Tax expenditures, compendium of background material on individual provisions

MISSING IMAGE

Material Information

Title:
Tax expenditures, compendium of background material on individual provisions
Physical Description:
Book
Creator:
United States -- Congress. -- Senate. -- Committee on the Budget
Publisher:
U.S. Govt. Print. Off. ( Washington )
Publication Date:

Record Information

Rights Management:
All applicable rights reserved by the source institution and holding location.
Resource Identifier:
aleph - 025783279
oclc - 02208875
System ID:
AA00022550:00001

Table of Contents
    Front Cover
        Page i
        Page ii
    Letter of transmittal
        Page iii
        Page iv
    Table of Contents
        Page v
        Page vi
    Introduction
        Page 1
        Page 2
        Page 3
        Page 4
        Page 5
        Page 6
    National defense
        Page 7
        Page 8
        Page 9
        Page 10
    International affairs
        Page 11
        Page 12
        Page 13
        Page 14
        Page 15
        Page 16
        Page 17
        Page 18
        Page 19
        Page 20
        Page 21
        Page 22
    Agriculture
        Page 23
        Page 24
        Page 25
        Page 26
    Natural resources, environment, and energy
        Page 27
        Page 28
        Page 29
        Page 30
        Page 31
        Page 32
        Page 33
        Page 34
        Page 35
        Page 36
        Page 37
        Page 38
        Page 39
        Page 40
    Commerce and transportation
        Page 41
        Page 42
        Page 43
        Page 44
        Page 45
        Page 46
        Page 47
        Page 48
        Page 49
        Page 50
        Page 51
        Page 52
        Page 53
        Page 54
        Page 55
        Page 56
        Page 57
        Page 58
        Page 59
        Page 60
        Page 61
        Page 62
        Page 63
        Page 64
        Page 65
        Page 66
        Page 67
        Page 68
        Page 69
        Page 70
        Page 71
        Page 72
        Page 73
        Page 74
        Page 75
        Page 76
        Page 77
        Page 78
        Page 79
        Page 80
        Page 81
        Page 82
    Community and regional development
        Page 83
        Page 84
    Education, training, employment, and social services
        Page 85
        Page 86
        Page 87
        Page 88
        Page 89
        Page 90
        Page 91
        Page 92
        Page 93
        Page 94
        Page 95
        Page 96
        Page 97
        Page 98
    Health
        Page 99
        Page 100
        Page 101
        Page 102
    Income security
        Page 103
        Page 104
        Page 105
        Page 106
        Page 107
        Page 108
        Page 109
        Page 110
        Page 111
        Page 112
        Page 113
        Page 114
        Page 115
        Page 116
        Page 117
        Page 118
        Page 119
        Page 120
        Page 121
        Page 122
        Page 123
        Page 124
        Page 125
        Page 126
        Page 127
        Page 128
        Page 129
        Page 130
        Page 131
        Page 132
        Page 133
        Page 134
        Page 135
        Page 136
        Page 137
        Page 138
        Page 139
        Page 140
        Page 141
        Page 142
        Page 143
        Page 144
        Page 145
        Page 146
    Veterans' benefits and services
        Page 147
        Page 148
    General government
        Page 149
        Page 150
    Revenue sharing and general purpose fiscal assistance
        Page 151
        Page 152
        Page 153
        Page 154
        Page 155
        Page 156
        Page 157
        Page 158
    Appendix A. Forms of tax expenditures
        Page 159
        Page 160
        Page 161
        Page 162
        Page 163
        Page 164
    Appendix B. Capital gains
        Page 165
        Page 166
Full Text













































































For sale b the Superintendent of Documents, U.S. Government Printing Office
Washington, D.C., 20402 Price $2.20
























COMMITTEE ON THE BUDGET

EDMUND S. MUSKIE, Maine, Chairman


WARREN G. MAGNUSON, Washington
FRANK E. MOSS, Utah
WALTER F. MONDALE, Minnesota
ERNEST F. HOLLINGS, South Carolina
ALAN CRANSTON, California
LAWTON CHILES, Florida
JAMES ABOUREZK, South Dakota
JOSEPH R. BIDEN, JR., Delaware
SAM NUNN, Georgia


HENRY BELLMON, Oklahoma
ROBERT DOLE, Kansas
J. GLENN BEALL, JR., Maryland
JAMES L. BUCKLEY, New York
JAMES A. McCLURE, Idaho
PETE V. DOMENICI, New Mexico


DOUGLAS J. BENNET, Jr., Staff Director
JOHN T. McEvoy, Chief Counsel
ROBERT S. BOYD, Minority Staff Director
W. THOMAS FOXWELL, Director of Publications
(II)








LETTER OF TRANSMITTAL


To THE MEMBERS OF THE COMMITTEE ON THE BUDGET:
The Congressional Budget and Impoundment Control Act of 1974
requires that the Budget Committees and the Congress examine tax
expenditures as part of overall Federal budgetary policy. This re-
quirement stems from a recognition that numerous provisions of
Federal tax law confer benefits on some individuals and institutions
that are comparable to direct Federal spending, but that these tax
law benefits seldom are reviewed, in comparison with direct spending
programs.
This Committee print has been prepared to gather together basic
background information concerning tax expenditures to assist members
of the Budget Committee and other Members of the Congress in
carrying out their responsibilities with respect to tax expenditures
under the Budget Act. It is a compendium of summaries which
describes the operation and impact of each tax expenditure; indicates
the authorization and rationale for its enactment and perpetuation;
estimates both the revenue loss attributable to each provision and,
where provisions affect individual taxpayers directly, the percentage
distribution by adjusted gross income class of the tax savings conferred
by the provision; and cites selected bibliography for each provision.
The concept of tax expenditures is a relatively new one which is
still in the process of being refined, both with respect to the provisions
classified as tax expenditures and the methods of calculating the rev-
enue losses stemming from such provisions. Nevertheless, failure to
take tax expenditures into account in the budget process now would
be to overlook significant segments of Federal policy. They should be
given particularly thorough scrutiny because, as the compendium
indicates, tax expenditures are generally enacted as permanent legis-
lation and thus are comparable to continuing direct spending entitle-
ment programs, often with increasing annual revenue losses.
This compendium was prepared jointly by Jane Gravelle of the
Congressional Research Service, Ronald Hoffman, Charles Davenport,
John Roth, and Roger Golden of the Congressional Budget Office, and
Ira Tannenbaum, Kenneth Biederman, and Bert Carp of the Budget
Committee staff.
Nothing in this compendium should be interpreted as representing
the views or recommendations of the Budget Committee or any of its
individual members.
Sincerely,
HENRY BELLMON, EDMUND S. MUSKIE,
Ranking Minority Member. Chairman.
WALTER F. MONDALE,
Chairman, Task Force on Tax
Policy, and Tax Expenditures.
(m)


















Digitized by the Internet Archive
in 2013












http://archive.org/details/taxexp00unit











CONTENTS


Page
Letter of transmittal----------------------------------------------- In
Introduction_ ---------------------------------------------------- 1
National defense:
Exclusion of benefits and allowances to Armed Forces --------------- 7
Exclusion of military disability pensions -------------------------- 9
International affairs:
Exclusion of gross-up on dividends of less developed country corpora-
tions ----------------------------------------------------- 11
Exclusion of certain income earned abroad by U.S. citizens ----------- 13
Deferral of income of Domestic International Sales Corporations
(DISCs) ------------------------------------15
Special rates for Western Hemisphere Trade Corporations------------ 19
Deferral of income of controlled foreign corporations- --------------- 21
Agriculture:
Expensing of certain capital outlays- ----------------------------- 23
Capital gain treatment of certain income- ------------------------- 25
Natural Resources, Environment, and Energy:
Expensing of intangible drilling, exploration and development costs-_ 27
Excess of percentage over cost depletion--------------------------- 31
Capital gain treatment of royalties on coal and iron ore -------------- 35
Timber: Capital gains treatment of certain income ------------------ 37
Pollution control: 5-year amortization- --------------------------- 39
Commerce and Transportation:
Corporate surtax exemption ------------------------------------ 41
Deferral of tax on shipping companies----------------------------- 43
Railroad rolling stock: 5-year amortization ------------------------ 45
Bad debt deductions of financial institutions in excess of actual losses -- 47
Deductibility of nonbusiness State gasoline taxes ------------------ 49
Depreciation on rental housing in excess of straight line, and deprecia-
tion on buildings (other than rental housing) in excess of straight
line-------------------------------------------------------- 51
Expensing of research and development costs----------------------- 55
Investment tax credit- ---------------------------------------- 57
Asset depreciation range---------------------------------------- 61
Dividend exclusion- ------------------------------------------63
Capital gains: Individual (other than farming and timber)---------- 65
Capital gains treatment: Corporate (other than farming and timber)- 67
Exclusion of capital gains at death -------------------------------71
Deferral of capital gains on home sales--------------------------- 73
Deductibility of mortgage interest and property taxes on owner-
occupied property------------------------------------------ 75
Exemption of credit unions- --------------------------------- 77
Deductibility of interest on consumer credit- -------------------- 79
Credit for purchasing new home--------------------------------- 81








Community and Regional Development: Page
Housing rehabilitation: 5-year amortization ----------------------- 83
Education, Training, Employment, and Social Services:
5-year amortization of child care facilities-------------------------- 85
Exclusion of scholarships and fellowships ------------------------- 87
Parental personal exemption for student age 19 or over------------- 89
Deductibility of charitable contributions to educational institutions
other than educational institutions---------------------------- 91
Deductibility of child and dependent care services ----------------- 95
Credit for employing public assistance recipients under Work In-
centive (WIN) Program-------------------------------------- 97
Health:
Exclusion of employer contributions to medical insurance premiums
and medical care--------------------------------------------- 99
Deductibility of medical expenses-------------------------------- 101
Income Security:
Exclusion of social security benefits (disability insurance benefits,
OASI benefits for the aged, and benefits for dependents and sur-
vivors) -----------------------------------------------------103
Exclusion of railroad retirement benefits---------------------- 105
Exclusion of sick pay ----------------------------------------- 107
Exclusion of unemployment insurance benefits ------------------- 109
Exclusion of worker's compensation benefits --------------------- 111
Exclusion of public assistance benefits---------------------------- 113
Net exclusion of pension contributions and earnings:
Employer plans ------------------------------------------- 115
Plans for self-employed and others--------------------------- 117
Exclusion of other employee benefits:
Premiums on group term life insurance ----------------------- 119
Premiums on accident and accidental death insurance------ ---- 121
Privately financed supplementary unemployment benefits------- 123
Meals and lodging---------------------------------------- 125
Exclusion of interest on life insurance savings- ------------------- 127
Exclusion of capital gains on house sales if over 65----------------- 129
Deductibility of casualty losses---------------------------------- 131
Excess of percentage standard deduction over low income allowance- 133
Additional exemption for the blind------------------------------- 135
Additional exemption for over 65-------------------------------- 137
Retirement income credit--------------------------------------- 139
Earned income credit ------------------------------------------ 143
Maximum tax on earned income--------------------------------- 145
Veterans' Benefits and Services:
Exclusion of disability compensation, pensions, and GI bill benefits- 147
General Government:
Credits and deductions for political contributions------------------ 149
Revenue Sharing and General Purpose Fiscal Assistance:
Exclusion of interest on State and local bond debt----------------- 151
Exclusion of income earned in U.S. possessions-------------------- 155
Deductibility of nonbusiness State and local taxes (other than on
owner-occupied homes and gasoline)--------------------------- 157
Appendix A:
Forms of tax expenditures -------------------------------------- 159
Appendix B:
Capital gains -------------------------------------------------- 165










INTRODUCTION


This compendium gathers basic information concerning 74 Federal
income tax provisions currently treated as tax expenditures. The
provisions included in this compendium are the same as those listed
in Estimates of Federal Tax Expenditijres, prepared for the Committee
on Ways and Means and the Committee on Finance by the staffs of
the Treasury Department and Joint Committee on Internal Revenue
Taxation (July 8, 1975). With respect to each of these expenditures,
this compendium provides:
An estimate of the Federal revenue loss associated with the
provision for individual and corporate taxpayers, for fiscal years
1975, 1976, and 1977;
The legal authorization for the provision (e.g., Internal Revenue
Code section, Treasury Department regulation, or Treasury
ruling);
A description of the tax expenditure, including an example of
its operation where this is useful;
A brief analysis of the impact of the provision;
An estimate, where applicable, of the percentage distribution-
by adjusted gross income (AGI) class-of the individual income
tax saving resulting from the provision;
A brief statement of the rationale for the adoption of the tax
expenditure where it is known, including relevant legislative
history; and
References to selected bibliography.
The information presented for each of these tax expenditures is not
intended to be exhaustive or definitive. Rather, it is intended to pro-
vide an introductory understanding of the nature, effect, and back-
ground of each of these provisions. Good starting points for further
research on each item are listed in the selected bibliography following
each provision.
Defining Tax Expenditures
Tax expenditures are revenue losses resulting from Federal tax
provisions that grant special tax relief designed to encourage certain
kinds of behavior by taxpayers or to aid taxpayers in special circum-
stances. These provisions may, in effect, be viewed as the equivalent
of a simultaneous collection of revenue and a direct budget outlay of an
equal amount to the beneficiary taxpayer.
Section 3(a)(3) of the Congressional Budget and Impoundment
Control Act of 1974 specifically defines tax expenditures as:
those revenue losses attributable to provisions of the Federal tax laws
which allow a special exclusion, exemption, or deduction from gross income or
which provide a special credit, a preferential rate of tax, or a deferral of tax
liability; . .
(1)







In the legislative history of the Congres- ional Budget Act, provisions
classified as tax expenditures are contrasted with those provisions
which are part of the "normal structure" of the individual and cor-
porate income tax necessary to collect government revenues.
The concept of tax expenditures is relatively new, having been
developed over only the past decade. Tax expenditure budgets which
list the estimated annual revenue lo.-ses associated with each tax
expenditure first were required to be published in 1975 as part of the
Administration budget for FY 1976, and will be required to be
published by the Budget Committees for the first time this April.
The tax expenditure concept is still being refined, and therefore the
classification of certain provisions as tax expenditures continues to
be discussed. Nevertheless, there is widespread agreement for the
treatment as tax expenditures of most of the provisions included
in this compendium.1
The listing of a provision as a tax expenditure in no way implies
any judgment about its desirability or effectiveness relative to other
tax or nontax provisions that provide benefits to specific classes of
individuals and corporations. Rather, the listing of tax expenditures,
taken in conjunction with the listing of direct spending programs, is
intended to allow Congress to scrutinize all Federal programs-both
nontax and tax-when it develops its annual budget. Only if tax ex-
penditures are included will Congressional budget decisions take into
account the full spectrum of Federal programs.
In numerous instances, the goals of these tax expenditure- might
also be achieved through the use of direct expenditure-, or loan
programs. Because any qualified taxpayer may reduce tax liability
through use of a tax expenditure, such provisions are comparable
to entitlement programs under which benefits are paid to all eligible
persons. Since tax expenditures are generally enacted as permanent
legislation, it is important that, as entitlement programs, they be
given thorough periodic consideration to see whether they are
efficiently meeting the national needs and goals that were the reasons
for their initial establishment.

Major Types of Tax Expenditures
Tax expenditures may take any of the following forms: (1) exclu-
sions, exemptions, and deductions, which reduce taxable income;
(2) preferential tax rates, which reduce taxes by applying lower
rates to part or all of a taxpayer's income; (3) credits, which are
subtracted from taxes as ordinarily computed; and (4) deferrals of
tax, which result from delayed recognition of income or from allowing
in the current year deductions that are properly attributable to a
future year.2
The amount of tax relief per dollar of each exclusion, exemption,
and deduction increases with the taxpayer's marginal tax rate. Thus,
the exclusion of interest income from State and local bonds saves $50
in tax for every $100 of interest for the taxpayer in the 50 percent tax
bracket, whereas the savings for the taxpayer in the 25 percent bracket
is only $25. Similarly, the extra exemption for persons over age 65 and
1 For a discussion of some of the conceptual problems involved in (Ifrfiling tax expenditures, see Budgct
of the Urnitd States Government, Fiscal 'fatr 1977, "Sp,, i,1 Analysis F", l16--122.
2 See Appendix A for further analysis of these types of tax expenditures.







any itemized deduction is worth twice as much in tax saving to a
taxpayer in the 50 percent bracket as to one in the 25 percent
bracket.
A tax credit is subtracted directly from the tax liability that would
otherwise be due; thus the amount of tax reduction is the amount of
the credit-which does not depend on the marginal tax rate.
The numerous tax expenditures that take the form of exclusions,
deductions, and exemptions are relatively more valuable to upper than
to lower or middle income individuals. However, this fact should be
viewed in the context of recent increases in the low-income allowance
and in the standard deduction, which provide more tax saving for
certain low-middle income taxpayers than itemized deductions,
thus reducing the number of them who itemize.
Moreover, even though some tax expenditures may provide most
of their tax relief to those with high taxable incomes, this may be
the consequence of overriding economic considerations. For example,
tax expenditures directed toward capital formation may deliberately
benefit savers who are primarily higher income taxpayers.

Estimating Tax Expenditures
The estimated revenue losses for all the listed tax expenditures
have been provided by the Congressional Budget Office (CBO) based
upon work done by the staffs of the Treasury Department and the
Joint Committee on Internal Revenue Taxation.3 Except for five
expenditures, the estimates are identical to those that appear for
the same provisions in the Administration's FY 1977 tax expenditure
budget.4 Most of these differences stem from CBO assumptions that
certain tax expenditures scheduled to expire during 1976 will be con-
tinued through FY 1977.
In calculating the revenue loss from each tax expenditure, it is
assumed that only the provision in question is deleted and that all
other aspects of the tax system remain the same. In using the tax
expenditure estimates, several points should be noted.
First, in some cases, if two or more items were eliminated, the
combination of changes would probably produce a lesser or greater
revenue effect than the sum of the amounts shown for the individual
items.
Second, the amounts shown for the various tax expenditure items
do not take into account any effects that the removal of one or more
of the items might have on investment and consumption patterns
or on any other aspects of individual taxpayer behavior, general
economic activity, or decisions regarding other Federal budget outlays
or receipts.
Finally, the revenue effect of new tax expenditure items added to
the tax law may not be fully felt for several years. As a result, the
eventual annual cost of some provisions is not fully reflected until
some time after enactment. Similarly, if items now in the law were
eliminated, it is unlikely that the full revenue effects would be im-
mediately realized.
3 The revenue estimates are based on the tax code as of January 1, 1976, with the exception that the tem-
porary provisions applying to the investment credit, surtax exemption, earned income
credit, and the standard deduction are estimated as if they will continue through FY 1977.
4 The Budget of the United States Government, Fiscal Year 1977, "Special Analysis F" at 125-127.






