support exclusions for modest amounts of capital gains and dividends to simplify tax filing.

AARP supports protecting asset holders from taxation on inflationary gains.

Taxing Medicare and In-Kind Benefits

Several past tax reform proposals would have taxed some part of Medicare’s insurance value. Unlike

Social Security, Medicare is not cash income. In

addition, aside from the issue of measuring the value

of benefits accurately, taxing in-kind benefits would

require people to make monetary payments on

nonmonetary income.

TAXING MEDICARE AND IN-KIND BENEFITS: Policy

Tax treatment FEDERAL

AARP opposes any attempt to tax the actuarial value of Medicare or the value of other in-kind benefits because it would set an undesirable precedent and could impose a serious hardship on those who otherwise would not pay income taxes.

Medical Expense Deduction

The 2010 Patient Protection and Affordable Care Act

increased the medical expense deduction threshold to 10 percent of adjusted gross income for taxpayers

under the age of 65, and after 2016 for all taxpayers, regardless of age. Older and sicker taxpayers who itemize their deductions bear the brunt of this increase because of their higher out-of-pocket expenses for medical care.

MEDICAL EXPENSE DEDUCTION: Policy

Threshold FEDERAL

Every effort should be made to keep the threshold for the medical expense deduction as low as possible to protect people with high health care costs.

Taxing Employer-Provided Benefits

Employer-provided benefits, such as pensions, health insurance, group term life insurance, dependent care assistance, employee discounts, memberships in athletic facilities, and small gifts are excluded from both taxable income and taxable wages. Lawmakers and others have proposed limiting the exclusion for employer-provided health benefits, or replacing it with some other form of subsidy, like a tax credit.

The Patient Protection and Affordable Care Act imposed a 40 percent excise tax on health insurance plans exceeding certain cost thresholds. This tax would apply to health plans per se as well as to various tax-preferred accounts, such as health savings or flexible spending accounts, which are used to pay for health care. Many argued that unlimited exclusion for employer-provided health insurance created an incentive to obtain more expensive coverage, offered no incentive for cost containment, and provided


greater benefits to more affluent taxpayers. It also violated the neutrality and equity principles by creating disparities between those who receive all of

their compensation in wages and those who receive a portion of compensation in the form of health insurance or other nonwage benefits.

TAXING EMPLOYER-PROVIDED BENEFITS: Policy

Pensions FEDERAL Lawmakers should maintain the tax-deferred status of employer-provided pensions as a critical way of promoting retirement savings.

Health insurance FEDERAL

Eligibility for the exclusion for employer-provided health insurance should be determined based on the coverage rules of the employer.

When structured correctly, the exclusion for employer-sponsored health insurance may be an important method of encouraging health insurance coverage. Limiting the health insurance exclusion to amounts below some threshold, and using the revenue thus derived to finance health insurance for low-income or uninsured families and individuals, makes the tax system more neutral and equitable and may be a factor in slowing the growth of health care costs.

Other benefits FEDERAL

Additional new limitations on the exclusions for other employer-provided benefits, such as life insurance, tuition, and parking, are a desirable method of broadening the tax base and making the income tax more progressive.

Tax-Exempt Interest

Interest on bonds issued by state and local governments is generally not subject to federal income tax. Because of the exemption, states and localities can borrow at a lower rate. Thus the federal government subsidizes state and local governments.

At the individual taxpayer level, tax-exempt bonds are most attractive to people in high tax-rate brackets. Thus, high-income taxpayers tend to benefit the most from this exemption. At the same

time taxpayers in lower tax brackets do not receive much or any benefit from this exemption, even if they receive tax-exempt interest.

While tax-exempt interest is excluded from gross income, it may be taken into account in determining the amount of Social Security income subject to tax, alternative minimum tax liability, and other tax calculations. If adjusted gross income plus tax-exempt interest and one-half of Social Security benefits exceeds $25,000 ($32,000 for joint filers), then a portion of Social Security benefits (up to 85 percent for higher-income taxpayers) is taxable.

TAX-EXEMPT INTEREST: Policy

Social Security taxation

FEDERAL Tax-exempt interest should not be taken into account in determining the amount of taxable Social Security benefits.

Earned Income Tax Credit

The earned income tax credit (EITC) is an important federal effort to assist the working poor. Created in 1975, this refundable tax credit first was intended to offset the burden of the Social Security payroll tax on low-income workers and to encourage low-income individuals to work. With time it grew into the largest anti-poverty entitlement program. About 25 million working families and individuals claimed $50.7 billion through the EITC for tax year 2008.

