**PRESENT LAW AND BACKGROUNDON FEDERAL TAX PROVISIONSRELATING TO RETIREMENT SAVINGS INCENTIVES,HEALTH AND LONG-TERM CARE, ANDESTATE AND GIFT TAXES**

Scheduled for a Public HearingBefore theHOUSE COMMITTEE ON WAYS AND MEANSon June 16, 1999

Prepared by the staffof theJOINT COMMITTEE ON TAXATION

June 15, 1999

JCX-29-99

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**CONTENTS**

**INTRODUCTION**

**PART ONE: PRESENT LAW AND BACKGROUND RELATING TO TAX INCENTIVES FOR RETIREMENT SAVINGS**

I.  PRESENT LAW

A.  In General

B.  Individual Retirement Arrangements ("IRAs")

C.  Employer-Sponsored Qualified Retirement Plans and Similar Arrangements

		1.	Employer-sponsored qualified retirement plans

		2.	SIMPLE retirement plans

		3.	Simplified employee pensions ("SEPs")

		4.	Tax-sheltered annuities ("section 403(b) annuities")

		5.	Eligible deferred compensation plans of State and local governments and tax-exempt entities ("section 457 plans")

D.  Other Tax Incentives for Saving

		1.	Annuity contracts

		2.	Life insurance

		3.	Medical savings accounts

		4.	Education tax incentives

II.  BACKGROUND INFORMATION RELATING TO TAX INCENTIVES FOR SAVING

A.  Role of Saving in the National Economy

B.  Tax Incentives for Saving

C.  The Adequacy of Retirement Savings

		1.	 Economic status of the elderly

		2.	 Expected retirement income and needs of current workers

		3.	Increased retirement costs

**PART TWO:  PRESENT LAW AND BACKGROUND ON FEDERAL TAX PROVISIONS RELATING TO HEALTH AND LONG-TERM CARE**

I.  PRESENT LAW AND LEGISLATIVE BACKGROUND

A.  Exclusion from Income and Wages for Employer-Provided Health Care

B.  Employer Deduction for Health Care for Employees

C.  Cafeteria Plans and Flexible Spending Arrangements

D.  Medical Savings Accounts

E.  Deduction for Health Insurance Expenses of Self-Employed Individuals

F.  Itemized Deduction for Medical Expenses

G.  Provisions Relating to Long-Term Care

H.  Group Health Plan Requirements

		1.	Health care continuation rules

		2.	Health Insurance Portability and Accountability Act rules

		3.	Newborns' and mothers' health protection; mental health parity

I.  Other Tax-Related Health Provisions

		1.   Voluntary employees' beneficiary association ("VEBAs")

		2.   Use of excess pension assets of fund retiree health benefits

II.  UTILIZATION OF SELECTED FEDERAL TAX PROVISIONS RELATED TO HEALTH CARE

A.  Exclusion from Income and Wages for Employer-Provided Health Care

B.  Itemized Deduction for Medical Expenses and Long-Term Care Expenses

C.  Deduction for Health Insurance and Long-Term Care Insurance Expenses of Self-Employed Individuals

D.  Medical Savings Accounts

**PART THREE:  PRESENT LAW AND BACKGROUND RELATING TO ESTATE AND GIFT TAXES**

I.  PRESENT LAW AND LEGISLATIVE HISTORY

A.  Present Law

B.  Legislative History

II.  BACKGROUND AND ANALYSIS RELATING TO ESTATE AND GIFT TAXATION

A.  Background Data

B.  Comparison of Transfer Taxation in the United States and Other Countries

C.  Economic Issues Related to Transfer Taxation

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**INTRODUCTION**
	The House Committee on Ways and Means has announced a series of public hearings onproposals to reduce the tax burden on individuals and businesses.  The first day of the series,scheduled for June 16, 1999, will focus on retirement and health security, and will include areview of proposals relating to retirement savings incentives, health and long-term careincentives, and estate and gift tax relief.

	This document,(1) prepared by the staff of the Joint Committee on Taxation, provides adescription of present law and background information relating to tax incentives for retirementsavings (Part One), health and long-term care (Part Two), and estate and gift taxes (Part Three).

**PART ONE:  PRESENT LAW AND BACKGROUND RELATING TO TAX INCENTIVES FOR RETIREMENT SAVINGS**

**I.  PRESENT LAW**

**A.  In General**

	Dividend and interest income generally is taxable under present law.  However, presentlaw also contains a number of provisions which permit individuals to save on a tax-favored basis. These include provisions relating to individual retirement arrangements, tax-qualified retirementplans and similar employer-sponsored arrangements, annuity contracts, life insurance, medicalsavings accounts, and various education savings vehicles.

**B.  Individual Retirement Arrangements ("IRAs")**

**In general**

	There are two different types of IRAs under present law: (1) "traditional" IRAs, to whichboth deductible and nondeductible contributions can be made, and (2) Roth IRAs.  The economicbenefits of making deductible contributions to a traditional IRA and contributions to a Roth IRAare similar,(2) although the rules applicable to each type of IRA contribution vary.

**Deductible IRA contributions**

	Under present law, an individual may make deductible contributions to an individualretirement arrangement ("IRA") up to the lesser of $2,000 or the individual's compensation if theindividual and the individual's spouse are not active participants in an employer-sponsoredretirement plan. In the case of a married couple, deductible IRA contributions of up to $2,000can be made for each spouse (including, for example, a homemaker who does not work outsidethe home), if the combined compensation of both spouses is at least equal to the contributedamount.  If the individual (or the individual's spouse) is an active participant in an employer-sponsored retirement plan, the $2,000 deduction limit is phased out for taxpayers with adjustedgross income ("AGI") over certain levels for the taxable year.

	The AGI phase-out limits for a single individual who is an active participant in anemployer-sponsored retirement plan are as follows: for 1999, $31,000 to $41,000; for 2000, 2001and 2002, the limits increase by $1,000 each year, so that the limits by 2002 are $34,000 to$44,000; for 2003, $40,000 to $50,000; for 2004, $45,000 to $55,000; and for 2005 andthereafter, $50,000 to $60,000.

	The AGI phase-out limits for a married individual filing a joint return who is an activeparticipant in an employer-sponsored plan are as follows: for 1999, $51,000 to $61,000; for 2000, 2001 and 2002, the limits increase by $1,000 each year, so that the limits by 2002 are$54,000 to $64,000; for 2003, $60,000 to $70,000; for 2004, $65,000 to $75,000; for 2005,$70,000 to $80,000; for 2006, $75,000 to $85,000; and for 2007 and thereafter, $80,000 to$90,000.

	If the individual is not an active participant in an employer-sponsored retirement plan, butthe individual's spouse is, the $2,000 deduction limit is phased out for taxpayers with AGIbetween $150,000 and $160,000.

	Amounts held in a traditional IRA are includible in income when withdrawn (except tothe extent the withdrawal is a return of nondeductible contributions). Includible amountswithdrawn prior to attainment of age 59-1/2 are subject to an additional 10-percent earlywithdrawal tax, unless the withdrawal is due to death or disability, is made in the form of certainperiodic payments, is used to pay medical expenses in excess of 7.5 percent of AGI, is used topurchase health insurance of an unemployed individual, is used for education expenses, or isused for first-time homebuyer expenses of up to $10,000.

**Roth IRAs**

	Individuals with AGI below certain levels may make nondeductible contributions to aRoth IRA. The maximum annual contribution that may be made to a Roth IRA is the lesser of$2,000 or the individual's compensation for the year. The contribution limit is reduced to theextent an individual makes contributions to any other IRA for the same taxable year. As underthe rules relating to IRAs generally, a contribution of up to $2,000 for each spouse may be madeto a Roth IRA provided the combined compensation of the spouses is at least equal to thecontributed amount. The maximum annual contribution that can be made to a Roth IRA isphased out for single individuals with AGI between $95,000 and $110,000 and for joint filerswith AGI between $150,000 and $160,000.

	Taxpayers with modified AGI of $100,000 or less generally may convert a deductible ornondeductible IRA into an Roth IRA.  The amount converted is includible in income as if awithdrawal had been made, except that the 10-percent early withdrawal tax does not apply and, ifthe conversion occurred in 1998, the income inclusion may be spread ratably over 4 years.

	Amounts held in a Roth IRA that are withdrawn as a qualified distribution are notincludible in income, nor subject to the additional 10-percent tax on early withdrawals. Aqualified distribution is a distribution that (1) is made after the 5-taxable year period beginningwith the first taxable year for which the individual made a contribution to a Roth IRA, and (2)which is made after attainment of age 59-1/2, on account of death or disability, or is made forfirst-time homebuyer expenses of up to $10,000.

	Distributions from a Roth IRA that are not qualified distributions are includible inincome to the extent attributable to earnings, and subject to the 10-percent early withdrawal tax(unless an exception applies).(3) The same exceptions to the early withdrawal tax that apply toIRAs apply to Roth IRAs.

**Nondeductible IRA contributions**

	To the extent an individual cannot or does not make deductible contributions to an IRA orcontributions to a Roth IRA, the individual may make nondeductible As described above,distributions from a traditional IRA are includible in income and subject to the 10-percent earlywithdrawal tax, except to the extent the distribution is attributable to nondeductiblecontributions.

**Legislative history**

	The IRA provisions were originally enacted in the Employee Retirement Income SecurityAct of 1974 ("ERISA"). Individuals who were active participants in an employer-sponsoredretirement plan were not permitted to make contributions to an IRA. The limit on the deductionfor IRA contributions was generally the lesser of (1) 15 percent of the individual's compensationfor the year, or (2) $1,500.

	The Economic Recovery Tax Act of 1981 increased the deduction limit for contributionsto IRAs and removed the restriction on IRA contributions by active participants in employer-sponsored retirement plans. Beginning in 1982, the deduction for IRA contributions wasgenerally the lesser of (1) 100 percent of the individual's compensation, or (2) $2,000. Anindividual was entitled to make a deductible contribution to an IRA even if the individual was anactive participant in an employer-sponsored retirement plan.

	The Tax Reform Act of 1986 ("1986 Act") added restrictions on deductible IRAcontributions if the individual (or the individual's spouse) was an active participant in employer-sponsored retirement plan. For years 1987 through 1997, if a single taxpayer or either spouse (inthe case of a married couple) was an active participant in an employer-sponsored retirement plan,the maximum IRA deduction was phased out between $25,000 and $35,000 of AGI. For marriedtaxpayers, the maximum deduction was phased out between $40,000 and $50,000 of AGI. Inaddition, the 1986 Act added the present-law rules permitting individuals to make nondeductiblecontributions to an IRA.

	The Small Business Job Protection Act of 1996 modified the rule relating to themaximum deductible IRA contribution by permitting deductible IRA contributions of up to$2,000 to be made for each spouse (including a spouse who does not work outside the home) ifthe combined compensation of both spouses is at least equal to the contributed amount.

	The Health Insurance Portability and Accountability Act of 1996 extended to IRAs theexception to the early withdrawal tax for medical expenses in excess of 7.5 percent of AGI andadded the exception for health insurance expenses for unemployed individuals.

	The Taxpayer Relief Act of 1997: (1) increased the AGI phase-out limits for deductibleIRAs; (2) modified the AGI phase-out limits for an individual who is not an active participant inan employer-sponsored retirement plan but whose spouse is; (3) provided exceptions from theearly withdrawal tax for withdrawals for education expenses and first-time home purchase (up to$10,000), and (4) created the Roth IRA.

**C.  Employer-Sponsored Qualified Retirement Plans and Similar Arrangements**

**1.  Employer-sponsored qualified retirement plans**

**In general**

	A plan of deferred compensation that meets the qualification standards of the InternalRevenue Code ("a qualified plan") is accorded special tax treatment under present law.Employees do not include qualified plan benefits in gross income until the benefits aredistributed, even though the plan is funded and the benefits are nonforfeitable. The employer isentitled to a current deduction (within limits) for contributions to a qualified plan even thoughthe contributions are not currently included in an employee's income. Contributions to a qualifiedplan are held in a tax-exempt trust.

	Employees, as well as employers, may make contributions to a qualified plan. Employeesmay, subject to certain restrictions, make both pre-tax and after-tax contributions to a qualifiedplan. Pre-tax employee contributions (e.g., contributions to a qualified cash or deferredarrangement (section "401(k) plan")) are generally treated the same as employer contributions fortax purposes.

	The tax treatment of contributions under qualified plans is essentially the same as that ofdeductible IRAs. However, the limits on contributions to qualified plans are much higher thanthe IRA contribution limits, so that qualified plans provide for a greater accumulation of fundson a tax-favored basis. The policy rationale for permitting greater accumulation under qualifiedplans than IRAs is that the tax benefits for qualified plans encourage employers to providebenefits for a broad group of their employees. This reduces the need for public assistance andreduces pressure on the social security system.

	Present law imposes a number of requirements on qualified plans that must be satisfied inorder for the plan to obtain tax-favored status.  For example, minimum participation andcoverage rules and nondiscrimination rules are designed to ensure that qualified plans benefit anemployer's rank-and-file employees as well as highly compensated employees.(4)   Under theminimum coverage rules, a plan must satisfy one of the following requirements: (1) the planbenefits at least 70 percent of employees who are nonhighly compensated employees(5); (2) theplan benefits a percentage of nonhighly compensated employees that is at least 70 percent of thepercentage of highly compensated employees benefitting under the plan; or (3) the plan satisfiesan average benefits test which compares the benefits received by highly compensated employeesand nonhighly compensated employees.  Present law also contains a general nondiscriminationrequirement which provides that plans may not discriminate in favor of highly compensatedemployees.  This requirement generally applies to all benefits, rights and features, not just tocontributions and benefits.  Special rules apply to plans that primarily benefit key employees(called "top-heavy plans").

	The plan qualification standards also define the rights of plan participants andbeneficiaries and provide some limits on the tax benefits for qualified plans.(6) Certain of the rulesrelating to qualified plans are designed to ensure that the amounts contributed to qualified plansare used for retirement purposes. Thus, for example, an early withdrawal tax applies to prematuredistributions from such plans, and the ability to obtain distributions prior to termination ofemployment from certain types of qualified plans is restricted.

**Types of qualified plans**

	Qualified plans are broadly classified into two categories, defined benefit pension plansand defined contribution plans, based on the nature of the benefits provided.

	Under a defined benefit pension plan, benefit levels are specified under a plan formula.For example, a defined benefit pension plan might provide an annual retirement benefit of 2percent of final average compensation multiplied by total years of service completed by anemployee. Benefits under a defined benefit pension plan are funded by the general assets of thetrust established under the plan; individual accounts are not maintained for employeesparticipating in the plan. Benefits under a defined benefit pension plan are guaranteed (withinlimits) by the Pension Benefit Guaranty Corporation ("PBGC"), a Federal corporation within theDepartment of Labor.

	Benefits under defined contribution plans are based solely on the contributions (andearnings thereon) allocated to separate accounts maintained for each plan participant.Profit-sharing plans and qualified cash or deferred arrangements (called 401(k) plans after thesection of the Code regulating such plans) are examples of defined contribution plans.

**Limits on contributions and benefits**

	Under present law, limits apply to contributions and benefits under qualified plans. In thecase of a defined benefit pension plan, present law limits the annual benefits payable under theplan to the lesser of (1) 100 percent of the participant's average compensation for his or her high3 years, or (2) $130,000 (for 1999).(7)   In general, the $130,000 dollar limit is increased forretirement after the social security retirement age, and decreased for retirement before the socialsecurity retirement age.  Under a defined contribution plan, the qualification rules limit theannual additions to the plan with respect to each plan participant to the lesser of (1) 25 percent ofcompensation or (2) $30,000 (for 1999). Annual additions are the sum of employer contributions,employee contributions, and forfeitures with respect to an individual under all definedcontribution plans of the same employer. The dollar limits are increased for cost-of-livingadjustments in $5,000 increments.  In some cases special, increased limits apply in the case ofState and local government plans.

	An overall limit applies if an individual is a participant in both a defined contributionplan and a defined benefit plan of the same employer. The Small Business Job Protection Act of1996 repealed this overall limit for years beginning after December 31, 1999.

**Taxation of distributions**

	Under present law, a distribution of benefits from a qualified plan generally is includiblein gross income in the year it is paid or distributed, except to the extent the amount distributedrepresents the employee's investment in the contract (i.e., basis). Special rules apply to lump-sumdistributions, distributions rolled over to an IRA or another qualified plan, and distributions ofemployer securities.

	Early distributions from qualified plans generally are subject to the same additional10-percent early withdrawal tax that applies to early distributions from IRAs.  The earlywithdrawal tax does not apply to distributions from a qualified plan made to an employee afterseparation from service after attainment of age 55.  The exceptions to the early withdrawal taxfor medical insurance expenses of unemployed individuals, education expenses, and first-timehomebuyer expenses do not apply to qualified plan distributions.

**Qualified cash or deferred arrangements**

	As mentioned above, a qualified cash or deferred arrangement is a type of qualified plan.Thus, such arrangements are subject to the rules generally applicable to qualified plans. Inaddition, special rules apply to such arrangements.(8)

	A profit-sharing or stock bonus plan, a pre-ERISA money purchase pension plan, or arural cooperative plan may include a qualified cash or deferred arrangement (section 401(k)plan). Under such an arrangement, an employee may elect to have the employer make paymentsas contributions to a qualified plan on behalf of the employee, or to the employee directly incash. Contributions made at the election of the employee are called elective deferrals. Themaximum annual amount of elective deferrals that can be made by an individual is $10,000 for1999. This dollar limit is indexed for inflation in $500 increments. An employee's electivedeferrals must be fully vested. A special nondiscrimination test applies to elective deferrals undercash or deferred arrangements. Employer matching contributions and after-tax employeecontributions under qualified defined contribution plans are also subject to a specialnondiscrimination test.

	Under a safe harbor, a cash or deferred arrangement is deemed to satisfy the specialnondiscrimination test if the plan satisfies one of two contribution requirements and satisfies anotice requirement. A plan satisfies the contribution requirement under the safe harbor rule forqualified cash or deferred arrangements if the employer either (1) satisfies a matchingcontribution requirement or (2) makes a nonelective contribution to a defined contribution planof at least 3 percent of an employee's compensation on behalf of each nonhighly compensatedemployee who is eligible to participate in the arrangement without regard to the permitteddisparity rules (sec. 401(1)). A plan satisfies the matching contribution requirement if, under thearrangement: (1) the employer makes a matching contribution on behalf of each nonhighlycompensated employee that is equal to (a) 100 percent of the employee's elective deferrals up to3 percent of compensation and (b) 50 percent of the employee's elective deferrals from 3 to 5percent of compensation; and (2), the rate of match with respect to any elective contribution forhighly compensated employees is not greater than the rate of match for nonhighly compensatedemployees.  Certain alternative matching arrangements also can be used to satisfy the safeharbor.

**2.  SIMPLE retirement plans**

	Under present law, certain small businesses can establish a simplified retirement plancalled the savings incentive match plan for employees ("SIMPLE") retirement plan. SIMPLEplans can be adopted by employers who employ 100 or fewer employees who received at least$5,000 in compensation during the preceding year and who do not maintain anotheremployer-sponsored retirement plan. A SIMPLE plan can be either an IRA for each employee orpart of a section 401(k) plan. If established in IRA form, a SIMPLE plan is not subject to thenondiscrimination rules generally applicable to qualified plans (including the top-heavy rules)and simplified reporting requirements apply.  If established as part of a 401(k) plan, the SIMPLEdoes not have to satisfy the special nondiscrimination tests applicable to 401(k) plans and is notsubject to the top-heavy rules. The other qualified plan rules continue to apply.  Within limits,contributions to a SIMPLE plan are not taxable until withdrawn.

	A SIMPLE retirement plan allows employees to make elective contributions whichcannot exceed $6,000 (for 1999). The $6,000 dollar limit is indexed for inflation in $500increments. The employer is required to satisfy one of two contribution formulas. Under thematching contribution formula, the employer generally is required to match employee electivecontributions on a dollar-for-dollar basis up to 3 percent of the employee's compensation. Undera special rule applicable to SIMPLE IRAs, the employer can elect a lower percentage matchingcontribution for all employees (but not less than 1 percent of each employee's compensation). Inaddition, a lower percentage cannot be elected for more than 2 out of any 5 years.

	Alternatively, for any year, an employer is permitted to elect, in lieu of making matchingcontributions, to make a 2 percent of compensation nonelective contribution on behalf of eacheligible employee with at least $5,000 in compensation for such year, whether or not theemployee makes an elective contribution.

	No contributions other than employee elective contributions, required employer matchingcontributions or employer nonelective contributions can be made to a SIMPLE plan. Allcontributions to an employee's SIMPLE account must be fully vested.

	Contributions to a SIMPLE plan generally are deductible by the employer and excludablefrom the employee's income. Early withdrawals from a SIMPLE plan generally are subject to the10-percent early withdrawal tax. However, in the case of a SIMPLE IRA, withdrawals ofcontributions during the 2-year period beginning on the date the employee first participated in theSIMPLE IRA are subject to a 25-percent early withdrawal tax.