However, these tax expenditure estimating considerations are similar
to estimating considerations involving entitlement programs. Like
tax expenditure;. ,nmuaJ budget estimates for each transfer and income
security program are computed separately. However, if one program,
such as veterans' pensions, were either terminated or increased, this
would affect the level of payments under other programs, such as
welfare payments. Also, like tax expenditure estimates, the elimination
or curtailment of a spending program, such as military spending or
unemployment benefits, would have substantial effects on consumption
patterns and economic activity that would directly affect the levels
of other spending programs. Finally, like tax expenditure%, the budge-
tary effect of terminating certain entitlement programs would not
be fully reflected until several years later because the termination
of benefits is usually only for new recipients with persons already
receiving benefits continued under "grandfather" provisions.

Adjusted Gross Income Class Distributions
Distributions of the tax benefits by adjusted gross income (AGI)
class are given for almost all tax expenditures providing direct tax
relief to individual taxpayers. These distribution figures show the por-
tion of the total estimated revenue loss attributed to each tax expendi-
ture that goes to all taxpayers with adjusted gross income falling within
the boundaries of the respective income classes. No distribution to
individual income classes is made of the tax expenditure benefits
provided directly to corporations, since to do so would require un-
substantiated assumptions concerning the ultimate beneficiaries
of these corporate tax relief provisions.
Taxable individual income tax returns falling within each AGI
class for calendar 1974 were:

Percent of
Taxable returns taxable returns
AGI class (thousands) in each class
0 to $7,000 -------------------------------------------------------............................................................ 19,909 29.7
$7,000 to $15,000--............................................................ ------------------------------------------------27,380 40.9
$15,000 to $50,000-----------------.....-.. --------------------------------- 18,862 28.2
$50,000 and over---------------- ----------.--.. ... ------------------------ 815 1.2

The tax expenditure distributions by AGI class are taken from a
study done by the Treasury Department in 1975 at the request of
Senator Walter F. Mondale of Minnesota and are the most recent
estimates of this type.
These distributions indicate in a general way whether specific tax
expenditures provide tax benefits largely to lower, middle, or high
income taxpayers. However, adjusted gross income includes less
than a fully comprehensive definition of income. It is total gross
(non-exempt) income reduced by allowable deductions. Adjusted
gross income will differ substantially from a more inclusive definition
of money income where individuals have relatively large amounts of
income which, pursuant to one or more tax expenditure provisions,
are exempt from tax. For example, the exclusion of income earned by
certain U.S. citizens working or residing abroad (see p. 13) permits up
to $25,000 a year of economic income to be excluded from adjusted
gross income. Thus, many of the provision's beneficiaries will appear in







the $0 to $7,000 AGI class, giving the appearance the provision largely
benefits low income persons. However, in fact, many of these persons
actually earned salaries in the area of $20,000 to $30,000.
Order of Presentation
The tax expenditures are presented in an order which parallels as
closely as possible, the budget functional categories used in the Con-
gressional budget, i.e., tax expenditures related to "national defense"
are listed first, and those related to "international affairs" are listed
next.
This order of presentation differs to a limited degree from that
used in the tax expenditure budgets published by the Administration
for 1976 and 1977 and prepared by the staffs of the Joint Committee on
Internal Revenue Taxation and the Treasury Department for 1976.
These budgets listed certain items under three headings-"business
investment", personal investment", and "other tax expenditures"-
that are not budget functional categories. However, in order that tax
expenditures be presented in a manner which parallels as closely as
possible the presentation of direct expenditures, the items that were
listed under those three headings have been distributed in this com-
pendium to the budget functional categories to which they are most
closely related. This format is consistent with the requirement of
Section 301 (d) (6) of the Budget Act, which requires the tax expendi-
ture budgets published by the Budget Committees as parts of their
April 15 reports to present the estimated levels of tax expenditures
"by major functional categories".

Rationale
The material on each tax expenditure contains a brief statement of
the rationale for the adoption of the tax expenditure where it is known.
These rationales are the principal ones which were publicly given at the
time the provisions were enacted.
Further Comment
In the case of a number of tax expenditures, additional information is
provided under the heading "Further Comment." It is material which
either focuses attention on some of the principal issues related to a pro-
vision or describes recent legislative proposals to amend a provision.
This is material that does not fit within the other elements of the
format of the compendium-either in the "Description," "Impact," or
"Rationale" sections. As the examples which are provided in the
descriptions of only some of the tax expenditures, the "Further
Comment" sections are included only where they were deemed to be
useful. Providing information under the "Further Comment" sections
for only certain tax expenditures in no way implies any judgment about
these provisions.














EXCLUSION OF BENEFITS AND ALLOWANCES
TO ARMED FORCES



Estimated Revenue Loss
[In millions of dollars]

Fiscal year Individuals Corporations Total

1977------- 650 ------ 650
1976------- 650 ------ 650
1975------- 650 ------ 650


Authorization
Sections 112 and 113,1 Regulation 1.61-2,2 and court decisions.

Description

Military personnel are not taxed on a variety of in-kind benefits
and cash payments given in lieu of such benefits. These tax-free bene-
fits include quarters and meals or-alternatively-cash allowances
for these purposes, certain combat pay, and a number of less signifi-
cant items.
Impact

All military personnel receive one or more of these benefits which
are generally greater in the higher pay brackets. The amount of tax
relief increases with the individual's tax bracket and therefore de-
pends on a variety of factors unrelated to the taxpayer's military
pay, such as other income including income from a spouse, and the
amount of itemized deductions. Therefore, the exclusion of these bene-
fits from taxation alters the distribution of net pay to service personnel.

Estimated Distribution of Individual Income Tax Expenditure by
Adjusted Gross Income Class
Percentage
Adjusted gross income class (thousands of dollars): distribution
0 to 7------------------------------------------------------ 46. 9
7 to 15 --------------------------------------------------36. 2
15 to 50 --------------------------------------------------16. 2
50 and over- ---------------------------------------------- 0.8

1 The word "Section" denotes a section of the Internal Revenue Code of 1954 as amended
unless otherwise noted.
2 Reference to "regulations" are to Income Tax Regulations unless otherwise noted.
(7)







Rationale
Although the principle of exemption of Armed Forces benefits
and allowance appeared early in the history of the income tax, it
has evolved through subsequent specific statute, regulations, revenue
rulings, and court decisions. For some benefits, the rationale was a
specific desire to reduce tax burdens of military personnel during
wartime (as in the use of combat pay provisions); other preferences
were apparently ba-ed on the belief that certain types of benefits
were not strictly compensatory but rather an intrinsic element in the
military structure.
Further Comment
Administntive difficulties and complications could be encountered
in taxing some military benefits and allowances that are tax exempt;
for example, it could be difficult to value meals and lodging when the
option to receive cash is not available. However, eliminating the
exclusions and adjusting pay scales accordingly might simplify
decision-making about military pay levels and make "actual" salary
more apparent to recipients.

Selected Bibliography
Binkin, Martin. The Military Pay Muddle, The Brookings Insti-
tution, Washington, D.C., April 1975.








EXCLUSION OF MILITARY DISABILITY
PENSIONS



Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total

1977------- 90 ------ 90
1976------- 80 ------ 80
1975 -------- 70 ------ 70

Authorization
Section 104(a)(4) and Regulation 1.104-1(e).
Description
Service personnel who have at least a 30-percent disability or who
have at least 20 years of service and any amount of disability may
draw retirement pay based on either percentage of disability or years
of service. If the chosen pension is less than 50 percent of the basic
pay, it will be raised to 50 percent during the first 5 years of retirement.
Pay based on percentage of disability is fully excluded from gross
income under Section 104. If pay is based on years of service, only
the portion that would have been paid on the basis of disability is
excluded from income.
Impact
Because it is exempt from tax, disability pay provides more net
income than taxable benefits at the same level. The tax benefit of
this provision increases as the pensioner's marginal tax rate increases.
Thus, the after-tax pension benefits increase as a percentage of active
duty pay as the individual's tax bracket increases.

Estimated Distribution of Individual Income Tax Expenditure
by Adjusted Gross Income Class
Percentage
Adjusted gross income clais (thousands of dollars): distribution
0 to 7------------------------------------------------------- 46. 2
7 to 15 ------------------------------------------------------- 36. 9
15 to 50----------------------------------------------------- 16. 9
50 and over--------------------------------------------------- 0
Rationale
The rationale for this exclusion is not clear. It was adopted in 1942
during World War II.
Selected Bibliography
Binkin, Martin. The Military Pay Muddle, The Brookings Institu-
tion, Washington, D.C., April 1975.
(9)














EXCLUSION OF GROSS-UP ON DIVIDENDS OF
LESS DEVELOPED COUNTRY CORPORATIONS


Estimated Revenue Loss
[In millions of dollars]


Fiscal year Individuals Corporations Total

1977------- ------ 55 55
1976------- ------ 55 55
1975------- ------ 55 55


Authorization
Sections 78 and 902 and Executive Order No. 11071, December 27,
1962.
Description
A domestic corporation that receives dividends from a foreign
corporation in which the domestic corporation owns 10 percent or
more of the voting stock may claim a foreign tax credit against its
U.S. tax liability for the foreign income taxes paid by the subsidiary.
If the foreign corporation is not a less developed country corporation
(LDCC), the dividend must be "grossed-up" (i.e., increased) by the
amount of foreign tax paid with respect to the dividend. The "grossed-
up" amount is included in taxable income, and the U.S. tax rate is
applied to the "grossed-up" taxable income to calculate the U.S. tax.
The foreign tax may then be credited against (i.e., deducted from) the
U.S. tax. However, dividends paid by LDCCs are not "grossed-up,"
but foreign taxes paid with respect to them are available as a foreign
tax credit. To qualify as an LDCC, a corporation must have 80 per-
cent or more of its gross income and assets connected with activities
in less developed countries. Shipping companies with ships or aircraft
registered in less developed countries qualify. Pursuant to Executive
Order No. 11071 of December 27, 1962, all countries qualify as less
developed except 16 Western European nations, Australia, New
Zealand, South Africa, Canada, and Sino-Soviet bloc members.

Example
Assume the foreign tax rate is 24 percent, and an LDCC earns $100,
pays a foreign tax of $24, and distributes the remaining $76 as a
dividend. If "gross-up" is required, the U.S. tax before the credit is
$48 (48 percent-the U.S. corporate tax rate-of $100) and the $24
(11)


67-312-76-2





12


foreign tax payment is credited against the $48 resulting in a $24
U.S. liability after the credit. Thus, the total tax rate, including both
the foreign and U.S. tax, is 48 percent which is equal to the U.S. rate.
If "gross-up" is not required, then the U.S. tax is $36.48 (48 percent
of $76) less $18.24 (24 percent of $76), which is the amount of the
foreign tax paid on the dividend and which therefore can be credited.
Thus, the net U.S. tax liability is $18.24, a total tax rate of 42.24 per-
cent ($18.24 plus $24.00 divided by $100). Failure to "gross-up"
therefore saves the parent corporation $5.76 ($24.00-$18.24) of U.S.
taxes.
Impact
Income remitted to parent companies by LDCCs is taxed at a
lower rate than dividends from other subsidiaries. The amount of the
benefit depends on the tax rate of the foreign country relative to the
U.S. tax rate. The benefit is greatest when the foreign tax rate is half
the 48 percent U.S. tax rate. In this case, the total U.S. and foreign
tax is 42.24 percent (see the example above). The benefit declines as
the foreign tax rate rises above or falls below half the U.S. tax rate;
thus the net U.S. tax liability varies with the foreign effective tax
rate. There is no benefit when the foreign tax rate equals or exceeds
the U.S. tax rate and no benefit when the foreign tax rate is zero.

Rationale
The "gross-up" requirement for developed countries was added in
1962. Prior to that time, "gross-up" was not required, and the method
of computing the tax was derived from a 1942 Supreme Court decision
(American Chicle Co. v. U.S., 316 U.S. 450) which interpreted the
language of the provision allowing a foreign tax credit. While the 1962
revision recognized that this provision should be corrected generally,
the Finance Committee recommended exempting dividends from
LDCCs from this requirement because it did not wish to discourage
investment in such countries.

Further Comment
This preferential treatment for LDCC dividends would be elimi-
nated by H.R. 10612, passed by the House in December 1975.

Selected Bibliography

Hellawell, Robert, "United States Income Taxation and Less
Developed Countries: A Critical Appraisal," Columbia Law Review,
December 1966, pp. 1393-4277.
U.S. Congress, House, Committee on Ways and Means, General
Tax Reform, Panel Discussions, 93rd Congress, 1st Sess., Part II-Tax
Treatment of Foreign Income, February 28, 1973, pp. 1671-1881.










EXCLUSION OF CERTAIN INCOME EARNED
ABROAD BY U.S. CITIZENS

Estimated Revenue Loss
[In millions of dollars]
F i-cal year Individuals Corporations Total

1977------- 160 ------ 160
1976------- 145 ------ 145
1975------- 130 ------ 130

Authorization
Sections 911-912.
Description
While U.S. citizens are 'generally taxable on their world-wide in-
come, up to $20,000 of foreign earned income (largely salary income)
may be excluded annually from income under section 911 by a citizen
who (1) is a bona fide resident of a foreign country for an uninterrupted
period that includes a taxable year, or (2) has been present in a foreign
country for 510 days (17 months) out of 18 consecutive months. The
annual exclusion is raised to $25,000 for an individual who has been a
bona fide resident of a foreign country for at least 3 consecutive years.
Section 911 does not apply to salaries received from the U.S. Govern-
ment.
Section 912 exempts from tax certain allowances that are received by
Federal civilian employees working abroad. The principal exempt
allowances are for high local living costs, education, and housing.

Impact
Some U.S. citizens living abroad pay no income taxes to the coun-
tries in which they reside. Section 911 allows their income up to the
appropriate ceiling to be tax free in the United States as well.
In cases where U.S. citizens pay foreign income taxes, those taxes,
including the taxes paid on the income excluded from taxation under
this section, can be credited against any U.S. tax liability that would
otherwise exist on other foreign income: earned income above the
$20,000 or $25,000 excludable limits and investment income. This
allows U.S. taxpayers to offset all the foreign tax-including that paid
on the amount of excluded income-against U.S. tax that would
otherwise be due on the income in excess of the excluded amount.
Thus, the combination of the exclusion and the foreign tax credit can
result in levels of income actually exempt from U.S. tax in excess of the
stated limits.
(13)






14


In addition to the U.S. citizens who directly benefit from this
favorable treatment, overseas employers also benefit to the extent
that salary levels are lower because of the exclusion. To the ex-
tent this occurs, they maintain an advantage relative to domestic
employers. U.S. corporations that bid on overseas construction proj-
ects assert that the salary savings make them more competitive with
foreign bidders, some of the employees of which also enjoy similar
salary savings.
The value of the Section 912 exemption for allowances received by
Federal civilian employees working abroad increases with the re-
cipient's tax bracket. The value therefore depends on a variety of
factors including the level of the recipient's Federal salary, the extent
of his other income, and the amount of his itemized deductions.

Estimated Distribution of Individual Income Tax Expenditure by
Adjusted Gross Income Class
Peretntaqe
Adjusted gross income class (thoiisands of dollars): distribution
0 to 7------------------------------------------------------- 38.9
7 to 15---------------------------------------------------- 17.8
15 to 50 ---------------------------------------------34.4
50 and over __-------------------------------------------- 8.9
Rationale
A less restrictive form of Section 911 was first enacted in 1926
to encourage foreign trade. After World War II, the exclusion was
justified as part of the Marshall Plan to encourage persons with
technical knowledge to work abroad. Although the provision was
revised on several occasions, dollar limitations were first enacted in
1953 at $20,000 and $35,000. The latter figure was reduced to $25,000
in 1964.
The exemption for civilian Federal employee overseas allowances
was enacted in 1943. The principal rationale was to provide additional
compensation for these employees, who were performing vital wartime
services.
Further Comment
H.R. 10612 passed by the House of Representatives in December
1975 would phase out Section 911 over a 3-year period. However, it
would provide a new tax deduction for amounts paid as tuition for
children of U.S. citizens working abroad.

Selected Bibliography
U.S. Congress, House, Committee on Ways and Means, General
Tax Reform, Panel Discussion, 93rd Congress, 1st Session, Part II-
Tax Treatment of Foreign Income, February 28, 1973, pp. 1671-1888.










DEFERRAL OF INCOME OF DOMESTIC INTER-
NATIONAL SALES CORPORATIONS (DISCs)


Estimated Revenue Loss
[In millions of dollars]


Fiscal year Individuals Corporations Total
1977------- ------- 1,420 1,420
1976------- ------- 1,340 1,340
1975 ------- ------- 1,130 1,130


Authorization
Sections 991-997.

Description
Corporations qualifying as DISCs (Domestic International Sales
Corporations) must be incorporated in the United States, at least 95
percent of their assets must be related to export functions, and at
least 95 percent of their gross receipts must stem from export sale or
lease transactions.
DISCs typically are wholly owned subsidiary corporations through
which parent corporations channel their export sales. DISCs are
not themselves subject to corporate income tax, but their parent
corporations are taxed on the DISC income when it is distributed or
attributed to them.
The tax savings from using a DISC result principally from two
interrelated aspects of the tax law: (1) the allocation rules that allow at
least half of the total, combined profit of the parent and DISC from
export sales to be attributed to the DISC, and (2) the potentially
permanent tax deferral that is allowed on half of those profits attributed
to the DISC under the liberal allocation rules. The other half of a
DISC's income is either actually or deemed to be distributed annually
to its parent corporation and thus does not qualify for deferral.
The allocation rules provide that a DISC is deemed to have earned
either: (1) 50 percent of the combined taxable income of the parent
corporation and DISC from export sales or (2) 4 percent of the gross
receipts from the export sales, whichever is greater. The 50 percent
allocation is used much more frequently. The rules for allocating
DISC profits are much more favorable than the otherwise applicable
tax law standard (Section 482) which requires a sale by a manufac-
turer or producer to a wholly owned sales subsidiary to be at an arm's
length price. If the Section 482 rule were applied to DISCs, only a
relatively small, or no, sales commission would be allocated to the
(15)







DISC, while the proportionately larger profits from production would
go to the pa'reit corporation.
The deferral of tax (on 50 percent of the income allocated to the
DISC) continue as long as the undistributed DISC income is invested
in qualified assets; the duration may be indefinite, and in such cases
constitutes the practical equivalent of a permanent tax exemption.

Example
Assume a company incurs total costs of $8,000 in producing goods
selling on the export market for $10,000. The allocation rule attributes
50 percent of the $2,000 total net profit to the DISC and 50 percent
to the parent firm. Taxes are deferred on $500 of the $1,000 allocated to
the DISC and the 48 percent corporate tax rate is applied to the
remaining $1,500 of direct profits and DISC earnings attributed or
paid to the parent firm. The total tax liability is $720. If a DISC had
not been used, the tax liability would have been $960 ($2,000 X .48
tax rate). The DISC provides a tax savings of $240 ($500 of deferrable
DISC income X .48 tax rate) and, therefore, lowers the effective tax
rate to 36 percent on this export sales income.
Impact
This provision reduces the marginal tax rate on DISC-related
export income from 48 percent to 36 percent (and to 24 percent in the
relatively few cases where the total profit on export sales of the DISC
and its parent is no more than 4 percent of gross export receipts).
Whether U.S. exporters reduce export prices in response to reduced
effective tax rates is unclear. To the extent they do, foreign purchasers,
as well as domestic exporters, would be subsidized.
According to several studies, the overall impact of DISC in stimu-
lating exports has been small in comparison to its annual revenue
cost. U.S. exports have increased dramatically since the DISC
provisions were added, but the increase is said to be due to the devalu-
ations of the dollar, worldwide inflation, and a stable U.S. share of
expanding worldwide trade. On the other hand, many companies which
utilize DISC argue it should be retained because: (1) in their view,
DISC has substantially increased exports which, in turn, have in-
creased U.S. employment levels; and (2) other countries employ a
variety of export promotion devices.
Corporations with profitable export operations benefit from the tax
reduction. The Treasury Department study cited below in the bibliog-
raphy reported that 72 percent of the net income of 1,510 DISCs with
corporate owners for which asset size data were available accrued to
186 companies with gross assets in excess of $250 million, with 44 per-
cent going to only 28 companies.