Taxpayers must file a tax return in order to claim the credit. The amount that eligible individuals may claim depends on their earned income and whether they have one, more than one, or no qualifying children. The maximum amount of the credit increases significantly for taxpayers with children (approximately $5,000) compared to childless taxpayers (approximately $500). In addition, low-income workers who do not have a qualifying child must be between the ages of 25 and 64 to qualify for the EITC.


Participation rates in the EITC are higher than those for many other low-income assistance programs and tax subsidies. Still, the credit may be underutilized by eligible workers who are confused by the eligibility criteria or simply do not know about the program. The AARP Tax-Aide counseling program is an important resource available to help low-income workers claim the credit. The Tax-Aide program helped 207,000 workers receive the credit in 2010.

The complicated structure of the credit decreases its effectiveness, hinders compliance, and raises administrative costs. While the EITC reduces marginal tax rates for the lowest income workers, the

phaseout of the credit as income rises increases

marginal tax rates and creates marriage tax penalties

for families with slightly higher income.

Nevertheless, the EITC is widely believed to provide

critical income support and work incentives to low-

income families at relatively little administrative cost.

Seventeen states now offer EITCs, which are

supported by businesses as well as social service

advocates. State EITCs can help reduce poverty

among workers with children and complement

welfare reform by helping low-wage workers support

their families as they leave public assistance.

EARNED INCOME TAX CREDIT: Policy

Earned income tax credit (EITC)

FEDERAL STATE

Congress should extend the EITC to low-income workers with no dependents, regardless of age provided they are not dependents themselves.

Congress should provide the Internal Revenue Service (IRS) with the revenue necessary to fund education and counseling programs that would encourage eligible taxpayers to obtain the credit. The IRS should increase funding for tax-assistance programs to help low-income workers eligible to receive the credit.

When states are experiencing surpluses that allow them to cut taxes, they should enact or expand EITCs so that low- and moderate-income workers and their families can also share in the tax benefits of prosperity.

States should allow working people of all ages who are not dependents to benefit from the state EITC.

Estate and Gift Taxes

The estate tax was enacted in 1916 in an effort to raise revenues, reduce the concentration of wealth, and increase economic equality by preventing the wealthy from passing all of their assets to subsequent generations. The estate tax is one of the most progressive elements of the federal tax system. Taxes must be paid on the amount of the estate that exceeds a certain threshold. The value of the threshold was set fairly high. Thus the tax has affected a small share of all estates throughout the years. For example in 2001 only 2.3 percent of estates paid any tax.

The 2001 tax legislation made significant changes to the federal estate and gift tax, increasing the exemption and reducing the rates between 2002 and 2009 (see Figure 3-1). By 2009 the exemption amount increased to $3.5 million. Estate tax was owed on fewer than 15,000 estate tax returns filed in 2009, with net estate tax liability of $20.6 billion. The

2001 legislation repealed the tax completely for 2010, but it became retroactively reinstated in 2010 with the passage of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act. Under the act, the estate tax in 2011 and 2012 will have a $5 million individual exemption and a 35 percent top rate. This two-year relief provision is estimated to cost over $68 billion.

Although some people were concerned about the burden of the estate tax on small family-owned businesses and farms, a study by the Congressional Budget Office concluded that the estate tax applied to only about 2 percent of family farms and businesses and found that most of these have sufficient liquid assets to pay the tax.

Estate taxes are also related to the capital gains tax (see this chapter’s section Capital Gains and Dividends). Capital gains are subject to the income tax when realized (when assets are sold), but they are often unrealized before the death of the asset holder.


Property transferred at a person’s death receives a

basis equal to fair-market value at death (known

as a “stepped-up” basis). This means that heirs

pay capital gains tax only on the appreciation that

occurs after they inherit the asset. Hence

unrealized gains are often a significant component

of assets passed between generations. One

rationale of the estate tax is to ensure that

unrealized gains are taxed at some point. Because

the great majority of heirs are not subject to the

estate tax (because of the generous exclusion) yet

benefit from stepped-up basis valuation, most

heirs avoid income tax on capital gains unrealized

by the decedent.

Figure 3-1

Estate and Gift Taxes, 2002–2013

Tax year

Estate and generation-skipping transfer tax

(effective exclusion amount)

Lifetime gift exemption

Highest estate and gift tax rates

2002 $1 million $1 million 50%


2004 $1.5 million $1 million 48%






2010 Special rules apply $1 million 35% for gift tax


2012 $5 million (indexed) $5 million (indexed)

35%


Source: Joint Committee on Taxation, Summary of Provisions Contained in the Conference Agreement for H.R. 1836, the Economic Growth and Tax Relief Reconciliation Act of 2001, JCX-50-01, May 26, 2001 and Joint Committee on Taxation, Technical Explanation Of The Revenue Provisions Contained In The “Tax Relief, Unemployment Insurance Reauthorization, And Job Creation Act Of 2010” Scheduled For Consideration By The United States Senate, JCX-55-10, December 10, 2010. Prepared by AARP Public Policy Institute.

