Statement of Richard M. Lipton on the Subject of Tax Simplification
April 26, 2001

2.  Individual Tax Provisions

1. Repeal Stealth Taxes

   The PEP and Pease provisions provide limitations on personal exemptions and itemized deductions. The PEP (or personal exemption phase-out) provision reduces otherwise available personal exemptions by 2 percent for each $2,500 ($1,500 for married individuals filing separately) of adjusted gross income over the threshold amount ($150,000 for married couples, $100,000 for singles). The Pease provision (limitation on itemized deductions) reduces otherwise available itemized deductions by the lesser of 3 percent of adjusted gross income over the "applicable amount" ($128,950 for both married couples and individuals in 2000) or 80 percent of the amount of itemized deductions otherwise available.

   Both of these provisions should be repealed. They are nothing more than hidden rate increases on upper-income taxpayers, and they add considerable complexity to the Code. These limitations prevent a taxpayer from determining his or her tax liability simply by multiplying gross income by the applicable tax rate. That is the definition of a complex, hidden tax.

   Congress should repeal these hidden taxes. That is the position not only of the Section of Taxation but of the ABA and its 400,000 members. If Congress is concerned about the revenue loss, then Congress should either substitute an explicit top rate bracket that would make the provision revenue neutral or reduce the amount of the tax cut for upper-income individuals to offset the repeal of these provisions.

2. Other Phase-Outs

   Many Code provisions confer benefits on individual taxpayers in the form of exclusions, exemptions, deductions, or credits. These provisions, many of which are complex in and of themselves, are further complicated because the benefits are specifically targeted to low and middle income taxpayers. The targeting is accomplished through the phasing out of benefits for individuals or families whose incomes exceed certain levels. We have witnessed, over the past two decades, a veritable explosion in the number of provisions subject to phase-outs, as Congress has moved increasingly toward the use of the Code for incentivizing taxpayer behavior.

   The list of provisions including phase-outs is long and varied. Regular and Roth IRAs, education IRAs, the earned income tax credit, the Hope Scholarship and lifetime learning credits, real estate exception to the passive loss rules to name a few. Each has a phaseout, which limits the benefits of the provision to particular classes of taxpayers over and above the technical requirements of the provision.

   The consistent theme of these phase-outs is that there is no consistency between them in the measure of income, the range of income over which the phase-outs apply, or the method of applying the phase-outs. Phase-outs are, in fact, hidden tax increases that create irrational marginal income tax rates for affected taxpayers. For example, assume a tax credit applies to married taxpayers with $100,000 or less of taxable income but begins to phase out thereafter at $1 of credit for each $100 of additional income. One family has $100,000 of taxable income while a second has $100,100. Each would be in the 31% bracket. However, instead of paying $31 (31% x $100) on its additional $100 of income, the second family would also lose $1 of credit. In effect, therefore, that family is paying tax at a 32% rate. Take this principle, apply to different phase-out rates over different phase-out ranges, and what you end up with is a checkerboard of tax rates that cannot be rationalized. The marginal rate of tax that any particular taxpayer pays is entirely arbitrary.

   Moreover, phase-outs add significantly to the length of tax returns, increase the potential for error, are difficult to understand, and make it extraordinarily difficult for taxpayers to know whether the benefits the provisions are intended to confer will ultimately be available. For example, taxpayers hoping to make a Roth IRA contribution may be unable to determine the extent to which they will be permitted to do so if they potentially fall within its phase-out range.

   With respect to phase-outs other than PEP and Pease discussed above, simplicity would be achieved by (a) eliminating phase-outs altogether where they currently exist, (b) avoiding enactment of new phase-outs, (c) substituting cliffs for the phase-outs, or (d) providing consistency in the measure of income, the range of phase-out, and the method of phase-out.