Rationale
Originally adopted as part of the Revenue Act of 1971, the stated
purpose of DISC was to stimulate exports and enhance the attractive-
ness of domestic manufacturing vis-a-vis manufacturing through for-
eign subsidiaries.





17


Further Comment
H.R. 10612, passed by the House in December 1975, would reduce
current DISC benefits by roughly one-third by limiting income
qualifying for deferral to that earned by exports in excess of 75 percent
of a company's exports during a prescribed base period.

Selected Bibliography
U.S. Congress, House, Committee on Ways and Means, General
Tax Reform, Panel Discussions, 93rd Congress, 1st Session, Part II-
Tax Treatment of Foreign Income, February 28, 1973, pp. 1671-1880.
U.S. Congress, Senate, Task Force on Tax Policy and Tax Expendi-
tures, Committee on the Budget, Seminar-DISC: An Ealuation of
the Costs and Benefits, Committee Print, November 1975.
U.S. Department of Treasury, "The Operation and Effect of the
Domestic International Sales Corporation Legislation," 1973 Annual
Report, April 1975, 30 pages.













SPECIAL RATES FOR WESTERN HEMISPHERE
TRADE CORPORATIONS



Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total

1977------- ------ 50 50
1976------- ------ 50 50
1975------- ------ 50 50

Authorization
Sections 921 and 922.

Description
Western Hemisphere Trade Corporations (WHTCs) are granted a
special deduction which has the effect of reducing the tax rate by
as much as 14 percentage points.1 The amount of the special deduction
is the taxable income of the corporation (before the special deduction)
multiplied by a fraction, the numerator of which is 14 percent and the
denominator of which is the overall rate (i.e. the sum of the normal
tax rate and the surtax rate) on the corporation's total taxable income.
A WHTC is a U.S. corporation: (1) all of whose business is done
in the Western Hemisphere; (2) 95 percent or more of whose income
over the last three years was derived from sources outside the U.S.;
and (3) 90 percent or more of whose income over the same three years
was derived from the active conduct of a trade or business.
WHTCs may not defer U.S. taxation of their income (as in the
case of a controlled foreign corporation), but they may take a tax
credit for foreign taxes imposed on that income. The WHTC deduction
may not be taken for a taxable year in which the corporation is a
Domestic International Sales Corporation (DISC) or in which it
owns any stock in a DISC or former DISC.
Example
If taxable income is $100,000 when computed without regard to
the WHTC deduction, the WHTC deduction equals $100,000 X (14
percent/48 percent) =$29,166.67; taxable income is reduced to
I Under the permanent corporate rate structure, the full 14 percentage point reduction applies to
all WHTCs with income in excess of $35,294. Corporations with less income obtain a deduction which will
reduce their tax rate by less than 14 percentage points. Under the temporary tax reductions in the Tax
Reduction Act of 1975 and the Revenue Adjustment Act of 1975 which expire on June 30,1976, the principle
remains the same, but the cut-off figure for the full 14 percent reduction is slightly higher.
(19)





20


$70,833.34, and tax liability on this amount is $27,500 (assuming a
22% rate on the first $25,000 of taxable income and a 48% rate on
the income in excess of $25,000). Without this special deduction the
tax would have been $41,500. Thus, the effective tax rate has been
reduced by 14 percentage points.
Impact
For many companies, tax deferral through foreign incorporation
has been more advantageous than the WHTC provision. But, because
only domestic corporations may take percentage depletion, com-
panies with Western Hemisphere extractive industry operations out-
side the U.S. were traditionally organized as WHTCs. Currently,
however, the WHTC provision yields little or no tax saving for such
operations because the application of large foreign tax credits com-
pletely or nearly completely offsets any U.S. tax liability.
The WHTC provision also has been used by sales subsidiaries.
However, the more recent DISC legislation can be more valuable
in many cases, and the absence of growth in use of WHTCs may
reflect replacement of WHTC sales subsidiaries by DISCs.
Rationale
The Revenue Act of 1942 enacted the WHTC provisions to exempt
a few corporations then engaged in operations outside the United
States but within the Western Hemisphere from the high wartime cor-
porate surtaxes. The current provisions were continued in 1950 when
the tax structure was changed. The WHTC treatment is now justified
by some persons as necessary to maintain the competitive position
of corporations competing in the Western Hemisphere with foreign
corporations.
Further Comment

H.R. 10612, passed by the House of Representatives in December
1975, would phase out this provision by the end of taxable years
that begin in 1980.
Selected Bibliography
Musgrave, Peggy, "Tax Preferences to Foreign Inves.tment" in
U.S. Congrce.s, Joint Economic Committee, The Economics of Federal
Subsidy Programs, Part 2-International Subsidies, 92nd Congress,
2nd Session, July 15, 1972, p. 195.
Surrey, Stanley S., "Current Issues in the Taxation of Corporate
Foreign Investment", Columbia Law Review, June 1956, pp. 830-838.
U.S. Congress, House Committee on Ways and Means, General
Tax Reform, Panel Discussion, Part II-Tax Treatment of Foreign
Income, 93rd Congress, 1st Session, February 28, 1973, pp. 1671-1888.
U.S. Congress, Joint Committee on Internal Revenue Taxation,
U.S. Taxation of Foreign Source Income of Indriduals and Corpora-
tions and the Domestic International Sales Corporationt Prorisions,
September 29, 1975.











DEFERRAL OF INCOME OF CONTROLLED
FOREIGN CORPORATIONS


Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total

1977------- ------ 365 365
1976------- ------ 525 525
1975------- ------ 590 590

Authorization
Sections ll(f), 882, and 951-964.

Description
A U.S. corporate parent of a foreign subsidiary is not taxed on the
income of that subsidiary until the income is remitted (or "repatri-
ated") to the parent. The deferral of U.S. tax liability on the sub-
sidiary's income is permanent to the extent that the income is rein-
vested(I in the subsidiary or other foreign subsidiaries rather than
remitted to the U.S. parent. A tax credit in the amount of foreign
taxes paid on repatriated income, plus any "gross up" required (see
page 11), is allowed at the time of repatriation.
On the other hand, income from foreign branches (as distinguished
from subsidiaries) of U.S. corporations is taxed on a current basis
since the branches are parts of U.S. corporations. Certain so-called
tax haven income also is taxed currently in the U.S. irrespective of
whether earned by a foreign subsidiary or a branch. The Tax Reduc-
tion Act of 1975 strengthened the provisions requiring current taxation
of such income.
Impact
Companies that operate in countries with effective income tax rates
less than the U.S. rate may receive tax benefits from this provision.
A substantial portion of the revenue loss is attributable to deferral
on shipping income, which is estimated to account for over $100
million of the current revenue loss. This occurs because shipping firms
are often based in countries without income taxes, such as Liberia and
Panama. U.S. Department of Commerce data indicate that 423 of the
678 foreign flag ships owned by U.S. corporations and their sub-
sidiaries are registered in Panama or Liberia. Much (485) of this total
shipping fleet is composed of tankers.
(21)





22

Rationale
Historically, the United States has not taxed foreign source income
of foreign corporations on the premise that only domestic corporations
or income with a U.S. source is subject to U.S. jurisdiction. In effect,
the separate corporate status of foreign subsidiaries of domestic
corporations was respected. In 1962 these principles were abrogated
for certain so-called tax haven income under subpart F of the Code.
Such income is taxed even though earned abroad and even though
not repatriated.
Further Comment
Opponents of deferral allege it encourages investment in foreign
countries and reduces domestic investment, thus reducing U.S. tax
revenues and U.S. exports, and adversely affecting the balance of
payments, the balance of trade, and domestic employment. Pro-
ponents deny such allegations and argue that deferral must be con-
tinued for U.S. corporations to remain competitive with foreign
companies in overseas markets.
Deferral of tax on foreign profits is not neutral compared to invest-
ment in the United States in the sense that if the foreign country
tax rate is less than the U.S. tax rate and the income is not going to
be repatriated, a U.S. corporation has a tax incentive to invest abroad
using a foreign subsidiary instead of investing at home. However,
the deferral rules do neutralize advantages foreign competitors
may have over U.S. corporations operating abroad. Moreover,
there are also offsetting tax rules which favor investment in the U.S.
by domestic companies rather than abroad such as the general limita-
tion of the investment credit and asset depreciation range (ADR)
depreciation to assets used in the United States.

Selected Bibliography
Krause, Lawrence B. and Kenneth W. Dam. Federal Tax Treat-
ment of Foreign Income, The Brookings Institution, Washington, D.C.
1964, 145 pages.
Musgrave, Peggy, "Tax Preferences to Foreign Investment,"
in U.S. Congress, Joint Economic Committee, The Economics of
Federal Subsidy Programs, Part 2-International Subsidiaries, 92nd
Congress, 2nd Session, July 15, 1972, pp. 176-219.
U.S. Congress, House, Committee on Ways and Means, General
Tax Reform, Panel Discussions, 93rd Congress, 1st Session, Part II-
Tax Treatment of Foreign Income, February 28, 1973, pp. 1671-1881.
U.S. Congress, House, Committee on Ways and Means, U.S.
Taxation of Foreign Income-Deferral and the Foreign Tax Credit,
Prepared by the Joint Committee on Internal Revenue Taxation,
Committee Print, September 27, 1975.
U.S. Taxation of American Business Abroad. An Exchange of Views,
A.E.I.-Hoover Policy Studies, American Enterprise Institute,
Washington, D.C., 1975, 101 pages.











AGRICULTURE: EXPENSING OF CERTAIN
CAPITAL OUTLAYS


Estimated Revenue Loss
[In millions of dollars]


Fiscal year Individuals Corporations Total
1977------- 360 115 475
1976------- 355 105 460
1975------- 475 135 610


Authorization
Sections 162, 175, 180, 182, 278 and Regulations 1.61-4, 1.162-11,
and 1.471-6.
Description
Farmers may use the cash method of tax accounting to deduct costs
attributable to goods held for sale and in inventory at the end of the
tax year. They are also allowed to expense (i.e., deduct when they are
incurred) some costs of developing assets that will produce income in
future years. Both of these rules deviate from generally applicable
tax accounting rules, which do not permit deduction of inventory costs
until the inventory is sold, and which require the cost of income-
producing assets to be deducted over their useful lives. These rules
thus allow farmers to claim deductions before realizing the income
associated with the deductions.
Items that may be deducted before income from them is realized in-
clude cattle feed, expenses of planting crops for the succeeding year's
harvest, and development costs such as those incurred in planting
vineyards and fruit orchards. There are special restrictions on the
expensing of farming outlays for citrus and almond groves.
In addition, the statute allows expensing of certain items that
otherwise might be considered capital expenditures rather than
current expenses. These items include expenses for soil and water
conservation (Section 175), land clearing (Section 182), and fertilizer
(Section 180).
Impact
The effect of deducting costs before the associated income is realized
is the understatement of income in that year followed by an over-
statement of income when it is realized. The net result is that tax lia-
bility is deferred from the time the deduction is taken to the period
of the asset's remaining useful life. This affords the taxpayer an
interest-free loan in the amount of the deferred tax. When the income


(23)






24


is finally taxed, it may be taxed at preferential capital gains rates
(see p. 25 below).
The expensing of capital outlays is available to all taxpayers who
have farm investments. Therefore, the-e rules provide a tax subsidy
for all farming operations, and particularly for those with a long de-
velopment period (such as orchards and vineyards).
Concern has focused on the use of farming as a tax shelter by high
income bracket individuals who seek to offset their nonfarm taxable
income with large, artificial, farming losses. Such investment packages
normally have been characterized by a highly leveraged capital struct u re.
To a high income taxpayer, this translates into a relatively riskless
investment, since tax savings generated through the deduction of
losses may return most or all of the initial cash outlay in the first year
of operation.

Estimated Distribution of Individual Income Tax Expenditure by
Adjusted Gross Income Class1
Per f!aae
Adjusted gross income class (thousands of dollars): di.stribitIton
0 to 7--------------------------------------------------------- 18. 1
7 to 15-------------------------------------------------------- 35.3
15 to 50------------------------------------------------------- 33.6
50 and over--------------------------------------------------- 12. 9
1 The distribution refers to the individual tax expenditure only. The corporate tax expenditure resulting
from these tax provisions is not reflected in this distribution table.
Rationale
The special rules with respect to development costs and cash ac-
counting were established in regulations issued very early in the de-
velopment of the tax law. At that time, because accounting methods
were less sophisticated, tax rates were low, and the typical farming
operation was small, the regulations apparently were adopted to
simplify record keeping for the farmer. The statutory rules permitting
deductions for soil and water conservation, land clearing expenses, and
fertilizer costs were added between 1954 and 1962 to encourage con-
servation practices. The special restrictions on the expensing of fann-
ing outlays for citrus and almond growers were enacted in 1969.
The current use of cash basis accounting for farmers is justified
by its proponents as much simpler, and more workable and consistent
than the accrual method.

Selected Bibliography
U.S. Congress, House, Committee on Ways and Means, Panel
Discussion on General Tax Reform, Part 5-Farm Operations, Febru-
ary 8,1973, pp. 615-96.
U.S. Congress, House, Joint Committee on Internal Revenue
Taxation, Tax Shelters: IFarm Operations, Prepared for the U-e of the
Committee on Ways and Means, September 6, 1975, 25 pages.
U.S. Congress, House, Committee on Ways and Means, Tax Re-
form Hearings. Tax Reform, Part 2-Farm Operations, July 15, 1975,
pp. 1360-1402.











AGRICULTURE: CAPITAL GAIN TREATMENT
OF CERTAIN INCOME


Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total
1977------- 565 40 605
1976------- 490 30 520
1975------- 455 30 485

Authorization
Sections 1201-1202,1221-1223,1231,1245, and 1251-1252.

Description
If gains from the sale or exchange of property used in a trade or
business exceed losses from such property in any year, the gain is
treated as long term capital gain. Real estate or depreciable property
used in farming operations and held for more than six months, but not
held for sale, generally qualifies as such property. However, horses and
cattle qualify only if they have been held more than 24 months, and all
other livestock, more than 12 months.
In some cases, all or much of the cost of the farm property used in the
business has previously been deducted under the farm accounting rules
discussed on page 23. Consequently, in 1969, Congress enacted legisla-
tion to tax as ordinary income some gains previously taxed as capital
gain. These gains are principally those from the sale of (a) land held for
less than ten years, but only to the extent of previously deducted soil
and water conservation expense, and (b) farm property, to the extent
that prior farm losses exceeded $25,000 in any year in which the tax-
payer had nonfarm income in excess of $50,000.

Impact
Subject to these rules, taxpayers owning farm assets may obtain long
term capital gain treatment on qualifying assets even though much of
the asset cost has been deducted against ordinary income. While this
favorable tax treatment is limited to property used in the farming
business, many farm assets have a dual potential of being held for sale
or for use in the business. Assets having this ambiguous nature are
(25)






26


often sold before the ambiguity is resolved, and the gain is treated as
capital gain. Over 90 percent of the tax saving is claimed by non-
corporate farmers. The tax benefit per dollar of capital gain increases
with the taxpayer's marginal tax rate. The interaction between the
deduction of costs and capital gain treatment for the sale of such assets
has resulted in many tax shelter operations in farming.

Estimated Distribution of Individual Income Tax Expenditure by
Adjusted Gross Income Class1
Percentage
Adjusted gross income class (thou-ands of dollars): distribution
0 to 7------------------------------------------------------- 18. 3
7 to 15------------------------------------------------------- 35.6
15 to 50------------------------------------------------------ 33.7
50 and over--------------------------------------------------- 12. 5
1 The distribution refers to the individual tax expenditure only. The corporate tax expenditure resulting
from these tax provisions is not reflected in this distribution table.

Rationale
Preferential treatment for capital gains for individuals was intro-
duced in 1921. However, long term capital gain treatment for property
used in a trade or business was not enacted until 1942. Between 1942
and 1951, there was a dispute whether livestock qualified as such
property, and legislation in 1951 gave livestock that status. The 1942
legislation was enacted to provide tax relief for war-related gains.

Further Comment
Many proposals for changing the present law have been made from
time to time. They include proposals to limit or eliminate the expensing
of capital outlays, to impede tax shelter operations, to lengthen the
holding periods for farm assets, and to change the definition of quali-
fying property.
Selected Bibliography
Carlin, Thomas A. and W. Fred Woods. Tax Loss Farming,
ERS-546, Economic Research Service, U.S. Department of Agri-
culture, April 1974.
U.S. Congress, House, Committee on Ways and Means, General
Tax Reform. Panel Discussions. Part 5-Farm Operations, February
8, 1973, pp. 615-96.
U.S. Congress, House, Joint Committee on Internal Revenue
Taxation, Tax Shelters: Farm Operations. Prepared for the Use of
the Committee on Ways and Means, September 6, 1975, 24 pages.
U.S. Congress, Committee on Ways and Means, Tax Refornm.
Hearings. Part 2-Farm Operations, July 15, 1975, pp. 1360-1402.











EXPENSING OF INTANGIBLE DRILLING,
EXPLORATION AND DEVELOPMENT COSTS


Estimated Revenue Loss
[In millions of dollars]


Fiscal year Individuals Corporations Total

1977------- 195 840 1,035
1976------- 155 650 805
1975 ------- 120 500 620


Authorization
Sections 263(c) and 616-617.

Description
Taxpayers engaged in drilling for oil and gas may deduct in-
tangible drilling costs as incurred while taxpayers engaged in other
mining activities may deduct exploration and development costs
as incurred (i.e., these costs may be expensedd").
Intangible drilling costs are certain expenses incurred in bringing
a well into production, such as labor, materials, supplies and repairs.
Expenses for tangibles such as tanks and pipes are recovered through
depreciation.
\Mining exploration costs are those for the purpose of ascertaining
the existence, location, extent or quality of a deposit incurred before
the development stage, such as core drillings and testing of samples.
nunThese expenses are limited in the case of foreign exploration. For-
eign exploration costs cannot be expensed after the taxpayer has total
foreign and domestic exploration costs of $400,000. Development
expenses include those incurred during the development stage of
the mine such as constructing -haft-; and tunnels and in some cases
drilling and te-ting to obtain additional information for planning
operations. There are no limits on t1he current deductibility of such
costs. Although both intangible drilling costs and mine development
costs may be taken in addition to percentage depletion, mining
exploration costs sub-equently reduce percentage depletion deductions.
In the ca;e of mines, there are al-o "recapture" provi-ions under
which capital gains from the sale of the property 8're taken as ordinary
income to the extent of prior deductions for exploration expenses.
(27)


67-9312-76---3






28


Impact
Generally, expenditures which improve assets that yield income
over several years must be capitalized and deducted over the period
in which the assets produce income. The tax advantage of treating
the-e expenditures as current expenses is the same as any other
allowing premature deductions; the taxpayer is allowed to defer cur-
rent tax liabilities; this treatment amounts to an interest-free loan
(see Appendix A).
These expensing provisions are additional benefits which supple-
ment the special percentage depletion allowances extended to the
mineral industry.1 Although the expensing and depletion provisions
operate somewhat independently, a firm or person may be eligible
for both and receive their combined benefits.