The 2001 tax legislation also repealed as of 2005 the

credit allowed under the federal estate tax for estate

or inheritance taxes levied by the states. The act replaced this with a deduction for estate taxes paid to

any state or the District of Columbia. In response a

number of states eliminated their estate taxes,

resulting in a significant revenue loss to the states (almost $5 billion in 2007).

ESTATE AND GIFT TAXES: Policy

Rationale FEDERAL STATE

Congress should retain an estate tax as an important component of our tax structure because it helps reduce the concentration of wealth in society and prevents large amounts of capital income from escaping tax entirely. In the absence of an estate tax, capital gains should be indexed to inflation and taxed at death.

Linking to federal tax

STATE States that have or choose to enact estate taxes should consider the advisability of structuring them independently of the federal estate tax.

Incidence FEDERAL STATE

Federal and state estate and inheritance taxes should affect only the largest transfers, and surviving spouses, domestic partners, and family farms and businesses should be protected from excessive burdens. Heirs should have some protection against the need to liquidate assets to pay taxes.


Energy and Environmental Taxes

Concerns about the price of energy, dependence on imported energy, and the contribution of fossil fuels to climate change have resulted in increasing interest in taxes on energy consumption. Energy taxes, including levies on domestic or imported oil, on emissions of carbon dioxide generated from the burning of fossil fuels, and on the production of other pollutants, would discourage consumption and could have a positive effect on the environment.

Nevertheless each type of energy tax has potential

negative effects (see Chapter 10, Utilities:

Telecommunications, Energy and Other Services, for a further discussion of utilities). Carbon taxes or

other levies could generate revenue that could be

used to reduce other, more distorting taxes.

All of these taxes are borne by consumers and may

be regressive. Some energy taxes also have different

urban-rural and regional effects (for example, heating-oil taxes hurt those in the Northeast).

ENERGY AND ENVIRONMENTAL TAXES: Policy

Rationale FEDERAL STATE

An auction of pollution or carbon emission permits (that is, a “cap and trade” program), a new tax on carbon emissions, or some other form of energy tax may be appropriate to raise revenues, promote energy conservation, and reduce global warming.

Compensation FEDERAL STATE

Policies such as a carbon tax or a cap-and-trade system that would increase energy-related and other prices must include measures to compensate for regional differences in energy costs and must adequately protect low-income consumers. Potential safeguards could include increased federal funding of energy assistance and weatherization programs or reductions in other taxes.

STATE AND LOCAL TAXES

For states and localities the largest source of combined tax revenue is the property tax, which accounted for 31 percent of state and local tax revenue in fiscal years (FYs) 2007 and 2008. The second largest source of tax revenue is the general sales tax, which is now used in 45 states and the District of Columbia and accounted for about 24 percent of state and local tax revenue in those years. The individual income tax, now used in some form by 43 states, is the third largest source, yielding 22 percent of state and local tax revenue. State fiscal experts advocate a balance among these “big three” revenue sources as a way of avoiding the severe revenue fluctuations of business cycles and limiting competition between neighboring states with disparate tax rates.

Overall the state and local tax structure is much less progressive than the federal one. Income taxes are generally the most progressive of state taxes, i.e., people with higher income pay a higher proportion

of income in taxes. Sales and excise taxes, however, are usually regressive, i.e., they take a higher proportion of income from low-income people than from high-income people. Property taxes are also regressive and burdensome because they continue to increase as people age, even though their income tends to decline in real terms.

Other significant state and local revenue sources include: corporate income tax; excise taxes on such products as motor fuels,

alcohol, and tobacco; public utility taxes; severance taxes on the extraction of minerals; estate and inheritance taxes; licenses and user fees and charges; and gaming.

A large nontax source of state revenue is federal aid. In FY 2008, federal aid contributed 20 percent of state and local general revenue.


STATE AND LOCAL TAXES: Policy

Ceilings and tax cuts

STATE LOCAL

States should not set rigid ceilings on total revenue or specific revenue sources.

States and localities should not enact tax cuts that could threaten vital spending programs when economic activity slows.

State and local incentives for

businesses

STATE LOCAL

State and localities should carefully evaluate the incentives they offer to attract or retain business, since such subsidies must be offset by greater tax burdens on consumers and other taxpayers and may have negative environmental consequences.