**3.  Simplified employee pensions ("SEPs")**

	A simplified employee pension ("SEP") is an IRA to which employers may makecontributions up to the limits applicable to defined contribution plans. The employee is always100-percent vested in employer contributions.   All employees who satisfy certain participationrequirements must be eligible to participate in the SEP.  An employee satisfies the participationrequirements if the employee (1) has attained age 21, (2) has performed services for the employerduring at least 3 of the immediately preceding 5 years, and (3) received at least $400 (for 1999)in compensation from the employer for the year.  Contributions to a SEP generally must bear auniform relationship to compensation.  An employee can participate even though he or she is alsoa participant in one or more other qualified retirement plans sponsored by the employer.However, SEP contributions are added to the employer's contribution to the other plans on theparticipant's behalf in applying the limits on contributions and benefits.

	Effective for taxable years beginning before January 1, 1997, certain small employerscould maintain a salary reduction SEP ("SARSEP") under which employees could elect to havecontributions made to the plan or to receive the contributions in cash.  The SARSEP rules weregenerally repealed with the adoption of SIMPLE plans.   However, employers may continue tomake contributions to SARSEPs that were established before 1997 (in accordance with the rulesin effect before 1997). In addition, employees hired after December 31, 1996, may participate inSARSEPs established by their employers prior to January 1, 1997.

**4.  Tax-sheltered annuities ("section 403(b) annuities")**

	Tax-sheltered annuities ("section 403(b) annuities") are another form of employer-basedretirement plan that provide the same tax benefits as qualified plans and IRAs. Employers maycontribute to such annuities on behalf of their employees, and employees may contribute on apre-tax basis through salary reduction. Tax-sheltered annuities are subject to rules similar tosome of the rules applicable to qualified plans. Tax-sheltered annuity plans may be maintainedonly by certain types of organizations, in particular, tax-exempt charitable organizations andeducational institutions.

	The annual contribution to a tax-sheltered annuity generally cannot exceed the lesser ofthe exclusion allowance or the limit applicable to defined contribution qualified plans.  Theexclusion allowance for a year is equal to 20 percent of the employee's includible compensation,multiplied by the employee's years of service, minus excludable contributions for prior yearsunder qualified plans, tax-sheltered annuities or section 457 plans of the employer.  In addition tothis general rule, employees of nonprofit educational institutions, hospitals, home health serviceagencies, health and welfare service agencies, and churches may elect to have one of severalspecial rules apply that increase the amount of the otherwise permitted contributions.  Theelection of a special rule is irrevocable; an employee may not elect to have more than one specialrule apply.

	Employer contributions to a section 403(b) annuity are generally subject to the samenondiscrimination rules as contributions to qualified plans.  Contributions made by the employeeunder a salary reduction agreement (i.e., contributions that are comparable to employee electivedeferrals under a section 401(k) plan) are not subject to nondiscrimination rules similar to thoseapplicable to section 401(k) plans.  Instead, all employees generally must be eligible to makesalary reduction contributions.  Certain employees may be disregarded for purposes of this rule.(9)

**5.  Eligible deferred compensation plans of State and local governments and tax-exemptentities ("section 457 plans")**

	Compensation deferred under an eligible deferred compensation plan (a "section 457plan") of a tax-exempt or State or local governmental employer is includible in income whenpaid or made available. The maximum annual deferral under such a plan generally is the lesser of(1) $8,000 (for 1999) or (2) 33-1/3 percent of compensation (net of the deferral).

	In general, amounts deferred under a section 457 plan may not be made available to aplan participant before the earlier of (1) the calendar year in which the participant attains age 70-1/2, (2) when the participant is separated from service with the employer, or (3) when theparticipant is faced with an unforeseeable emergency. Amounts that are made available uponseparation from service are includible in gross income in the taxable year in which they are madeavailable.

	Amounts deferred under a governmental section 457 plan must be held in trust.  Amountsdeferred under a section 457 plan of a tax-exempt entity must remain the property of theemployer, subject only to the claims of the employer's general creditors.

	With certain exceptions, section 457 generally applies to all deferred compensation ofemployees of tax-exempt and State and local governmental employers other than compensationdeferred under a qualified plan (or a tax-sheltered annuity).  Section 457 does not apply to anybona fide vacation, sick leave, compensatory time, severance pay, disability pay, or death benefitplan.  In addition, section 457 does not apply to qualified governmental excess benefit plans thatprovide benefits in excess of those that are provided under a qualified plan maintained by thegovernmental employer.

	Section 457 plans are not qualified retirement plans; rather, such plans have traditionallybeen more like unfunded, nonqualified deferred compensation arrangements of private, taxableemployers.  Present law does not limit the amount of deferred compensation payable undernonqualified deferred compensation plans of taxable employers because there is tension betweenthe employer and the employee-employers generally want a current deduction for compensation,whereas deferred compensation is not deductible until includible in employees' income.  Thistension is not present in the case of deferred compensation plans of tax-exempt and governmentalemployers.  Thus, section 457 limits the amount that can be deferred under such plans andprovides other rules regarding such plans.

	Section 457 plans do not benefit from all the favorable tax rules applicable to qualifiedplans because section 457 plans generally have not been subject to all of the same restrictionsand rules as qualified plans (e.g., the maximum permitted annual deferral is lower).  However,recent changes in the rules relating to section 457 plans of governmental employers have blurredthe distinction between governmental section 457 plans and governmental qualified plans.  Inparticular, assets of governmental section 457 plans must now be held in trust, and governmentalqualified plans are not subject to nondiscrimination rules.

**D.  Other Tax Incentives for Saving**

**1.  Annuity contracts**

	Present law provides that income credited to a deferred annuity contract generally is notcurrently includible in the gross income of the owner of the contract.   No deduction is providedfor, and no dollar limits are imposed on, amounts used to purchase annuity contracts. No incomecap limit applies to individuals purchasing annuity contracts.  In general, amounts received bythe owner of an annuity contract before the annuity starting date (including loans under orsecured by the contract), as well as lump sum distributions after the annuity starting date, areincludible in gross income as ordinary income to the extent that the cash value of the contractexceeds the owner's investment in the contract. A portion of each annuity payment received afterthe annuity starting date is treated as ordinary income based on the ratio of the investment in thecontract to the total distributions expected to be received.

	A 10-percent additional income tax is imposed on certain early withdrawals under anannuity contract. This additional tax does not apply to any distribution made after the owner ofthe contract attains age 59-1/2, dies or becomes disabled, made in the form of certain periodicpayments, or that satisfies certain other requirements.

**2.  Life insurance**

	No Federal income tax generally is imposed on a policyholder with respect to theearnings under a life insurance contract ("inside buildup").  Further, death benefits paid under alife insurance contract are excluded from income, so that neither the policyholder nor thepolicyholder's beneficiary is ever taxed on the inside buildup if the proceeds of the policy arepaid to the policyholder's beneficiary by reason of the death of the insured.  In addition, certainamounts received under a life insurance contract on the life of a terminally ill or chronically illindividual are treated as being received by reason of the death of the insured and therefore areexcludable from income.  This same favorable tax treatment applies to amounts received fromthe sale or assignment to a viatical settlement provider of a life insurance contract on the life of aterminally ill or chronically ill individual.  The favorable tax treatment for life insurancecontracts is available only if the policyholder has an insurable interest in the insured when thecontract is issued and if the life insurance contract meets certain requirements designed to limitthe investment character of the contract.

	Except as described above, distributions from a life insurance contract (other than amodified endowment contract) that are made prior to the death of the insured generally areincludible in income only to the extent that the amounts distributed exceed the taxpayer'sinvestment in the contract; such distributions generally are treated first as a tax-free recovery ofthe taxpayer's investment in the contract, and then as income.  In the case of a modifiedendowment contract, distributions are treated as income first, loans are treated as distributions(i.e., income rather than basis recovery first), and an additional 10-percent tax is imposed on theincome portion of distributions made before age 59-1/2 and in certain other circumstances.  Amodified endowment contract is a life insurance contract that does not meet a statutory "7-pay"test, i.e., generally is funded more rapidly than 7 annual level premiums.

	No deduction is provided for, and no dollar limits are imposed on, amounts used by anindividual to purchase life insurance contracts.

**3.  Medical savings accounts**(10)

	Under present law, eligible individuals covered under a high deductible health plan mayhave a medical savings account ("MSA").  In general, eligible individuals are individualsemployed by a small employer and self-employed individuals.  Within limits, contributions madeby an individual to an MSA are deductible, and contributions made by the individual's employerare excludable from gross income.  Earnings on amounts held in an MSA are not currentlyincludible in income.  Amounts withdrawn for medical expenses are not taxable.  Amountswithdrawn for nonmedical purposes are includible in income and subject to an additional 15-percent tax unless the distribution is made after death, disability, or age 65.

	While MSAs are not available to all individuals, when used for nonmedical purposes,MSAs provide the same tax benefits as IRAs and qualified plans.  When used for medicalpurposes, they provide greater tax benefits, because both contributions and withdrawals are taxfree.

**4.  Education tax incentives**

	Present law contains a number of provisions intended to assist individuals to save foreducation.

**Exclusion for interest earned on savings bonds**

	Interest earned on a qualified U.S. Series EE savings bond issued after 1989 is excludablefrom gross income if the proceeds of the bond upon redemption do not exceed qualified highereducation expenses paid by the taxpayer during the taxable year (sec. 135).  "Qualified highereducation expenses" include tuition and fees (but not room and board expenses) required for theenrollment or attendance of the taxpayer, the taxpayer's spouse, or a dependent of the taxpayer atcertain colleges, universities, or vocational schools.  The exclusion is phased out for certainhigher-income taxpayers, determined by the taxpayer's modified AGI during the year the bond isredeemed.  For 1999, the exclusion is phased out for taxpayers with modified AGI between$53,100 and $68,100 ($76,650 and $109,650 for joint returns).  To prevent taxpayers fromeffectively avoiding the income phase-out limitation through issuance of bonds directly in thechild's name, present law provides that the interest exclusion is available only with respect toU.S. Series EE savings bonds issued to taxpayers who are least 24 years old.

**Qualified State tuition programs**

	Present law provides tax-exempt status to "qualified State tuition programs," meaningcertain programs established and maintained by a State (or agency or instrumentality thereof)under which persons may (1) purchase tuition credits or certificates on behalf of a designatedbeneficiary that entitle the beneficiary to a waiver or payment of qualified higher educationexpenses of the beneficiary, or (2) make contributions to an account that is established for thepurpose of meeting qualified higher education expenses of the designated beneficiary of theaccount (sec. 529).  "Qualified higher education expenses" are defined as tuition, fees, books,supplies, equipment and certain room and board expenses required for the enrollment orattendance at a college or university (or certain vocational schools).  Present law also providesthat no amount is included in the gross income of a contributor to, or beneficiary of, a qualifiedState tuition program with respect to any distribution from, or earnings under, such program,except that (1) amounts distributed or educational benefits provided to a beneficiary (e.g., whenthe beneficiary attends college) will be included in the beneficiary's gross income (unlessexcludable under another Code section) to the extent such amounts or the value of theeducational benefits exceed contributions made on behalf of the beneficiary, and (2) amountsdistributed to a contributor (e.g., when a parent receives a refund) will be included in thecontributor's gross income to the extent such amounts exceed contributions made by that person.

**Education IRAs**

	Present law provides tax-exempt status to "education IRAs," meaning certain trusts (orcustodial accounts) which are created or organized in the United States exclusively for thepurpose of paying the qualified higher education expenses of a named beneficiary.  Annualcontributions to education IRAs may not exceed $500 per designated beneficiary (except in casesinvolving certain tax-free rollovers, as described below), and may not be made after thedesignated beneficiary reaches age 18.(11)  The $500 annual contribution limit is phased out ratablyfor single contributors with modified AGI between $95,000 and $110,000 ($150,000 and$160,000 for joint returns).

	Amounts distributed from education IRAs are excludable from gross income to the extentthat the amounts distributed do not exceed qualified higher education expenses of an eligiblestudent incurred during the year the distribution is made (provided that a HOPE credit orLifetime Learning credit is not claimed with respect to the beneficiary for the same taxable year). If a HOPE credit or Lifetime Learning credit is claimed with respect to a student for a taxableyear, then a distribution from an education IRA may (at the option of the taxpayer) be made onbehalf of that student during that taxable year, but an exclusion is not available for the earningsportion of such distribution.

	Distributions from an education IRA that exceed qualified higher education expenses areincludible in the distributee's gross income, and subject to an additional 10-percent tax (unlessthe distribution is made on account of the death, disability, or scholarship receipt of thedesignated beneficiary).

**II.  BACKGROUND INFORMATION RELATING TO TAX INCENTIVES FOR SAVING**

**A.  Role of Saving in the National Economy**

**Investment and economic growth**

	When an economy's rate of investment increases, the economy's stock of capitalincreases. A larger capital stock permits greater production of goods and services. Because alarger capital stock leads to more productive workers, investment also leads to higher real wagesand salaries. Thus, increases in investment lead to future increases in a nation's standard ofliving.

	It is important to distinguish gross investment from net investment. Gross investmentincludes investment in new capital as well as investment that is undertaken to replace depreciatedor worn out capital. Net investment measures increases to the capital stock. (Net investment isequal to gross investment less depreciation).

	In the short run, increases in gross investment will increase the capital stock. As thecapital stock increases and worker productivity increases, the economy will experience a higherrate of growth. In the long run, any given rate of investment will just be sufficient to replace theexisting, though larger, capital stock as it depreciates. Thus, in the long run, an increase in thelevel of investment increases a nation's standard of living, but may not increase a country's long-run rate of growth.

	It is possible that a higher investment level can lead to a higher growth rate even in thelong run. Even if there is no growth in net investment, investment to replace depreciated capitalmay still enhance economic growth to the extent that the replacement capital embodies improved(and more efficient) equipment and technologies. The higher the gross investment rate, the morenew capital is purchased each year, and thus the rate at which new technologies get adopted maybe higher.

**Sources of investment funds**

	Investment involves a trade-off between consumption today and consumption tomorrow.Investment can either be financed by national saving, or by foreign borrowing (saving byforeigners). A basic accounting identity of the national income and product accounts states that:(12)

Investment = Private Saving + Government Saving + Net Foreign Borrowing

	Many analysts in the past ignored the foreign sector, primarily because at the time it wassmall relative to the U.S. economy. These analysts interpreted this basic relationship as sayingthat national investment must equal national saving, where national saving is the sum of privatesaving and public saving.

	However, national investment need not equal national saving if foreigners can invest inthe United States. The experience of the 1980s, when investment in the United States greatlyexceeded national savings, demonstrates how important this source of funds can be. Whendemand for investment funds in the United States outstrips the supply of national savings,interest rates rise in response. Increases in interest rates attract foreign capital to the UnitedStates, and the excess of investment over national saving is financed by foreigners' saving.

	Foreign investment in the United States also is related to the value of the dollar and thetrade deficit. To take advantage of higher interest rates in the United States, foreign investorsfirst must convert their currencies to dollars. This increases demand for the dollar, therebyincreasing the dollar's exchange rate relative to the foreign currency. A stronger dollar makesimported goods relatively cheaper and our exports relatively more expensive. As a consequence,net exports fall and the trade deficit increases. A further accounting identity states that:(13)

Net Foreign Borrowing = (Imports-Exports)

	When net foreign borrowing increases, the trade deficit (the difference between importsand exports of goods and services) also increases. Thus, many people have blamed the U.S. tradedeficits of the 1980s on the low national savings rate during that period.(14)

**Is the United States' saving rate too low?**

          Consequences of a low saving rate

	The consequences of a low saving rate depend on the mobility of international capital. Ifcapital is not mobile, then, as discussed above, investment is equal to national savings. When thesaving rate is low, so is the investment rate. Historically, there has been a strong relationshipbetween a country's rate of investment and its rate of saving.(15) Although this relationship hasbecome weaker over time,(16) it is still true that countries with high saving rates also generallyhave high investment rates.

	If capital is mobile (that is, if foreigners can invest in the United States at low cost andwithout a lot of added risk), then investment will not decline as much when the saving rate falls.Instead, investment will be financed by foreigners, either by direct foreign investment in theUnited States or by foreign lending to U.S. investors. When domestic saving rates are low,foreign financing of domestic investment results in a higher rate of investment than would bepossible if investment were financed by domestic saving. Foreign investment in the United Statesdoes increase the productivity of U.S. workers. However, the profits generated by foreigninvestment flow abroad, since the United States has to pay interest on the funds it borrows.Furthermore, eventually the debt will have to be repaid, so the net wealth that is left to futuregenerations of U.S. residents is smaller than it would be if the investment were financed bydomestic saving.

          Trends in national saving and investment

	National saving is generally divided into private saving and public saving. Private savingis comprised of household or personal saving and business saving. Households save by notspending all of their disposable income (i.e., after-tax income). In the tables that follow, personalsaving is measured as the difference between household income and household consumption. Inaddition, the National Income and Product Accounts attribute all corporate pension contributionsand earnings on accumulated pension balances as saving by the household sector and, hence, partof personal saving.  Personal saving does not include changes in values of household assets, suchas have occurred over the past few years as stock market values have increased. Businesses saveby retaining some of their earnings. Tables 1 and 2 present net saving, which equals gross savingless capital consumption (depreciation). Public saving reflects the extent to which the Federal,State, and local governments run budget surpluses or deficits. The National Income and ProductAccounts also adjust government surpluses for depreciation of government assets. Hence, publicsaving, like business saving, is measured as net saving. Table 1 presents data on the componentsof net national saving in the United States.

	Table 2 presents net saving by component as a percentage of gross domestic product("GDP"). As the table demonstrates, net business saving, net private saving, and public savingwere all lower during the 1980s then in any of the three previous decades. Net national savingdeclined through most of the 1980s, and has fallen to lower levels in the 1990s.  Figure 1 plotsthe data of Table 2 for net national saving, net private saving, and net public saving.  Over thepast five years, reductions in the Federal Government's deficit ( and actual surplus in 1998)combined with increasing surpluses by State and local governments have more than offsetmeasured declines in private saving.

	Some analysts suggest that because households save out of their disposable income (i.e.,after-tax income), it is more appropriate to examine personal saving relative to disposableincome than to examine personal saving relative to GDP. Table 3 presents personal saving as apercentage of disposable income.  Generally, the same trends observed in Table 2 are evident inTable 3.

**TABLE 1**

**TABLE 2**

**FIGURE 1**

**Table 3.-U.S. Personal Savingas a Percentage of DisposablePersonal Income, Selected Years, 1929-1998**

**Year**
**Personal saving as a percentageof disposable personal income**
1929	

1939	

1944	

1949	

1954	

1959	

1964	

1969	

1974	

1975	

1976	

1977	

1978	

1979	

1980	

1981	

1982	

1983	

1984	

1985	

1986	

1987	

1988	

1989	

1990	

1991	

1992	

1993	

1994	

1995	

1996	

1997	

1998	
   .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .     3.2

   .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .     2.6

   .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .     25.1

   .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .     3.9

   .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .     6.3

   .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .     7.2

   .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .     7.9

   .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .     7.2

   .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .     9.5

   .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .     9.3

   .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .     7.9

   .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .     6.9

   .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .     7.5

   .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .     7.7

   .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .     8.5

   .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .     9.4

   .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .     9.0

   .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .     6.7

   .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .     8.6

   .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .     6.9

   .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .     5.9

   .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .     5.0

   .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .     5.4

   .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .     5.0

   .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .     5.1

   .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .     5.6

   .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .     5.7

   .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .     4.4

   .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .     3.5

   .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .     3.4

   .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .     2.9

   .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .     2.1

   .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .     0.5

Source:  Department of Commerce, Bureau of Economic Analysis.

	Prior to 1980, domestic saving generally financed domestic investment as well asproviding funds for the United States to be a net investor abroad (negative net foreigninvestment). During the 1980s, net savings fell short of domestic investment as a share of GDP.Domestic investment declined from its 1984 peak and net foreign investment provided for thedifference in domestic savings and investment. Thus, although the decline in U.S. saving wascoincident with a decline in investment, this decline was not as severe as it might have been hadthere not been foreign investment.

          Comparison between the saving rates of the U.S. and other countries

	The United States' national saving rate is low when compared to that of other nations.Table 2 shows that the United State's net national saving averaged approximately 6 percent ofGDP in the 1980s and approximately 5 percent thus far in the 1990s. The net national saving rateof Canada during the 1980s averaged 7.3 percent of GDP. For Japan, the comparable rate was17.9 percent; Germany, 9.2 percent; Italy, 8.3 percent; France, 6.7 percent; the United Kingdom,4.5 percent; and Australia, 3.4 percent.(17) Table 4 presents a comparison for household or personalsaving. As Table 4 indicates, the household saving rate of the United States during the pastdecade was below the household saving rates of Canada, Germany, Japan, and the UnitedKingdom.(18)

**Table 4.-Net Household Saving as a Percentage of Disposable HouseholdIncome in Certain Countries, Selected Years, 1972-1997**
**Country**
**1972**
**1976**
**1980**
**1984**
**1988**
**1990**
**1992**
**1994**
**1995**
**1996**
**1997**
**Average1988-1997**United States7.57.68.48.65.35.25.74.24.94.44.05.2Japan18.223.217.915.813.012.113.112.813.013.813.613.2Germany14.413.312.811.412.813.812.911.711.611.711.812.4United Kingdom6.410.913.411.16.28.212.010.411.711.411.110.0Canada8.711.813.615.09.79.710.37.67.05.91.99.1Australia11.811.110.89.96.16.94.63.22.64.63.94.1
Source: Organization for Economic Co-Operation and Development, *OECD Economic Outlook*, 63, June 1998 and earlier issues.
	Generally, saving rates of all nations have declined from the rates of the late 1960s. Inpercentage terms, the decline in the national saving rate of the United States between 1967 and1995 is greater than the decline of the saving rates of Japan and Germany, but comparable to thedecline of some other western, industrialized countries.