Estimated Distribution of Individual Income Tax Expenditure by
Adjusted Gross Income Class
Percentage
Adjusted gross income class (thousands of dollars): distributiun
0 to 7-------------------------------------------------------- 2.5
7 to 15 -----------------------------------------------------15.0
15 to 50------------------------------------------------------ 33. 8
50 and over----------------------------------------------- 48. 8
1 The distribution refers to the individual tax expenditure only. The corporate tax expenditure resulting
from these tax provisions is not reflected in this distribution table.

Rationale
The option to expense intangible drilling costs (as well as dry hole
costs) of oil and gas wells developed through regulations issued in
1917 (19 Treas. Dec., Int. Rev. 31 (1917)). These regulations reflected
the view that such costs were ordinary operating expenses. In 1942,
the Treasury Department recommended that the provisions be re-
moved, but Congress did not consider the suggestion. (Hearings on
Revenue Revision of 1942 before the Committee on Ways and Means,
p. 2996, Vol. 3, 77th Cong., 2nd Sess.) In 1945, when a court decision
invalidated the regulations (F.H.E. Oil Co. v. Commissioner, 147 F.2d
1002, 5th Cir. 1945), Congress adopted a resolution (H. Con. Res. 50,
79th Cong., 1st Sess.) approving the treatment and later incorporated
it into law in the 1954 Code. The legislative history of this resolution
indicates that it was intended to reduce uncertainty in mineral ex-
ploration and stimulate drilling for military and civilian purposes.
(H. Rep. No. 761, 79th Cong., st ess., pp. 1-2.) Expcnsing of
mine development expen ituri, was enacted in 1951 to reduce am-
biguity in current treatment and encoui'rage mining. The provision
for mine explonition was added in 1966.
Prior to the Tax Reform Act of 1969, a taxpayer could elect either
to deduct without dollar limitation exploration expenditures in the
United States, which subsequently reduced percentage depletion bene-
fits, or to deduct up to $100,000 a year with a total not to exceed
$400,000 of foreign11 and domestic explonation expenditures without the
al))plication of the recal)ture rule. The 1969 Act subjected all po-t-1969
exl)loration exl)peiditures to r(Cnlpturiie.
1 P're, id a'p depletion hIrs been eliminated for larger producers of oil and f:;s and isi ip:g reduced for other
producers; see Ip 1 -. 31-32, below.





29

Selected Bibliography
Agria, Susan, "Special Tax Treatment of Mineral Industric-," in
The Taxation of Income from Capital, The Brookings Institution,
Washington, D.C., 1969, pp. 77-122.
U.S. Congress, Senate, Committee on Interior and Insular Affairs,
An Analysis of the Federal Tax Treatment of Oil and Gas and Some
Policy Alternatives, 1974, 58 pages.














EXCESS OF PERCENTAGE OVER COST
DEPLETION


Estimated Revenue Loss
[In millions of dollars]


Fiscal year Individuals Corporations Total

1977------- 575 1,020 1,595
1976------- 500 1,080 1,580
1975------- 465 2,010 2,475


Authorization
Section 613.
Description
Most firms engaged in oil, gas, and other mineral extraction are
permitted to include in their business costs a "depletion" allowance for
the exhaustion of the mineral deposits. Depletion is similar in concept
to depreciation. The depletion allowance is used to recover the cost of a
mineral deposit. There are two methods of calculating depletion:
percentage depletion and cost depletion. Taxpayers who qiuailify for
percentage depletion must use it if it is greater than cost depletion.
Under percentage depletion, a taxpayer deducts a fixed percentage
of gross income from mining as a depletion allowance regardless of the
amount invested in the deposit. The deduction for gas and oil (which
was 27.5 percent from 1926-69) is now set at 22 percent. However,
beginning in 1975 the percentage depletion allowance was repealed
for major oil and gas companies. Other companies (independents)
have been exempted from repeal of 2,000 barrels a day for 1975. The
amount of this exempt portion is being phased down gradually to
1,000 barrels a day. In addition, beginning in 1981, the depletion rate
will be gradually phased down to 15 percent for qualifying producers.
Percentage depletion also applies to other mineral resources at
percentages currently ranging from 22 percent to 5 percent. Sulphur,
uranium, and most other metals mined in the United States qualify
for the 22 percent rate; however, domestic gold, silver, and iron ore
qualify for a 15 percent rate; most minerals mined outside the U.S.
qualify for a 14 percent rate; coal qualifies for a 10 percent rate; and
several forms of clay, gravel, and stone qualify for 5 and 72 percent
rates.
Percentage depletion may not exceed 50 percent of the net income
from the property. This limitation is known as the "net income
limitation." The total cost which can be recovered by percentage
depletion is not limited to the cost of the property.
(31)






32


Cost depletion re-emble- depreciation based upon the number of
units produced. The share of the original cost deduction each year is
equal to the portion of the estimated total production (over the life-
time of the well or mine) which is produced in that year. Using cost
depletion, capital recovery cannot exceed the initial cost.
The value of the percentage depletion provision to the taxpayer is
the amount of tax savings on the excess of the percentage depletion
over cost depletion.
Impact
Issues of principal concern are the extent to which percentage
depletion: (1) decreases the price of qualifying oil, gas and other
minerals, and therefore encourages their consumption; (2) bids up
the price of drilling and mining rights; and (3) encourages the develop-
ment of new deposits and increases production.
Most analyses of percentage depletion have focused on the oil and
gas industry, which prior to 1975 accounted for the bulk of percentage
depletion. Since 1975 legislation repealed the percentage depletion
allowance for most oil and gas production, only one-quarter of
oil and gas production is estimated to be currently eligible for per-
centage depletion. Sales of all other mineral deposits were unaffected
by the 1975 legislation.
Because of the prior focus on oil and gas percentage depletion,
there has been relatively little analysis of the impact of percentage
depletion on other industries. The relative value of the percentage
depletion allowance in reducing the effective tax rate of mineral
producers is dependent on a number of factors, including the statutory
percentage depletion rate, the effect of the net income limitation, and
the basic cost structure of the industry. For example, the greater
the mining cost as a percentage of the selling price of the final mineral
product, the greater the value of percentage depletion to the industry.
This effect may account in part for the greater value of percentage
depletion to the copper industry, as reported in SEC data as compared
to the aluminum industry-since the mining of bauxite constitutes a
much smaller portion of the cost of producing aluminum than the
mining of copper does to the cost of finished copper.
In the past, the net income limitation kept the effective percentage
depletion rate for coal at around 6 percent although the statutory
rate is 10 percent. Because the rising price of imported oil has in-
creaed the average price of all oil, coal has been substituted for oil,
resulting in dramatic increases in the price of coal. The price in-
creases will make the net income limitation inapplicable to much
coal production, so the effective depletion rate is likely to rise to nearly
the statutory rate.

Estimated Distribution of Individual Income Tax Expenditure by
Adjusted Gross Income Class'
Percentage
Adjusted grn,- income cl:~s (thom-ands of dollars): distribution
0 to 7-------------------------------------------------------- 3.3
7 to 15------------------------------------------------------- 9.8
15 to 50----------------------------------------------------- 31.8
50 and ovcr --------------------------------------------------- 55. 1
I ThIo distribution refers to the individual tax expenditure only. T Ihe corporate tax expenditure resulting
from liese tax provisions is not reflected in this distribution table.






33


Rationale
Deductions in excess of depletion based on cost were first allowed
in 1918 in the form of "discovery value depletion" which allowed
depletion on the market value of the deposit after discovery rather
than on its cost. The purpose was to stimulate exploration during
wartime and to relieve the tax burdens on small scale prospectors.
Treasury believed that taxpayers often established high discovery
values and thus claimed excessive depletion. In 1926, to avoid the
administrative problems raised by the need to establish market value,
Congress substituted percentage depletion for oil and gas properties.
Beginning in 1932 percentage depletion was extended to most other
minerals.
In 1950, President Truman recommended the reduction of percent-
age depletion to a maximum of 15 percent, but Congress failed to take
action on this recommendation. Only minor changes were made until
1969 when the depletion allowance for oil and gas was reduced from
27.5 percent to 22 percent, and "excess" depletion was made subject
to the minimum tax beginning in 1970.

Selected Bibliography
Agria, Susan, "Special Tax Treatment of Mineral Industries," in
The Taxation of Income from Capital, The Brookings Institution,
Washington, D.C., 1969, pp. 77-122.
U.S. Congress, Senate Committee on Interior and Insular Affairs,
An Analysis of the Federal Tax Treatment of Oil and Gas and Some
Policy Alternatires, 1974, 58 pages.













CAPITAL GAIN TREATMENT OF ROYALTIES
ON COAL AND IRON ORE


Estimated Revenue Loss
[In millions of dollars]
Fiscal year Inidividuals Corporations Total

1977------- 50 20 70
1976------- 45 15 60
1975------ 40 10 50

Authorization
Section 631(c).
Description
Lessors of coal and iron ore deposits (which have been held more
than 6 months prior to disposition or lease) in which they retain an
economic intereAt may treat royalties as capital gains rather than as
ordinary income. Percentage depletion is not available in such cases.
This provision cannot be used by taxpayers obtaining iron ore
royalties from related individuals or corporations. No similar limita-
tion applies to coal royalties.
Impact
The extent to which this provision results in tax saving depends on
how the benefits compare with those from percentage depletion. In
past years, percentage depletion on coal often has been large enough
relative to profits to subject many firms to the "net income limitation"
which limits percentage depletion to 50 percent of net income. This
apparently has not been the case for iron ore where Mthe percentage
depletion deduction is less likely to be subject to the net income
limitation.
For corporations, a percentage depletion deduction equal to 50
percent of net income reduces the effective tax rate to 24 percent (one-
half of 48 percent) whereas the capital gains treatment results in a
30 percent tax rate. However, if the mine has a high basis for calcu-
lating cost depletion (which can be claimed ratably as an offset to
capital gains), the election of this provision may result in a lower
tax. Similarly, if the percentage depletion deduction is less than the
net income limitation, capital gains treatment may be preferred.
For individuals, the tax reduction from the capital gains deduction
is equivalent to that for percentage depletion when the net income
limitation is applicable-taxable income is reduced by 50 percent. If
the net income limitation for percentage depletion does not apply, or


(35)






36


if the individual elects the alternative capital gain rate, capital gains
treatment will be more favorable.
Note that in view of recently rising coal prices, the percentage
depletion allowance will be lee; likely to reach the net income limita-
tion and thus les-., likely to reduce tax rates by one-half. The value of
newly purchased coal deposits also will be likely to rise-thus in-
reaming tihe value of cost depletion. As a consequence, capital gains
treatment which reduces tax rates by one-half for individuals may
become relatively more valuable than percentage depletion for a
larger number of individuals.1

Rationale
Capital gains treatment for coal royalties was adopted in the Reve
nue Act of 1951. The legislative history sugg-sts it was adopted to
(1) extend the same treatment to coal lessors as that allowed to timbe
lessors (see p. 37), (2) provide benefits to long-term lessors with low
royalty rates who were unlikely to benefit significantly from the
percentage depletion deduction, and (3) to encourage the leasing and
production of coal.
Capital gains treatment of iron ore royalties was added in the
Revenue Act of 1964 to make the treatment of iron ore generally
consistent with coal, and to encourage leasing and production of
iron ore deposits in response to foreign competition.

Selected Bibliography
Agria, Susan. "Special Tax Treatment of Mineral Industries",
in The Taxation of Incomne, from Capital, Arnold C. Harberger and
Martin J. Bailey, eds. Washington, D.C., The Brookings Institution,
1969, pp. 77-122.
U.S. Congress. House Committee on Ways and Means. General
Tax Reform. Public Hearings. Testimony of E. V. Leisenring, National
Coal Association, Part 5, March 19-20, 1973, pp. 2223-30.
1 No estimated distribution of the individual tax expenditure by adjusted gross income class is provided
because in 1975 when the distributions were prepared by the Treasury Department, there was so rela-
tively little known usage of this provision by individuals that no distribution was prepared.










TIMBER: CAPITAL GAINS TREATMENT OF
CERTAIN INCOME

Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total

1977 ------ 65 165 230
1976------- 60 155 215
1975------ 60 145 205

Authorization
Sections 631 (a) and (b), 1221 and 1231.
Description
If a taxpayer has held standing timber or the right to cut it for more
than 6 months by the first day of the taxable year, the taxpayer may
elect to treat the cutting of this timber as the sale of a long-term
capital asset at a price equal to its fair market value on the first day
of the taxable year. Therefore, if an election is made, gain realized up
to the first of the year on the cut timber is capital gain. Changes in the
value of the timber after the first of the year as it is processed or manu-
factured will result in ordinary income or loss, and not capital gain or
loss. Capital gain treatment also can apply to the sale of a stand of
timber and the sale of timber as it is cut by the buyer. Timber includes
ornamental evergreens which are 6 years of age when severed from the
roots.
Some of a timber owner's costs which maintain or even arguably
improve his trees, such as disease control and thinning costs, can be
expensed currently (see Appendix A), even though their effects may
continue beyond the year in which they are made, and though they
are related to income which only will be recognized many years in the
future. Therefore, timber ownership offers opportunities for some tax-
payers to deduct current expenses associated with such ownership
against ordinary income from other sources.

Impact
The capital gains treatment of the cutting and sale of timber
constitutes a departure from the general rule that sale of a taxpayer's
inventory yields ordinary income. However, when timber is inventory,
it is usually held substantially longer than other types of inventory.
Both individual and corporate taxpayers are eligible for this treat-
ment. The graduated structure of the individual income tax rates


(37)






38


makes the provision more beneficial to individuals with high incomes
because the value of the deduction for capital gains increases with the
marginal income tax rate.
Two industries--paper and allied products and lumber and wood
products-claim disproprotionately large amounts of corporate capital
i iin-. According to 1972 Preliminary Statistics of Income for Corpora-
tions, 24 percent of taxable income of paper and allied products in-
(lustries and 42 percent of taxable income of lumber and wood prod-
iucts were long-term capital gains. This proportion may be contrasted
with a proportion of 4.4 percent for all other corporations. These two
industries reported 16.9 percent of all corporate capital gains while
accounting for only 2.7 percent of taxable income. Treasury Depart-
mnent studies published in 1969 indicate that in these industries there
were five corporations which account for about one-half of the capital
gains. claimed, 16 firms account for about two-thirds, and 80 percent
of the gains are accounted for by approximately 60 corporations.

Estimated Distribution of Individual Income Tax Expenditure by
Adjusted Gross Income Class1
Percena qe
Adjusted gross income class (thousands of dollars): distribution
Oto7-------------------------------------------------------- 7.3
7 to 15------------------------------------------------------ 12.7
15 to 50------------------------------------------------------ 23.6
50 and over--------------------------------------------------- 56.4
1 The distribution refers to the individual tax expenditure only. The corporate tax expenditure resulting
from these tax provisions is not reflected in this distribution table.
Rationale
The sale of a timber stand that had not been held in the course of
business was long considered the sale of a capital asset. The Revenue
Act of 1943 extended this capital gain treatment to all persons who
cut and sell their timber and to those who lease timber stands for
cutting. One reason for adopting this provision was to equalize treat-
mnent between the taxpayer who sold timber as a stand outright, and
the taxpayer who cut timber for use in his business. It was also sug-
gested that this treatment would encourage con ervation of timber
through selective cutting and that taxing the capital gain at ordinary
rates was an unfair practice because of the comparatively long de-
velopinent time of timber.

Selected Bibliography
Briggos, Charles W. and Condrell, William K., Tax Treatmnent of
Tiriber, 5th ed., Forest Industries Committee on Timber Valuation
d" Ta xation, Washington, D.C. 1969.
Sunley, Emil M., Jr., The Federal Tax Subsidy of the Timber
!mindistry, U.S. Congress, Joint Economic Committee, The Economics
of 1P',bral Sibsidy Programs, Part 3-Tax Subsidies, July 15, 1972,
pp. 317-42.
U.S. Congress Joint Publication of the Committee on Ways and
(Ieans and the Committee on Finance. Tax Reform Studies and
Proposals. U.S. Treasury Department. Part 3, February 3, 1969,
pp. 434-:8.










POLLUTION CONTROL: 5-YEAR AMORTIZATION


Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total

1977----- ----- 15 15
1976------- ------ 20 20
1975------- ------ 30 30

Authorization
Section 169.

Description
In lieu of depreciation, pollution control facilities that have been
certified by both State and Federal agencies may be amortized over
a 5-year period using the straight line method (i.e., 20 percent of the
cost may be deducted each year). This rapid amortization is currently
available only with respect to treatment facilities placed in service
before 1976. Certification requires that the new facility be: (1) in-
stalled in connection with a polluting facility; (2) designed specifically
for pollution abatement and not for any other purposes; (3) in com-
pliance with both the Federal Water Pollution Control Act and the
Clean Air Act; and (4) a new structure. The provision applies only
to tangible abatement facilities installed in connection with polluting
facilities in operation before 1969.
Taxpayers may not claim an investment tax credit for property
amortized under this provision.

Impact
The amortization provision has been used much less than it would
otherwise have been because the investment tax credit cannot be
used with amortized property. With the recent temporary increase
of the investment tax credit to 10 percent (for 1975 and 1976) and the
shortening of depreciation lives in 1971, the combined benefit of the
credit and accelerated depreciation is usually greater than the bene-
fit of rapid amortization. However, to the extent it is used, 5-year
amortization for assets with longer useful lives benefits the taxpayer
by effectively deferring current tax liability (see Appendix A).
Rather than functioning as an incentive, the 5-year amortization
of pollution control facilities subsidizes corporations that must
comply with Federal or State law regarding pollution. State pollution
(39)





40


regulations vary, and there are regional cost differences for a given
facility; both may account for geographical differences in the usage
of the subsidy.
Rationale
Section 169 was introduced for a 5-year period to ease the financial
burden of complying with environmental regulations when the Tax
Reform Act of 1969 repealed the investment tax credit. When the
inve'tnient tax credit was reinstated in 1971, rapid amortization
was retained as an option.
Further Comment
Congress, in 1974, extended the availability of the amortization
election for an additional year until December 31, 1975. Although
the extension recently has expired, it still will have a revenue impact
for all years in which property is amortized under its provisions. The
provision may be reinstated retroactively.