Principles STATE LOCAL

In addition to raising sufficient revenue, state and local tax systems should follow other general guiding principles of equity, neutrality, administrative efficiency, and consistency with broader social goals.

Income Taxes

Income taxes are a major revenue source for states and localities, accounting for about a quarter of state and local taxes. Most states and the District of Columbia have a broad-based income tax; nine states do not. In addition, some localities impose a local income tax.

Generally state income taxes are the most progressive of state taxes, i.e., people with higher income pay a higher proportion of income in taxes. Even so, state and local income tax systems are typically much less progressive than the federal income tax. A number of states have a flat, or nearly flat, tax system, where the same rate applies to all, or nearly all, of taxable income. Unlike the federal income tax, most state tax systems are not automatically indexed for inflation, which over time flattens their tax structure and leads to automatic tax increases. States can make their

systems more progressive by increasing standard deductions and personal exemptions, adjusting income tax brackets, and regularly indexing tax parameters. State earned income tax credits, currently in place in some states, are another way to make income taxes more progressive.

State income taxes are closely linked to the federal tax structure through state conformity with federal definitions of income and provisions such as the deductibility of state income and local property taxes from federal taxable income. This link is generally desirable because it simplifies tax administration, enhances compliance and enforcement, and makes it easier for taxpayers to file their state returns. Yet whenever the federal government modifies its tax base, it can create adjustment problems for states. In response to difficult budget situations, many states recently changed their systems so they no longer conform, fully or in part, to the federal scheme.

INCOME TAXES: Policy

Personal income tax

STATE

States that do not have a broad-based personal income tax should enact one to increase equity, improve balance among revenue sources, and promote economic and budgetary stability.

Increasing progressivity

STATE

States should exempt from state tax rolls individuals and families below the poverty line.

States should increase the progressive nature of their income tax systems by adjusting personal exemptions, standard deductions, credits, tax rates, and brackets, and indexing them for inflation.

Taxing Social Security benefits

STATE

Social Security cash benefits should be exempt from state income tax, at least to the extent that they are exempt under the federal income tax.

Treatment of taxes paid to other states

STATE

States with income taxes should allow credits for taxes paid by their residents to other states so that no taxpayer is subject to double taxation.


Retail Sales Taxes

Sales taxes are an important source of revenue at the state and local levels. Forty-five states and the District of Columbia tax retail sales. In addition, many localities impose local sales taxes, even if no statewide sales tax exists. General sales taxes are one of the largest revenue sources for state and local governments, bringing in about a quarter of total tax revenues. This share is considerably higher for states that lack a broad-based personal income tax.

Taxes on consumption, including retail sales taxes, are regressive, i.e., they take a higher percentage of income from low-income people than they do from those with higher incomes. This happens because consumption typically represents a higher share of income for lower-income taxpayers and the rate of sales tax does not increase with the taxpayer’s income level.

States often attempt to ameliorate the sales tax’s regressive nature by lowering the tax on or exempting certain necessities, such as prescription drugs and food purchased for home preparation, which make up a larger share of consumption for lower-income households.

Any such exemptions, however meritorious, narrow the tax base and must be offset by higher tax rates or additional taxes elsewhere. In addition, they complicate tax compliance and create opportunities for tax avoidance. State and local sales tax systems are also riddled with exceptions based on criteria that have no clear rationale (such as whether a beverage is purchased in a grocery or convenience store; whether it is served hot, cold, or at room temperature; or whether it has more or less than 30 percent real fruit juice).

Other options for dealing with regressive taxes may include providing rebates and taxing services. These options may provide a better way to offset the regressivity, although they have limitations as well.

Few states subject services to a retail sales tax. Eliminating tax exemptions for services has several advantages as a way of raising sales tax revenues:

Services are the largest and an expanding part of the economy, so they cannot be ignored as an important source of needed revenue.

Taxing goods but not services violates the principle of tax neutrality, because it biases consumer choices against the taxed goods; and fairness, since only some products are taxed. Moreover services and goods are sometimes

close substitutes (such as repairing an appliance or buying an appliance, using a copy service or

buying a copy machine). Because service consumption is greater among

those with higher incomes, especially for professional services such as legal and accounting help, taxing services is probably more

progressive than taxing goods.

Currently sales taxes go uncollected on most

consumer Internet and catalog sales. This is because the US Supreme Court has ruled that states can

require out-of-state merchants to collect and remit sales tax only when the merchant has a physical presence, or “nexus,” in the customer’s state. In the

absence of nexus, consumers are required to remit the tax, called the “use” tax, to the states themselves,

but in general they fail to do so. Enforcement efforts by states often are costly and ineffective.