	Although many people have pointed to the low saving rate in the United States as a causeof declining productivity, others argue that the United States has long been a relativelylow-saving nation, and yet has enjoyed substantial economic growth. They note that many of thenations with higher saving rates were nations which needed to rebuild after the destruction of waron their own territory.

	Furthermore, some argue that the low saving rate in the United States may be a product ofdemographics, and that the saving rate will increase as the baby boomers continue to enter theirforties and fifties, typically the years during which people do much of their retirement saving.However, others note that in the past, demographic changes have not been very successful atpredicting saving rates.

	In general, the decline in private saving rates is not well understood. It is likely thatdemographic changes, capital market liberalization, increased insurance availability, andincreased social security benefits have all contributed to the decline. However, these factors havenot proved significant enough to account for the total decline in the saving rate. Similarly, thereis no convincing explanation for why saving rates have declined in other nations as well.

**B.  Tax Incentives for Saving**

**Goals of tax incentives for saving**

	Some argue that tax incentives for saving are appropriate because the income tax systemtaxes the return to income that is saved, thereby lowering the return to saving. This lower returnon saving affects both the national saving rate, as well as the assets that taxpayers accumulate forparticular purposes. There is some disagreement about whether the goal of tax incentives forsaving should be to encourage saving for particular purposes or to increase national saving.These purposes are not mutually exclusive; if effective, incentives to save for particular purposeswill increase national saving. However, general saving incentives will not necessarily fulfill morespecific goals. Whether new tax incentives for saving should be aimed at increasing nationalsaving in general, or increasing retirement saving, depends on the perceived adequacy of eachtype of saving.

**Efficacy of tax incentives for saving**

          Overview

	Tax incentives for saving may have a number of attributes that may affect a taxpayer'ssaving decision. First, investments in tax-advantaged assets or accounts earn a higher after-taxrate of return than investments in other assets which may lead to an increase or decrease insaving. Second, a targeted savings incentive may provide an incentive for a specific form ofsaving relative to other forms of saving. Third, a tax incentive for saving may provide apsychological incentive to save. Fourth, advertising by banks and other financial institutions oftax-benefitted savings vehicles may influence people's saving decisions. The followingdiscussion focuses on each of these attributes.

          Rate of return

	Tax exclusions or deferrals for the income earned from saving increase the rate of returnto saving. When the return on saving increases, the price of future consumption decreases,because the taxpayer has to forgo fewer dollars today to consume a dollar's worth ofconsumption in the future.

	This price decrease can affect saving in two ways. Since future consumption is nowcheaper, taxpayers may choose to substitute future consumption for current consumption. Thiseffect increases saving. When the price of future consumption falls, though, the amount ofinvestment necessary to achieve any particular level of income in the future decreases. Forexample, a taxpayer in the 28-percent marginal tax bracket may set aside $1,300 today to helpdefray tuition expenses of his child 15 years from now. If the taxpayer's investment earns 8percent annually and those earnings are taxed annually at a 28-percent tax rate, in 15 years theinvestment will be worth $3,000. If the taxpayer instead invested in a Roth IRA, an investment ofonly $946 today would be worth $3,000 in 15 years (assuming the same 8-percent return). Thiseffect decreases saving because the tax benefit permits the taxpayer to save less to accumulatethe same amount of money in the future.

	Substantial disagreement exists among economists as to the effect on saving of increasesin the net return to saving. Some studies have argued that one should expect substantial increasesin saving from increases in the net return.(19) Other studies have argued that large behavioralresponses to changes in the after-tax rate of return will not necessarily occur.(20) Empiricalinvestigation of the responsiveness of personal saving to after-tax returns provides no conclusiveresults. Some find personal saving responds strongly to increases in the net return,(21) while othersfind little or a negative response.(22)

	Even if increasing the rate of return on all saving does increase saving generally, it is stillpossible that increasing the rate of return on qualified plans or IRAs would not affect saving. Forincreased rates of return to influence taxpayers to substitute future consumption for currentconsumption, the marginal rate of return on savings must increase so that if the taxpayerincreases saving, that saving receives a higher rate of return. In order for a savings incentive toincrease the marginal return to saving, taxpayers must not be able to finance the tax-preferredsaving profitably by borrowing, must not have other similar assets that can be easily shifted intotax-preferred assets or accounts, and must (in the absence of the saving incentive) intend to saveless than the maximum contribution allowed.

          Type of saving

	The above discussion focused on saving in general. Many authors have noted thatqualified plans and IRAs may provide incentives for retirement saving, as opposed to saving forother purposes.(23) For instance, consider the effect of a qualified plan, distributions from whichare subject to additional tax unless held until retirement or used for other qualified purposes. Anindividual who is saving only for a "rainy day" may not have much saving that is expected to lastuntil retirement. When offered a higher rate of return on retirement saving, that individual maychoose to increase the total amount of saving by maintaining the rainy day saving and addingretirement saving.

          Psychological factors and effects of increased advertising

	Several observers have observed that factors other than rates of return, or what might betermed "non-economic" factors, are important in motivating saving through qualified plans andother saving incentives.  Researchers have found that both participation in and contributions tovoluntary savings plans, such as qualified pension plans, are significantly higher when employersoffer retirement seminars.  These analysts found that the effect was stronger for nonhighlycompensated employees than for highly compensated employees.  Moreover, the frequency ofsuch seminars was an important correlate to saving behavior, but the provision of writtenmaterials in the absence of seminars appeared to have no effect.(24)  Other research suggests thathigh school level education in financial decision-making appears to raise asset accumulation bythe students once they reach adulthood.(25)

	Some observers have noted that IRAs may have a larger impact on saving than standardeconomic analyses would predict.(26) These observers suggest that the immediate reward of the taxdeduction and the active marketing campaigns in the mid-1980s contributed to the high IRAparticipation rates observed; in fact, IRA participation was larger than was expected. The sharpdecline in advertising after 1986 may explain the decline in IRA contributions among taxpayerswho are still eligible.

	Furthermore, there may also be a psychological factor that contributes to the impact ofIRAs on saving. One study found that taxpayers who owed money to the IRS in excess of taxeswithheld were significantly more likely to make IRA contributions than were other taxpayers.(27)One might expect this psychological factor only to induce deductible IRA contributions, whichwill have an immediate effect on taxes paid. However, another author(28) noted that taxpayers whoowe the IRS money generally have higher incomes and this may be why they are more likely tocontribute to IRAs, rather than any psychological factor.

**C.  The Adequacy of Retirement Savings**

**1.  Economic status of the elderly**

**Sources of retirement income**

	Social Security is the largest source of retirement income (39 percent in 1996), followedby earnings (22 percent in 1996), employee pensions, annuities, and alimony (18 percent in1996), and income from assets (17 percent in 1996).(29)  (See Figure 2.)  Many researchers haveattempted to measure whether people have adequate savings for retirement. A common measureof retirement savings adequacy is called the replacement rate, which is defined as the ratio ofretirement income to income during the working years.

**FIGURE 2**

	The issue of what replacement rate should be called adequate depends on a number offactors. A replacement rate of 100 percent means that the person's income during retirement isequal to their income during working years. There are a number of reasons that a replacementrate of 100 percent may not be optimal. First, people may desire to have more income during theworking years because some of that income is saved for retirement. If people choose to haveconstant consumption over time, they save during their working years and dissave duringretirement. Thus, if a household has a 10-percent saving rate during their working years, a 90-percent replacement rate would be sufficient for the household to maintain constant consumptionin retirement. Second, most elderly own their own homes (in 1996, more than 81 percent of thosehouseholds headed by an individual aged 65 to 74 and 75.3 percent of households headed by anindividual age 75 or over(30)) and most of these have paid off their mortgages. Only 25 percent ofhouseholds headed by a person aged 65 to 74 years old had any mortgage or home equity debt.Among households headed by a person aged 75 years or older, only seven percent had anymortgage or home equity debt.(31)  Thus, most elderly receive housing without incurring anyexpenses beyond maintenance, property taxes, insurance, and utilities, whereas during theirworking years, they were likely to have been making mortgage payments. Third, few elderlyhouseholds care for children, and therefore household expenses are likely to be lower. Fourth, theelderly are generally covered by Medicare, which provides insurance against large medicalexpenses and pays for most expenditures on health. Fifth, retirement income generally bears alower tax burden than does wage income.  Salaries and wages are subject to the payroll tax. Retirement benefits are not.  Also, Social Security benefits, which represent the major source ofretirement income, are largely untaxed.(32) Thus, Social Security benefits can be smaller thanincome earned during the working years and still provide the same after-tax income. For thelowest income groups, this effect is not large since earned income is subject to the payroll tax,but may not be subject to the income tax.

	These arguments suggest that the appropriate replacement rate for the elderly to haveadequate retirement savings is less than 100 percent. However, there may be some factors whichdictate that the replacement rate should be higher than 100 percent. First, although the elderly arecovered by Medicare, they are also more likely to incur large medical expenses which may not becompletely covered by medicare. Similarly, Medicare generally does not cover nursing homecare or the costs of care in other long-term care facilities, and only those elderly poor enough toreceive Medicaid or eligible through veterans' assistance are covered.  Second, the elderly mayfind it necessary to hire service providers for tasks that younger households provide forthemselves.  For example, elderly households may contract for home repair work that younghouseholds self-provide.

	Replacement rates for Social Security and pension income for retired workers arecalculated using two methods. The first method calculates the ratio of Social Security andpension benefits relative to a worker's highest career earnings.(33) The second method calculatesbenefits relative to the average earnings in the five years preceding retirement.(34) It seems likelythat the career high earnings overstate average earnings, and earnings during the five yearspreceding retirement understate average earnings. Thus, these two replacement rates may be seenas upper and lower bounds of estimates of the replacement of average career earnings. Thesereplacement rates measure the replacement of income through retirement benefits, and do notinclude any income earned during retirement or any income from savings. Such calculationsindicate that Social Security and pension benefits replace roughly 33 percent of the career highearnings and 50 percent of earnings over the last five years for individuals. When spousalbenefits are taken into account, replacement rates are slightly higher, averaging 30 to 33 percentof highest earnings but 60 to 70 percent of last earnings. Such calculations also demonstrate thatreplacement rates are highest for the poor. For the lowest income quartile, individual replacementrates varied between 34 and 39 percent of highest earnings, and 72 to 94 percent of lastearnings.(35)

	Analysis of more recent retirees suggests similar outcomes.  A recent study calculatedreplacement rates for families with at least one individual between the ages 52 and 61 years oldin 1992.  Such individuals generally would be expected to retire between 1993 and 2006.(36)  Thisstudy attempted to account for all sources of non-earnings income of retiree households: socialsecurity benefits; pension benefits; private saving; equity in personal residences; and equity inbusiness assets.  The authors calculate that in 1992, prior to actual retirement, these households,on average, held assets sufficient to produce income in retirement that would replace 86 percentof their pre-retirement income.  For households in the median 10 percent of the population (i.e.,those with incomes between the 45th and 55th percentiles of the income distribution), thereplacement rate was 97 percent.  The bottom 10 percent of earners had the highest replacementrates and the top 5 percent of earners had the lowest replacement rates.(37)  However, other analystsreviewing the same data suggest a less optimistic outlook.  They conclude that, if the medianhousehold intended to retire at age 62, it would need to save 16 percent of future annual earningsto preserve pre-retirement consumption.  The authors observe that a saving rate of 16 percentexceeds the median household's observed saving rate of approximately 5 percent.(38)

	Finally, Social Security benefits have increased over time. Social Security benefitsrelative to the income of the elderly have increased substantially over the past 40 years.  On theother hand, a current concern is whether the Federal Government will be able to continue payingthe promised benefits.  If benefits were to be reduced for future retirees, the replacement ratesreported above would overstate likely future replacement rates.

**Poverty**

	Another method used to examine the economic status of the elderly is to compare theirrates of poverty to those of the general population. Poverty among the elderly has declineddramatically over the last 30 years, from over 35 percent in 1959 to 12.6 percent in 1985. By1985, the poverty rate of the elderly was less than the poverty rate of the general population. In1996, the poverty rate of the elderly was 10.8 percent and the poverty rate of elderly personsliving in families (with a spouse or children) was 5.6 percent, lower than for any other group.(39)The major explanation for this decline in poverty is the increase in Social Security benefits andcoverage described above.

**2.  Expected retirement income and needs of current workers**

	The above discussion demonstrates that, as a group, the elderly are as well off as the restof society, indicating that, given Social Security and pension benefits, savings were adequate.However, to determine whether the savings of current workers are enough to provide adequateretirement income, it is necessary to examine how this group might differ from current retirees.

**Social Security and employer-provided pension plan coverage**

Social Security coverage.--Because Social Security coverage of workers has increasedover time,(40) and because the labor force participation of women has also been increasing, currentworkers are more likely to be covered by Social Security than current retirees.  In 1996, out ofmore than 150 million workers, 6.6 million workers were not in employment covered by SocialSecurity.  Most of these were Federal, State, and local government employees.  The percentageof uncovered workers will further decrease in the future as all Federal employees hired after 1983are covered and beginning in 1991 all State and local employees who are not members of apublic retirement system were mandatorily covered under Social Security.

Current pension coverage.--Similarly, pension coverage of current workers is alsosubstantially larger than that of current retirees.(41)  The term "covered," as used here, means thatan employee is accruing benefits in an employer pension or other retirement plan. The bestcurrent comprehensive evidence on pension coverage comes from a supplement to the April 1993Current Population Survey conducted by the Bureau of the Census.  The data referred to belowcome from that survey unless otherwise noted.

	As of April 1993, 63 percent of full-time wage and salary workers employed in theprivate sector reported that they worked in firms with an employer-sponsored pension plan. Halfof the full-time wage and salary workers employed in the private sector were covered by anemployer-sponsored pension plan. Most of these workers were covered by basic defined benefitor defined contribution plans (23 percent), and another 10 percent had both a basic plan and a401(k) type contributory plan (see Table 5).(42) For another 17 percent, a 401(k) type plan wastheir only retirement plan.

	Pension coverage varies substantially among full-time, privately employed workers.Differences depend on the age of the worker, job earnings, the industry of employment, and thesize of the firm.  Younger workers are much less likely to be covered by a pension than middleaged and older workers. Coverage rates rise steadily from 21 percent for those under age 25 toabout 60 percent for those between ages 40 and 60 before falling off somewhat. This patternholds for both men and women. However, the jump in coverage for middle aged men is slightlylarger than the increase for middle aged women (see Table 6).

	Higher paying jobs are more likely to offer pensions. Just 8 percent of full-time privatewage and salary workers earning less than $10,000 per year in 1993 were covered compared to81 percent of those earning $50,000 or more (see Table 7). Coverage may be higher for higherpaying jobs because of the greater value of the pension tax benefits to workers in higher taxbrackets and because of the declining replacement rate of Social Security at higher earningslevels.

**Table 5.-Employer Sponsorship and EmployeeCoverage Under Pension or Retirement Plan,Private Wage and Salary Workers, 1993**

**[Percent]**
**Item****Total****Full time****Part time**Employer sponsorship:
      Employer sponsors plan

      Basic pension only

      Basic and 401(k) type

      401(k) type only

      Employer does not sponsor

      Does not know58
24

14

21

35

763
24

16

23

32

537
23

4

10

49

14Employer Coverage:
       Employee covered under plan

       Basic pension only

       Basic and 401(k) type

       401(k) type only

       Employee is not covered

       Does not know43
20

8

15

50

750
23

10

17

44

612
7

2

4

73

14Number of private wage and salary workers (in thousands)88,67972,75215,927Source:  Department of Labor, 1994, tables A2, B1, B2.
**Table 6.-Coverage Under Employer-Sponsored Pensionor Retirement Plans for Full-Time Private Wage andSalary Workers, 1993**

**Percent covered****Age (in years)**Total**Men**WomenUnder 25	21192225-29	41414230-34	50505135-39	54575140-44	58615445-49	63665950-54	61606255-59	59605760-64	56595265 or older	465434      Total	505148Source:  U.S. Department of Labor, 1994, table B5.
**Table 7.-Coverage Under Employer-Sponsored Pensionor Retirement Plans for Full-Time Private Wage andSalary Workers by Workers' Wages, 1993**

**Percent covered****Wages**Total**Men**WomenUnder $10,000	879$10,000-$14,999	272131$15,000-$19,999	423549$20,000-$24,999	575165$25,000-$29,999	626164$30,000-$34,999	676671$35,000-$39,999	737472$40,000-$49,999	787977$50,000-$74,999	818180$75,000 or over	818178      Total15051481Total includes workers not responding on wages, not shown separately.
Source:  U.S. Department of Labor, 1994, table B11.

	Significant differences in coverage also are apparent between full-time private wage andsalary workers and other wage and salary workers. Coverage is much lower among part-timeworkers and much higher among public employees. Among part-time, private wage and salaryworkers, 12 percent are covered. Seventy-seven percent of public sector wage and salary workersare covered including 85 percent of those who are full-time workers (see Table 8).

	Coverage is much lower for smaller firms. Smaller firms are less likely to offercomprehensive fringe benefit packages as part of total compensation. Only 13 percent offull-time private wage and salary workers in firms with fewer than 10 employees are covered.The rate rises with employer size but does not reach 50 percent (the average across all firm sizes)until firms have 100 or more employees.

	The data above report pension coverage of individuals.  When assessing the effectivenessof pensions in providing retirement income, it is more relevant to think of pension coverage ofhouseholds.  Thus, if both the husband and wife work and only the wife accrues pension benefits,the tables above would record that 50 percent of individuals are covered by a pension.  However,in this example, 100 percent of the households (the married couple) receive pension retirementbenefits.  A recent study highlights the importance of this distinction.  It found that in 1992, halfof all individuals aged 51 to 61 years old, that is on the verge of retirement, had rights to apension from a current or prior job, but two-thirds of all households with at least one memberaged 51 to 61 years old owned the rights to a pension from a current or prior job.(43)

Trends in pension coverage.-- At the outset of World War II, private employer pensionswere offered by about 12,000 firms. Pensions spread rapidly during and after the war,encouraged by high marginal tax rates and wartime wage controls that exempted pensionbenefits. By 1972, when the first comprehensive survey was undertaken, 48 percent of full-timeprivate employees were covered. Subsequent surveys found that coverage reached 50 percent in1979, but by 1983 had fallen back to 48 percent. The decline continued in the 1980s, reaching 46percent in 1988.(44) By 1993, coverage had returned to 50 percent.

**Table 8.-Coverage Under Employer-Sponsored Pensionor Retirement Plans for Full-Time Private Wage andSalary Workers by Workers' Wages, 1993**

**Percent covered****Sector**Total**Men**WomenAll wage and salary workers	
      Men	

      Women	49
51

4656
56

5615
9

17Private sector	
      Men	

      Women	43
46

3950
51

4812
8

15Public sector
      Men	

      Women	77
80

7485
86

8430
22

33
Source:  U.S. Department of Labor, 1994, table B1.
	The decline in coverage in the 1980s was concentrated among younger men.  Thecoverage rate among older men has fallen less dramatically, and among women it has risen atsome ages and fallen at others.

	The decline in pension coverage has occurred at the same time that employers have beenshifting from defined benefit plans.  Defined benefit plans provided basic plan coverage for 87percent of private wage and salary workers in 1975.(45)  This proportion dropped to 83 percent by1980 and to 71 percent by 1985.  This shifting composition has largely been the result of rapidgrowth in primary defined contribution plans.  Employee stock ownership plans and 401(k) planshave been among the most rapidly growing defined contribution plans.

	Figures 3 and 4 utilize data from the Federal Reserve Board's Flow of Funds Accounts toshow the value of assets accumulated in defined benefit and defined contribution pension plans. At the end of 1977, the value of assets in each type of plan was equal to approximately $1.8trillion.  The figures also document the rapid accumulation in assets in defined contribution planscompared to that of defined benefit plans over the past 10 years.

**FIGURE 3**

**FIGURE 4**

**Personal saving**

Aggregate saving.--Although coverage by pensions and Social Security is expected to behigher for current workers than it is for current retirees, the saving rate of current workers may belower than the rate at which current retirees saved during their working lives. This would implythat although two sources of retirement income, Social Security and pension benefits, areexpected to be higher for current workers, another source, income from savings, may be lower.

	The measure of personal saving used in the National Income and Product Accountsattributes all corporate pension contributions and earnings to the household sector. Thus, theincreased pension coverage is already included in the measure of household saving. Table 2,above, and Figure 5, show that personal saving has been declining over the past 15 years. Privatesaving, which includes the saving of business, and which may provide a better measure of totalhouseholds saving since businesses are ultimately owned by household, exhibits the samedownward trend. Thus, the saving of the current generation of workers for their retirement seemsto be low relative to the past.  On the other hand, the National Income and Product Accountsmeasures of saving measure only cash flows not consumed.  The purpose of saving for retirementis to accumulate wealth which can be drawn upon in retirement.  If, as in the past few years, themarket value of assets increases, adequate wealth accumulation may be attained with relativelylow saving rates.