Selected Bibliography
Moore, Michael L. and G. Fred Streuling, "Pollution Control
Devices: Rapid Amortization Versus the Investment Tax Credit,"
Taxes, January 1974, pp. 25-30.
McDaniel, Paul R. and Alan S. Kaplinsky, "The Use of the Federal
Income Tax to Combat Air and Water Pollution," Boston College
Industrial and Commercial Law Review, February 1971, pp. 351-86.











CORPORATE SURTAX EXEMPTION


Estimated Revenue Loss
[In millions of dollars]

Fiscal year Individuals Corporations Total

1977------- ------ 6,185 6,185
1976------- ------ 5, 015 5,015
1975------- ------ 3,345 3,345


Authorization
Section 11.
Description
The permanent corporate income tax consists of a normal tax rate
of 22 percent and a surtax of 26 percent for a total tax rate of 48 per-
cent. The first $25,000 of profits are exempted from the surtax.
Temporary provisions in the Tax Reduction Act of 1975 and the
Revenue Adjustment Act of 1975 reduce the normal tax rate to 20
percent on the first $25,000 of profits and 22 percent on the next
$25,000 of profits, thus raising the exemption from the surtax to $50,000.
These changes are presently in effect only through June 30, 1976.

Impact
The surtax exemption is available to all corporations. It tends to
neutralize the tax differential between a busine-s operating as a sole
proprietorship or a partnership and a corporation by lowering the
corporate tax rate on the first .25,000 ($50,000 in 1975 and part of
1976) to rates comparable to the individual rates. The exemption
encourages the use of the corporate structure and allows some small
corporate bu-ine-:ses that might otherwise operate as sole proprietorships
or partnerships to provide fringe benefits. It also encourages the
splitting of operations between sole proprietorships, partnerships and
corporations. Most businesses are not incorporated; only about 5
percent of all bu-i-e-ses are affected by this provision, and not all
of those receive the full tax benefit because their taxable income is
less than $25,000 ($50,000 in 1975 and part of 1976).

Rationale
Since almost the earliest days of the corporate income tax, some
level of profits has been exempted from the full corporate tax rate.
The split between a normal tax and a surtax was not, however, fully
accomplished until the Revenue Act of 1941. The surtax exemption
(41)





42


in its present form was adopted as part of the 1950 Revenue Act.
The purpose was to provide relief for small buine-,e-. However, many
large business es fragmented their operations into numerous corpora-
tions to obtain numerous exemptions from the surtax. Some remedial
steps were taken in 1963; in 1969, legislation was enacted limiting
groups of corporations controlled by the same interest to a single surtax
exemption.
Selected Bibliography

Capital Formation. Prepared for the use of the Committee on Ways
and Means by the Staff of the Joint Committee on Internal Revenue
Taxation, October 2, 1975.
Pechman, Joseph. Federal Tax Policy. Rev. ed. Washington, D.C.:
The Brookings Institution, 1971, pp. 131-33.










DEFERRAL OF TAX ON SHIPPING COMPANIES


Estimated Revenue Loss
[In :i ioili- of d(:I a .1a -


Fiscal year Individuals Corporations Total

1977------ -------- 130 130
1976------ -------- 105 105
1975------ --------- 70 70


Authorization
46 U.S.C. Section 1177 ( 607 of the Merchant Marine Act of 1936
as amended).
Description
United States operators of vessels operating in foreign, Great Lakes,
or noncontiguous dome-:tic trade or in the U.S. fisheries may establish
a capital construction fund (CCF) in which they may deposit income
earned by the ve--els. Such depos-its are deductible from taxable
income, and income tax on earnings of depo-its in the CCF is deferred.
When iich tax-deferred depo-its and their earnings are withdrawn
from a CCF, no tax is paid if the withdrawal is used for qualifying pur-
po;es, such as to con-truct or acquire a new vessel or to pay off the
indebtedness on a qualifying vessel. The tax basis of the ve-^el (usually
its co-st to the taxpayer) on which the operator's depreciation is com-
puted is reduced by the amount of such withdrawal. Thus, over the life
of the vezsel, tax depreciation will be reduced and taxable income will
be increased by the amount of such withdrawal, thereby reversing the
effect of the deposit. However, since gain on the sale of the vessel and
income from the operation of the replacement vessel may also be de-
posited into the CCF, the tax deferral may be extended indefinitely.
Only withdrawals for purpose; other than for construction, acquisi-
tion, or payment on indebtedness of a qualifying vessel are taxed at
the time of withdrawal, subject to an interest charge for the period dur-
ing which tax was deferred.
Impact
Since 1970, over $550 million has been deposited into CCFs by 96
carriers, and almost $250 million hias been withdrawn.

Rationale
The provision is designed to stimulate American shipbuilding and to
recapture some of the foreign yard construction now being done for
U.S. companies.


(43)


67-312-76--4






44


Further Comment
An important unresolved issue is whether the investment tax
credit should be extended to ves-sels constructed with funds withdrawn
from CCFs. Currently, it does not. However, a provision of the
Maritime Appropriation Authorization Act of 1975, as adopted by
the Senate but dropped in Conference, would have allowed the credit
on such vessels.

Selected Bibliography
Jantscher, Gerald R. Bread Upon the Waters.-Federal Aid to the
Maritime Industries, The Brookings Institution-Washington, D.C.,
1975, 164 pages.











RAILROAD ROLLING STOCK: 5-YEAR
AMORTIZATION


Estimated Revenue Loss
[In millions of dollars]


Fiscal year Individuals Corporations Total

1977------- ------ 10 10
1976------- ------ 30 30
1975------- ------ 55 55


Authorization
Section 184.
Description
Instead of being depreciated on an accelerated basis over its normal
useful life, qualified railroad rolling stock placed in service after 1968
and before 1976 may be amortized over a 5-year period using the
straight line method. The use of five-year amortization for assets
whose useful lives are longer benefits the taxpayer by effectively
deferring current tax liability (see Appendix A). The investment tax
credit is not available for property subject to this rapid amortization.

Impact
Since this tax incentive was adopted to increase the supply of rail-
road rolling stock, there has been a decline in both total dollar amount
of railroad rolling stock purchases and use of the 5-year amortization
provision. The decreasing use can be explained largely by the rein-
statement of the investment tax credit in 1971, which is generally
more advantageous than rapid amortization.
There are 67 Class I railroads in the United States. Since 1972, 27
of them have used the amortization provision.
Only railroad companies with taxable income benefit directly from
the rapid amortization provision. Railroad companies without taxable
income, in effect, sell their right to this rapid amortization to financial
companies who initially acquire the rolling stock and then lease it to
the railroads. As a result, some of the tax benefits from this provision
accrue to lessors that are not railroad companies.

Rationale
Section 184 was adopted as part of the Tax Reform Act of 1969 when
the investment tax credit was repealed. The purpose was to encourage
the modernization of railroad equipment, increase railroad efficiency,
(45)





46

reduce freight car shortages during seasonal peaks, and aid the
financing of new equipment acquisitions. Although it expired Decem-
ber 31, 1975, a retroactive reinstatement may occur in 1976.
Selected Bibliography
Benevenutto II, Frank A., "Lease Rolling Stock and Enjoy Con-
siderable Benefits", Taxes, September 1973, pp. 530-36.










BAD DEBT DEDUCTIONS OF FINANCIAL
INSTITUTIONS IN EXCESS OF ACTUAL LOSSES


Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individual. Corporations Total

1977------- ------ 570 570
1976------ ------ 815 815
1975------ ------ 880 880

Authorization
Sections 585, 593, and 596; Revenue Rulings 65-92 (C.B. 1965-1,
112), 68-630 (C.B. 1968-2, 84).

Description
In general, businesses are permitted to deduct as a current operating
expense a reasonable allowance for bad debts. The allowance usually
is based on the experience of prior years. However, the special formulae
used by financial institutions to compute bad debt reserves permits
deductions in excess of actual experience.
Prior to 1969, commercial banks were permitted a bad debt deduc-
tion of 2.4 percent of outstanding loans. The 1969 Tax Reform Act
reduced this figure to 1.8 percent for years through 1975, 1.2 percent
from 1976-81, and .6 percent from 1982 through 1987. After 1987,
commercial banks will be limited in their loss reserve deductions to
actual recent loss experience.
As an alternative to this treatment available for commercial banks,
mutual savings banks and savings and loan associations have an
option, under certain circumstances, to deduct a specified percentage
of their taxable income. Under the provisions of the Tax Reform Act
of 1969, this percentage-of-net-income allowance is being reduced
from 60 to 40 percent by 1979. (The allowance for 1976 is 43 percent
of taxable income.) Thereafter, the percentage allowance will remain
at 40 percent. The total bad debt re-erve of thrift institutions may
may not exceed 6 percent of qualifying real property loans, or
the percentage-of-net-income bed debt deduction will be disallowed.
In addition, the annual bad debt deduction under this latter method
will be reduced if the thrift institution's inves-tments do not comprise
specified proportions of certain "qualified" assets, which for "thrifts"
are essentially re.identiai mortgages.
(47)






48


Impact
Bad debt reserve deductions in excess of actual experience lower the
effective tax rates of financial institutions, particularly thrift in-
stitutions, below the normal corporate tax rate of 48 percent. Apart
from any other means of reducing tax liability, the 60 percent bad
debt allowance resulted in a maximum effective tax rate for a thrift
institution prior to the 1969 Tax Reform Act of 19.2 percent.1 With
full phase-in of the bad debt provisions of the 1969 Tax Act, the maxi-
mum effective tax rate of a thrift institution qualifying for the full
bad debt allowance will be 28.8 perec'rnt.2 Therefore, to the extent the
bad debt deduction induced thrift institutions to hold qualified
assets, such as residential mortgages, before 1969, the provisions of
the 1969 Tax Act have reduced the incentive effect of this tax
expenditure.
Rationale
The tax treatment of commercial banks evolved separately from
that of thrift institutions. The allowance for special bad debt reserves
of commercial banks was first provided by IRS ruling in 1947, when
there was fear of a postwar economic downturn. It was intended to
reflect the banking industry's experience during the depression
period.
The special treatment of bad debt reserves for thrift institutions
was added by statute in 1951. Prior to that time, savings and loan
associations and mutual savings banks were exempt from taxation,
in most instances because they were viewed as mutual organizations
rather than corporations. Upon removal of this tax exempt status,
special, and very favorable, treatment of bad debt reserves was
provided for savings and loan institutions and mutual savings banks,
which in effect left them virtually tax-exempt for a number of years
thereafter. Some of the same factors which led to their tax exemption
probably account for the special allowance for bad debts, especially
in that these institutions are thought to fill an important role in
providing home mortgage funds.

Selected Bibliography
U.S. Congre-. Joint Publications of the Committee on Ways and
Means and the Committee on Finance, Tax Reform Studies and Pro-
posals, U.S. Treary Department, Part 3; Chapter IX-D, Tax
Treatment of Financial Institutions, pp. 458-75.
U.S. Treasury Department, Report on the Financial Institutions
Act of 1973, A Section-by-Section Analysis, Department of the
Treasury News, October 11, 1973.
1 .4. .6(.48)=.192.
2 .4,-.4(.48) =.288 (without kitki t he minimum tax into account).











DEDUCTIBILITY OF NONBUSINESS STATE
GASOLINE TAXES


Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total

1977------- 600 ------ 600
1976------- 575 ---- 575
1975------ 820 ---- 820


Authorization
Section 164(a) (5).

Description
State and local sales taxes on gasoline, diesel fuel, and other major
fuels are deductible even if the taxes are not trade or business expenses
or expenses for the production of income. Federal fuel taxes are not
so treated.
Impact
This deduction benefits only taxpayers who own motor vehicles
and itemize deductions rather than take the standard deduction.
These tend to be middle and higher income taxpayers. Gasoline
prices are reduced for taxpayers who claim the deduction, and the
amount of this tax benefit per dollar of deduction increases with the
tax bracket of the taxpayer.
State and local gasoline taxes are "user taxes" in the sense that the
revenues they generate are generally earmarked for road maintenance
and other State and local services provided highway users. The de-
duction allowed for these taxes is contrary to the general nondeduct-
ible treatment of user taxes. Therefore, one effect of this deduction
is to shift some of the burden of these user taxes to all Federal tax-
payers, regardless of the extent to which they use these local road
facilities.

Estimated Distribution of Individual Income Tax Expenditure by
Adjusted Gross Income Class
Percentage
Adjusted gross income class (thousands of dollars): distribution
0 to 7 -------------------------------------------------------3.2
7 to 15------------------------------------------------------ 32. 3
15 to 50------------------------------------------------------ 60.3
50 and over--------------------------------------------------- 4.2
(49)





50


Rationale
Before 1964, a deduction for both business and nonbu4ness State
and local taxes was allowe(I in computing taxable income. The Rev-
enue Act of 1964 eliminated the deduction for many taxes. The bill
first passed by the Ways and Means Committee also eliminated the
deduction for gasoline taxes, but the Senate Finance Committee
restored it. It was retained by the Conference. The stated rationale
for retention of the deduction was to prevent large shifts in the tax
burden of individuals, to assist the States with fiscal coordination
in a Federal system, and to allow the States free choice in their selec-
tion of a tax structure.

Selected Bibliography
Goode, Richard. The Individual Income Tax, Rev. ed. The Brook-
ings Institution, Washington, D.C., 1976, pp. 168-71.
Davie, Bruce F. and Bruce F. Duncombe, "The Income Distri-
bution Aspects of Energy Policies", Studies in Energy Tax Policy,
Cambridge, Massachusetts, Ballinger Publishing Company, 1975,
pp. 343-72.
Simplification of the Tax Return and Other Mliscellaneous Sinm-
plfication Items, Prepared for the use of the Committee on Ways and
Means by the Joint Committee on Internal Revenue Taxation,
October 2, 1975.








DEPRECIATION ON RENTAL HOUSING IN EX-
CESS OF STRAIGHT LINE, AND DEPRECIATION
ON BUILDINGS (Other Than Rental Housing) IN
EXCESS OF STRAIGHT LINE


Estimated Revenue Loss
[In millions of ,',..1uh! u,]
Dopre'iation on Depreciation on
rental housing buildings
Indi- Cor- Indi- Cor-
Fiscal year vid- pora- Total vid- pora- Total
uals tions uals tions

1977----- 455 125 580 215 280 495
1976----- 430 120 550 215 275 490
1975----- 405 115 520 220 220 440

Authorization
Section 167(b) and (j).
Description
Businesses are allowed to recover the cost'of their durable assets
that wear out or become obsolete by deducting from gross income an
allocable portion of the cost of the assets. Normally these depreciation
deductions are spread over the useful life of the asset, and the total
amount equals the asset's cost less salvage value. Taxpayers are
generally offered the choice of using the straight line method (in which
an equal amount of depreciation is deducted each year of the asset's
life) or accelerated methods of depreciation (in which greater amounts
are deducted in the early years). A taxpayer can switch from the de-
clining balance or the sum of the years-digits methods of accelerated
depreciation to straight line depreciation when it becomes advantage-
ous to do so as the asset grows older.
The use of accelerated depreciation on structures is limited as
follows:
RESIDENTIAL RENTAL UNITS
(1) New construction may be depreciated under any method
allowed by the Internal Revenue Code.
(2) Used buildings having at least a 20-year life when acquired
may be depreciated under the declining balance method using a
rate not in excess of 125 percent of the straight line rate.

OTHER STRUCTURES
(1) New construction may be depreciated by any accelerated
method which does not yield depreciation greater than the
decliningtbalance method using a rate not exceeding 150 percent of
the straight line rate.
(51)





52


(2) Used buildings may be depreciated on the straight line
method or any other reasonable method that is neither a declining
balance or sum of the years digits method.

Example
Assume a used residential structure with a basis of $10,000, an
expected remaining life of 25 years, and no salvage value. If the
straight line method were used, the deduction would be $400 each
year. Under accelerated depreciation, the first-year depreciation allow-
ance can be computed as follows:

Depreciation allowance=125%Xl1/25X$10,000=$500
In the second year, the depreciation allowance is computed in the
same way except the original basis of $10,000 is now reduced by
the amount previously depreciated. Hence, the new basis equals
$9,500. The second year computation is:
Depreciation allowance= 125%X 1/25X $9,500 =$475
Thus, in each succeeding year, there is a decrease in the amount of
depreciation claimed for tax purposes, and therefore an increase in
tax liability compared to what it would be otherwise.
Impact
Because accelerated depreciation allows for larger deductions in
the early years of the asset's life and smaller depreciation deductions
in the later years, accelerated depreciation results in a deferral of
tax liability. It is a tax expenditure to the extent it is faster than
economic (i.e. actual) depreciation. It is widely believed to be con-
sistent with actual experience to allow accelerated depreciation for
some machinery and equipment which, in many cases, decline in value
more rapidly in their early years than later years. However, similar
treatment for buildings is generally believed inconsistent with their
rates of economic decline in value which are generally much slower
than those of machinery and equipment.
The direct benefits of accelerated depreciation for structures
accrue to owners of business buildings and rental housing. The benefit
is estimated as the tax saving resulting from the depreciation deduc-
tions in excess of straight line depreciation. About 77 percent of the
tax saving from rental housing and 44 percent of the tax saving from
nonre-idential buildings accrue to individual owners. The remaining
portion of each class of benefit goes to corporate owners.
Efforts to repeal accelerated depreciation for real estate have been
opposed on the ground that without this treatment, real estate invest-
ments would be so unattractive relative to other forms of investment
that drastic cut backs in building programs would result. On the
other hand, it is argued that the tax benefits increase the production
of new buildings only to the extent that demand for new buildings
re-ponds to small price changes, and that this response is relatively
small. The impact of accelerated depreciation on rental housing is
generally estimated to be greater than for nonresidential buildings
since the demand for housing is more price elastic.






53

Estimated Distribution of Individual Income Tax Expenditure by
Adjusted Gross Income Class1
DEPRECIATION ON RENTAL HOUSING
Percentage
Adjusted gross income class (thousands of dollars): distribution
0 to 7-------------------------------------------------------- 4.8
7to 15------------------------------------------------------- 16.8
15 to 50----------------------------------------------------- 44. 3
50 and over--------------------------------------------------- 34. 1

DEPRECIATION ON BUILDINGS
Percentage
Adjusted gross income class (thousands of dollars): distribution
0 to 7-------------------------------------------------------- 5.0
7 to 15------------------------------------------------------- 17.3
15 to 50 -----------------------------------------------------44.1
50 and over-------------------------------------------------- 33. 6
i The distribution refers to the individual tax expenditures only. The corporate tax expenditures result-
ing from these tax provisions is not reflected in this distribution table.