This situation raises concerns among states and

traditional retailers. States worry about possible erosion of sales taxes as a major revenue source.

Traditional retailers argue that the failure to tax web-based sales confers an unfair advantage on Internet

and catalog retailers, or “remote” sellers.

Partly in response to these concerns, some states have embarked on the Streamlined Sales Tax Project, designed to simplify and harmonize sales and use tax systems across states. Participating states agree to a set of common definitions of specific products; limit the number of sales tax rates effective in the state; standardize sourcing rules, which determine where the tax is imposed; centralize the sales tax remittance system; and make other changes. By 2010, 23 of the 44 participating states had passed the conforming legislation. As a result of these efforts, states encourage voluntary compliance by Internet and catalog vendors and offer tax amnesty for prior sales.

Though some online merchants have begun voluntarily collecting the sales tax, many observers believe it would

take an act of Congress to compel remote sellers to collect the sales tax. Such legislation has been introduced

in recent years but has not been adopted.

In 1998, however, Congress did impose a federal moratorium on new, discriminatory Internet taxes

(e.g., Internet access fees). The moratorium has been extended three times and is currently in effect until

2014. The moratorium does not affect states’ ability to collect sales taxes under existing laws, but several

(primarily antitax) groups have proposed abolishing the sales tax on Internet purchases altogether.


Older people, minorities, and people with lower incomes may be disadvantaged by the failure to collect sales and use taxes on remote sales, because these groups are less likely to have Internet access and shop online. At the same time these groups may depend more heavily than others on various state programs funded by sales tax revenues. As ever

greater volumes of retail transactions occur online, the resulting erosion of the tax base could adversely affect funding for many state-provided services for seniors and low-income residents. Eventually states might be forced to seek additional revenues through higher property or other taxes, which may weigh more heavily on seniors than on others.

RETAIL SALES TAXES: Policy

Effects on low-income people

STATE LOCAL

Although state and local sales taxes are major revenue raisers, they are regressive, and raising them should not be the first choice for increasing tax revenues where they already exist.

Legislators should minimize the impact of sales taxes on low-income people.

Taxes on services STATE LOCAL

States and localities should include services in the taxable base to reduce regressivity and improve neutrality.

Exemptions STATE LOCAL

Exemptions from state retail taxes should be narrowly designed for the purposes of avoiding “pyramiding” and reducing regressivity.

Taxes on out-of-state sales

FEDERAL STATE

Goods sold over the Internet and through catalogs should be subject to the same sales tax treatment as goods sold by traditional brick-and-mortar retailers.

Gross Receipts Taxes

A gross receipts tax is a levy on all business sales, regardless of whether the item is sold for consumption or intermediate use. There are no deductions for the cost of producing the item, previous taxes on the item, or other costs (as provided for in a value-added or income tax). As a result the base is simple to measure and the tax is easy to administer, but the tax is highly inefficient. The gross receipts tax results in multiple layers of tax on the intermediate goods and the final product, sometimes called

“pyramiding.” The extent of the pyramiding depends on how many stages of production there are, whether the stages are conducted within a firm or by different firms, and the extent to which the tax is passed on to the buyer at each stage. As a result the total burden of a gross receipts tax varies capriciously, in ways that policymakers generally do not intend. The tax is non-neutral and likely to distort the behavior of consumers and businesses. In addition the tax is not transparent; the buyer cannot determine the total tax burden associated with the final cost of a good when taxes are levied at intermediate stages.

GROSS RECEIPTS TAXES: Policy

Gross receipts taxes

STATE LOCAL

Gross receipts taxes should not be used. Other, more efficient taxes should be used to raise revenue.

Real Property Taxes

The mainstay of local taxation is the property tax, which pays for most elementary and secondary public education, as well as many other local services. But using property taxes to pay for schools leads to disparities in educational quality among school districts according to respective property values. This means that people from poorer districts may face

higher effective property tax rates than residents of wealthier communities yet have access to inferior educational facilities and services.

States play a central role in local property taxation because they:

prescribe assessment ratios and practices,

establish tax-rate limits and property classifications,


offer property tax relief through “circuit-breaker” programs (which limit the property tax burdens of certain groups and income levels), and

provide substantial aid to public education, resulting in lower local property tax burdens.

The property tax is the single most burdensome tax

for many low-income and older people. It affects

older people directly as homeowners but also indirectly as renters, because landlords pass on at

least part of any property tax in the form of higher

rents.

Forty-three states and the District of Columbia

alleviate or shift property tax burdens through limits

on assessed property values, property tax rates, property tax liabilities, or property tax revenues on a

jurisdiction-wide basis. The limits can apply to

individual homeowners or local taxing districts, or

they can be statewide. Some caps apply only to

specific types of taxes, such as school property taxes.