**FIGURE 5**

Retirement saving of individuals.--It is difficult to determine how much saving outside ofqualified plans is "retirement saving."  Contributions to IRAs represent one measure of such non-pension plan retirement saving.  Assets within IRAs have grown substantially over the past 10years.  Figure 6 below shows that IRA balances, approximately $1.6 trillion in 1996, are nearlyequal in size to the asset balances in both defined benefit and defined contribution plan. (SeeFigures 3 and 4 above.)

	The growth of these balances is impressive in its magnitude, particularly given therelatively modest contributions of recent years.  Table 9, below, reports IRA contributionsbetween 1979 and 1996.  Deductible IRAs have been very popular with taxpayers. As Table 9reports, contributions to IRAs increased significantly when eligibility restrictions wereeliminated in 1982. At the peak in 1985, over $38 billion was contributed to IRAs. Thisrepresented almost 20 percent of personal saving for that year.

	In addition to annual contributions, the current value of IRA balances, as reported inFigure 6, is comprised of balances rolled over into IRAs from qualified plans and increases in themarket valuation of IRA investments.

**FIGURE 6**

**Table 9.-IRA Participation, 1980-1996**
****Year**Returns claimingIRA deduction(millions)****Percentage of**
**all returns**

**(percent)****Deductions**
**claimed**

**($ billions)**1979	2.5            2.6           3.2          1980	2.6            2.7           3.4          1981	3.4            3.6           4.8          1982	12.0            12.6           28.3          1983	13.6            14.1           32.1          1984	15.2            15.3           35.4          1985	16.2            15.9           38.2          1986	15.5            15.1           37.8          1987	7.3            6.8           14.1          1988	6.4            5.8           11.9          1989	5.8            5.2           10.8          1990	5.2            4.6           9.9          1991	4.7            4.1           9.0          1992	4.5            3.9           8.7          1993	4.4            3.8           8.5          1994	4.3            3.7           8.4          1995	4.3            3.6           8.3          1996	4.4            3.6           8.6          Source:  Statistics of Income.
	As with pension coverage, IRA coverage is not universal.  Tables 10 and 11 summarizeinformation on IRA participation in 1985 and 1996.  Some have expressed concern about thedistribution of taxpayers who contribute to IRAs.  The concern is two-fold.  First, unequalparticipation may lead to some taxpayers having accumulated substantial wealth for retirementwhile other taxpayers have accumulated little wealth.  Second, because IRA contributions receivepreferential tax treatment, the distribution of the tax expenditure may be viewed as inequitable.In 1985, 71 percent of all returns reporting IRA contributions had AGI below $50,000, and 29percent had AGI of $50,000 or above. However, taxpayers with AGI of $50,000 or aboverepresented only 8 percent of all returns eligible for IRAs. Thus, although many lower-incomeindividuals contributed to IRAs, most did not, whereas most taxpayers with AGI of $50,000 orabove did contribute when eligible. Taxpayers with AGI of $50,000 or above were more thanfour times as likely to contribute to an IRA than were taxpayers with AGI below $50,000--61.8percent of eligible returns with AGI of $50,000 or above reported contributions to an IRA, whileonly 13.8 percent of eligible returns with AGI below $50,000 reported IRA contributions. On theother hand, the data for 1985 or 1996 represent one-year snapshots of IRA contributions.  If theearning power of young individuals increases over time, an individual who did not contribute toan IRA when earning $20,000 per year may later contribute when earning $40,000 per year.

	Higher income taxpayers made larger contributions as well. Taxpayers with adjustedgross incomes of $50,000 or more constituted approximately 29 percent of all IRA contributorsin 1985, but accounted for more than 35 percent of IRA contributions. In 1996, taxpayers withadjusted gross incomes of $50,000 or more constituted approximately 25 percent of all IRAcontributors, but accounted for approximately 34 percent of IRA contributions. 

	Because the value of the IRA is the effective exemption of the earnings from tax, thehigher a taxpayer's marginal tax rate, the more valuable the ability to invest through an IRA.Because people in higher income classes generally have higher tax rates, the value of their IRA islarger than the value of IRAs for taxpayers in lower income classes. However, the value of theIRA depends on tax rates throughout the period the IRA is held, and not just the marginal tax ratein the year the contribution is made.

**Table 10.-IRA Participation By Income Class, 1985**

**Returns reporting IRA contributions******Adjusted gross income class******Number inmillions****Percent ofeligiblereturns1**Contri-butions

**($ billions)**All classes	16.2         17.8        38.2       Under $10,000	0.6         2.3        1.1       $10,000 to $30,000	5.1         13.6        9.7       $30,000 to $50,000	5.7         32.9        13.5       $50,000 to $75,000	3.0         56.5        8.7       $75,000 to $100,000	0.9         74.1        2.7       Over $100,000	0.8         76.1        2.6       1Eligible taxpayers include self-employed persons as well as wage and salary employees.  However, taxpayerswhose income consists solely of interest income, for example, are ineligible to contribute to IRAs.
Source:  Internal Revenue Service, *1985 Statistics of Income*.

**Table 11.-IRA Participation By Income Class, 1996**

**Returns reporting IRA contributions******Adjusted gross income class******Number inmillions****Percent

**of returnswith earnedincome1******Contri-butions**

**($ billions)**All classes	4.44.18.6Under $10,000	0.31.10.4$10,000 to $30,000	1.64.32.8$30,000 to $50,000	1.46.92.4$50,000 to $75,000	0.53.51.1$75,000 to $100,000	0.24.50.7Over $100,000	0.46.61.11Because of the income limitations enacted by the Tax Reform Act of 1986, not all taxpayers with earned incomeare eligible to make deductible contributions to IRAs.
Source:  Internal Revenue Service, *1996 Statistics of Income*.

	It is too soon to assess the effects that the Taxpayer Relief Act of 1997 may have on IRAparticipation and retirement asset accumulation.  Tables 12a and 12b, below, presents the JointCommittee on Taxation staff estimates of the eligibility of taxpayers to make deductible IRAcontributions under present law for 1999.  The percentage of taxpayers eligible to makedeductible IRA contributions differs modestly by filing status.  Among married couples filingjoint returns, 58 percent are eligible for up to a $4,000 deductible contribution, an additional 15percent are eligible for up to a $2,000 deductible contribution, and approximately 20 percent areineligible to make a deductible contribution.  Among single filers and head of household filers,only 14 percent are ineligible to make a deductible contribution.

**Table 12a.-Eligibility of Taxpayers with Earned Income to Make DeductibleIRA Contributions Under Present Law, Projected 1999 Returns(Returns with Earned Income for Joint Returns)**
****AGI****Returns**Percenteligible for fulldeduction forboth spouses****Percent eligiblefor fulldeduction forone spouse only******Percent inphaseoutrange****Percent noteligible for anyIRA deductionLess than $10,000	2,987100.00.00.00.0$10,000 to $20,000	4,442100.00.00.00.0$20,000 to $30,000	4,728100.00.00.00.0$30,000 to $40,000	4,627100.00.00.00.0$40,000 to $50,000	4,98597.30.02.70.0$50,000 to $75,000	10,27524.326.132.117.4$75,000 to $100,000	6,16313.740.70.045.7$100,000 to $200,000	5,30719.627.02.750.7Over $200,000	1,82115.70.00.084.3      Total	45,33658.014.67.919.5Average dollars eligible
per return	$3,803$1,997$2,685Source:  Joint Committee on Taxation staff estimates.
**Table 12b.-Eligibility of Taxpayers with Earned Income to Make DeductibleIRA Contributions Under Present Law, Projected 1999 Returns(Returns with Earned Income For Other Filers)**
****AGI****Returns****Percent eligiblefor full deduction****Percent in phaseout range**Percent noteligible for anyIRA deduction**Less than $10,000	22,146100.00.00.0$10,000 to $20,000	15,766100.00.00.0$20,000 to $30,000	11,82199.90.10.0$30,000 to $40,000	7,51739.960.10.0$40,000 to $50,000	5,30923.98.667.4$50,000 to $75,000	5,30117.60.082.4$75,000 to $100,000	1,25312.20.087.8$100,000 to $200,000	86316.20.083.8Over $200,000	22213.00.087.0      Total	40,18878.77.114.2Average dollars eligible per return$1,915$1,050Source:  Joint Committee on Taxation staff estimates.
	Other authors have noted that even the taxpayers with low income who did contribute toIRAs owned more financial assets than other low-income taxpayers and that, therefore, IRAcontributors may not be representative of taxpayers in general. Table 13 presents information onthe assets of households with IRAs compared to the assets of households without IRAs.  For eachincome category, the table reports the gross financial asset holdings and non-retirement assetholdings of the median (50th percentile) household.(46) As the table details, families with IRAshave larger holdings of financial assets than do families without IRAs.  However, it is also thecase that families with IRAs have larger holdings of financial assets than do families withoutIRAs even when all IRA and pension assets are excluded.  Part of the reason that IRAcontributors have larger holdings of assets than noncontributors is that contributors to IRAs tendto be older than noncontributors, and older taxpayers have been accumulating assets longer.

**Table 13.-Estimated Median Financial Assets of FamiliesWith IRAs and Families Without IRAs, 1995**
******Families with IRAs****Families without IRAs**Income**Gross financial assets1****Gross financial assets less retirement assets2****Gross financial assets1****Gross financial assets lessretirement assets2**Less than $10,000	$56,15033,080$300$300$10,000 to $20,000	49,49518,0001,5051,200$20,000 to $30,000	45,85023,8504,5052,500$30,000 to $40,000	51,87526,8009,0004,450$40,000 to $50,000	81,00038,00011,4006,050$50,000 to $75,000	118,00068,30033,65017,800$75,000 to $100,000	181,00099,60053,75033,750$100,000 and over	1,570,0001,200,0001,385,5001,350,000Source:  Congressional Budget Office tabulations of the Federal Reserve Board of Governors 1995 Survey of Consumer Finances.
1  "Gross financial assets" reports only the "asset side" of family's balance sheet.  These figures do not net off the value of any of the family's financialliabilities such as mortgage or consumer debt.

2Gross financial assets less IRA balances and value of defined contribution pension plan assets.  Does not include information regarding the accrued value ofany defined benefit pension plan benefits.

Estimates of saving rate adequacy.--The Congressional Budget Office ("CBO") reportedthat while the saving rate of current workers appears low relative to the past, this may not implythat the level of savings is inadequate for retirement. That CBO study concludes that theso-called "baby boom" generation appears to be accumulating assets at a rate equivalent to that oftheir parents who are currently retired. The CBO concludes that the continued increase in realwages, the fact that baby boomers are more highly educated than their parents, and the increasedparticipation of women in the labor force portend "increases in household incomes of babyboomers in retirement."(47)  Some have criticized the conclusion of this study as too optimistic.Critiques note that finding that baby boomers have accumulated approximately the same amountof assets as had their parents at a similar age does not bode well for retirement income. Havingthe same amount of assets would imply only the potential for the same amount of income asexperienced by current retirees, and as incomes grow this would imply future retirees would beless well off compared to the rest of society than are current retirees. Critics also note that currentretirees benefitted from increases in Social Security benefits and unexpected capital gains onhousing that the baby boomers may not reasonably expect to experience.(48)  All studies of thisquestion have emphasized the important difference within the so-called baby boom generation. Most studies note that those with the least education appear to be least well prepared forretirement in terms of accumulating private assets.  Some studies suggest that the first cohort ofthe baby boom generation is likely to be better prepared for retirement than the last cohort of thebaby boom generation.(49)

**3.  Increased retirement costs**

	Finally, it is possible that the need for retirement income is increasing over time.Increases in life expectancies and trends toward earlier retirement increase the number of years inretirement and therefore increase the need for saving. Furthermore, the normal retirement age forsocial security was changed in 1983. For those born in 1937 or earlier, the normal retirement ageis 65 years old.  Thus, in 1999, the normal retirement for Social Security (the age at whichretirees receive full benefits) is 65.  For those individuals born in 1960 or later, the normalretirement age is 67 years old.  That is, by 2027, the normal retirement age will be 67 years. Ifthe increase in the normal retirement age means that individuals will be working more years, thencurrent saving need not adjust. However, if the historical trend toward earlier retirementcontinues, then the increase in normal retirement age for receipt of full social security benefitsmeans that individuals should increase their retirement saving.

	Similarly, increased life expectancies and rapid medical cost inflation increase theprobability of large medical expenses. Out-of-pocket medical expenditures for the elderly havebeen steadily increasing over the last 15 years. Also, many people have noted that the probabilityof an individual requiring long-term care some time in their lifetime has been increasing.

**PART TWO:  PRESENT LAW AND BACKGROUND ON FEDERAL TAX PROVISIONS RELATING TO HEALTH AND LONG-TERM CARE**

**I.  PRESENT LAW AND LEGISLATIVE BACKGROUND**

**A.  Exclusion from Income and Wages for Employer-Provided Health Care**

**Present Law**

	In general, employer contributions to an accident or health plan are excludable from anemployee's income (sec. 106 of the Code). This exclusion for employer-provided healthcoverage also generally applies to coverage provided to former employees. In the case of a self-insured medical reimbursement plan, the exclusion is conditioned on the coverage beingprovided under a plan meeting certain nondiscrimination requirements (sec. 105(h)). Insuredhealth plans are generally not subject to nondiscrimination rules. Employer-provided accident orhealth coverage is generally excludable from wages for employment tax purposes as well withoutregard to whether the coverage is provided on a nondiscriminatory basis (sec. 3121(a)(2)).

	Benefits paid under employer-provided accident or health plans are also generallyexcludable from income to the extent they are reimbursements for medical care (as defined insec. 213) or to the extent the benefits constitute payments for the permanent loss of use of amember or function of the body or permanent disfigurement and are computed with reference tothe nature of the injury and without regard to the period the employee is absent from work (sec.105).(50)

**Legislative Background**

	In 1943, the Internal Revenue Service ruled that employer contributions to group healthinsurance policies were not taxable to the employee. Employer contributions to individual healthinsurance policies, however, were declared to be taxable income in an IRS revenue ruling in1953.

	Section 106 of the Internal Revenue Code, enacted in 1954, reversed the 1953 IRS ruling.As a result, employer contributions to all accident or health plans generally are excluded fromgross income and therefore are not subject to tax. In addition, section 105 of the Code providesthat benefits received under an employer's accident or health plan generally are not included inthe employee's income.

	The provision relating to self-insured medical reimbursement plans was added by theRevenue Act of 1978.

**B.  Employer Deduction for Health Care for Employees**

**Present Law**

	Under present law, amounts paid or accrued by an employer within a taxable year for asickness, accident, hospitalization, medical expense, or similar health plan for its employees aregenerally deductible as ordinary and necessary business expenses under section 162 of the Code.The deduction is available provided the amounts are used to pay accident and health insurancepremiums or to pay or reimburse benefits directly. Amounts paid for premiums are notdeductible if the proceeds of the policy are payable to the employer rather than the employee. The timing of the deduction is based on the employer's method of accounting. Under the cashmethod, the expenses are deductible for the taxable year for which they were paid. Under theaccrual method, the expenses are deductible for the taxable year in which all events haveoccurred to determine the fact and amount of the expenses.

	Contributions by an employer to a welfare benefit fund are not deductible under the usualincome tax rules (sec. 162), but if they otherwise would be deductible under the usual rules (e.g.,if they are ordinary and necessary business expenses), the contributions are deductible withinlimits for the taxable year in which such contributions are made to the fund.  A welfare benefitfund is, in general, any fund that is part of a plan of an employer, and through which theemployer provides welfare benefits (i.e., benefits other than pension benefits) to employees ortheir beneficiaries.

	The amount of the deduction otherwise available to an employer for a contribution to awelfare benefit fund for any taxable year may not exceed the qualified cost of the fund for theyear. The qualified cost of a welfare benefit fund for a year is the sum of (1) the amount thatwould be deductible for benefits provided during the year if the employer paid them directly andwas on the cash method of accounting, and (2) the addition (within limits) to a qualified assetaccount under the fund for the year, reduced by (3) the after-tax income of the fund.(51)

	A qualified asset account under a welfare benefit fund is an account consisting of assetsset aside to provide for the payment of disability benefits, medical benefits, supplementalunemployment compensation or severance pay benefits, or life insurance benefits. Under presentlaw, an account limit is provided for the amount in a qualified asset account for any year.

	The account limit for any taxable year may include a reserve to provide certain post-retirement medical and life insurance benefits. This limit allows amounts reasonably necessary toaccumulate reserves under a welfare benefit plan so that the liabilities for post-retirement medicaland life insurance benefits with respect to a group of employees can be prefunded.

	Each year's computation of contributions with respect to post-retirement medical benefitsis to be made under the assumption that the medical benefits provided to future retirees will havethe same costs as medical benefits currently provided to retirees. Because the reserve iscomputed on the basis of the current year's medical costs, neither future inflation nor futurechanges in the level of utilization may be taken into account until they occur.

	In the case of an employee who is a "key employee" (as defined in sec. 416), a separateaccount is required to be established and maintained on a per-participant basis, and benefitsprovided to such employee (and his or her spouse and dependents) are payable only from theseparate account. Contributions to the separate account of a key employee are considered annualadditions to a defined contribution plan for purposes of the limits on contributions and benefitsapplicable to retirement plans (sec. 415), except that the 25-percent-of-compensation limits (sec.415(c)(1)(B)) does not apply.

	Under present law, if an employer maintains a welfare benefit fund that provides adisqualified benefit during any taxable year, the employer is subject to an excise tax equal to 100percent of the disqualified benefit. A disqualified benefit includes (1) a benefit provided to a keyemployee other than from a separate account required to be established for such an employee, (2)any post-retirement medical or life insurance benefit that is provided in a discriminatory manner,and (3) any portion of a welfare benefit fund reverting to the employer.

**Legislative Background**

	The provisions relating to employer deductions for amounts contributed to welfarebenefit plans were added by the Deficit Reduction Act of 1984.

**C.  Cafeteria Plans and Flexible Spending Arrangements**

**Present Law**

**Cafeteria plans**

          In general

	Under present law, compensation generally is includible in gross income when actually orconstructively received. An amount is constructively received by an individual if it is madeavailable to the individual or the individual has an election to receive such amount. Under oneexception to the general principle of constructive receipt, amounts are not included in the grossincome of a participant in a cafeteria plan described in section 125 of the Code solely because theparticipant may elect among cash and certain employer-provided qualified benefits under theplan.  This constructive receipt exception is not available if the individual is permitted to revokea benefit election during a period of coverage in the absence of a change in family status orcertain other events.

	In general, a qualified benefit is a benefit that is excludable from an employee's grossincome by reason of a specific provision of the Code. Thus, employer-provided accident orhealth coverage, group-term life insurance coverage (whether or not subject to tax by reason ofbeing in excess of the dollar limit on the exclusion for such insurance), and benefits underdependent care assistance programs may be provided through a cafeteria plan. However, acafeteria plan may not provide qualified scholarships or tuition reduction (sec. 117), educationalassistance (sec. 127), miscellaneous employer-provided fringe benefits (sec. 132) or long-termcare insurance (sec. 7702B). In addition, a cafeteria plan may not offer deferred compensationexcept through a qualified cash or deferred arrangement (sec. 401(k)).

	A cafeteria plan must be in writing, must include only employees (including formeremployees) as participants, and must satisfy certain nondiscrimination requirements. Anemployer that maintains a cafeteria plan is required to file an annual return relating to such plan.

	The cafeteria plan exception from the principle of constructive receipt generally alsoapplies for employment tax (FICA and FUTA) purposes.(52)

          Nondiscrimination rules

	The exception to the constructive receipt principle provided for cafeteria plans does notapply to highly compensated individuals if the plan discriminates in favor of such individuals asto eligibility to participate or as to contributions or benefits under the plan. A plan is notdiscriminatory as to eligibility if the plan benefits a nondiscriminatory classification ofemployees and requires no more than 3 years of employment as a condition of participation.Special rules apply for determining whether a plan that provides health coverage isdiscriminatory with respect to contributions and benefits. In addition, a plan is deemed not to bediscriminatory if the plan is maintained pursuant to a collective bargaining agreement.

	For purposes of these nondiscrimination requirements, a highly compensated individual isan officer, a shareholder owning more than 5 percent of the employing firm, a highlycompensated individual (determined under the facts and circumstances of the case), or a spouseor dependent of the above individuals.

	In the case of key employees, the exception to the constructive receipt principle does notapply if the qualified benefits provided under the plan to such employees exceed 25 percent ofthe aggregate of such benefits provided for all employees under the plan. A key employee isdefined under the top-heavy rules applicable to qualified pension plans (sec. 416).

**Flexible spending arrangements**

	A flexible spending arrangement ("FSA") is a reimbursement account or otherarrangement under which an employee is reimbursed for medical expenses or other nontaxableemployer-provided benefits, such as dependent care. An FSA may be part of a cafeteria plan andmay be funded through salary reduction. FSAs may also be provided by an employer outside acafeteria plan. FSAs are commonly used, for example, to reimburse employees for medicalexpenses not covered by insurance.

	There is no special exclusion for benefits provided under an FSA. Thus, benefits providedunder an FSA are excludable from income only if there is a specific exclusion for the benefits inthe Code (e.g., the exclusion for employer-provided health care (other than long-term care) ordependant care assistance coverage). FSAs that are part of a cafeteria plan must comply with therules applicable to cafeteria plans generally. One of these rules is that a cafeteria plan may notoffer deferred compensation except through a qualified cash or deferred arrangement (sec.401(k)). According to proposed Treasury regulations, a cafeteria plan would permit the deferralof compensation if it includes a health FSA which reimburses participants for medical expensesincurred beyond the end of the plan year.(53)  Thus, amounts in an employee's account that are notused for medical expenses incurred before the end of a plan year must be forfeited. This rule isoften referred to as the "use it or lose it" rule.