Rationale
Prior to 1954, depreciation policy had developed through adminis-
trative practices and rulings. The straight line method was favored
by IRS and generally used. A ruling issued in 1946 authorized the use
of the 150 percent declining balance method. Authorization for it and
other accelerated depreciation methods first appeared in the statute in
1954 when the double declining balance and other methods were
authorized. The discussion at that time focused primarily on whether
the value of machinery and equipment declined faster in their earlier
years. However, when the accelerated methods were adopted, real
property was included as well even though it did not decline more
rapidly in value in its first years. By the 1960s, most commentators
agreed that accelerated depreciation resulted in excessive allowances
for buildings. In 1964, a provision was enacted which "recaptured"
accelerated depreciation as ordinary income in varying amounts
when a building was sold, depending on the length of time the property
was held. However, recapture was not required for straight line de-
preciation upon the transfer of real estate. In 1969, the current limi-
tations were imposed and the "recapture" provision was slightly
strengthened.
Further Comment
Several proposals have been made either to eliminate accelerated
depreciation or to limit its benefits. One of the more generally ad-
vocated changes would limit depreciation to the equity investment in
the property. Another would not allow real estate losses to offset
income from other sources. There are many variations and combina-
tions of these proposals (see for example H.R. 10612, 94th Cong.,
1st Sess.).





54


Selected Bibliography
Surrey, Stanley S. Pathways to Tax Reform, Cambridge, M.Iassa-
chusetts, Harvard University Press, 1973. Chapter VII-Three Special
Tax Expenditure Items: Support to State and Local Governments, to
Philanthropy, and to Housing, pp. 209-46.
Taubman, Paul and Robert Rasche. "Subsidies, Tax Law and
Real Estate Investment". U.S. Congress, Joint Economic Committee.
The Economics of Federal Sabsidy Prograllms. Part 3. Tax Subsidies,
July 15, 1972, pp. 343-69.
U.S. Congress, House, Committee on Ways and Means, General
Tax Reform, Panel Discussions, Part 4, "Tax Treatment of Real
Estate", February 8, 1973, pp. 507-611.
U.S. Congre-s, IHouse, Committee on Ways and Means, Tax Reform.
Hearings, Part 2, Panel Nos. 1 and 2, "Tax Shelters and Minimum
Tax", July 16, 1975, pp. 1403-1607.











EXPENSING OF RESEARCH AND
DEVELOPMENT COSTS


Estimated Revenue Loss
[In millions of dollars]


Fiscal year Individuals Corporations Total

1977------- ------ 695 695
1976------- ------ 660 660
1975 ------- ------ 635 635


Authorization
Section 174.
Description
Taxpayers may elect to deduct costs for research and development as
incurred (i.e., these costs may be expensedd") even though such costs
may be associated with income that is earned over several years. The
cost then is deducted before the income it earns is realized.

Impact
The mismatching of costs and income operates, as accelerated
depreciation does, to defer tax liability and thereby provide the tax-
payer with an interest-free loan.
For example, if Corporation Z expends $1,000 on an R&D program
in a given taxable year, the entire sum is treated as a deduction from
taxable income and represents a cash flow of $480 to the firm ($1,000
X48 percent marginal tax rate=$480). The value of the current
expense treatment, however, is the amount by which the present value
of the immediate deduction exceeds the present value of periodic
deductions taken over the useful life of the expenditure.
The direct beneficiaries of this provision are firms which undertake
research and development. Mainly, these are large manufacturing
corporations. The scanty evidence available suggests that, of the total
amount claimed as research and experimental costs, about 10 percent
is basic research and 90 percent is product development.
Expensing of research and development costs for tax purpose; is
consistent with the recent practice of a growing number of companies
that expense these costs for financial accounting purposes. This
treatment was approved by the Financial Accounting Standards
Board in October 1974.
(55)





56


Rationale
This provision was added to the tax law in 1954. The general rule,
then as now, was that the cost of assets that benefit future years must
be capitalized and amortized over the assets' useful lives. Probably
because there was difficulty in determining the useful life of such
benefits, deduction was generally allowed. The treatment in a specific
case was determined by the IRS administrative practice and court
decisions. The purpose of the 1954 statute was to eliminate uncertainty
in this area and to encourage expenditures for rear-ch and
development.
development. Selected Bibliography

U.S. Congress, House, Committee on Ways and Means, Tax
Revision Compendium, beginning Nov. 16, 1959, vol. 2, section G(4)-
"Research and Development Expenditures," pp. 1105-23.







INVESTMENT TAX CREDIT



Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total

1977------- 1, 530 7, 585 9,115
1976------- 1, 410 6, 850 8, 260
1975------- 950 4,860 5,810


Authorization
Sections 38 and 46-50.

Description
The investment tax credit (ITC) is available to any taxpayer who
invests in income-producing property which is eligible for the credit.
Eligible investment is largely limited to tangible personal property,
such as machinery and equipment, that is used in the United States.
Most buildings are not eligible.1
The amount of the credit is subtracted from tax liability calculated
without the credit. The credit is currently 10 percent of the qualified
investment but will revert to 7 percent (4 percent for regulated util-
ities) after December 31, 1976. The amount of investment that quali-
fies for the credit is the full purchase price of property with a life of at
least 7 years, two-thirds for property with a useful life of from 5 to 7
years, one-third for property with 3- to 5-year life, and zero for
property with a life of less than 3 years. Only $100,000 of investment
in used property ($50,000 after December 31, 1976) qualifies in any
year. The maximum credit which can be claimed in any one year is
$25,000 plus 50 percent of tax liability over s25,000 (this rule is tem-
porarily liberalized for regulated utilities). Any unused amount of the
credit may be carried back 3 years and carried over 7 years (for pre-
1971 carryovers a 10-year period is allowed). Use of the credit does not
reduce the cost of an asset for purposes of calculating depreciation.
A corporate taxpayer may elect an additional 1 percent credit until
December 31, 1976, if an amount equal to 1 percent of the qualified
investment is contributed to an employee stock ownership plan.

Impact
The credit has two effects. First, it increases the recipient's cash
flow. Second, it reduces the cost of capital and, therefore, can turn an
unprofitable investment into a profitable one (or a profitable one into
1 Wi h certain exceptions, investments eig il >e for the ..rd it include depreciable or amortizable property
having a useful life of three years or more and include: (1) tangible personal property; (2) other tngible
pi'opt rty (not including a building or its con-poni-nts) used as an ii,,g(ral part of (a) ni;1,'-uf. (.tu ire. I., ex-
traction, (c) production, or (d) furnishing of truJILS1ort nation. cormnunicaiinTns, -.1etrical energy, p .s-. water, or
stiwagP disposal se: vicefs; (3) elevators and escalators; and -,4,' 1 itia,. h fL.-i hit is and facilities for the bulk
storage of fungible commodities.
(57)






58


a more profitable one). Assume that an investor requires a 15 percent
iate of return to undertake an investment project. A machine which
costs $1,000 and provides an annual return of $135 does not meet the
15 percent target. However, a 10 percent ITC reduces the net cost
of the machine to $900, so the $135 annual return qualifies at the 15
percent standard (15 percent of $900-=$135).
While noncorporate businesses and individual investors benefit
from the credit, 80 percent of the credit accrues to corporations. Since
the credit is directly related to investment in durable equipment, much
of the direct benefit is concentrated in manufacturing and utilities.
According to 1972 tax data, 64 percent of the ITC is claimed by
corporations with assets of $250 million or more. Two major industry
categories account for 77 percent of the credit: manufacturing (44
percent) and transportation, communication, electric, gas, and sani-
tary services (33 percent).
For some firms, e.g., public utilities, the credit on an investment may
exceed the company's tax liability. Instead of purchasing the property,
the firm may find it profitable to lease the equipment from a bank
that is able to obtain full benefit from the credit. Securities and Ex-
change Commission data indicate sub-tantial use of the credit by
banks through leasing arrangements. A refundable investment
credit has been recommended by some persons for business firms that
lose unused credits at the end of the carry-forward period.
Several studies have produced little evidence that suggests the past
changes in the application of the credit have been effective as short-
run business cycle stabilization tools. Other studies have produced
conflicting evidence as to the long-run effectiveness of the credit in
stimulating investment which increases the rate of capital accumula-
tion and economic growth.

Estimated Distribution of Individual Income Tax Expenditure by
Adjusted Gross Income Class1
Percentage
Adjusted gross income cla~s (thou-iands of dollars): distribution
Oto 7-------------------------------------------------------- 5.1
7 to 15------------------------------------------------------- 25.0
15 to 50------------------------------------------------------49. 3
50 and over-------------------------------------------------- 20. 5
1 The distribution refers to the individual tax expenditure only. The corporate tax expenditure resulting
from these tax provisions is not ruk. ted in this distribution table.
Rationale
Originally adopted as part of the Revenue Act of 1962, the purpose
of the credit was to stimulate investment and economic growth. The
credit was also justified as a means of increasing the ability of American
firms to compete abroad and of compensating for the effect of inflation
on capital replacement. The credit was modified in 1964, suspended
in September 1966, restored in 'March 1967, repealed in April 1969,
reenacted in August 1971, and temporarily liberalized in March
1975 until the end of 1976.






59


Selected Bibliography
Brannon, Gerard M., "The Effects of Tax Incentives for Business
Investment: A Survey of the Economic Evidence," U.S. Congress,
Joint Economic Committee, The Econom'.s3 of Federal Subsidy Pro-
grams, Part 3, Tax Subsidies, 92d Congress, 2d Ses-sion, July 15,
1972, pp. 245-68.
Tax Incentircs an-d Capital Spcnding, Gary Fromm, ed., the Brook-
inc Institution, Washington, D.C., 1971, 301 p:ges.
U.S. Senate, Task Force on Tax Policy and Tax Expenditures
and Task Force on Capital Needs and Monetary Policy, Committee
on the Budget, Seminar-Encouraging Capital Formation Through
The Tax Code, Committee Print, September 18-19, 1975.
U.S. Congress, House, Committee on Ways and Means, Gcural
Tax Reform, Panel Discui-ions, 93d Congre--s, 1st Session, Part 3,
Tax Treatment of Capital Recovery, February 7, 1973, pp. 345-504.
U.S. Library of Congress, "An Analy-:;i; of Tax Provisions Affecting
Business Investment: Depreciation and the Investment Tax Cr'odit"
by Jane Gravelle, Congressional Research Service, Multilith 74-151E,
August 14, 1975.


67-312--76-----5













ASSET DEPRECIATION RANGE


Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total
1977------- 175 1, 630 1, 805
1976------- 155 1,435 1,590
1975------- 140 1,270 1,410


Authorization
Section 167(m); Regulation 1.167(a)-11; Rev. Proc. 72-10.

Description
The Internal Revenue Service has established useful lives for classes
of depreciable assets. The asset depreciation range (ADR) system
permits taxpayers to choose any useful life within a range of 20 percent
more or less than the class life specified for a particular asset. If ADR
is chosen, the taxpayer is not required to justify retirement and re-
placement policies nor to show that they are consistent with the actual
useful lives of their assets.

Example
Assume that a taxpayer has a $1,500 asset for which the class life-
established by the Internal Revenue Service is 10 years. Using double-
declining balance depreciation, without ADR, the deduction in the-
first year would be 200 percentX.10X$1,500=$300. After deduction
of this depreciation charge, the adjusted basis of the asset is $1,200
($1,500- $300). In the second year, the deduction would be 200 per-
centX.10X$1,200=$240.
Under the asset depreciation range, a useful life of between 8 and'.
12 years may be selected. If the taxpayer chose 8 years, the first year-
deduction would be 200 percentXX$1,500=$375. In the second;
year, the deduction would be 200 percent XX$1,125 =$281.25..
Therefore, the use of ADR would result in additional deductions of $75*
the first year ($375-300) and $41.25 the second year ($281.25--
240.00).
Impact
The ADR system, as accelerated depreciation (see Appendix A),
reduces taxes early in the life of depreciable assets and thus increases
(61)






62


cash flow during that time. The subsidy value of ADR is the tax saving
from the allowance of a tax depreciation life shorter than the guideline
life of the as-et. Capital intensive businesses such as manufacturing
firms and utilities are necessarily the most likely to take advantage of
ADR.
Securities and Exchange Commission data indicate significant use
of ADR by railroads, utilities, airline companies, and truck and
equipment companies. Tren-sury Department data indicate that the
use of ADR is more probable the larger the company, and the percent
of investment covered by ADR increases with the asset size of the
company. Sixfy percent of all business fixed investment is covered by
ADR, but about 80 percent of the business fixed investment of the
360 lariv,-t corporations is covered.

Estimated Distribution of Individual Income Tax Expenditure by
Adjusted Gross Income Class'
PiTrc ntage
Adjusted gross income cli (thousands of dollars):- distribution
0 to 7---------------------------------------------------- 4.8
7 to 15 ---------------------------------------------------18. 1
15 to 50--------------------------------------------------- 43.8
50 and over-----------------------------------------------33. 3
1 The distribution refers to the individual tax expenditure only. The corporate tax expenditure resulting
from these tax provisions is not reflected in this distribution table.
Rationale
The ADR system wav established in 1971 principally to stimulate
investment and economic growth by deferring taxes through the ac-
celeration of depreciation deductions. In addition, it was asserted the
system would simplify the administration of the existing depreciation
rules.
Selected Bibliography
Brannon, Gerard M. "The Effects of Tax Incentives for Business
Investment: A Survey of the Economic Evidence." In U.S. Congress.
Joint Economic Committee, The Economics of Federal Subsidy Pro-
grams, Part 3, Tax Subsidies, 92d Congress, 2d Session, July 15, 1972,
pp. 245-68.
U.S. Congress House Committee on Ways and Means, General
Tax Reform. Panel Discussions. 93rd Congress, 1st Session. Part 3-
Tax Treatment of Capital Recovery, February 7, 1973, pp. 345-504.
U.S. Library of Congress. "An Analysis of Tax Provisions Affecting
Business Investment: Depreciation and the Investment Tax Credit"
by Jane Gravelle. Congressional Research Service, Multilith 74-
151E. August 14, 1975, 50 pages.











DIVIDEND EXCLUSION



Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total

1977------- 350 ------ 350
1976------- 335 ------ 335
1975------- 315 ------ 315


Authorization
Section 116.
Description
An individual may exclude up to $100 ($200 for a joint return) of
dividends received from domestic corporations.

Impact
Although this provision benefits all taxpayers who receive dividend
income and have tax liability, only a small percentage of total divi-
dends is affected by the provision because of the dollar limitation.
The tax saving per dollar of exclusion increases with the taxpayer's
marginal tax bracket. In the aggregate, the benefits tend to accrue
to middle- and high-income taxpayers because they are more likely
to own stock.

Estimated Distribution of Individual Income Tax Expenditure by
Adjusted Gross Income Class
Percentage
Adjusted gross income class (thousands of dollars): di'.!ribution
0 to 7--------------------------- ------------------------- 6.9
7 to 15------------------------- --------------------------21. 3
15 to 50------------------------ --------------------------56. 3
50 and over ----------------------------------------------- 15.6

Rationale
In 1954 a dividend exclusion of $50 and a credit of 4 percent of
dividends above that amount were adopted. The stated purpose was
to provide partial relief from the "double taxation" of dividends (the
corporate income tax and the individual income tax on dividends)
which, it was argued, hampered the ability of companies to raise
capital. The exclusion was stated to be designed to afford greater relief
for the low-income investor.


(63)





64


In 1964, although the Administration recommended repeal of both
the credit and exclusion, the credit was repealed and the exclusion
was doubled. The reasons offered were (1) that the provisions had not
achieved their objectives, (2) the change would remove the discrimina-
tion in favor of high income taxpayers, (3) the change would en-
courage broader ownership of stock, and (4) the change would raise
revenues that could be used to reduce the individual taxes in general.
Further Comment
As indicated above the issue that gave rise to the initial enactment
of the exclusion and credit is the "double taxation" of dividends or,
more generally, the burden of taxes on capital and on corporate equity
capital in particular. While the exclusion survives, it does relatively
little to resolve this problem because of the low dollar ceiling. Many
proposals for partial and full integration of the corporate and in-
dividual income taxes have been made; some are cited in the selected
bibliography.
Selected Bibliography
Goode, Richard. The Individual Income Tax, Rev. ed., the Brook-
ings Institution, Washington, D.C., 1976, pp. 138-9.
The Taxation of Income from Corporate Shareholding, Symposium
sponsored by the National Tax Association-Tax Institute of America
and Fund for Public Policy Research, National Tax Journal, Septem-
ber 1975.
Richard and Peggy Musgrave, Public F;nance in Theory and
Practice, New York: McGraw-Hill Book Co., 1973, pp. 267-297.








CAPITAL GAINS: INDIVIDUAL (Other Than
Farming and Timber)


Estimated Revenue Loss
[In millions of dollars]


Fiscal year Individuals Corporations Total

1977------- 6,225 ------ 6,225
1976------- 5,455 ------ 5,455
1975------- 5,090 ------ 5,090


Authorization
Sections 1201-1253.
Description
Gains on the sale of capital assets held for more than six months
are subject to preferentially lower tax rates (see Appendix B). Also,
gain on the sale of property used in a tride or business is treated as
long term capital gain if all gains for the year on such property exceed
all losses for the year on such property. Qualifying property used in a
trade or business generally is depreciable property or real estate which
is held more than six months, but not inventory.
Only one-half of long-term capital gains are included in income;
or alternatively, on the first $50,000 of capital gain, the taxpayer
may elect to pay a tax of 25 percent.

Impact
The deduction from gross income of half of capital gains results in
tax rates half the normal rates. The alternative (25 percent) tax
benefits only those individuals whose marginal tax rate is above 50
percent. The tax treatment of capital gains increases the after-tax
earnings on assets and thereby may encourage people to invest in
assets which may appreciate in value. Furthermore, the tax preference
mavy reduce the inhibiting effects of taxation on the sale of assets.
The benefits of this provision are concentrated among high income
individuals, with approximately two-thirds of the benefit received by
those with adjusted gross incomes of $50,000 or more. The tax saving,
per dollar of capital gain, increases with the tax bracket of the tax-
payer.

Estimated Distribution of Individual Income Tax Expenditure by
Adjusted Gross Income Class
Percentage
Adjusted gross income class (thousands of dollars): distribution
0 to 7------------------------------------------------- 3.1
7 to15------------------------------------------------------- 7.5
15 to 50--------------------------------------------- 23. 1
50 and over--- ----------------------------------------- 66.3
(65)







Rationale


Although the oi iginal 1913 law taxed capital gains at ordinary
rates, the 1921 law provided for an alternative flat rate tax of 12.5
percent. The intent of this treatment was to minimize the influence
of the high progressive rates on market transactions. The Committee
Report noted that these gains are earned over a period of years but
are nevertheless taxed as a lump sum. Over the years many revisions
in this treatment have been made including the temporary adoption
of a sliding scale treatment (where lower rates applied the longer
the asset was held). The current approach was adopted in 1942 and
has remained in that form with minor revisions.
Further Comment
Many reasons have been advanced for preferential treatment of
capital gains income with the major ones being: (1) capital gains are
accrued over a long period of time and should not be subject to tax
under progresive rates as a lump sum, (2) capital gains reflect infla-
tion to a substantial extent and are thus not real income, and (3)
because an asset owner has discretion as to when to realize gains, the
existence of ordinary tax acts as a barrier to transactions in the
capital market and leads to "lock-in" effects (asset owners refrain
from selling because of the tax) with attendant distorting effects on
savings, investment, and economic efficiency.
On the other hand, arguments have been advanced against the
preferential treatment of capital gains: (1) even if capital gains were
taxed as ordinary income, the advantage remains of the deferral of
tax on unrealized gains, (2) inflation affects returns on assets in
general, not just capital 2 .:ns transactions, and assists asset purchases
made with borrowed funds, (3) the "lock-in" problem might be dealt
with in other ways, such as taxing gains transferred at death (thus
removing the opportunity to avoid capital gains taxes entirely), and
(4) the "bunching" problem can be met by a special averaging
provision.
Selected Bibliography
Bailey, Martin J., "Capital Gains and Income Taxation," in The
Taxatio,, of Income from Capital, The Brookings Institution, Washing-
ton, D.C., pp. 11-49.
David, Nlartin. Alternatire Approaches to Capital Gains Taxation,
The Brookings Institution, Washington, D.C., 1968.
Martin, David and Roger Miller, "The Lifetime Distribution of
Realized Capital Gains," U.S. Cong'rce-, Joint Economic Committee,
The Econormics of Federal Subsidy Programs, Part 3-Tax Subsidies,
July 15, 1972, pp. 269-85.
U.S. (Congress, House Committee on Ways and Means, Panel
Discu- -,ons. General Tax Jlrform, Part 2-Capital Gains and Losses,
February 6, 1973, pp. 245-341.