Over time these caps can be extremely damaging

because they erode local governments’ revenue and

reduce essential police, ambulance, and fire protection services, as well as spending for schools,

libraries, and road maintenance. For example, in

California, which enacted the first such initiative in

1978 (Proposition 13), the level of education quality

has moved from among the nation’s highest to the

bottom third.

Limiting assessed property values can create inequities between existing and new property owners, in situations where fair-market property values increase faster than the annual property valuation for tax purposes. Property tax caps may also give tax breaks to many people whose income is adequate to pay the tax; in resort areas such caps benefit wealthy out-of-state owners of vacation properties who do not otherwise contribute substantially to state and local coffers.

States promote homeownership and reduce property tax burdens in a number of other ways, the most common of which are homestead exemptions and credits, circuit breakers, and property tax deferrals.

Homestead exemptions and credits—Homestead exemptions reduce the amount of assessed property

value subject to taxation. Thirty-nine states and the District of Columbia provide homestead exemptions; of these, 15 limit the exemption to low- and middle-income homeowners. Of the 18 states that provide homestead credits, eight limit credits to low- and middle-income owners. Three states (Indiana, Massachusetts, and Mississippi) offer some combination of homestead exemptions and homestead credits. While many states offer these benefits only to homeowners under a specific income threshold, the exempt or credited amount does not vary with income. Homestead exemptions and credits are enacted at the state level, but they also reduce the local property tax base, and thus local revenues.

Circuit breakers—Circuit breakers (the term derives from the mechanism used to relieve an overloaded electrical circuit) usually ease the property tax burden of residents with low- and low-middle incomes by setting a threshold (usually equal to a percentage of income) above which property tax burdens cannot rise. Eligible residents receive a property tax rebate equal to the difference between the amount of property tax otherwise due and the threshold amount. Renters as well as homeowners may be eligible for tax relief. Thirty-three states and the District of Columbia now have circuit breakers, with provisions in six of these jurisdictions strictly limited to older homeowners and renters. The remaining state circuit breakers apply to varying combinations of the blind, the disabled, widows, the elderly, and young owners and renters. Of the 33 states that offer circuit breakers, four (Nebraska, New York, North Dakota, and Washington) offer homestead exemptions that act as circuit breakers (i.e., the value of the exemption decreases as income increases). The other states and the District of Columbia offer circuit breaker tax credits. Most states reimburse local jurisdictions for the property tax revenue lost due to circuit breaker provisions. Circuit breaker provisions tend to be more progressive than homestead provisions, because the amount of circuit breaker relief varies by income, and renters are often eligible for relief.

Property tax deferrals—Twenty-six states and the District of Columbia offer property tax deferrals, primarily to older homeowners or to older and disabled homeowners. The deferred taxes are to be paid upon the sale of the home or the owner’s death.

REAL PROPERTY TAXES: Policy

Education financing

STATE

States should broaden their methods of financing public education, thereby taking some of the burden off the regressive property tax systems and shifting it to less regressive taxes, which are better correlated with ability to pay.


Property tax caps STATE States should generally avoid arbitrary property tax caps.

Equity in assessments

STATE LOCAL

To ensure equity in property taxation, assessors should use fair-market value as the starting basis for determining property values, so that owners of similar properties in the same area face the same property tax burden.

Assessors should meet professional standards, and properties should be assessed annually, if possible, to help ensure that property taxes do not increase abruptly.

The assessment appeals process should be easy to understand, appeals should be easy to file, and decisions should be reached within a reasonable time and in an equitable manner.

Property tax relief STATE LOCAL

Property tax relief should be provided in an equitable manner to low- and moderate-income homeowners and renters. AARP supports circuit breakers rather than homestead exemptions because the former tend to be more progressive.

Voluntary property tax deferral programs should be enacted to allow low-income homeowners to defer property taxes until the property changes hands or the owner dies, especially when there is no other property tax relief program or where tax burdens are high. Any interest charged for the deferral should be at fair and equitable rates.

Full disclosure by localities

LOCAL

Full-disclosure laws should require that localities inform taxpayers annually of the property tax rate required to maintain revenues at the same level as the prior year and identify new spending or revenue reductions that warrant any proposed tax increase. To be effective, localities need to make such disclosures prior to the date they confirm annual financial decisions.