	In addition, proposed Treasury regulations contain additional requirements with whichhealth FSAs must comply in order for the coverage and benefits provided under the FSA to beexcludable from income.(54) These rules apply with respect to a health FSA without regard towhether the health FSA is provided through a cafeteria plan (i.e., without regard to whether anemployee has an election to take cash or benefits).

	The proposed regulations define a health FSA as a benefit program that providesemployees with coverage under which specified, incurred expenses may be reimbursed (subjectto reimbursement maximums and any other reasonable conditions) and under which themaximum amount of reimbursement that is available to a participant for a period of coverage isnot substantially in excess of the total premium (including both employee-paid and employer-paid portions of the premium) for such participant's coverage. A maximum amount ofreimbursement is not substantially in excess of the total premium if the maximum amount is lessthan 500 percent of the premium.(55)

	Under the proposed regulations, the employer-provided health coverage under the FSAand the reimbursements and other benefits received under the health FSA are excludable from anemployee's income only if the health FSA satisfies certain additional requirements. According tothe proposed regulations, health FSAs are required to (1) provide the maximum amount ofreimbursement available under the FSA at all times during the period of coverage (properlyreduced as of any particular time for prior reimbursements for the same period of coverage), (2)offer coverage for 12 months or, in the case of a short plan year, the entire short plan year, (3)only reimburse medical expenses which meet the definition of medical care under section 213(d)of the Code, (4) reimburse medical expenses for which the participant provides a writtenstatement from an independent third party stating the amount of the medical expense and that themedical expense has not been reimbursed or is not reimbursable under any other health plan, (5)reimburse medical expenses which are incurred during the participant's period of coverage, and(6) allocate experience gains with respect to a year of coverage among premium payers on areasonable and uniform basis.(56)

**Legislative Background**

	The Employee Retirement Income Security Act of 1974 ("ERISA") provided that anemployer contribution made before January 1, 1977, to a cafeteria plan in existence on June 27,1974, was required to be included in an employee's gross income only to the extent that theemployee actually elected taxable benefits. If a plan did not exist on June 27, 1974, the employercontribution was to be included in income to the extent the employee could have elected taxablebenefits. The Revenue Act of 1978 set up permanent rules for plans that offer an electionbetween taxable and nontaxable benefits.

	The Deficit Reduction Act of 1984 clarified the types of employer-provided benefits thatcould be provided through a cafeteria plan, added a 25-percent concentration test, and requiredannual reporting to the IRS by employers.

	The Tax Reform Act of 1986 also modified the rules relating to cafeteria plans in severalrespects.

**D.  Medical Savings Accounts**

**Present Law**

**In general**

	Present law provides favorable tax treatment for medical savings accounts ("MSAs").Within limits, contributions to an MSA are deductible in determining adjusted gross income("AGI") if made by an eligible individual and are excludable from gross income and wages foremployment tax purposes if made by the employer of an eligible individual.  Earnings onamounts in an MSA are not currently taxable.  Distributions from an MSA for medical expensesare not taxable.  Distributions not used for medical expenses are includible in income.  Inaddition, distributions not used for medical expenses are subject to an additional 15-percent taxunless the distribution is made after age 65, death, or disability.

**Eligible individuals**

	MSAs are available to employees covered under an employer-sponsored high deductibleplan of a small employer and self-employed individuals covered under a high deductible planregardless of the size of the entity for which the individual performs services.(57)

	An employer is a small employer if it employed, on average, no more than 50 employeeson business days during either the preceding or the second preceding year.  In determiningwhether an employer is a small employer, a preceding year is not taken into account unless theemployer was in existence throughout such year.  In the case of an employer that was not inexistence throughout the first preceding year, the determination of whether the employer has nomore than 50 employees is based on the average number of employees that the employerreasonably expects to employ on business days in the current year.  In determining the number ofemployees of an employer, controlled groups of corporations (sec. 414(b)), unincorporated tradesor businesses under common control (sec. 414(c)), affiliated service groups (sec. 414(m)), andcertain businesses as provided in regulations (sec. 414(o)) are treated as a single employer.

	In order for an employee of a small employer to be eligible to make MSA contributions(or to have employer contributions made on his or her behalf), the employee must be coveredunder an employer-sponsored high deductible health plan (see the definition below) and must notbe covered under any other health plan (other than a plan that provides certain permittedcoverage, described below).  In the case of an employee, contributions can be made to an MSAeither by the individual or by the individual's employer.  However, an individual is not eligible tomake contributions to an MSA for a year if any employer contributions are made to an MSA onbehalf of the individual for the year.  Similarly, if the individual's spouse is covered under thehigh deductible plan covering such individual and the spouse's employer makes a contribution toan MSA for the spouse, the individual may not make MSA contributions for the year.  Forexample, suppose individual A works for a small employer and is covered under a highdeductible plan that covers A and her spouse, B.  A's employer makes a contribution for a year toan MSA for A.  B is not entitled to make contributions to an MSA for that year.

	Similarly, in order to be eligible to make contributions to an MSA, a self-employedindividual must be covered under a high deductible health plan and no other health plan (otherthan a plan that provides certain permitted coverage, described below).  A self-employedindividual is not an eligible individual (by reason of being self-employed) if the high deductibleplan under which the individual is covered is established or maintained by an employer of theindividual (or the individual's spouse).

	An individual with other coverage in addition to a high deductible plan is still eligible foran MSA if such other coverage is certain permitted insurance or is coverage (whether providedthrough insurance or otherwise) for accidents, disability, dental care, vision care, or long-termcare.  Permitted insurance is: (1) Medicare supplemental insurance; (2) insurance if substantiallyall of the coverage provided under such insurance relates to (a) liabilities incurred under worker'scompensation law, (b) tort liabilities, (c) liabilities relating to ownership or use of property (e.g.,auto insurance),  or (d) such other similar liabilities as the Secretary may prescribe byregulations; (3) insurance for a specified disease or illness; and (4) insurance that provides afixed payment for hospitalization.

	If a small employer with an MSA plan (i.e., the employer or its employees madecontributions to an MSA) ceases to become a small employer (i.e., exceeds the 50-employeelimit), then the employer (and its employees) can continue to establish and make contributions toMSAs (including contributions for new employees and employees that did not previously havean MSA) until the year following the first year in which the employer has more than 200employees.  After that, those employees who had an MSA (to which individual or employercontributions were made in any year) can continue to make contributions (or have contributionsmade on their behalf) even if the employer has more than 200 employees.

**Tax treatment of and limits on contributions**

	Individual contributions to an MSA are deductible (within limits) in determining AGI(i.e., "above the line").  In addition, employer contributions are excludable from gross incomeand wages for employment tax purposes (within the same limits), except that this exclusion doesnot apply to contributions made through a cafeteria plan.   No deduction is allowed to anyindividual for MSA contributions if such individual is a dependent on another taxpayer's taxreturn.

	In the case of a self-employed individual, the deduction cannot exceed the individual'searned income from the trade or business with respect to which the high deductible plan isestablished.  In the case of an employee, the deduction cannot exceed the individual'scompensation attributable to the employer sponsoring the high deductible plan in which theindividual is enrolled.

	The maximum annual contribution that can be made to an MSA for a year is 65 percentof the deductible under the high deductible plan in the case of individual coverage and 75 percentof the deductible in the case of family coverage.  No other dollar limits on the maximumcontribution apply.  The annual contribution limit is the sum of the limits determined separatelyfor each month, based on the individual's status and health plan coverage as of the first day of themonth.

	Contributions for a year can be made until the due date for the individual's tax return forthe year (determined without regard to extensions).

**Comparability rule for employer contributions**

	If an employer provides high deductible health plan coverage coupled with an MSA toemployees and makes employer contributions to the MSAs during a calendar year, the employermust make available a comparable contribution on behalf of all employees with comparablecoverage during the same coverage period in the calendar year.  Contributions are consideredcomparable if they are either of the same dollar amount or the same percentage of the deductibleunder the high deductible plan.  If an employee is employed for only a portion of the calendaryear, a contribution to the MSA of such employee is treated as comparable if it is an amountwhich bears the same ratio to the comparable contribution as the portion of the year he or she isemployed bears to the calendar year.  The comparability rule is applied separately to part-timeemployees (i.e., employees who are customarily employed for fewer than 30 hours per week). No restrictions are placed on the ability of the employer to offer different plans to differentgroups of employees.  The comparability rule does not restrict contributions that can be made toan MSA by a self-employed individual.

	If employer contributions do not comply with the comparability rule during a calendaryear,  then the employer is subject to an excise tax equal to 35 percent of the aggregate amountcontributed by the employer to MSAs of the employer for the year.  The excise tax is designed asa proxy for the denial of employer contributions.  In the case of a failure to comply with thecomparability rule which is due to reasonable cause and not to willful neglect, the Secretary maywaive part or all of the tax imposed to the extent that the payment of the tax would be excessiverelative to the failure involved.

	For purposes of the comparability rule, employers under common control are aggregatedin the same manner as in determining whether the employer is a small employer.  Thecomparability rule does not fail to be satisfied in a year if the employer is precluded from makingcontributions for all employees with high deductible plan coverage because the employer hasmore than 200 employees or due to operation of the cap during the initial 4-year period.

**Definition of high deductible plan**(58)

	A high deductible plan is a health plan with an annual deductible of at least $1,550 andno more than $2,300 in the case of individual coverage and at least $3,050 and no more than$4,600 in the case of family coverage.  In addition, the maximum out-of-pocket expenses withrespect to allowed costs (including the deductible) must be no more than $3,050 in the case ofindividual coverage and no more than $5,600 in the case of family coverage.  The dollar amountsare indexed for inflation in $50 dollar increments.

	A plan does not fail to qualify as a high deductible plan merely because it does not have adeductible for preventive care as required by State law. A plan does not qualify as a highdeductible health plan if substantially all of the coverage under the plan is for permitted coverage(as described above).  In the case of a self-insured plan, the plan must in fact be insurance (e.g.,there must be appropriate risk shifting) and not merely a reimbursement arrangement.

**Tax treatment of MSAs**

	Earnings on amounts in an MSA are not currently includible in income.

**Taxation of distributions**

	Distributions from an MSA for the medical expenses of the individual and his or herspouse or dependents are generally excludable from income.(59)  However, in any year for which acontribution is made to an MSA, withdrawals from an MSA maintained by that individualgenerally are excludable from income only if the individual for whom the expenses wereincurred was covered under a high deductible plan****for the month in which the expenses wereincurred.(60)  This rule is designed to ensure that MSAs are in fact used in conjunction with a highdeductible plan, and that they are not primarily used by other individuals who have health plansthat are not high deductible plans.

	For this purpose, medical expenses are defined as under the itemized deduction formedical expenses, except that medical expenses do not include expenses for insurance other thanqualified long-term care insurance, premiums for health care continuation coverage, andpremiums for health care coverage while an individual is receiving unemployment compensationunder Federal or State law.

	Distributions that are not for medical expenses are includible in income.  Suchdistributions are also subject to an additional 15-percent tax unless made after age 65, death, ordisability.

**Estate tax treatment**

	Upon death, any balance remaining in the decedent's MSA is includible in his or hergross estate.

	If the account holder's surviving spouse is the named beneficiary of the MSA, then, afterthe death of the account holder, the MSA becomes the MSA of the surviving spouse and theamount of the MSA balance may be deducted in computing the decedent's taxable estate,pursuant to the estate tax marital deduction provided in Code section 2056.  The MSA qualifiesfor the marital deduction because the account holder has sole control over disposition of theassets in the MSA.  The surviving spouse is not required to include any amount in income as aresult of the death; the general rules applicable to MSAs apply to the surviving spouse's MSA(e.g., the surviving spouse is subject to income tax only on distributions from the MSA fornonmedical purposes).  The surviving spouse can exclude from income amounts withdrawn fromthe MSA for expenses incurred by the decedent prior to death, to the extent they otherwise arequalified medical expenses.

	If, upon death, the MSA passes to a named beneficiary other than the decedent's survivingspouse, the MSA ceases to be an MSA as of the date of the decedent's death, and the beneficiaryis required to include the fair market value of MSA assets as of the date of death in gross incomefor the taxable year that includes the date of death.  The amount includible in income is reducedby the amount in the MSA used, within one year of the death, to pay qualified medical expensesincurred prior to the death.  As is the case with other MSA distributions, whether the expensesare qualified medical expenses is determined as of the time the expenses were incurred.  Incomputing taxable income, the beneficiary may claim a deduction for that portion of the Federalestate tax on the decedent's estate that was attributable to the amount of the MSA balance(calculated in accordance with the present-law rules relating to income in respect of a decedentset forth in sec. 691(c)).

	If there is no named beneficiary for the decedent's MSA, the MSA ceases to be an MSAas of the date of death, and the fair market value of the assets in the MSA as of such date areincludible in the decedent's gross income for the year of the death.  This rule applies in all casesin which there is no named beneficiary, even if the surviving spouse ultimately obtains the rightto MSA assets (e.g., if the surviving spouse is the sole beneficiary of the decedent's estate).  

**Cap on taxpayers utilizing MSAs**

	The number of taxpayers benefitting annually from an MSA contribution is limited to athreshold level (generally 750,000 taxpayers).  If it is determined in a year that the thresholdlevel has been exceeded (called a "cut-off" year) then, in general, for succeeding years during the4-year pilot period 1997-2000, only those individuals who (1) made an MSA contribution or hadan employer MSA contribution for the year or a preceding year (i.e., are active MSAparticipants) or (2) are employed by a participating employer, would be eligible for an MSAcontribution.  In determining whether the threshold for any year has been exceeded, MSAs ofindividuals who were not covered under a health insurance plan for the six-month period endingon the date on which coverage under a high deductible plan commences are not taken intoaccount.(61)  However, if the threshold level is exceeded in a year, previously uninsured individualswould be subject to the same restriction on contributions in succeeding years as otherindividuals.  That is, they would not be eligible for an MSA contribution for a year following acut-off year unless they are an active MSA participant (i.e., had an MSA contribution for the yearor a preceding year) or are employed by a participating employer.

	The number of MSAs established has been well below the threshold level.(62)

**End of pilot project**

	After December 31, 2000,  no new contributions may be made to MSAs except by or onbehalf of individuals who previously had MSA contributions and employees who are employedby a participating employer.  An employer is a participating employer if (1) the employer madeany MSA contributions for any year to an MSA on behalf of employees or (2) at least 20 percentof the employees covered under a high deductible plan made MSA contributions of at least $100in the year 2000.

	Self-employed individuals who made contributions to an MSA during the period 1997-2000 also may continue to make contributions after 2000.

**Legislative Background**

	The provisions relating to MSAs were added by the Health Insurance Portability andAccountability Act of 1996.

**E.  Deduction for Health Insurance Expenses of Self-Employed Individuals**

**Present Law**

	Under present and prior law, the tax treatment of health insurance expenses depends onwhether the taxpayer is an employee and whether the taxpayer is covered under a health planpaid for by the employee's employer. An employer's contributions to a plan providing accidentor health coverage for the employee and the employee's spouse and dependents are excludablefrom an employee's income. The exclusion is generally available in the case of owners of abusiness who are also employees.

	Under present law, self-employed individuals (i.e., sole proprietors or partners in apartnership), are entitled to deduct a portion of the amount paid for health insurance for the self-employed individual and the individual's spouse and dependents. Self-employed individuals maydeduct the amount paid for health insurance as follows:  45 percent in 1999, 50 percent in 2000and 2001, 60 percent in 2002, 80 percent in 2003 through 2005, 90 percent in 2006, and 100percent in 2007 and all years thereafter.

	The deduction is available with respect to the cost of self insurance as well as commercialinsurance. In the case of self insurance, the deduction is not available unless the self-insured planis in fact insurance (e.g., there is adequate risk shifting) and not merely a reimbursementarrangement. The deduction is not available for any month in which the taxpayer is eligible toparticipate in a subsidized health plan maintained by the employer of the taxpayer or thetaxpayer's spouse. In addition, no deduction is available to the extent that the deduction exceedsthe taxpayer's earned income from self employment. Expenses for health insurance in excess ofthe deductible amount may be taken into account in determining whether the individual isentitled to an itemized deduction for medical expenses.

	Payments for personal injury or sickness through an arrangement having the effect ofaccident or health insurance (and not merely a reimbursement arrangement) are excludable fromincome. In order for the exclusion to apply, the arrangement must be insurance (e.g., there mustbe adequate risk shifting). A self-employed individual who receives payments from such anarrangement can exclude the payments from income.

	For purposes of these rules, more than 2-percent shareholders of S corporations aretreated the same as self-employed individuals. Thus, they are entitled to the same healthinsurance deduction.

**Legislative Background**

	The provision relating to the deduction for health insurance costs of self-employedindividuals was added by the Tax Reform Act of 1986. Under that Act, the deduction was limitedto 20 percent of health insurance costs. The Self-Employed Health Insurance Act of 1995increased the level of deduction from 25 to 30 percent, beginning in 1995. The Health InsurancePortability and Accountability Act of 1996 increased the level of deduction as follows: thededuction is 40 percent in 1997; 45 percent in 1998 through 2002; 50 percent in 2003; 60 percentin 2004; 70 percent in 2005; and 80 percent in 2006 and thereafter. The Taxpayer Relief Act of1997 increased the level of deduction as described above under present law.

**F.  Itemized Deduction for Medical Expenses**

**Present Law**

	Under present law, individuals who itemize deductions may deduct amounts paid duringthe taxable year (if not reimbursed by insurance or otherwise) for medical care of the taxpayer,the taxpayer's spouse, and dependents, to the extent that the total of such expenses exceeds 7.5percent of the taxpayer's adjusted gross income ("AGI").

	Under a special rule, premiums paid during the taxable year by a taxpayer before theattainment of age 65 for insurance covering medical care for the taxpayer, his or her spouse, or adependent after the taxpayer attains the age of 65 are treated as expenses paid during the taxableyear for insurance which constitutes medical care if premiums for the insurance are payable (on alevel payment basis) under the contract for a period of 10 years or more or until the year in whichthe taxpayer attains the age of 65 (but in no case for a period of less than 5 years).

**Legislative Background**

	An itemized deduction for unreimbursed medical expenses above a specified floor hasbeen allowed since 1942. From 1954 through 1982, the floor under the medical expensededuction was 3 percent of the taxpayer's AGI; a separate floor of 1 percent of AGI applied toexpenditures for medicine and drugs.

	In the Tax Equity and Fiscal Responsibility Act of 1982 ("TEFRA"), the floor wasincreased to 5 percent of AGI (effective for 1983 and thereafter) and was applied to the total ofall eligible medical expenses, including prescription drugs and insulin. TEFRA madenonprescription drugs ineligible for the deduction and eliminated the separate floor for drugcosts.

	The Tax Reform Act of 1986 increased the floor under the medical expense deduction to7.5 percent of AGI, beginning in 1987.

	Beginning in 1991, The Omnibus Budget Reconciliation Act of 1990 disallowed themedical expense deduction for cosmetic surgery or other similar procedures, unless the surgeryor procedure is necessary to ameliorate a deformity directly related to a congenital abnormality, apersonal injury resulting from an accident or trauma, or disfiguring disease.

**G.  Provisions Relating to Long-Term Care**

**Present Law**

**In general**

	Present law provides favorable tax treatment for qualified long-term care insurancecontracts and qualified long-term care services similar to the favorable tax treatment that appliesto medical insurance and services and employer-provided accident or health plans.

	In general, amounts received under a qualified long-term care insurance contract areexcludable from income (subject to an annual dollar cap in the case of per diem contracts). Employer contributions for qualified long-term care insurance are excludable from income,except that this exclusion does not apply to long-term care insurance or services provided under acafeteria plan.  Up to certain dollar limits, premiums for long-term care insurance are treated as amedical expense for purposes of the itemized deduction for medical expenses, and are deductibleunder the rules relating to deduction of health insurance expenses for self-employed individuals. Expenses for qualified long-term care services are treated as medical expenses for purposes ofthe itemized deduction for medical expenses.

**Exclusion of long-term care proceeds**

	Amounts (other than policyholder dividends or premium refunds) received under aqualified long-term care insurance contract generally are excludable from income as amountsreceived for personal injuries and sickness, subject to a cap of $190 per day, or $69,350 annually(for 1999), on per diem contracts only.  The dollar cap is indexed by the medical care costcomponent of the consumer price index.

**Employer-provided long-term care coverage**

	A plan of an employer providing coverage under a long-term care insurance contractgenerally is treated as an accident and health plan.  Thus, employer contributions for long-termcare insurance are deductible by the employer.  Amounts received from long-term care insurancepurchased by the employer are excludable from income (subject to the cap on per diemcontracts).

	Employer-provided coverage under a long-term care insurance contract is not excludableby an employee if provided through a cafeteria plan; similarly, expenses for long-term careservices cannot be reimbursed under a flexible spending arrangement.  Thus, employercontributions (other than through a cafeteria plan) for long-term care insurance for the employee,his or her spouse, and his or her dependents (as defined for tax purposes) are excludable fromincome and wages for employment tax purposes.