CAPITAL GAINS TREATMENT: CORPORATE
(Other Than Farming and Timber)


Estimated Revenue Loss
[In millions of dollars]


Fiscal year Individuals Corporations Total

1977 ------ ------ 900 900
1976------- ------ 760 760
1975-------- ------ 695 695


Authorization
Sections 1201, 1231, 1245, 1250, and miscellaneous others.

Description
Two main types of long-term capital gains are realized by cor-
porations-the sale of a capital asset held for more than 6 months
and, if gains for the year exceed loses for the year, the sale of property
used in a trade or business for more than 6 months. (See Appendix B.)
Most corporate capital gain is of the latter kind.
Long term capital gains realized by corporations generally require
a dual tax computation. They are first included in income, and a tax
on the total income, including the capital gain, is computed using the
regular rates. In the "alternative" computation, a tax on all income
other than long-term capital gain is computed at regular rates. The
long term capital gain is taxed at a 30 percent rate, and the two result-
ing taxes are added together to yield the "alternative" tax. The lower
of the tax computed the regular way or the "alternative" tax is the
tax liability. Thus, a corporation must include the full amount of net
long-term capital gains in taxable income but may apply the speciall
30 percent alternative capital gain tax rate on the gain.
Regular tax rateS for corporations are 22 percent on the first $25,000
and 48 percent on any taxable income over $25,000. (Temporary pro-
visions allow a 20-percent rate on the first $25,000, 22 percent on the
next $25,000, and 48 percent on amounts over $50,000. These pro-
visions will expire on June 30, 1976 unless renewed.)
Corporations are allowed to offset capital losses only against capital
gains. Any remaining capital lo:-ses may be carried back for 3 years
and forward for 5 years. Gain on most, depreciable tangible per-onal
property used in a trade or busine-s will be treated as ordinary income
to the extent it arises from depreciation that has been allowed after
1961, i.e., the depreciation is recaptured; but only a small part of
depreciation on real estate is "recaptured."
(67)






68

Example
To illustrate, assume a corporation has, for the taxable year 1975,
taxable income of $250,000, which includes net long-term capital
gains of $60,000.
Tax Computed in Regular Manner:
Taxable income-------------------------------------------- $250, 000
Tax:
(20 percentX $25,000)----------------------------------- 5, 000
(22 perccntX$25,000) ------------------------------- 5, 500
(48 percent X $200,000) --------------------------------- 96, 000
Total-------------------------------- ---------------106,500
Alternative tax:
Partial tax on $190,000 ($250,000-60,000):
(20 percent X $25,000)--------------------------------- -- 5, 000
(22 percentX $25,000)----------------------------------- 5, 500
(48 percent X$140,000)---------------------------------- 67, 200
30 percent of $60,000--------------------------------------- 18, 000
Alternative tax------------------------------------------ 95, 700

The alternative tax is $10,800 less than the regular tax, and in this
example, the tax expenditure is the tax savings attributable to the
alternative tax computation.

Impact

Corporations with taxable income over the surtax exemption that
realize income from the sale of long-term capital assets are the direct
beneficiaries of this provision. Corporations that make use of the al-
ternative tax reduce their tax liability and consequently increase their
cash flow.
According to 1972 tax return data, capital gains taxed at alternative
rates averaged 5 percent of taxable income for all corporations. For the
following industries (excluding farming and timber) the percentage
was higher than the average: metal mining; primary metals industries;
banks; holding and investment companies; and real estate. Finance,
insurance, and real estate combined claimed 30 percent of all corporate
capital gains taxed at alternative rates.

Rationale
The Revenue Act of 1942 introduced the alternative tax for cor-
porations at a 25-percent rate, the alternative tax rate for individuals.
This tax relief was premised on the belief that many wartime sales
were involuntary conversions which could not be replaced during
wartime and that resulting gains should not be taxed at the greatly
escalated wartime rates. The Tax Reform Act of 1969 increased the
alternative rate to 30 percent. The adoption of this revision was based
on several considerations, including the adoption of the limitation of
the alternative capital gains tax for individuals to the first $50,000
of capital gains and the absence of the "bunching" problem (i.e.,
income earned over several years is recognized in a single year) that
arises mostly in the individual tax because of graduated rates.





69

Further Comment
The effect of the difference in tax rates on ordinary income versus
capital gains is not the same for corporations as for individuals for a
number of reasons. Much of the capital gain results from sales in the
normal course of business for a corporation. Further, the ability to
exempt gains from tax by death transfers is not available. Finally,
there is little "bunching" problem since the corporate rate is generally
not a graduated rate.

Selected Bibliography
David, Martin. Alternative Approaches to Capital Gains Taxation,
The Brookings Institution, Washington, D.C., 1968, 280 pages.
U.S. Congress, House Committee on Ways and Means, "Tax
Treatment of Capital Gains," Tax Revision Compendium. Prepared
for the House Committee on Ways and Means by Dan Throop Smith,
1959, Washington, D.C.: Government Printing Office, pp. 1233-1241g














EXCLUSION OF CAPITAL GAINS AT DEATH


Estimated Revenue Loss
[In millions of dollars]


Fiscal year Individuals Corporations Total

1977_----- 7,280 --- 7,280
1976------- 6,720 ------ 6,720
1975------- 6,4 6,450 6450


Authorization
Sections 1001, 1002, 1014, 1221, and 1222.

Description
A capital gains tax generally is imposed on the increased value of a
capital asset when the asset is sold, transferred, or exchanged. This
tax, however, is not imposed on the appreciated value of such property
jf it is transferred as a result of the death of the owner; and any sale
by the transferee is taxable only to the extent of appreciation subse-
quent to the transferor's death (or six months after death if the
alternative valuation for estate tax is elected). Thus, appreciation
during the decedent's life is not subject to the income tax.
However, the assets are subject to the Federal estate tax based
upon their value at the time of death.

Impact
The exclusion of capital gains at death is most advantageous to
individuals who need not dispose of their assets to achieve financial
liquidity. Generally speaking, these tend to be wealthier investors.
The deferral of tax on the appreciation involved combined with the
exemption for the appreciation before death is a significant benefit
for these investors and their heirs.
Failure to tax capital gains at death encourages "lock-in" of assets
which in turn means less turnover of funds available for investment.
Certain revisions in the portfolio of an investor might result in more
profitable before-tax rates of return, but might not be undertaken if
the resulting capital gain tax would reduce the ultimate size of the
estate. The investor may, therefore, choose to retain his assets until
his death, at which time portfolio revisions can be made by executors
without incurring a capital gains tax liability. Taxpayers arc said to be
"locked into" such investment-.


(71)






72


Estimated Distribution of Individual Income Tax Expenditure by
Adjusted Gross Income Class
Percentage
Adjusted gross income class (thousands of dollars): distribution
0 to 7---------------------------------------------------- 6.3
7 to 15------------------------------------------------------- 15.1
15 to 50 -------------------------------------------------36.9
50 and over ----------------------------------------------- 41.7

Rationale
The rationale for this exclusion is not indicated in the legislative
history of any of the several interrelated applicable provisions. How-
ever, one current justification given for the exclusion is that death is
considered as an inappropriate event to result in the recognition
of income.
Further Comment
Taxation of capital gains at death could cause liquidity problems
for some taxpayers such as owners of small farms and businesses.
Most proposals for taxing capital gains at death would combine
substantial averaging provisions, deferred tax payment schedules,
and a substantial deductible floor in determining the amount of the
gain to be taxed. Another approach would require that the decedent's
tax basis be carried over to the heirs who would be taxed on apprecia-
tion if they sell the property. This solution continues the deferral and
lock-in effect discussed above.

Selected Bibliography
Break, George F. and Pechman, Joseph A. Federal Tax Reform:
The Impossible Dream, The Brookings Institution, Washington, D.C.
1975, pp. 47-8.
Pechman, Joseph A. Federal Tax Policy, Rev. ed., the Brookings
Institution, Washington, D.C., 1971, p. 97.
U.S. Congress, House, Committee on Ways and Means, General
Tax Reform, Panel Discussions, Part 10-Estate and Gift Tax Re-
vision, February 27, 1973, pp. 1487-1668.











DEFERRAL OF CAPITAL GAINS ON HOME SALES


Estimated Revenue Loss
[In millions of dollars]


Fiscal year Individuals Corporations Total

1977------- 890 --- 890
1976------ 845 ----- 845
1975------ 805 ----- 805


Authorization
Section 1034.
Description
Gain from selling a residence is not taxed if the taxpayer purchases
another residence with a cost at least equal to the sale price of the old
residence within 18 months before or after the sale of the old residence.
This treatment also applies if the seller constructs a new home of equal
or greater value if construction begins within 18 months of the sale
and if the taxpayer occupies the new residence within 2 years of the
sale.
If the new residence costs less than the sale price of the old, the
difference in price is subject to tax.
The tax basis of the new residence is reduced by the amount of the
untaxed gain on the sale of the old residence. Therefore, the gain on
the sale of the first home will be recognized, if at all, at the time of the
sale of the second home. However, the tax may again be deferred on
the gain from the sale of both homes if another home is purchased by
a taxpayer meeting the requirements of section 1034. The interaction
of section 1034 and section 121 which benefits those over 65 (see p. 129)
will result in ultimate exemption from tax of part or all of the pre-
viously unrecognized gain if the taxpayer sells his second or subsequent
home with a carryover basis after he is 65.

Impact
As with any tax deferral, the taxpayer receives the equivalent of an
interest-free loan. This provision benefits primarily middle and upper
income taxpayers (about four-fifths of the benefit accrues to those in
the $7,000-$50,000 adjusted gross income (AGI) class). This subsidy
facilitates the ownership of increasingly expensive homes, much of
the increase in which in many cases is attributable to inflation.
(73)






74


Estimated Distribution of Individual Income Tax Expenditure by
Adjusted Gross Income Class
Percentage
Adjusted gross income class (thoum-ands of dollars): distribution
0 to 7--------------------------------------------.-------- 6.7
7 to 15 --------------------------------------------------23.9
15 to 50 ---------------------------------------------------56. 9
50 ;ind over-----------------------------------------------_ 12. 5

Rationale
The provision was adopted in 1951 to relieve financial hardship.
when a personal residence is sold, particularly when the sale is neces-
sitated by su(h1 circumstances as an increase in family size or change
in the place of employment. The Senate Committee Report noted
that sales in these circumstances are particularly numerous in periods
of rapid change such as mobilization or reconversion (presumably
referring to wartime conditions).

Further Comment
Many have questioned the taxation of any gain from the sale of a
personal residence, particularly since the tax law does not allow the
deduction of personal capital losses and because the purchase of a per-
sonal residence is less of a profit motivated investment than many
other types of investment. On the other hand, tax deferral of gain
from home sales does favor investment in homes as compared to
other types of investment and, along with other features of the tax
law, contributes to the general favorable treatment afforded home-
owners in the tax law.

Selected Bibliograpthy
U.S. Congress, 11011oue, Committee on Ways and Means, Panel
Discussions. General Tax Reform, Part 2-Capital Gains and Losses
(note, particularly, testimony of Kenneth B. Sanden, p. 254).











DEDUCTIBILITY OF MORTGAGE INTEREST AND
PROPERTY TAXES ON OWNER-OCCUPIED
PROPERTY



Estimated Revenue Loss
[In millions of dollars]

Individuals
Fiscal year Corpora- Total
Property Mortgage tions
taxes interest

1977------ 3,825 4,710 ------ 8,535
1976------ 3,690 4,545 ------ 8,235
1975------ 4,510 5,405 ------ 9,915

Authorization

Sections 163 and 164.
Description

A taxpayer may take an itemized deduction for mortgage interest
and property tax paid on his owner-occupied home.

Impact

The deduction of nonbusiness mortgage interest and property
taxes allows homeowners to reduce their housing costs; tenants
have no such opportunity because they cannot deduct rental pay-
ments.1 High income individuals receive greater proportional
benefits than low income persons, not only because of higher marginal
tax rates, but also because higher income taxpayers are more likely
to own one or more homes (and higher income people are likely to
own higher priced homes with larger mortgages and higher property
taxes) and to itemize deductions.
These provisions encourage home ownership by reducing its cost in
comparison to renting. Some observers believe that these deductions,
together with other favorable income tax provisions accorded to
homeowners, have been an important factor in the rapid rise of home-
ownership since World War II. Other observers suggest that the hous-
ing market has adjusted for these deductions and that home price
increases have compen-'ated for the tax benefit.
1 In contrast to the rental income paid to a landlord by a tenant, the rental value of an
owner-occupied home is not imputed-i.e. not included-in the income of the owner. Such
income thus is tax exempt, but the mortgage interest and property tax expense of earning
it is allowed as a deduction from other taxable income. These deductions favor investment
in owner occupied homes over investments in residential rental property or other assets
such as securities.


(75)


67- 312-76--






76


To the extent that the deductibility of State and local property
taxes allows these taxes to be higher than they would otherwise be,
the provision has an effect similar to a revenue sharing program.

Estimated Distribution of Individual Income Tax Expenditure by
Adjusted Gross Income Class

Percentage distribution
Property Mortgage
Adjusted gross income class taxes interest
0 to $7,000 ....---------------------------------------------------........................................................... 2.2 1.3
r $7,000 to $15,000..........-----------------------..........--..-......--------------------------................. 19.8 23.6
$15,000 to $50,000.----...-..- --...--------------------............... ----------------------- 62.7 65.9
$50,000 and over......................-----------------------------------------------------.................................... 15.3 9.1


Rationale
Generally, the deductibility of interest and of State and local taxes
has been a characteristic of the Federal income tax structure since the
Civil War income tax. An explicit rationale was never advanced, but
close examination of the legislative histories suggests that these pay-
ments were viewed as reductions of income. No distinction was made
between business and nonbusiness expenses. There is no evidence that
deductibility of these items was originally intended to encourage home
ownership or to subsidize the housing industry, which is the present
justification offered for this treatment.
The Code was revised in 1964 to specify the types of nonbusiness
taxes which could be deducted. The treatment for property taxes was
retained because removing the deduction would have precipitated a
large shift in overall tax burdens.

Selected Bibliography
Goode, Richard. The Individual Income Tax, Rev. Ed., The Brook-
ings Institution, Washington, D.C., 1976, pp. 117-25.
Aaron, Henry. Who Pays the Property Tax, The Brookings Institu-
tion, Washington, D.C., 1975.
"Federal Housing Subsidies," U.S. Congress, Joint Economic Com-
mittee, The Economics of Federal Subsidy Programs, Part 5-Housing
Subsidies, October 9, 1972, pp. 571-96.
Laidler, David, "Income Tax Incentives for Owner-Occupied
Homes," Taxation of Income From Capital. Bailey and Harberger,
eds. Washington, D.C., The Brookings Institution, 1969, pp. 50-76.








EXEMPTION OF CREDIT UNIONS


Estimated Revenue Loss
[In millions of dollars]


Fiscal year Individuals Corporations Total
1977------ ------ 135 135
1976------- ------ 125 125
1975------ ------ 115 115


Authorization
Section 501 (c) (14).
Description
Credit unions without capital stock, and organized and operated
for mutual purposes and without profit, are not subject to Federal
income tax.
Impact
Because their income is exempt from the income tax, credit unions
are treated more favorably than are competing financial institutions
whose income is taxed. On the other hand, credit unions are subject
to certain special constraints not required of their competitors, such
as limits on the interest rate charged on loans, on the duration of loans,
and on the types of investments that are allowed. In addition, credit
unions may lend only to members; however, only a small deposit may
be required for membership that qualifies the member for a loan
greatly in excess of the deposit.

Rationale
Credit unions have never been subject to the Federal income tax.
Initially, they were included in the provision that exempted domestic
building and loan associations-whose business was at one time
confined to lending to members-and nonprofit cooperative banks
operated for mutual purposes. The exemption for mutual banks and
savings and loan institutions was removed in 1951, but credit unions
retained their exemption. No specific reason was given for continuing
the exemption of credit unions.

Selected Bibliography
Gelb, Bernard A., Tax Exempt Business Enterprise, The Conference
Board, New York, 1971.
U.S. Congress, House, Committee on Ways and Means, "Some
Considerations on the Taxation of Credit Unions" Prepared by John
T. Crotean for the House Committee on Ways and Means, Tax
Revision Compendium, Vol. 3, 1959, pp. 1833-66.
(77)













DEDUCTIBILITY OF INTEREST ON CONSUMER
CREDIT


Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total
1977------- 1,075 --- 1,075
1976------- 1,040 ---- 1,040
1975------- 1, 185 --1, 1185


Authorization
Section 163.
Description
A taxpayer may take an itemized deduction for interest paid or
accrued on nonbusiness indebtedness (for example, personal and auto
loans and credit account purchases).

Impact
This provision reduces net interest, charges and thereby reduces the
price of consumer purchases financed by debt. If the purchase is an
asset that earns income, that is then subject to tax (e.g., borrowing
to purchase mutual fund shares), the interest charge is an expense of
earning income and it would cusomarily be deductible as an invest-
ment expense. For other items the interest deduction acts as a subsidy
and thus encourages their purchase, financed by borrowing. Because
higher income taxpayers are more likely to itemize deductions, they
are more likely to benefit from this provision than are taxpayers in
lower brackets.
Under 1954 legislation, the deduction for carrying charges on most
consumer credit (unless explicitly denominated "interest") was
limited to about 6 percent on the declining balance of consumer debt.
In more recent years, bank charge cards have proliferated, and the
Internal Revenue Service has ruled that charges on those cards
generally can be fully deducted as interest. On the other hand, pur-
chases under deferred payment contracts usually remain subject to
the limitation already mentioned. Thus, the theoretical treatment of
bank charge cards differs substantially from deferred payment sales
where carrying charges are often not called "interest." Whether this
distinction is observed in practice is unknown.
(79)






80


Estimated Distribution of Individual Income Tax Expenditure by
Adjusted Gross Income Class
Percentage
Adjusted gross income class (thousands of dollars): di8tribution
0 to 7---------------------------------------------------- 1.4
7 to 15----------------------- --------- ------------------23.7
15 to 50------------------------------------------------- 66. 0
50 and over ------------------------------------------------ 9.0

Rationale
While the 1862 income tax statute did not contain a special provision
for the deduction of interest, it was allowed. When the income tax
was reinstituted in 1913, a special provision allowing the deduction of
interest was included, apparently because of concern that interest
might not be treated as a business expense and deducted under the
general business expense provision. At that time, no distinction was
drawn between business and nonbusiness interest expense, presumably
because the latter constituted a very small proportion of total interest
expense. However, today the nonbusiness interest cost is perceived as
a consumption item and hence different from business interest.