OTHER TAXES AND ISSUES

Excise Taxes on Motor Fuels, Tobacco, and Alcohol

Excise taxes are selective sales taxes on individual commodities, such as motor fuel, cigarettes, and alcohol or on transactions such as home sales. Excise taxes on motor fuel, alcoholic beverages, and tobacco yielded 7.4 percent of total state tax collections (excluding federal aid) in fiscal years (FYs) 2007 and 2008 and 3 percent of federal revenue in FY 2008. Revenue from gasoline taxes is the major source of funding for investment in transportation infrastructure.

Excise taxes serve a useful social purpose by discouraging the consumption of commodities potentially harmful to health or the environment, such as tobacco or gasoline. For this reason they are sometimes referred to as “sin taxes.” The public also tends to object less to these taxes, in part because of the nature of taxed commodities and because they are paid only if people choose to

purchase the affected goods or services. It often makes these taxes a politically convenient tool to raise revenues.

For example, cigarette taxes help finance expanded health insurance coverage for children. To this end the Children’s Health Insurance Program Reauthorization Act of 2009 increased the federal cigarette tax from 39 cents to just over $1 per pack. The money helps offset the societal health care costs imposed by tobacco, estimated at about $89 billion in public and private health care expenditures. The tax increase not only raises additional revenue, but may significantly reduce the number of smokers. In recent years lawmakers have proposed increasing alcohol taxes because excess alcohol consumption may also contribute to rising health care costs.

Many states recently have substantially raised their tobacco and, to a lesser degree, alcohol taxes, so state taxes on these items are higher than ever. In 2009, two-thirds of all states considered legislation increasing tobacco taxes.


In 16 states the bills became law. Additional increases were enacted in 2010. In many instances, such increases were proposed for general revenue raising, without connection to funding health-specific programs.

Taxes on alcohol, tobacco, and gasoline do not automatically keep pace with inflation because they are based on units sold. Thus revenues do not increase proportionately with the price. This issue can be addressed either by changing the tax structure

from a per unit to ad valorem (per dollar) tax or by indexing per unit taxes for inflation.

Excise taxes typically are regressive, i.e., they take a higher percentage of income from low-income people. The regressive nature of tobacco and alcohol taxes can be mitigated if the revenue is used to finance programs such as health care for those with low incomes. In addition, excise taxes may violate the AARP principle of neutrality if they tax individual commodities in excess of the social costs not captured by market prices.

EXCISE TAXES ON MOTOR FUELS, TOBACCO, AND ALCOHOL: Policy

Gasoline taxes STATE Gasoline taxes should be indexed for inflation and increased as necessary to fund transportation infrastructure and services.

Taxes on tobacco and alcohol

STATE

Excise taxes on tobacco and alcohol should at least keep pace with inflation. Levying them on an ad valorem basis (i.e., on the value of the purchase) rather than a per unit basis would automatically adjust them for inflation.

Ideally the revenue from increases in excise taxes on alcohol and tobacco should be used to help fund public health or other programs targeted to the population negatively affected by consumption of tobacco and alcohol products.

User Fees and Asset Sales

User fees are based on the principle that people should pay according to the benefits they receive. However, these fees tend to fall relatively heavily on lower-income people. Asset sales represent the privatization of government activity through the sale of public assets such as parks and open spaces. Such sales produce short-term revenue gains but can result in longer-term revenue losses and reduced future public enjoyment of assets.

State and local governments also levy utilities taxes

and a variety of user fees, including road tolls and fees for vehicle registration, park entrance, and various permits. User fees may have great potential in the infrastructure area, where increased tolls, gasoline taxes, vehicle registration fees, utility hook-up fees, and water charges could raise revenue to be earmarked for the maintenance and repair of roadways and utility systems.

States also may levy impact fees on developers of commercial, industrial, or residential real estate projects to defray some of the public infrastructure costs such projects entail.

USER FEES AND ASSET SALES: Policy

User fees STATE

User fees should not unfairly burden low-income people or unduly limit access to public services.

States should rely on user fees only when they bear a direct relationship to the services received. Charges should take into account the limited ability of low-income people to afford necessary services.

States should consider requiring developers to bear their fair share of development costs by funding infrastructure improvements, paying impact fees, or contributing to housing construction.

Asset sales STATE

Public assets should not be sold to raise revenue if the sale would sacrifice valuable and efficient capital resources that serve important national and regional purposes and would harm the common interests of present and future generations.


Taxpayer Assistance, Compliance, and IRS Administration

Taxpayer assistance for older Americans—Through the Tax Counseling for the Elderly program, the Internal Revenue Service (IRS) provides grants to nonprofit organizations whose volunteers offer free tax counseling to senior citizens and help them prepare basic income tax returns. The IRS has also developed the Tax Guide for Seniors (Publication 554), which gives an overview of the tax laws that apply to all taxpayers and highlights certain provisions that give special treatment to older Americans. In addition large-print tax forms are made available for easier reading and to help older and visually impaired Americans prepare their returns. The IRS has reduced the availability of tax forms and publications available in public libraries and other easily accessible places, limiting the ability of some taxpayers to meet their tax filing obligations.