**Definition of long-term care insurance contract**

	A long-term care insurance contract is defined as any insurance contract that providesonly coverage of qualified long-term care services and that meets other requirements.  The otherrequirements are that (1) the contract is guaranteed renewable, (2) the contract does not providefor a cash surrender value or other money that can be paid, assigned, pledged or borrowed, (3)refunds (other than refunds on the death of the insured or complete surrender or cancellation ofthe contract) and dividends under the contract may be used only to reduce future premiums orincrease future benefits, and (4) the contract generally does not pay or reimburse expensesreimbursable under Medicare (except where Medicare is a secondary payor, or the contractmakes per diem or other periodic payments without regard to expenses).

	A contract does not fail to be treated as a long-term care insurance contract solely becauseit provides for payments on a per diem or other periodic basis without regard to expensesincurred during the period. 

**State-maintained plans**

	An arrangement is treated as a qualified long-term care insurance contract if an individualreceives coverage for qualified long-term care services under a State long-term care plan, and theterms of the arrangement would satisfy the requirements for a long-term care insurance contractunder the provision, were the arrangement an insurance contract.  For this purpose, a State long-term care plan is any plan established and maintained by a State (or instrumentality of such State)under which only employees (and former employees, including retirees) of a State or of apolitical subdivision or instrumentality of the State, and their relatives, and their spouses andspouses' relatives, may receive coverage only for qualified long-term care services. "Relative" isdefined as under section 152(a)(1)-(8).  No inference was intended with respect to the taxconsequences of such arrangements under prior law.

**Definition of qualified long-term care services**

	Qualified long-term care services means necessary diagnostic, preventive, therapeutic,curing, treating, mitigating and rehabilitative services, and maintenance or personal care servicesthat are required by a chronically ill individual and that are provided pursuant to a plan of careprescribed by a licensed health care practitioner.  Maintenance and personal care services mayinclude meal preparation, household cleaning, and other similar services which the chronically illindividual is unable to perform.  It is anticipated that the scope of maintenance and personal careservices will be defined in Treasury regulations.

	A chronically ill individual is one who has been certified within the previous 12 monthsby a licensed health care practitioner as (1) being unable to perform (without substantialassistance) at least 2 activities of daily living for at least 90 days(63) due to a loss of functionalcapacity, (2) having a similar level of disability as determined under regulations prescribed bythe Secretary of the Treasury in consultation with the Secretary of Health and Human Services,or (3) requiring substantial supervision to protect such individual from threats to health andsafety due to severe cognitive impairment.  Activities of daily living are eating, toileting,transferring, bathing, dressing and continence.(64)

	An individual who is physically able but has a cognitive impairment such as Alzheimer'sdisease or another form of irreversible loss of mental capacity be treated similarly to anindividual who is unable to perform (without substantial assistance) at least 2 activities of dailyliving.  Because of the concern that eligibility for the medical expense deduction not bediagnosis-driven, the provision requires the cognitive impairment to be severe.  It was intendedthat severe cognitive impairment mean a deterioration or loss in intellectual capacity that ismeasured by clinical evidence and standardized tests which reliably measure impairment in: (1)short- or long-term memory; (2) orientation to people, places or time; and (3) deductive orabstract reasoning.  In addition, it was intended that such deterioration or loss place theindividual in jeopardy of harming self or others and therefore require substantial supervision byanother individual.

	A licensed health care practitioner is a physician (as defined in sec. 1861(r)(l) of theSocial Security Act) and any registered professional nurse, licensed social worker, or otherindividual who meets such requirements as may be prescribed by the Secretary of the Treasury. A licensed social worker includes any social worker who has been issued a license, certificate, orsimilar authorization to act as a social worker by a State or a body authorized by a State to issuesuch authorizations.

**Expenses for long-term care services treated as medical expenses**

	Unreimbursed expenses for qualified long-term care services provided to the taxpayer orthe taxpayer's spouse or dependent are treated as medical expenses for purposes of the itemizeddeduction for medical expenses (subject to the present-law floor of 7.5 percent of adjusted grossincome).  For this purpose, amounts received under a qualified long-term care insurance contract(regardless of whether the contract reimburses expenses or pays benefits on a per diem or otherperiodic basis) are treated as reimbursement for expenses actually incurred for medical care.

	For purposes of the deduction for medical expenses, qualified long-term care services donot include services provided to an individual by a relative or spouse (directly, or through apartnership, corporation, or other entity), unless the relative is a licensed professional withrespect to such services, or by a related corporation (within the meaning of Code section 267(b)or 707(b)).(65)

**Long-term care insurance premiums treated as medical expenses**

	Long-term care insurance premiums that do not exceed specified dollar limits are treatedas medical expenses for purposes of the itemized deduction for medical expenses.(66)  The limits(for 1999) are as follows:

In the case of an individual with an attainedage before the close of the taxable year of:

The limitation on premiums paid for such taxable years is:Not more than 40	$ 210                          More than 40 but not more than 50	400                           More than 50 but not more than 60	800                           More than 60 but not more than 70	2,120                           More than 70	2,660                           

	These dollar limits are indexed for inflation.

**Deduction for long-term care insurance of self-employed individuals**

	The self-employed health insurance deduction applies to eligible long-term care insurancepremiums.

	The deduction for health insurance expenses of a self-employed individual is notavailable for a month for which the individual is eligible to participate in any subsidized healthplan maintained by any employer of the individual or the individual's spouse.  The fact that anindividual is eligible for employer-subsidized health insurance is not intended to affect the abilityof such an individual to deduct long-term care insurance premiums, so long as the individual isnot eligible for employer-subsidized long-term care insurance.

**Long-term care riders on life insurance contracts**

	In the case of long-term care insurance coverage provided by a rider on or as part of a lifeinsurance contract, the requirements applicable to long-term care insurance contracts apply as ifthe portion of the contract providing such coverage were a separate contract.  The term "portion"means only the terms and benefits that are in addition to the terms and benefits under the lifeinsurance contract without regard to long-term care coverage.  As a result, if the applicablerequirements are met by the long-term care portion of the contract, amounts received under thecontract as provided by the rider are treated in the same manner as long-term care insurancebenefits, whether or not the payment of such amounts causes a reduction in the contract's deathbenefit or cash surrender value.  The guideline premium limitation applicable under section7702(c)(2) is increased by the sum of charges (but not premium payments) against the lifeinsurance contract's cash surrender value, the imposition of which reduces premiums paid for thecontract (within the meaning of sec. 7702(f)(1)).  In addition, it is anticipated that Treasuryregulations will provide for appropriate reduction in premiums paid (within the meaning of sec.7702(f)(1)) to reflect the payment of benefits under the rider that reduce the cash surrender valueof the life insurance contract.

**Inclusion of excess long-term care benefits**

	Long-term care benefits in excess of the annual dollar cap under per diem contracts areincludible in gross income.  The amount of the dollar cap with respect to any one chronically illindividual (who is not terminally ill) is $190 per day or $69,350 annually (for 1999), reduced bythe amount of reimbursements and payments received by anyone for the cost of qualified long-term care services for the chronically ill individual.(67)  If more than one payee receives paymentswith respect to any one chronically ill individual, then everyone receiving periodic paymentswith respect to the same insured is treated as one person for purposes of the dollar cap.  Theamount of the dollar cap is utilized first by the chronically ill person, and any remaining amountis allocated in accordance with Treasury regulations.  If payments under such contracts exceedthe dollar cap, then the excess is excludable only to the extent of actual costs (in excess of thedollar cap) incurred for long-term care services.  Amounts in excess of the dollar cap, withrespect to which no actual costs were incurred for long-term care services, are fully includible inincome.

	The $190 per day limit is indexed for inflation for increases in the medical carecomponent of the consumer price index.

	A payor of long-term care benefits (defined for this purpose to include any amount paidunder a product advertised, marketed or offered as long-term care insurance) is required to reportto the IRS the aggregate amount of such benefits paid to any individual during any calendar year,and the name, address and taxpayer identification number of such individual.  In addition, apayor is required to report the name, address, and taxpayer identification number of thechronically ill individual on account of whose condition such amounts are paid, and whether thecontract under which the amount is paid is a per diem-type contract.  A copy of the report mustbe provided to the payee by January 31 following the year of payment, showing the name of thepayor and the aggregate amount of benefits paid to the individual during the calendar year. Failure to file the report or provide the copy to the payee is subject to the generally applicablepenalties for failure to file similar information reports.

**Life insurance company reserves**

	In determining reserves for insurance company tax purposes, the Federal income taxreserve method applicable for a long-term care insurance contract issued after December 31,1996, is the method prescribed by the NAIC (or, if no reserve method has been so prescribed, amethod consistent with the tax reserve method for life insurance, annuity or noncancellableaccident and health insurance contracts, whichever is most appropriate).  The method currentlyprescribed by the NAIC for long-term care insurance contracts is the one-year full preliminaryterm method.  As under prior and present law, however, in no event may the tax reserve for acontract as of any time exceed the amount which would be taken into account with respect to thecontract as of such time in determining statutory reserves.

**Consumer protection provisions**

	Long-term care insurance contracts, and issuers of contracts, are required to satisfycertain provisions of the long-term care insurance model Act and model regulations promulgatedby the NAIC (as adopted as of January 1993).

	The contract requirements relate to disclosure, nonforfeitability, guaranteed renewal ornoncancellability, prohibitions on limitations and exclusions, extension of benefits, continuationor conversion of coverage, discontinuance and replacement of policies, unintentional lapse, post-claims underwriting, minimum standards, inflation protection, preexisting conditions, and priorhospitalization.  Disclosure and nonforfeiture requirements also apply.  The nonforfeitureprovision gives consumers the option of selecting reduced paid-up insurance, extended terminsurance, or a shortened benefit period in the event a policyholder who elects a nonforfeitureprovision is unable to continue to pay premiums.  The requirement that insurers offerpolicyholders a nonforfeiture benefit does not preclude the imposition of a reasonable delayperiod.  The consumer protection provisions that apply with respect to the terms of the contractapply only for purposes of determining whether a contract is a qualified long-term care insurancecontract.

	The requirements for issuers of long-term care insurance contracts relate to applicationforms, reporting requirements, marketing, appropriateness of purchase, format, delivering ashopper's guide, right to return, outline of coverage, group plans, policy summary, monthlyreports on accelerated death benefits, and incontestability period.   A tax is imposed equal to$100 per insured per day for failure to satisfy these requirements.  The consumer protectionrequirements for issuers of contracts apply with respect to contracts that are qualified long-termcare insurance contracts.

	An otherwise qualified long-term care insurance contract will not fail to be a qualifiedlong-term care insurance contract solely because it satisfies a consumer protection standardimposed under applicable State law that is more stringent than the analogous standard providedin the Code.

**Legislative Background**

	The provisions relating to long-term care were added by the Health Insurance Portabilityand Accountability Act of 1996.

**H.  Group Health Plan Requirements**

**1.  Health care continuation rules**

**Present Law**

	The health care continuation rules (commonly referred to as "COBRA" rules, after theConsolidated Omnibus Budget Reconciliation Act of 1985 in which they were enacted) requirethat most employer-sponsored group health plans must offer certain covered employees and theirdependents ("qualified beneficiaries") the option of purchasing continued health coverage in the event of loss of coverage resulting from certain qualifying events. These qualifying eventsinclude: termination or reduction in hours of employment, death, divorce or legal separation,enrollment in Medicare, the bankruptcy of the employer, or the end of a child's dependencyunder a parent's health plan.  The term qualified beneficiary includes individuals who were eitherthe spouse or the dependent of the covered employee at the time of the qualifying event andincludes a child born to or placed for adoption with the covered employee during the period ofCOBRA coverage

	In general, the maximum period of COBRA coverage is 18 months.  An employer ispermitted to charge qualified beneficiaries 102 percent of the applicable premium for COBRAcoverage.  A tax equal to $100 per day may be assessed against employers (plans in the case ofmultiemployer plans) for failures to comply with the COBRA rules, subject to certain exceptionsand limitations.  This tax may be assessed against a person who is responsible (other than in acapacity as an employee) for administering or providing benefits under a plan and whose act orfailure to act caused (in whole or in part) the failure to comply with the COBRA rules.

	The 18-month maximum COBRA coverage period is extended to 29 months if thequalified beneficiary was determined under the Social Security Act to have been disabled at thetime of the qualifying event and the qualified beneficiary provided notice of such determinationto the employer before the end of the 18-month period.  The Health Insurance Portability andAccountability Act of 1996 ("HIPAA") clarified that this extended COBRA coverage applies ifthe disability exists at any time during the first 60 days of initial 18-month COBRA coverage asopposed to requiring the disability to exist at the time of the qualifying event.  A qualifiedbeneficiary has 60 days to notify the employer of a disability determination.  During the 11-month period of extended COBRA coverage, the qualified beneficiary may be charged 150percent of the applicable premium.

	COBRA coverage may be terminated before the 18-month maximum coverage period inthe case of the following events: (1) the employer ceases to maintain any group health plan; (2)the qualified beneficiary fails to pay the premium; (3) the qualified beneficiary becomes coveredunder another group health plan even if such group health plan contains a preexisting conditionlimitation or exclusion, provided the preexisting condition limitation or exclusion does not applyto the qualified beneficiary by reason of requirements added by HIPAA restricting theapplication of preexisting condition limitations and exclusions; or (4) the qualified beneficiarybecomes entitled to Medicare.

	A group health plan is required to notify each covered employee and the coveredemployee's spouse of their COBRA rights upon commencement of participation in the plan. Further, the group health plan administrator must notify each qualified beneficiary of theirCOBRA rights within 14 days after the administrator is notified of the occurrence of a qualifyingevent.

**Legislative Background**

	The COBRA rules were added by the Consolidated Omnibus Budget Reconciliation Actof 1985.  Provisions modifying the COBRA rules were added by the Health Insurance Portabilityand Accountability Act of 1996.

**2.  Health Insurance Portability and Accountability Act ("HIPAA") rules**

**Present Law**

**HIPAA requirements-in general**

	Under HIPAA, certain group health plans are subject to certain requirements regardingportability of coverage through limitations on preexisting condition exclusions, prohibitions ondenial of coverage based on health status, and guaranteed renewability of health insurancecoverage.  An excise tax is imposed with respect to any failure of a group health plan to complywith the requirements.(68)  The tax is generally imposed on the employer sponsoring the plan. However, the tax is imposed on the plan in the case of a multiemployer plan and, with respect toviolations of the requirements relating to guaranteed renewability, on the arrangement in the caseof a multiple employer welfare arrangement.

	These group health plan requirements do not apply to governmental plans and planswhich on the first day of the plan year cover fewer than 2 current employees.  In addition, no taxmay be imposed on a small employer (defined as an employer who employed an average of 50 orfewer employees on business days during the preceding calendar year) that provides health carebenefits through a contract with an insurer or HMO if the violation is solely because of thecoverage offered by the insurer or HMO. 

**Group health plan requirements**

          Limitations on preexisting condition exclusions

	HIPAA restricts the use of preexisting condition exclusions by group health plans.  Apreexisting condition exclusion is a limitation or exclusion of benefits relating to a condition,whether physical or mental, based on the fact that the condition was present before theenrollment date, whether or not any medical advice, diagnosis, care, or treatment wasrecommended or received before that date.  Genetic information is not considered a condition inthe absence of a diagnosis of the condition related to such information.

	HIPAA permits a group health plan to impose a preexisting condition exclusion if theexclusion relates to a condition (whether physical or mental), regardless of the cause ofcondition, for which medical advice, diagnosis, care, or treatment was recommended or receivedwithin the 6-month period ending on the enrollment date.  The exclusion may extend to not morethan 12 months (18 months for late enrollees) after the enrollment date.  The exclusion is reducedby the aggregate of the periods of creditable coverage prior to a break in coverage of at least 63days.  Creditable coverage includes coverage under a group health plan, health insurancecoverage, Medicare, a state health benefit risk pool and a public health plan.  Enrollment date isdefined as the date of enrollment in the plan or coverage or, if earlier, the first day of the waitingperiod for such enrollment.

	Any waiting period or affiliation period runs concurrently with any preexisting conditionexclusion period.  A preexisting condition exclusion period may not be applied to a newborn, anadopted child, or a child placed for adoption under age 18, so long as the individual becomescovered under creditable coverage within 30 days of birth or adoption or placement for adoption. These exceptions for newborns and certain adopted children do not apply if the individual had abreak in coverage longer than a 63-day period.  Preexisting condition exclusions may not applyto pregnancies.

	A group health plan offering health insurance coverage through an HMO, or an HMOwhich offers health insurance coverage in connection with a group health plan, may impose anaffiliation period only if no preexisting condition exclusion is imposed, the period is imposeduniformly without regard to health status, and does not exceed 2 months for timely enrollmentand 3 months for late enrollment.  The affiliation period must apply to all new enrollees andbeneficiaries.  During the affiliation period, the HMO cannot be required to provide health careservices or benefits and no premium can be charged to the participant or beneficiary.  Theaffiliation period begins on the enrollment date and runs concurrently with any other applicablewaiting period under the plan.  An HMO may use alternative methods to address adverseselection as approved by state regulators.

          Prohibiting exclusions based on health status

	Except as specified below, a group health plan cannot establish rules for eligibility(including continued eligibility) of an individual to enroll under the terms of the plan based onany of the following health-related factors in relation to the individual or a dependent of theindividual:  health status, medical condition (including both physical and mental illness), claimsexperience, receipt of health care, medical history, genetic information, evidence of insurability(including conditions arising out of domestic violence), or disability.

	The inclusion of evidence of insurability in the definition of health status is intended toensure, among other things, that individuals are not excluded from health care coverage due totheir participation in activities such as motorcycling, snowmobiling, all-terrain vehicle riding,horseback riding, skiing, and other similar activities.

	A plan cannot knowingly be designed to exclude individuals and their dependents on thebasis of health status.  However, generally applicable terms of the plan may have a disparateimpact on individual enrollees.  For example, a plan may exclude all coverage of a specificcondition, or may include a lifetime cap on all benefits, or a lifetime cap on specific benefits. Although individuals with the specific condition would be adversely affected by an exclusion ofcoverage for that condition, and individuals with serious illnesses may be adversely affected by alifetime cap on all or specific benefits, such plan characteristics are permitted as long as they arenot directed at individual sick employees or dependents.

	HIPAA does not require a group health plan to provide particular benefits other thanthose provided under the terms of the plan or coverage.  Nor does it prevent any plan or coveragefrom establishing limitations or restrictions on the amount, level, extent, or nature of the benefitsor coverage for similarly situated individuals enrolled in the plan or coverage.  Rules definingany applicable waiting periods for enrollment may not be based on factors related to healthstatus.

	A plan cannot single out an individual based on health status or related factors for denialof a benefit otherwise provided other individuals covered under the plan.  For example, the planmay not deny coverage for prescription drugs to a particular beneficiary or dependent if suchcoverage is available to other similarly situated individuals covered under the plan.  However,the plan could deny coverage for prescription drugs to all beneficiaries and dependents.  Theterm "similarly situated" means that a plan is permitted to vary benefits available to differentgroups of employees, such as full-time versus part-time employees or employees in differentgeographic locations.  In addition, a plan may have different benefit schedules for differentcollective bargaining units.

	HIPAA provides that a group health plan cannot require a premium or contribution whichis greater than such premium or contribution for a similarly situated individual enrolled in theplan on the basis of any factor relating to the health status of individual or any individualenrolled under the plan as a dependent of the individual.  HIPAA does not restrict the amountthat an employee may be charged for coverage under a group health plan.  The group health planmay establish premium discounts or rebates, or modify otherwise applicable copayments ordeductibles in return for adherence to programs of health promotion and disease prevention.

	These provisions preclude insurance companies from denying coverage to employeesbased on health status and related factors that they have traditionally used.  In addition, thisprovision is meant to prohibit insurers or employers from excluding employees in a group fromcoverage or charging them higher premiums based on their health status and other related factorsthat could lead to higher health costs.  This does not mean that an entire group cannot be chargedmore.  But it does preclude health plans from singling out individuals in the group for higherpremiums or dropping them from coverage altogether.

          Guaranteed renewability in multiemployer plans and certain multiple employer welfare arrangements

	HIPAA provides that a group health plan which is a multiemployer plan or a multipleemployer welfare arrangement may not deny an employer continued access to the same ordifferent coverage under the terms of such plan except:  (1) for nonpayment of contributions; (2)for fraud; (3) for noncompliance with plan provisions; (4) because the plan is ceasing to offer anycoverage in a geographic area; (5) in the case of a network plan, there is no longer any individualenrolled through the employer who lives, resides, or works in the service area of the networkplan, and the plan applies this provision uniformly without regard to claims experience or healthstatus-related factors; or (6) due to a failure to meet the terms of an applicable collectivebargaining agreement, to renew a collective bargaining agreement or other agreement requiringor authorizing contributions to the plan, or to employ employees covered by such an agreement.

**Excise tax on failure to satisfy group health plan requirements**

	The excise tax on the failure to satisfy the group health plan requirements is generallyequal to $100 per day for each day during which a failure occurs until the failure is corrected. The tax applies separately with respect to each individual affected by the failure.  In general, thetax is not imposed if the violation was unintentional and is corrected within 30 days.(69)  Themaximum tax for unintentional violations that can be imposed generally is the lesser of (1) 10percent of the employer's payments during the taxable year in which the failure occurred undergroup health plans (or 10 percent of the amount paid by the multiemployer plan or multipleemployer welfare arrangement during the plan year in which the failure occurred for medicalcare, if applicable), or (2) $500,000.  The Secretary of the Treasury may waive all or part of thetax to the extent that payment of the tax would be excessive relative to the failure involved.