Selected Bibliography
Kahn, C. Harry. Personal Deductions in the Federal Income Tax,
Princeton, Princeton University Press, 1960, pp. 109-24.










CREDIT FOR PURCHASING NEW HOME

Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total

1977------ 100 ------ 100
1976------ 625 ------ 625
1975------------ ----- -----

Authorization
Section 44.
Description
A credit against tax liability is allowed for 5 percent of the purchase
price of a "new principal residence" purchased after March 12, 1975,
and before January 1, 1976. The maximum amount of the credit is
$2,000 or tax liability for 1975, whichever is less. Only houses on which
construction began before March 26, 1975, are eligible. Single family
houses, condominium and cooperative units, and mobile homes all
qualify. The purchase price may be no higher than it was on Feb-
ruary 28, 1975.
Example
A taxpayer who purchases a new home in July 1975 costing $40,000
or more may claim a credit of $2,000 against his income tax for 1975.
If his tax for 1975 is $3,000, the $2,000 credit can be subtracted directly
from the tax and the tax due will be only $1,000. If the purchase
price of the house is less than $40,000, the credit will be 5 percent of
the purchase price. The amount of the credit may not exceed tax
liability. Thus, if a taxpayer earns a credit of $2,000 but owes a tax
of only $1,500, the credit will be $1,500.

Impact
The distribution of the tax savings by income class will not be known
until 1975 tax returns are filed and analyzed. While some portion of
the benefit from the credit will be received by home sellers who did not
reduce their asking price as much as they would have otherwise, home
buyers-particularly those with taxable income above $20,000-will
also benefit. Some families who qualify will not receive the full amount
of the credit because their tax liability will be less than the credit.
For example, for a family of four, tax liability begins only when income
reaches nearly $6,000, and tax liability does not amount to $2,000 until
income is about $17,500.
1In calculating the amount of the credit, the purchase price must be reduced by the
amount of gain on the sale of a previous residence unless tax is paid on the gain.
(81)






82


The impact of the credit on housing and on the economy is difficult
to measure because it cannot be isolated from the other factors at
work in the housing industry at the same time. Some initial evidence in-
dicates the credit had little or no favorable impact on the inventory of
unsold new houses, new home sales, housing starts, or construction
industry employment.1 On the other hand, evidence cited by the home
building industry indicates the credit did have an impact on home
sales.
Rationale
The home purchase tax credit was enacted as part of the Tax
Reduction Act of 1975. Its purpose was described as primarily to
reduce the existing inventory of unsold new homes.

Selected Bibliography
U.S. Congress, Senate, Senate Report No. 94-36, March 17, 1975,
p. 12.
U.S. Congressional Budget Office, "An Analysis of the Impact of
the $2,000 Home Purchase Tax Credit" (processed November 20,
1975).
1 Federal Home Loan Bank Board Newsletter, Oct. 14, 1975; Secretary of Housing and
Urban Development Carla Hills, testimony before the Senate Committee on Banking, Hous-
ing and Urban Affairs, Nov. 5, 1975.










HOUSING REHABILITATION: 5-YEAR
AMORTIZATION

Estimated Revenue Loss
[In millions of dollars]


Fiscal year Individuals Corporations Total
1977-.---- 40 25 65
1976------- 55 35 90
1975------ 65 40 105


Authorization
Section 167(k).
Description
In lieu of depreciation, certain expenditures incurred to rehabilitate
low or moderate income rental housing may be amortized over five
years using the straight line method and no salvage value. This rapid
amortization is permitted only with respect to expenditures incurred
after July 24, 1969, and before 1976, or, if made under a pre-1975
binding contract, before 1978. Moreover, the write-off is available only
where during a period of two consecutive years, expenditures exceed
$3,000 per unit, and applies only to expenditures not in excess of
$15,000 per rental unit. The use of 5-year amortization for assets
whose useful lives are longer benefits the taxpayer by effectively
deferring current tax liability (see Appendix A).

Example
Assume a taxpayer spends $10,000 on structural rehabilitation of a
low or moderate income rental housing with a useful life of 20 years.
Without the amortization provision (using the double declining
balance method of computing depreciation), his deduction in the
first year would be:
200 percentXo0X$10,000=$1,000
In the second year his depreciation would be:
200 percentXY20X$9,000=$900
The deductions for depreciation would continue in smaller amounts
over the remaining life of the asset.
With five-year amortization, one-fifth of the amount ($2,000) is
deducted each year for 5 years. Afterwards no additional deduction
for amortization or depreciation may be taken.
(83)






84


Impact
The tax benefit accrues to investors in projects to rehabilitate low
and moderate income housing; about 60 percent of the tax relief goes
to individual taxpayers. Even though the properties in question may
not be currently earning income, the rapid amortization may be de-
ducted against other income from housing investments and may pro-
vide a tax shelter for totally unrelated income. Low income renters
benefit only to the extent that rehabilitated units rent for less than
new units of comparable quality, or to the extent that more units are
rehabilitated than would be otherwise. The very small amount of
evidence available does not indicate a flow through of tax benefits to
the renters.

Estimated Distribution of Individual Income Tax Expenditure by
Adjusted Gross Income Class1
Percentage
Adjusted gross income cl:iss (thousands of dollars): distribution
0 to 7------------------------------------------------------- 4.0
7to 15------------------------------------------------------- 4.0
15 to 50------------------------------------------------------ 16.0
50 and over-------------------------------------------------- 76.0
1 The distribution refers to the individual tax expenditure only. The corporate tax expend-
iture resulting from this tax provision is not reflected in this distribution table.

Rationale
This provision was adopted as part of the Tax Reform Act of 1969
as a temporary provision to stimulate rehabilitation of low and
moderate income housing. It was subsequently extended for 1 year by
P.L. 93-625 (January 3, 1975). Although it expired December 31,
1975, a retroactive reinstatement may be passed in 1976.

Selected Bibliography
Heinberg, John D. and Emil M. Sunley, Jr., "Tax Incentives for
Rehabilitating Rental Housing," in Housing 1971-1972. AMS Press
(1974). Reprinted as Urban Institute Reprint, URI-10122.
McDaniel, Paul R. "Tax Shelters and Tax Policy." National Tax
Journal, Vol. XXVI, No. 3, September 1973, pp. 353-88.
Surrey, Stanley S. Pathways to Tax Reform. Cambridge, Massa-
chusetts, Harvard University Press, 1973. Chapter VII-Three
Special Tax Expenditure Items: Support to State and Local Gov-
ernments, to Philanthropy, and to Housing, pp. 209-46.
U.S. Congress. House Committee on Ways and Means. General
Tax Reform, Panel Discussions. 93rd Congress, 1st Session. Part
4-Tax Treatment of Real Estate, February 8, 1973 and Part 6-
Minimum Tax and Tax Shelter Devices, February 20, 1973, pp.
507-611 and 697-912.
U.S. Congress, House Committee on Ways and Means, Tax Reform.'
Hearings, Part 2. Panels Nos. 1 and 2-Tax Shelters and MIinimum
Tax, July 16, 1975, pp. 1403-1607.







FIVE YEAR AMORTIZATION OF CHILD CARE
FACILITIES


Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total
1977 ------------- 5 5
1976----- ------ 5 5
1975------- ------ 5 5

Authorization
Section 188.
Description
In'lieu'of depreciation, an employer may amortize, on a straight line
basis over 60 months, capital expenditures to acquire, construct, re-
construct, or rehabilitate property that qualifies as an employee
child care facility. The types of facilities which qualify are described
generally by regulation as those where children of employees receive
personal care, protection, and supervision in the absence of their
parents. Section 188 applies only to expenditures made after Decem-
ber 31, 1971, and prior to January 1, 1977. The investment credit
cannot be claimed for property subject to this amortization.

Impact
As with any rapid amortization provision, the taxpayer is allowed
to defer some current tax liability (see Appendix A). The effect of this
provision in increasing the number of child care facilities is unclear.

Rationale
This tax benefit, adopted in 1971, is intended to encourage em-
ployers to provide more child care facilities for children of single
parents and working mothers.

Selected Bibliography
U.S. Congress. Joint Committee on Internal Revenue Taxation.
General Explanation of the Revenue Act of 1971, H.R. 10947, 92d
Congress, P.L. 92-178, December 15, 1972, Washington, D.C., U.S.
Government Printing Office, 1972, pp. 62-4.
U.S. Department of Labor, Women's Bureau, Day Care Services!
Industry's Involvement, Bulletin 296, Washington, D.C., U.S. Govern-
ment Printing Office, 1971, p. 33.
Maymi, Carmen R. "Working Mothers-Their Child Care Needs."
Address delivered at meeting of the Chicago Community Coordinated
Child Care Committee. Chicago, Illinois, November 2, 1974.
(85)














EXCLUSION OF SCHOLARSHIPS AND
FELLOWSHIPS



Estimated Revenue Loss
[In millions of dollars]


Fiscal year Individuals Corporations Total

1977------ 220 ---------- 220
1976------- 210 ---------- 210
1975-------- 200 ---------- 200


Authorization
Section 117.
Description
Generally, individuals may exclude from taxable income amounts
received as scholarships or fellowships. The exclusion includes amounts
received to cover such incidental expenses as travel, research, clerical
assistance, or equipment, but does not apply to any amount received
as payment for teaching, research, or similar services. The amount
that degree candidates may exclude is unlimited. Scholarships and
fellowships for nondegree candidates may be excluded only if the
grantors meet certain requirements; further, the amount that they
may exclude is limited.

Impact
The value of the tax benefit received by each recipient of a tax
exempt scholarship or fellowship grant is small in many cases because
grants are of modest amounts and the recipients have little or no tax
liability.
However, the amount of the tax benefit increases with the in-
dividual's tax bracket, and therefore, increases with the existence of
other income such as a spouse's earnings. Furthermore, university
professors often convert sabbatical pay into tax free fellowships.


Estimated Distribution of Individual Income Tax Expenditure by
Adjusted Gross Income Class
Percentage
Adjusted gross income class (thousands of dollars): distribution
0 to 7------------------------------------------------------ 47. 7
7 to 15----------------------------------------------------- 36. 9
15 to 50---------------------------------------------------- 15. 4
50 and over------------------------------------------------- 0
(87)





88


Rationale
Prior to the Internal Revenue Code of 1954, scholarships were in-
cluded in income unless the taxpayer could show that the grant was a
gift. This treatment was considered to lack uniformity. The ostensible
purpose of the exclusion was to make treatment of taxpayers con-
sistent and uniform. The only amendment to this section, made in
1961 (P.L. 87-256), expanded the category of qualifying grantors of
nondegree candidates' scholarships and fellowship grants.
Selected Bibliography
U.S. Congress, House Committee on Ways and Means. Internal
Revenue Code of 1954, Report to Accompany H.R. 8300, A Bill to Revise
the Internal Revenue Laws of the United States, Washington, D.C.,
U.S. Government Printing Office, 1954, pp. 16-17, A37-A38 (83rd
Congress, 2nd Session, House Report No. 1337).
U.S. Congress, Senate Committee on Finance. Internal Revenue
Code of 1954, Report to Accompany H.R. 8300, A Bill to Revise the
Internal Revenue Laws of the United States, Washington, D.C., U.S.
Government Printing Office, 1954, pp. 17-18, 188-90 (83rd Congress,
2nd Session, Senate Report No. 1622).










PARENTAL PERSONAL EXEMPTION FOR
STUDENT AGE 19 OR OVER


Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total

1977------- 715 --------- 715
1976------- 690 --------- 690
1975------- 670 ---------- 670

Authorization
Section 151(e).
Description
A taxpayer is allowed to deduct $750 as an exemption for each
dependent. A person with gross income in excess of $750 may not be
claimed as a dependent unless that person is the child of the taxpayer
and is either (a) less than 19 years of age or (b) a full-time student.
Unless support is provided by several taxpayers, a person is a depend-
ent only if the taxpayer claiming him as a dependent provided more
than one-half of the person's support.

Impact
This provision benefits families with tax liability and with children
who are students and have earnings. The value of each $750 personal
exemption deduction is $525 for families with the highest marginal
tax rate of 70 percent and $150 for families taxed at the median
marginal rate of 20 percent. No relief is avail a.ble-to the parents of
students who provide more than one-half of their own support.
Therefore, parents are aided by this dependency exemption if their
student-children do not rely on their earnings or other income to
provide a majority of their support.

Estimated Distribution of Individual Income Tax Expenditure by
Adjusted Gross Income Class
Percentage
Adjusted gross income class (thousands of dollars): dizributon
0 to 7-------------------------------------------------------- 7.0
7 to 15------------------------------------------------------ 47.6
15 to50----------------------------------------------------- 31.0
50 and over-- ----------------------------------14.4
(89)





90


Rationale
A p,.r-onal exemption for dependents was first provided by the
Revi mue Act of 1918, apparently to provide some tax relief for parents
supporiing young children or students. The definition of a dependent
wvas revised over the years and a gross income test was added in 1944.
The 1954 revision of the Internal Revenue Code eliminated the
gro--; income test for dependent children under the age of 19 and
dependent children of any age who were students. Except for increases
in the amount of the exemption to $750, this provision has been
unchanged since 1954.

Selected Bibliography
U.S. Congrc-s, House, Committee on Ways and Means. Internal
Revenue Code of 1954, Report to Accompany H.R. 8300, A Bill to
Revise the Internal Revenue Laws of the United Statcs, Washington,
D.C., U.S. Government Printing Office, 1954, pp. 18-9, A40-A41,
Tax Revision Compendium. Papers on Broadening the Tax Base,
November 16, 1959, vol. 1, Washington, D.C, U.S. Government
Printing Office, pp. 533-4.
Groves, Harold M. Federal Tax Treatment of the Family, The Brook-
ings Institution, Washington, D.C., pp. 39-43.
Seltzer, Lawrence H. The Personal Exemption in the Income Tax,
National Bureau of Economic Research, New York, 1968, pp. 113-20.








DEDUCTIBILITY OF CHARITABLE
CONTRIBUTIONS


(1) EDUCATIONAL INSTITUTIONS

(2) OTHER THAN EDUCATION-AL INSTITUTIONS


Estimated Revenue Loss
[In millions of dollars]
Individuals Corporations
Fiscal year Educa- Other Educa- Other Total
tional tional

1977----- 500 3,955 280 525 5,260
1976---- 450 3,820 215 395 4,880
1975----- 440 4,385 205 385 5,415


Authorization
!
Sections 170 and 642(c).
Description
Subject to certain limitations, charitable contributions may be
deducted by individuals, corporations, and estates and trusts.
The contributions must be made to specific types of organizations
including charitable, religious, educational and scientific organiza-
tions, and Federal, State, and local governments.
Individuals may itemize and deduct qualified contributions amount-
ing up to 50 percent of their adjusted gross income (AGI); however,
the deduction for gifts of appreciated property is limited to 30 percent
of AGI. In the case of a corporation, the limit is 5 percent of taxable
income (with some adjustments).

Impact
The deduction for charitable contributions reduces tax liability
and thus makes the net cost of contributing less than the amount of
the gift. In effect, the Federal Government provides the donee with
a matching grant which, per dollar of contribution, increases in
value with the donor's tax bracket. Thus, a taxpayer in the 70 percent
bracket who itemizes deductions can contribute $100 to a charitable
organization at a net cost of $30 while one in the 20 percent bracket
can contribute the same amount at a net cost of $80. An individual
who takes the standard deduction or a non-taxpayer receives no
benefit from the provision.
(91)
67-312-76-----7








Types of contributions may vary substantially among income
classes. Contributions to religious organizations are far more con-
centrated at the lower end of the income scale than contributions to
hospitals, the arts, and educational institutions, with contributions
to other types of organizations falling between these levels. However,
the volume of donations to religious organizations is greater than to
all other organizations as a group.
Organizations that receive the contributions (and their clients)
benefit from this provision to the extent it increases charitable giving.
Empirical studies have not reached a consensus as to how much the
deduction encourages charitable contributions and how the deduction
affects the composition of contributions. Tentative conclusions are
that the deduction increases charitable giving by more than the
forgone Treasury revenue, and that it favors educational contribu-
tions relatively more than would a tax credit or a matching grant
program outside the tax system.

Estimated Distribution of Individual Income Tax Expenditure by
Adjusted Gross Income Class

Percentage distributions
Adjusted gross income class Educational Other
0 to $7,000 ----- ---------------------------------------------------------- 0.3 2.3
$7,0G0 to $15,000 ------------------------------------------------------............................................................... 1.4 16.6
$15,000 to $50,000 ----.---..------------.-------------------------------- 23.7 47.1
$50,000 and over ----------.----------------------...----------.-.--------- 74.6 34.0
1 The distribution refers to the individual tax expenditure only. The corporate tax expend-
iture resulting from these tax provisions is not reflected in this distribution table.

Rationale
This deduction was added on the Senate floor in 1917. Senator
Hollis, the sponsor, argued that the war and high wartime tax rates
had an adverse impact on the flow of funds to charitable organizations.
He preferred a tax deduction to a direct Government subsidy. The
deduction was extended to estates and trusts in 1918 and to corpora-
tions in 1935.
Selected Bibliography
Bittker, Borris, "Charitable Contributions: Tax Deductions or
Matching Grants?" 28 Tax Law Review 37 (1972).
Feldstein, Martin, "The Income Tax and Charitable Contributions:
Part I-Aggregate and Distributional Effects", National Tax Journal,
March 1975, pp. 81-11; "The Income Tax and Charitable Contribu-
tions: Part II-The Impact on Religious, Educational, and Other
Organizations", National Tax Journal, June 1975, pp. 209-226.
McDaniel, Paul R., "Federal Matching Grants for Charitable
Contributions: A Substitute For The Income Tax Deduction", 27
Tax Law Review 377 (1972).






93
Surrey, Stanley R., Pathways to Tax Reform, Chapter VII-Three
Special Tax Expenditure Items: Support to State and Local Govern-
ments, to Philanthropy, and to Housing", Cambridge, Massachusetts,
Harvard University Press, 1973, pp. 209-46.
National Tax Association-Tax Institute of America. Tax Impacts
on Philanthropy-a Sympo.siwrn. Washington, D.C., December 2-3,
1972. Princeton: NTA-TIA and Fund for Public Policy Research,
1972.
Commission on Private Philanthropy and Public Needs, John H.
Filer, Chairman, Giving in America: Toward a Stronger Voluntary
Sector, 1975.