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This Congressional Budget Office (CBO) memorandum, prepared at the request of Senator Pete V. Domenici, Ranking Minority Member of the Senate Committee on the Budget, calculates illustrative tax rate schedules for a saving-exempt income tax (SEIT).
Jon Hakken and Frank Sammartino wrote the memorandum under the supervision of Rosemary Marcuss, John Sabelhaus, formerly with CBO and now at the Urban Institute, and Frank Sammartino developed the family income and saving data used in the analysis and simulated the many variations of the prototype SEIT. The final version of the manuscript was edited by Sherwood Kohn. Denise Jordan prepared the manuscript for publication with help from Simone Thomas.
Questions about the memorandum may be addressed to Jon Hakken or Frank
Sammartino.
SUMMARY AND INTRODUCTION
At the request of Senator Domenici, the Congressional Budget Office (CBO) has calculated tax rate schedules for a prototype saving-exempt income tax (SEIT) that meet a prescribed set of revenue and distributional requirements. Senators Domenici and Nunn have proposed a SEIT as a replacement for the current individual and corporate income taxes. The SEIT would be collected partly from businesses and partly from individuals and families. The SEITs business tax would be levied on cash flow--the difference between business sales and business purchases. All business purchases would be immediately deductible, including investment in plant, equipment, and inventory. The SEITs tax on individuals and families would resemble the current individual income tax, but would not tax the income that taxpayers save until it is withdrawn from savings and spent for consumption. Because the SEIT would not tax income that taxpayers save and businesses invest, it would not lower the return on saving, as an income tax does. As a result, taxpayers would have an incentive to save more than they do under the current income tax.
The SEIT would incorporate a refundable credit for all of the Social Security payroll tax paid by employers and for some portion of the payroll tax paid by employees. (The credit for employees would phase out for higher-income taxpayers.) Total revenues from the SEIT would equal total revenues from individual and corporate income taxes, plus the revenues needed to pay for the Social Security payroll tax credit. Social Security payroll taxes would continue to be collected and deposited in the Social Security trust funds just as they are now.
Estimates for the Prototype SHIT
CBO has calculated tax rate schedules for a prototype SECT. CBO used a prototype because many of the details of the actual proposal are still being formulated. Although the general features of the prototype should closely resemble those of the Domenici-Nunn proposal, some of the details will probably differ.
For the tax rate schedules calculated by CBO, the prototype SECT would replace the individual and corporate income taxes (after the changes in the Omnibus Budget Reconciliation Act of 1993 are fully phased in) without changing:
Because the SEIT does not tax savings, knowing how much families save is a crucial element of the tax schedule calculations. Existing data yield inconsistent estimates of the amount saved by families with different incomes. Because this inconsistency is unresolved, CBO has used two different approaches to measure household saving. The first approach measures annual saving as the difference between a family's income and expenditures during the year (residual saving). The second approach measures annual saving as the change in a family's net worth during the year (net worth saving). Although these two measures are equivalent by definition and should yield the same results, the actual measures, using the same sample of families, differ substantially* Each measure of saving yields a different estimate of the tax rate schedules that meet the objectives of revenue and distributional neutrality for the prototype SEIT.
The prototype tax for individuals maintains most of the features of the current individual income tax. The prototype has a standard deduction and personal exemptions, although the amounts are higher than those of the current individual income tax. Itemized deductions are limited to medical expenditures in excess of 7.5 percent of income, state and local income tax payments, and charitable contributions. (Mortgage interest payments can be deducted regardless of whether the taxpayer itemizes or takes the standard deduction.) The prototype has a refundable earned income credit that is larger than that of the current income tax, and a new refundable credit for Social Security payroll taxes.
The prototype employs four tax brackets that start at the same levels of taxable income as the first four tax brackets of the current individual income tax. (The SEEPs definition of taxable income, however, is not identical to that of the current individual income tax.) Tax rates for the four tax brackets depend on which measure of saving is used and on assumptions about the distribution of current-law taxes. Using assumptions consistent with a more progressive distribution of income taxes under current law, tax rates for a distributionally neutral SEIT range from 16 percent in the lowest tax bracket to 55 percent in the highest bracket when saving is measured by the residual approach, and from 13 percent to 41 percent when saving is measured by the net worth approach. Using assumptions consistent with a somewhat less progressive distribution of current taxes reduces the top tax rate for a distributionally neutral SEIT to 49 percent when saving is measured by the residual method and to 36 percent when saving is measured by the net worth approach.
The prototype SEIT for businesses is levied on business cash flow and has a single tax rate of 7.1 percent.
Limitations on Distributional Neutrality
Based on CBO's distributional method, the estimated tax rate schedules give the prototype SEIT the requisite properties of revenue and distributional neutrality. These properties, however, apply only within the context of this analysis. Official estimates for a fully specified SEIT may differ depending upon how saving is measured and how "distributional neutrality" is defined in that analysis.
Even in the context of the present analysis, distributional neutrality is achieved only for certain groupings of the population. Although the estimated tax rate schedules under the SEIT maintain the same distribution of the tax burden among income quintiles as current law, they do not necessarily maintain the same distribution for narrower income categories. For example, even though the tax burden for the entire top income quintile would be unchanged by the prototype SEIT, the burden on some families within the top quintile could be higher or lower than under current law if those families save a smaller or larger share of their income than others in the same income quintile. If saving rates increase with income within a quintile, then the most well-to-do families in the quintile will receive a tax reduction that is entirely financed by a tax increase on the other families in it.
The estimated tax rate schedules also do not maintain the tax burden on specific subgroups of the population. For example, the annual tax burden on larger families might go up under the SEIT because larger families typically spend more and save less than smaller families with the same income. The annual tax burden on the young and the old also might rise under the SEIT because these people tend to save less of their incomes than other families. The young save less because they expect their income to rise in the future, and the old save less because they can draw upon past saving.
Higher tax burdens for larger families and the young and old reflect the time perspective for distributional neutrality that is used here. In the current analysis, tax burdens are measured in relation to annual income, but annual income may be a poor reflection of a person's lifetime economic status. Incomes may fluctuate from year to year for workers who are prone to temporary unemployment, the self-employed, or people who receive a large share of their income from returns on investments. Incomes usually vary systematically over people's lifetimes, increasing as they move into their peak earning years and declining in retirement. Measuring tax burdens over a taxpayer's entire lifetime would eliminate differences caused by transitory and life-cycle variations in income and saving.
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