Compliance—The tax gap is the amount of taxes owed but not paid; it results from both intentional and unintentional noncompliance. The most recent estimate from the IRS shows a total tax gap of $345 billion for tax year 2001. According to the agency about $55 billion of that amount will eventually be recovered through compliance activities.

The tax gap for individual income taxpayers was estimated to be close to $245 billion in 2001, of which $165 billion is due to income underreporting. Noncompliance is more prevalent among high-income taxpayers. The IRS National Research Program found underreporting on two-thirds of all returns on incomes of over $100,000, compared with one-third of returns below $50,000.

The IRS estimated the corporate tax gap was $32 billion in 2001. The use of corporate tax shelters

remains a significant source of revenue loss only partially reflected in the tax gap estimate. In response to numerous cases of accounting fraud and other corporate scandals, the Sarbanes-Oxley Act of 2002 enacted broad accounting and corporate reforms, but they did little to address corporate tax shelters. Corporations continue to engage in complex and aggressive transactions that have little or no economic purpose other than to reduce tax liability. The other major source of the tax gap is employment taxes, which accounted for $59 billion of the 2001 tax gap. Most of this is the result of underreporting of self-employment income and wages. The tax gap attributable to the estate tax and excise taxes is estimated to be around $8 billion.

Administration—IRS budget cuts and staff reductions have hindered enforcement. The IRS Oversight Board concluded in 2001 that “enforcement activities have dropped to a dangerous level, giving the impression that it is easy to get away with cheating.”

In 1997 the National Commission on Restructuring the Internal Revenue Service, established by Congress, made sweeping recommendations for improving the agency’s structure, organization, and management. The recommendations formed the basis of the Internal Revenue Service Restructuring and Reform Act of 1998. The law set goals for increasing taxpayers’ use of electronic filing; broadened taxpayer rights and protections in dealing with the IRS, including shifting the burden of proof to the IRS and providing innocent-spouse relief; made several changes to the interest and penalty rules; and provided new protections for taxpayers subject to an audit or a collection process. However, the quality of phone-based taxpayer help is still lacking, taxpayer notices are still confusing, and the goal for electronic filing in 2007 was not met.

TAXPAYER ASSISTANCE, COMPLIANCE, AND IRS ADMINISTRATION: Policy

Taxpayer assistance

FEDERAL STATE

The Internal Revenue Service (IRS) should increase support for the Tax Counseling for the Elderly program, including its counselor training program, which is particularly important in light of frequent tax code changes.

States should help fund the Tax Counseling for the Elderly program, because it often helps taxpayers calculate and pay state income taxes.

Access to forms FEDERAL

The IRS should increase its efforts to make tax forms, including electronic forms, publications, and correspondence, more accessible and comprehensible. The forms should be written in a manner taxpayers will understand. If necessary the IRS printing budget


Access to forms (cont’d.)

FEDERAL

should be increased to pay for large-type forms for vision-impaired taxpayers. The IRS should resume its previous practice of making forms and publications widely available in public places such as libraries and should not charge for individual taxpayer forms or assistance.

Reducing the need to file

FEDERAL

The government should explore ways to simplify the recovery of money withheld each year and reduce the need for elderly individuals who do not owe income tax to file tax returns.

Electronic filing FEDERAL The IRS should continue encouraging taxpayers to file electronically but maintain the option of paper filing without penalty.

Compliance and curbing tax

shelters FEDERAL

Tax laws should be vigorously enforced to protect revenue and ensure fairness. Enforcement measures should be applied equitably across income classes and types of taxpayers.

The IRS should improve its taxpayer assistance programs, increase its audit rate, and raise penalties for noncompliance, yet preserve individual privacy and scrupulously protect the rights of taxpayers.

AARP supports the adoption of measures that would curb the use of corporate tax shelters and tax havens. Such provisions can include:

requiring increased disclosure of corporate tax shelter activity,

increasing the penalties related to understatements of income attributable to undisclosed transactions,

imposing penalties on all parties associated with an illegal corporate tax shelter, and

disallowing the use of tax benefits generated by a corporate tax shelter.

Documents

Chapter 3 Taxation - AARP · PDF fileAARP POLICY BOOK 2011–2012 CHAPTER 3 TAXATION 3-1 AARP PRINCIPLES Five broad principles guide AARP’s evaluation of tax options