**Legislative Background**

	The provisions relating to group health plan requirements were added by the HealthInsurance Portability and Accountability Act of 1996.

**3.  Newborns' and mothers' health protection; mental health parity**

**Present Law**

	The Newborns' and Mothers' Health Protection Act of 1996 amended the EmployeeRetirement Income Security Act ("ERISA") and the Public Health Service Act to impose certainrequirements on group health plans with respect to coverage of newborns and mothers, includinga requirement that a group health plan cannot restrict benefits for a hospital stay in connectionwith childbirth for the mother or newborn to less than 48 hours following a normal vaginaldelivery or less than 96 hours following a cesarean section. These provisions are effective withrespect to plan years beginning on or after January 1, 1998.

	The Mental Health Parity Act of 1996 amended ERISA and the Public Health Service Actto Provide that group health plans that provide both medical and surgical benefits and mentalhealth benefits cannot impose aggregate lifetime or annual dollar limits on mental health benefitsthat are not imposed on substantially all medical and surgical benefits. The provisions of theMental Health Parity Act are effective with respect to plan years beginning on or after January 1,1998, but do not apply to benefits for services furnished on or after September 30, 2001.

	The Internal Revenue Code requires that group health plans meet certain requirementswith respect to limitations on exclusions of preexisting conditions and that group health plans notdiscriminate against individuals based on health status. An excise tax of $100 per day during theperiod of noncompliance is imposed on the employer sponsoring the plan if the plan fails to meetthese requirements. The maximum tax that can be imposed during a taxable year cannot exceedthe lesser of 10 percent of the employer's group health plan expenses for the prior year or$500,000. No tax is imposed if the Secretary determines that the employer did not know, andexercising reasonable diligence would not have known, that the failure existed.

	Failures to comply with the provisions of the Newborns' and Mothers' Health ProtectionAct and the Mental Health Parity Act are subject to the excise tax applicable to failures tocomply with other group health plan requirements.

**Legislative Background**

	The provision incorporating the provisions of the Newborns' and Mothers' HealthProtection Act of 1996 and the Mental Health Parity Act of 1996 relating to group health plansinto the Internal Revenue Code was added by the Taxpayer Relief Act of 1997.

**I.  Other Tax-Related Health Provisions**

	Under present law, post-retirement medical benefits are generally excludable from thegross income of a plan participant or beneficiary. In addition, an employer may deductcontributions, within limits, made to a welfare benefit fund for retiree health and life insurancebenefits of its employees.

**Legislative Background**

**1.  Voluntary employees' beneficiary associations ("VEBAs")**

**Present Law**

	Under present law, a voluntary employees' beneficiary association ("VEBA") is a taxexempt welfare benefit fund that provides for the payment of life, sick, accident, or other benefitsto the members of such association or their dependents or designated beneficiaries, and underwhich no part of the net earnings of such association may inure (other than through suchpayments) to the benefit of any private shareholder or individual. In addition the VEBAgenerally is required to satisfy certain rules prohibiting the provision of benefits on a basis thatfavors the employer's highly compensated employees.

	Although a VEBA generally is exempt from tax, it is taxable on its unrelated businesstaxable income ("UBTI"). Income set aside to provide for post-retirement medical benefits isconsidered UBTI. This rule does not apply to a VEBA if substantially all of the contributions toit were made by employers who are exempt from income tax throughout the 5-taxable-yearperiod ending with the taxable year in which the contributions were made. Further, VEBAsmaintained pursuant to a collective bargaining agreement and certain employee pay all VEBAsare not subject to UBTI because no account limits apply to such VEBAs.

**Legislative Background**

	The provisions relating to VEBAs were added by the Deficit Reduction Act of 1984.

**2.  Use of excess pension assets to fund retiree health benefits**

**Present Law**

	Under present law, a tax-qualified pension or annuity plan may provide for the paymentof sickness, accident, hospitalization and medical expenses for retired employees, their spouses,and their dependents under a separate account method of prefunding post-retirement medical andlife insurance benefits provided certain additional qualification requirements are satisfied withrespect to the post-retirement medical benefits (sec. 401(h)). First, the medical benefits, whenadded to any life insurance protection provided under the plan, are required to be incidental to theretirement benefits provided by the plan. The medical benefits are considered incidental orsubordinate to the retirement benefits if, at all times, the aggregate of employer contributions toprovide such medical benefits and any life insurance protection does not exceed 25 percent of theaggregate contributions, other than contributions to fund past service credits.

	The second requirement is that a separate account is to be maintained with respect tocontributions to fund such medical benefits. This separate accounting generally is determined onan aggregate, rather than on a per-participant basis, and is solely for recordkeeping purposes. Inaddition, separate accounts are required to be maintained for each key employee in the samemanner as under a welfare benefit fund.

	The third requirement is that the employer's contributions to the separate account are tobe reasonable and ascertainable. Fourth, the plan is required to preclude the use of amounts in theseparate account for any other purposes at any time prior to the satisfaction of all liabilities withrespect to the post-retirement medical benefits. Fifth, upon the satisfaction of all plan liabilitiesto provide post-retirement medical benefits, the remaining assets in the separate account are torevert to the employer and cannot be distributed to the retired employees.

	If these requirements are satisfied, the income earned in the separate account (sec. 401(h)account) is not taxable. In addition, employer contributions to fund the benefits are deductibleunder the general rules relating to the timing of deductions for contributions to qualified pensionplans. The deduction for such contributions are not taken into account in determining the amountdeductible with respect to contributions for retirement benefits. The amount deductible may notexceed the total cost of providing the medical benefits, determined in accordance with anygenerally accepted actuarial method that is reasonable in view of the provisions and coverage ofthe plan and any other relevant considerations. In addition, the amount deductible for any taxableyear may not exceed the greater of (1) an amount determined by allocating the remainingunfunded costs as a level amount or a level percentage of compensation over the remainingfuture service of each employee, or (2) the amount necessary to amortize the unfunded costs overa 10-year period. Certain contributions in excess of the deductible limit may be carried over anddeducted in succeeding taxable years.

**Legislative Background**

	The provision relating to the transfer of excess assets to retiree health accounts was addedby the Omnibus Budget Reconciliation Act of 1990.

**II.  UTILIZATION OF SELECTED FEDERAL TAX PROVISIONS RELATED TO HEALTH CARE**

**A.  Exclusion from Income and Wages for Employer-Provided Health Care**

	Table 14 shows the Federal tax expenditures for selected health care related tax provisions. By far the most significant provision, both in terms of the number of taxpayers that benefit andthe cost to the Federal Government, is the exclusion from income and wages for employer-provided health care.  The staff of the Joint Committee on Taxation estimates that the revenueloss from the exclusion from income is $57.9 billion in fiscal year 1999 (see Table 14).  Thisestimate includes employer-provided health insurance obtained through cafeteria plans.  Thisestimate does not include the effects of the exclusion for employment tax purposes.

	A majority of the population now receives health insurance as a consequence of their ownemployment or of a family member's employment.  In 1996, for 58 percent of the population,employment based health insurance was the primary source of health coverage, while 5 percentpurchased insurance privately, 13 percent received Medicare benefits, 9 percent receivedMedicaid benefits, and 15 percent had no health insurance.(70)

	Cafeteria plans are a growing part of compensation plans, particularly for largeemployers.  Benefits provided through cafeteria plans are excluded from income to the extentsuch benefits are eligible for an exclusion based on other provisions of the Code.  Thus,employer-provided health care benefits that are provided through cafeteria plans are eligible foran income exclusion. The Bureau of Labor Statistics estimates that in 1995, 55 percent ofemployees at large and medium sized firms were eligible for flexible benefits and/orreimbursement accounts.  Smaller firms generally do not offer cafeteria plans.  In 1994, only 19percent of workers in small, private establishments (nonfarm establishments with fewer than 100employees) were eligible to participate in a cafeteria plan.

**B.  Itemized Deduction for Medical Expenses and Long-Term Care Expenses**

	The staff of the Joint Committee on Taxation estimates that 4,701,000 tax returns haditemized deductions for medical expenses in 1998, resulting in a loss of Federal revenues of $3.7billion in 1998.(71)  The itemized deduction for medical expenses is intended to apply only toextraordinary medical expenses, and hence only medical expenses in excess of 7.5 percent ofAGI can be deducted.  The utilization of this provision thus depends on both the extent of ataxpayer's medical expenses in a given year, and on the taxpayer's AGI.  Additionally, to theextent that AGI is low, taxpayers may find it more advantageous to claim the standard deductionrather than itemize deductions, even if their medical expenses exceeded 7.5 percent of their AGI. The 7.5-percent floor for the medical expense deduction has a significant impact on the numberof taxpayers who can claim the deduction.  For example, when the medical deduction floor wasincreased from 3 percent of AGI to 5 percent of AGI, the number of tax returns claiming thededuction dropped from 22 million in 1982 to 9.7 million in 1983.  Similarly, the increase from 5percent of AGI to 7.5 percent saw a drop in the number of tax returns claiming the deductionfrom 10.5 million in 1986 to 5.4 million in 1987.(72)  Table 15 shows the distribution by incomeclass of the tax expenditure resulting from the deduction for medical expenses.

	Unreimbursed expenses for qualified long-term care services provided to the taxpayer orthe taxpayer's spouse or dependents are treated as medical expenses for purposes of the itemizeddeduction for medical expenses.  Similarly, long-term care insurance premiums that do notexceed specified dollar limits are treated as medical expenses for purposes of the itemizeddeduction for medical expenses. The staff of the Joint Committee on Taxation estimates that thetax expenditure for the itemized deduction for medical expenses and long-term care expensescombined is $4.2 billion for fiscal year 1999 (see Table 14).

**C.  Deduction for Health Insurance and Long-Term Care Insurance Expenses of Self-Employed Individuals**

	The Federal tax revenues forgone by the deduction for health insurance premiums andlong-term care insurance premiums by the self-employed is estimated by the staff of the JointCommittee on Taxation to be $800 million in fiscal year 1998 (see Table 14).  Currently, theself-employed may deduct 45 percent of their premiums; this amount will gradually increaseuntil it reaches 100 percent for 2007 and subsequent years.  The rise in the deductible fractionimplies a greater subsidy to self-employed health and long-term care insurance, and thus it islikely that the increased subsidy will induce more self-employed to purchase such insurance.

**D.  Medical Savings Accounts**

	As described previously, eligibility for contributions to MSAs is limited by a number ofstatutory provisions relating to the size of the employer and the nature of the health insuranceoffered by that employer. There is also an overall limit on the total number of MSAs that may beestablished.  The utilization of MSAs has been well below the applicable numerical limit to date. The Internal Revenue Service ("IRS") determined that only 7,383 MSAs had been established asof April 30, 1997, 17,154 MSAs had been established as of June 30, 1997, and 44,523 had beenestablished as of December 31, 1998.  The tax expenditure cost of MSAs is estimated to be lessthan $50 million in each of the fiscal years 1999 through 2003 (see Table 14).

	The General Accounting Office, ("GAO") was directed to contract with an organizationwith expertise in health economics, health insurance markets, and actuarial science to conduct astudy regarding the effects of MSAs in the small group market on (1) selection (includingadverse selection), (2) health costs, including the impact on premiums of individuals withcomprehensive coverage,  (3) use of preventive care,  (4) consumer choice, (5) the scope ofcoverage of high deductible plans purchased in conjunction with an MSA and (6) other relevantissues, to be submitted to the Congress by January 1, 1999.

	The GAO issued its final report an MSA experience in December 1998.(73)  The GAOlimited its study to a survey of insurers; because of the relatively low enrollment in MSAs, theGAO found it impossible to conduct useful surveys of enrollees, employers, or financialinstitutions at a reasonable cost.  Key findings of the GAO study include the following:
- 	Consumer demand has been lower than many in the industry anticipated.  Lowerdemand reflects, in part, the complexity of the qualifying plan/MSA product forboth agents and consumers.  Insurers and the Internal Revenue Service report thatproduct sales have continued in the second year of the demonstration, but remainwell below the HIPAA-imposed limits.
- 	The insurance industry responded to the legislation rapidly, with more than 50companies offering qualifying products by the summer of 1997; between 1997and 1998 the total number of companies offering qualifying products declinedslightly.
- 	A wide range of insurers offer qualifying plans, and both traditional indemnityproducts and plans with managed care features (principally preferred providerorganizations) are available.
- 	A minority of insurers offering qualifying plans are marketing them aggressivelyand remain optimistic that MSAs will be an important option in the market; otherinsurers are currently more passively in the market and have more of a "wait-and-see" view of MSAs.
- 	Insurers report that the supply of qualifying plans available and the enthusiasmwith which they are marketed have been limited by features of the demonstrationdesign.
- 	A majority of insurers sell qualifying plans bundled with the MSA; the accountsthemselves are offering a wider variety of investment options and bankingfeatures as the demonstration matures.
- 	Qualifying plans have somewhat more generous benefits than other highdeductible products offered by the same insurers; premiums for qualifying plans,initially set very similarly to non-qualifying high deductible plans, have droppedin some cases between 1997 and 1998.

**Table 14.-Tax Expenditure Estimates for Selected Health Care Provisions, Fiscal Years 1998-2002**

[Billions of Dollars]

**Provision******1999******2000******2001******2002******2003****Total 1999-2003Exclusion of employer contributions for medical care, health insurance premiums, and long-term care insurance premiums157.961.365.169.273.8327.3Deduction for medical expenses and long-term care expenses	4.24.34.54.74.922.6Deduction for health insurance premiums and long-term careinsurance premiums by the self-employed	1.01.21.21.52.47.3Medical savings accounts	(2)(2)(2)(2)(2)0.1Source:  Joint Committee on Taxation, *Estimates of Federal Tax Expenditures for Fiscal Years, 1999-2003* (JCS-7-98), December 14, 1998.  Tax expenditureestimates are for Federal income taxes only and do not include any effects on Social Security payroll taxes.
1Estimate includes employer-provided health insurance purchased through cafeteria plans.

2Less than $50 million.

**Table 15.-Distribution By Income Class of Medical Deduction Tax Expenditureat 1998 Rates and 1998 Income Levels1**

[Money amounts in millions of dollars; returns in thousands]

**Medical deduction3****Income class2**Returns**AmountBelow $10,000	7            $       2            $10,000 to $20,000	170            49            $20,000 to $30,000	556            172            $30,000 to $40,000	827            352            $40,000 to $50,000	794            406            $50,000 to $75,000	1,424            934            $75,000 to $100,000	578            683            $100,000 to $200,000	306            830            $200,000 and over	38            319                  Total	4,701           $3,746            Source:  Joint Committee on Taxation, *Estimates of Federal Tax Expenditures for Fiscal Years**1999-2003* (JCS-7-98), December 14, 1998.  Tax expenditure estimates are for Federal income taxes only and do not include anyeffects on Social Security payroll taxes.
1Tax law as in effect on January 1, 1998.  Excludes individuals who are dependents of other taxpayers.

2The income concept used to place tax returns into classes is adjusted gross income ("AGI") plus:  (a) tax-exemptinterest, (b) employer contributions for health plans and life insurance, (c) employer share of FICA tax, (d)workers' compensation, (e) nontaxable Social Security benefits, (f) insurance value of Medicare benefits, (g)alternative minimum tax preference items, and (h) excluded income of U.S. citizens living abroad.

3Tax expenditures estimates does not include revenue losses attributable to deductions for long-term care andlong-term care insurance premiums.

**PART THREE:  PRESENT LAW AND BACKGROUND RELATING TO ESTATE AND GIFT TAXES**

**I.  PRESENT LAW AND LEGISLATIVE HISTORY**

**A.  Present Law**

**Application of the estate and gift tax**

	A gift tax is imposed on lifetime transfers and an estate tax is imposed on transfers atdeath. Since 1976, the gift tax and the estate tax have been unified so that a single graduated rateschedule applies to cumulative taxable transfers made by a taxpayer during his or her lifetimeand at death.(74) The unified estate and gift tax rates begin at 18 percent on the first $10,000 incumulative taxable transfers(75) and reach 55 percent on cumulative taxable transfers over $3million.  In addition, a 5-percent surtax is imposed on cumulative taxable transfers between $10million and the amount necessary to phase out the benefits of the graduated rates.(76)

	The amount of gift tax payable for any calendar year generally is determined bymultiplying the applicable tax rate (from the unified graduated rate schedule) by the cumulativelifetime taxable transfers made by the taxpayer and then subtracting any gift taxes payable forprior taxable periods. This amount is reduced by any available unified credit (and otherapplicable credits) to determine the gift tax liability for the taxable period.

	The amount of estate tax payable generally is determined by multiplying the applicabletax rate (from the unified graduated rate schedule) by the cumulative post-1976 taxable transfersmade by the taxpayer during his lifetime or at death and then subtracting any gift taxes payablefor prior calendar years (after 1976). This amount is reduced by any available unified credit (andother applicable credits) to determine the estate tax liability.

	A 100-percent marital deduction generally is permitted for the value of propertytransferred between spouses.

**Unified credit**

	A unified credit is available with respect to taxable transfers by gift and at death.  From1987 to 1997, the unified credit amount was $192,800, which effectively exempted a total of$600,000 in cumulative taxable transfers from the estate and gift tax.  The Taxpayer Relief Actof 1997 ("1997 Act") increased the effective exemption to $625,000 in 1998, $650,000 in 1999,$675,000 in 2000 and 2001, $700,000 in 2002 and 2003, $850,000 in 2004, $950,000 in 2005,and $1 million in 2006 and thereafter.(77)

**Annual exclusion for gifts**

	A taxpayer may exclude $10,000 of gifts made to any one donee during a calendar year. For gifts made after 1998, the $10,000 exclusion will be increased annually for inflationoccurring after 1997. This annual exclusion does not apply to gifts of future interests (e.g.,reversions or remainders). Prior to 1982, the annual exclusion was $3,000.

**Valuation**

	Generally, for Federal transfer tax purposes, the value of property is its fair market value,i.e., the price at which the property would change hands between a willing buyer and a willingseller, neither being under any compulsion to buy or sell and both having reasonable knowledgeof relevant facts. For Federal estate tax purposes, fair market value is determined at either (1) thetime of the decedent's death, or (2) the "alternate" valuation date of six months after thedecedent's death.  For Federal gift tax purposes, fair market value generally is determined at thedate of the gift.

	Under Code section 2032A, an executor may elect for estate tax purposes to value certain"qualified real property" used in farming or another qualifying closely-held trade or business atits current-use value, rather than its highest and best use value. Currently, the maximumreduction in the value of such real property resulting from an election under Code section 2032Ais $750,000.  For decedents dying after 1998, the $750,000 maximum reduction in value will beindexed annually for inflation occurring after 1997.

	An estate may qualify for current-use valuation under section 2032A if: (1) the decedentwas a citizen or resident of the United States at the time of death; (2) the value of the farm orclosely held business assets in the decedent's estate, including both real and personal property(but reduced by debts attributable to the real and personal property) is at least 50 percent of thedecedent's gross estate (reduced by mortgages and other secured debts); (3) at least 25 percent ofthe adjusted value of the gross estate is qualified farm or closely held business real property(78); (4)the real property qualifying for current-use valuation passes to a qualified heir(79); (5) such realproperty was owned by the decedent or a member of the decedent's family and used or held foruse as a farm or closely held business ("a qualified use") for 5 of the last 8 years prior to thedecedent's death; and (6) there was material participation in the operation of the farm or closelyheld business by the decedent or a member of the decedent's family in 5 years out of the 8 yearsimmediately preceding the decedent's death.  If, after an election is made to specially valueproperty at its current-use value, the heir who acquired the real property ceases to use it in itsqualified use within 10 years (15 years for individuals dying before 1982) of the decedent'sdeath, an additional estate tax is imposed in order to "recapture" the estate-tax benefit of thecurrent-use valuation.

**Qualified family-owned business interests**

	An estate is permitted to deduct the adjusted value of the qualified "family-ownedbusiness interests" of the decedent, up to a total of $675,000.  The deduction plus the unifiedcredit exclusion amount may not exceed $1.3 million.  (Code sec. 2057.)

	A qualified family-owned business interest is defined as any interest in a trade or business(regardless of the form in which it is held) with a principal place of business in the United Statesif one family owns at least 50 percent of the trade or business, two families own 70 percent, orthree families own 90 percent, as long as the decedent's family owns at least 30 percent of thetrade or business.  An interest in a trade or business does not qualify if any interest in thebusiness (or a related entity) was publicly-traded at any time within three years of the decedent'sdeath.  An interest in a trade or business also does not qualify if more than 35 percent of theadjusted ordinary gross income of the business for the year of the decedent's death was personalholding company income (as defined in sec. 543).  In the case of a trade or business that owns aninterest in another trade or business (i.e., "tiered entities"), special look-through rules apply.  Thevalue of a trade or business qualifying as a family-owned business interest is reduced to theextent the business holds passive assets or excess cash or marketable securities.

	To qualify for the exclusion, the decedent (or a member of the decedent's family) musthave owned and materially participated in the trade or business for at least 5 of the 8 yearspreceding the decedent's date of death.  In addition, each qualified heir (or a member of thequalified heir's family) is required to actively participate in the trade or business for at least 10years following the decedent's death.

	The benefit of the exclusion for qualified family-owned business interests is subject torecapture if, within 10 years of the decedent's death and before the qualified heir's death, one ofthe following "recapture events" occurs: (1) the qualified heir ceases to meet the materialparticipation requirements; (2) the qualified heir disposes of any portion of his or her interest inthe family-owned business, other than by a disposition to a member of the qualified heir's familyor through a qualified conservation contribution; (3) the principal place of business of the tradeor business ceases to be located in the United States; or (4) the qualified heir loses U.S.citizenship.

	The portion of the reduction in estate taxes that is recaptured depends upon the number ofyears that the qualified heir (or members of the qualified heir's family) materially participated inthe trade or business between the date of the decedent's death and the date of the recapture event. If the qualified heir (or his or her family members) materially participated in the trade or businessafter the decedent's death for less than six years, 100 percent of the reduction in estate taxesattributable to that heir's interest is recaptured; if the participation was for at least six years butless than seven years, 80 percent of the reduction in estate taxes is recaptured; if the participationwas for at least seven years but less than eight years, 60 percent is recaptured; if the participationwas for at least eight years but less than nine years, 40 percent is recaptured; and if theparticipation was for at least nine years but less than ten years, 20 percent of the reduction inestates taxes is recaptured.  In general, there is no requirement that the qualified heir (or membersof his or her family) continue to hold or participate in the trade or business more than 10 yearsafter the decedent's death.  As under section 2032A(c)(7)(A), however, the 10-year recaptureperiod may be extended for a period of up to two years if the qualified heir does not begin to usethe property for a period of up to two years after the decedent's death.

**Exclusion for land subject to permanent conservation easement**

	An executor may elect to exclude from the taxable estate 40 percent of the value of anyland subject to a qualified conservation easement, up to a maximum exclusion of $200,000 in1999, $300,000 in 2000, $400,000 in 2001, and $500,000 in 2002 and thereafter.  (Code sec.2031(c).)  If the value of the conservation easement is less than 30 percent of the value of theland without the easement (reduced by the value of any retained development rights), then theexclusion percentage is reduced by 2 percentage points for each percentage point (or fractionthereof) by which the value of the qualified conservation easement is less than 30 percent of thevalue of the land.

	A qualified conservation easement is one that meets the following requirements:  (1) theland is located within 25 miles of a metropolitan area (as defined by the Office of Managementand Budget) or a national park or wilderness area, or within 10 miles of an Urban National Forest(as designated by the Forest Service of the U.S. Department of Agriculture); (2) the land hasbeen owned by the decedent or a member of the decedent's family at all times during the three-year period ending on the date of the decedent's death; and (3) a qualified conservationcontribution (within the meaning of sec. 170(h)) of a qualified real property interest (as generallydefined in sec. 170(h)(2)(C)) was granted by the decedent or a member of his or her family.  Forpurposes of the provision, preservation of a historically important land area or a certified historicstructure does not qualify as a conservation purpose.

	In order to qualify for the exclusion, a qualifying easement must have been granted by thedecedent, a member of the decedent's family, the executor of the decedent's estate, or the trusteeof a trust holding the land, no later than the date of the election.  To the extent that the value ofsuch land is excluded from the taxable estate, the basis of such land acquired at death is acarryover basis (i.e., the basis is not stepped-up to its fair market value at death).  Propertyfinanced with acquisition indebtedness is eligible for this provision only to the extent of the netequity in the property.  The exclusion from estate taxes does not extend to the value of anydevelopment rights retained by the decedent or donor.

**Generation-skipping transfer tax**

	A generation-skipping transfer tax ("GST tax") generally is imposed on transfers, eitherdirectly or through a trust or similar arrangement, to a "skip person" (i.e., a beneficiary in ageneration more than one generation below that of the transferor). Transfers subject to the GSTtax include direct skips, taxable terminations, and taxable distributions.(80) Thegeneration-skipping transfer tax is imposed at a flat rate of 55 percent on cumulativegeneration-skipping transfers in excess of $1 million. Because both the generation-skippingtransfer tax and the estate or gift tax can apply to the same transfer, the combined marginal taxrate on a generation-skipping transfer can reach nearly 80 percent.

**Installment payment of estate tax**

	In general, the estate tax is due within nine months of a decedent's death. Under Codesection 6166, an executor generally may elect to pay the Federal estate tax attributable to aninterest in a closely held business in installments over, at most, a 14-year period. If the election ismade, the estate pays only interest for the first five years, followed by up to 10 annualinstallments of principal and interest.  A special 2-percent interest rate applies to the amount ofdeferred estate tax attributable to the first $1,000,000 in taxable value of the closely-heldbusiness. The interest rate applicable to the amount of estate tax attributable to the taxable valueof the closely held business in excess of $1,000,000 is equal to 45 percent of the rate applicableto underpayments of tax under section 6621 (i.e., 45 percent of the Federal short-term rate plus 3percentage points).  Interest paid on estate taxes deferred under section 6166 is not deductible forestate or income tax purposes.

	To qualify for the installment payment election, the decedent must have been a citizen orresident of the United States and the decedent's interest in the closely held business must exceed35 percent of the decedent's adjusted gross estate. An interest in a closely held business includes:(1) any interest as a proprietor in a business carried on as a proprietorship; (2) any interest in apartnership carrying on a trade or business if the partnership has 15 or fewer partners, or if atleast 20 percent of the partnership's assets are included in determining the decedent's gross estate;or (3) stock in a corporation if the corporation has 15 or fewer shareholders, or if at least 20percent of the value of the voting stock is included in determining the decedent's gross estate. Ingeneral, the installment payment election is available only if the estate directly owns an interestin a closely held active trade or business. Under a special rule, however, an executor may elect tolook through certain non-publicly traded holding companies that own stock in a closely heldactive trade or business, but if the election is made, neither the five-year deferral (i.e., theprovision that requires no principal payments until the fifth year) nor the special 2-percent rateapplies.

	If the installment payment election is made, a special estate tax lien applies to anyproperty on which tax is deferred for the installment payment period.

**State death tax(81) credit**

	A credit is allowed against the Federal estate tax for any estate, inheritance, legacy, orsuccession taxes actually paid to any State (or the District of Columbia) with respect to anyproperty included in the decedent's gross estate.  The maximum amount of credit allowable forState death taxes is determined under a graduated rate table, based on the size of the decedent'sadjusted taxable estate.  Most States impose a "pick-up" or "make-up" estate tax equal to thedifference between the maximum State death tax credit and any inheritance or other successiontaxes the State imposes.  The effect of the "pick-up" tax is to ensure maximum revenues for theState without increasing the total tax burden on the estates of its residents.

**B.  Legislative History**

**Federal death taxes before World War I**

	While States extensively used death taxes, Federal death taxes in this country, for most ofits history, were imposed primarily to finance wars or threat of war. The first Federal death taxwas imposed from 1797 until 1802 as a stamp tax on inventories of deceased persons, receipts oflegacies, shares of personal estate, probates of wills, and letters of administration to pay for thedevelopment of strong naval forces felt necessary because of strained trade relations withFrance.(82) Subsequent to the repeal of the stamp tax,(83) there were no death taxes imposed by theFederal Government until the Civil War when the Federal Government imposed an inheritancetax between 1862 and 1870.(84) In order to finance the Spanish-American War, the FederalGovernment imposed its first estate tax in 1898, which remained in effect until its repeal in1902.(85) While prior death taxes were primarily imposed to finance warfare, President TheodoreRoosevelt proposed, in 1906, a progressive tax on all lifetime gifts and death time bequests tolimit the amount that one individual could transfer to another, although no legislationimmediately resulted from such proposal.(86)

**Estate taxes from World War I through World War II**

          Estate taxes to finance World War I

	The commencement of World War I caused revenues from tariffs to fall. The FederalGovernment in 1916(87) adopted a progressive estate tax on all property owned by the decedent athis or her death, certain lifetime transfers which were for inadequate consideration,(88)  transfersnot intended to take effect until death,(89) and transfers made in contemplation of death.

	The 1916 estate tax provided an exemption (in the form of a deduction) of $50,000 withrates from 1 percent on the first $50,000 of transferred assets to 10 percent on transferred assetsin excess of $5 million. The next year, the revenue needs from the War resulted in increases inestate tax rates with a top rate of 25 percent on transfers in excess of $10 million.(90)

          Estate and gift taxes between World Wars I and II

	In the Revenue Act of 1918, estate tax rates on transfers under $1 million were reduced,but the tax was extended to life insurance proceeds in excess of $40,000 that were receivable bythe estate or its executor and property subject to a general power of appointment.(91)

	In 1924, the estate tax was changed by: (1) increasing the maximum rate to 40 percent;(2) broadening property subject to the tax to include jointly-owned property and property subjectto a power retained by the decedent to alter, amend, or revoke the beneficial enjoyment of theproperty;(92) and (3) allowing a credit for State death taxes of up to 25 percent of the Federal tax.In addition, the first gift tax was imposed.

	In 1926, the gift tax was repealed and estate tax rates were reduced to a maximum rate of20 percent on transfers over $10 million. The exemption was increased from $50,000 to$100,000, and the credit for State death taxes was increased to 80 percent of the Federal tax.(93)

	In 1932, with the advent of the Depression which reduced revenues from other sourcesand the need for revenues for new Government projects, estate tax rates were increased with atop rate of 45 percent on transfers over $10 million.(94) The tax was made applicable to lifetimetransfers in which the transferor retained a life estate or the power to control who shall benefitfrom the property or income therefrom.(95) The exemption was reduced to $50,000, and the Federalgift tax was reimposed (at 75 percent of the estate tax rates) for cumulative lifetime gifts inexcess of $5,000 per year.

	Estate and gift tax rates were increased in 1934 to top rates of 60 percent and 45 percent,respectively, on transfers in excess of $10 million and again in 1935 to top rates of 70 percentand 52.5 percent, respectively, on transfers in excess of $50 million.(96) The exemption for boththe estate and gift tax was reduced in 1935 to $40,000 each.(97)

	In 1940, a 10-percent surcharge was imposed on both income and estate and gift taxes, inlight of the need for additional revenue necessitated by the military build-up just prior to WorldWar II.(98) Estate and gift tax rates were increased in 1941, with a top estate tax rate of 77 percenton transfers in excess of $50 million.(99)

          Estate and gift taxes during World War II

	In 1942, Congress again altered estate and gift taxes by: (1) setting the exemption fromthe estate tax at $60,000, the lifetime exemption from the gift tax at $30,000, and providing anannual gift tax exclusion of $3,000;(100) and (2) attempting to equate property in communityproperty States with property owned in non-community property States by providing that in bothcommunity property States and non-community States, each spouse would be taxed on theportion of jointly owned or community property that each spouse contributed to that property'sacquisition cost.(101)

**Estate and gift taxes after World War II**

          Post-World War II through 1975

	The 1942 solution to the community property problem was viewed as complex. Congressprovided a different solution in 1948 for equating community property States andnon-community property States by providing the decedent or donor spouse a marital deductionfor 50 percent of the property transferred to the other spouse and, thus, effectively allowing bothspouses to be taxed on one-half of the property's value.(102)

	In 1954, the estate tax treatment of life insurance was changed to a rule that subjected lifeinsurance proceeds to estate tax if the proceeds were paid to the decedent's estate or executor or ifthe decedent retained "incidents of ownership" in the life insurance policy.(103)

	The Small Business Tax Revision Act of 1958(104) provided for payment of Federal estatetax on certain closely held businesses in installments over a 10-year period.(105)

          Legislation from 1976 through 1980

	In the Tax Reform Act of 1976,(106) Congress substantially revised estate and gift taxes by:(1) providing for a single unified rate structure for cumulative lifetime and deathtime transfers;(107)(2) providing an exemption in the form of a credit (called the "unified credit") which exempted$175,625 of transfers from tax when fully phased-in; (3) revising and lowering the unified ratestructure such that the maximum rate of tax was 70 percent; (4) changing the income tax rulesapplicable to the disposition of inherited assets from a rule that only taxed post-deathappreciation (i.e., the basis in the hands of the heir was "stepped-up" to its value on the date ofthe decedent's death) to one that provided that the heir's basis generally would be the same as itsbasis to the decedent (i.e., the decedent's basis in the property would "carryover" to be the basisto the heir); (5) providing a 100-percent marital deduction for the first $250,000 of propertytransferred to a surviving spouse; (6) changing the treatment of gifts made in contemplation ofdeath from a rebuttable presumption that gifts made within three years of death would be subjectto estate tax to a rule that subjects all gifts made within three years of death to the estate tax;(108)(7) providing that each spouse was rebuttably presumed to have contributed equally to theacquisition cost of jointly held property; (8) providing that a farm or other real property used in aclosely held business could be valued at its "current use value" instead of its "highest and bestuse" value, so long as the heirs continued to so use the property for 15 years after the decedent'sdeath;(109) (9) providing a limited deduction for bequests to children with no living parents (theso-called "orphan's deduction"); (10) providing a new transfer tax on generation-skippingtransfers basically equal to the additional estate or gift tax that the decedent's children wouldhave paid if the property had passed directly to the children instead in a form where the childrenreceived only an income interest or power to control the enjoyment of the property; (11)providing statutory rules governing the disclaimer of gifts and bequests under which anunqualified, irrevocable refusal to accept any benefits from the gift or bequest generally within 9months of the creation of the transferee's interest is not treated as a gift by the disclaimingindividual;(110) and liberalized the provision which permits installment payment of estate tax onclosely-held business by providing that only interest need be paid for the first four years afterdeath and lengthening the period of installment an additional four years to 14 years.

	In 1980, the "carryover basis" rule was retroactively repealed and replaced by the"stepped-up basis" rules that applied before the 1976 legislation.(111)

          Legislation from 1981 through 1985

	The Economic Recovery Act of 1981 ("1981 Act")(112) made the following changes to theestate and gift taxes: (1) increased the unified credit such that, when fully phased-in in 1987, iteffectively exempted the first $600,000 of transfers from the unified estate and gift tax; (2)reduced the top unified estate and gift tax rate from 70 percent to 50 percent over a four-yearperiod (1982-1985); (3) provided for an unlimited deduction for transfers to spouses andpermitted such a deduction (the so-called "QTIP deduction") even where the donee spouse couldnot control disposition of the property after that spouse's death, so long as that spouse had anincome interest in that property and that property was subject to that spouse's estate and gifttax;(113) (4) increased the annual gift tax exemption from $3,000 per year per donee to $10,000 peryear per donee; (5) changed the presumption that each spouse equally provided for theacquisition cost of jointly held property to an irrebuttable presumption; (6) modified the "currentuse" valuation rules by shortening to 10 years the period that heirs who inherit farms or other realproperty used in a closely held business were required to so use the property, and by increasingthe maximum reduction in the value of such property from $500,000 to $750,000; (7) repealedthe so-called "orphan's deduction;" (8) delayed the effective date of the generation-skippingtransfer tax, (9) further liberalized and simplified the rules which permit the installment paymentof estate tax on closely-held businesses.

	The Deficit Reduction Act of 1984: (1) delayed for three years the scheduled reduction ofthe maximum estate and gift tax rates (such that maximum rate remained at 55 percent until1988); (2) eliminated the exclusion for interests in qualified pension plans; (3) provided rules forthe gift tax treatment of below-market rate loans; and (4) extended the rules which permit theinstallment payment of estate taxes on closely-held businesses to certain holding companies.

          1986 and subsequent legislation

	The Tax Reform Act of 1986(114) substantially revised the tax on generation-skippingtransfers by applying a single rate equal to the highest estate tax rate (i.e., 55 percent) to allgeneration-skipping transfers in excess of $1 million and by broadening the definition of ageneration-skipping transfer to include direct transfers from a grandparent to a grandchild (i.e.,"direct skips").

	The Omnibus Budget Reconciliation Act of 1987(115) made the following modifications:(1) provided special rules for so-called "estate freeze transactions" under which the person whoengaged in such a transaction would be subject to estate tax on the value of such property; (2)provided a higher estate or gift tax rate on transfers in excess of $10 million in order to phase-outthe benefits of the graduated rates under 55 percent and the unified credit; and (3) again delayedfor five years the scheduled reduction in the estate and gift tax rates from 55 percent to 50percent.

	The Omnibus Budget Reconciliation Act of 1990 replaced the special rules for estatefreeze transactions with a new set of rules that effectively subject to gift tax the full value ofinterests in property, unless retained interests in that property take certain specified forms.(116)

	The maximum estate, gift, and generation-skipping transfer tax rate dropped to 50 percentafter December 31, 1992, but the Omnibus Budget Reconciliation Act of 1993(117) restored the55-percent top rate retroactively to January 1, 1993, and made that top rate permanent. TheTaxpayer Relief Act of 1997(118) provided for gradual increases in the unified credit from$625,000 in 1998 to $1 million in 2006 and thereafter.  A conforming amendment made to the 5-percent surtax continues to phase out the benefit of the graduated rates, but the benefit of theunified credit is no longer phased out.  New exclusions for qualified family-owned businessesand for certain land subject to permanent conservation easements and a number of other changeswere also enacted in 1997.

**Summary**

	Table 16 provides a summary of the annual gift tax exclusion, the exemption value of theunified credit, the threshold level of the highest statutory estate tax rate, and the highest statutoryestate tax rate for selected years, 1977-1998.

**Table 16.-Annual Gift Exclusion Amount, Exemption Value of UnifiedCredit for Taxable Transfers, Threshold Level of Highest StatutoryTax Rate, and Highest Statutory Tax Rate Applicable toTaxable Transfers, Selected Years, 1977-1998**
****Year**Annual giftexclusionsingle/joint(dollars)******Exemptionvalue of unifiedcredit (dollars)**Threshold ofhigheststatutory taxrate (dollars)******Higheststatutory taxrate (percent)1977
3,000/6,000120,6675 million70198210,000/20,000225,0004 million65198310,000/20,000275,0003.5 million60198410,000/20,000325,0003 million55198510,000/20,000400,0003 million55198610,000/20,000500,0003 million55198710,000/20,000600,0003 million55198910,000/20,000600,0003 million551199110,000/20,000600,0003 million551199310,000/20,000600,0003 million551199510,000/20,000600,0003 million551199710,000/20,000600,0003 million551199810,000/20,000625,0003 million551Source:  Joint Committee on Taxation.
Note:  Since 1987, the benefits of the graduated rate structure and unified credit have been phased out at a 5-percentrate for estates between $10,000,000 and $21,040,000, creating an effective marginal tax rate of 60 percent foraffected estates (with a $600,000 unified credit).  The Taxpayer Relief Act of 19971 provided for gradual increasesin the unified credit from $625,000 in 1998 to $1 million in 2006 and thereafter.  A conforming amendment made tothe 5-percent surtax continues to phase out the benefit of the graduated rates, but the benefit of the unified credit isno longer phased out.  Thus, the 5-percent surtax applied to taxable estates between $10 million and $17,184,000.

**II.  BACKGROUND AND ANALYSIS RELATING TO ESTATE AND GIFT TAXATION**

**A.  Background Data**

**Estates subject to the estate tax**

	Table 17 details the percentage of decedents subject to the estate tax for selected yearssince 1935. The percentage of decedents liable for the estate tax grew throughout the postwar erareaching a peak in the mid-1970s. The substantial revision to the estate tax in the mid-1970s(119)and subsequent further modifications in 1981 reduced the percentage of decedents liable for theestate tax to less than one percent in the late 1980s. Since that time, the percentage of decedentsliable for the estate tax has gradually increased.

**Table 17.-Number of Taxable Estate Tax ReturnsFiled as a Percentage of Deaths,Selected Years, 1935-1997**

**Taxable estate tax returns filed1****Year**Deaths**Number**Percent of deaths
1935

1940

1945

1950

1995
1,172,245

1,237,186

1,239,713

1,304,343

1,379,826
8,655

12,907

13,869

17,411

25,143
0.74

1.04

1.12

1.33

1.82
1961

1966

1970

1973

1977
1,548,665

1,727,240

1,796,940

1,867,689

1,819,107
45,439

67,4042

93,4242

120,7612

139,1152
2.93

3.90

5.20

6.47

7.65
1982

1983

1984

1985

1986

1987

1988

19894
1,897,820

1,945,913

1,968,128

2,068,440

2,105,361

2,123,323

2,167,999

2,150,466
41,6202,3

35,1482,3

31,5072,3

30,5182,3

23,731

21,335

18,948

20,856
2.19

1.81

1.60

1.46

1.13

1.00

0.87

0.97
19904

19914

19924

19934

19944

19954

19964

19974
2,148,463

2,169,518

2,175,613

2,268,553

2,278,994

2,312,132

2,314,690

2,314,738
23,215

24,897

27,187

27,506

31,918

31,564

37,711

42,901
1.08

1.15

1.25

1.21

1.40

1.37

1.63

1.85
1Estate returns need not be filed in the year of the decedent's death.
2Not strictly comparable with pre-1966 data.  For later years the estate tax after credits was the basis fordetermining taxable returns.  For prior years, the basis was the estate tax before credits.

3Although the filing requirement was for gross estates in excess of $225,000 for 1982 deaths, $275,000 for 1983deaths, and $325,000 for 1984 deaths, the data are limited to gross estates of $300,000 or more.

4Taxable estate data from 1989-1997 are from Internal Revenue Service, *Statistics of Income*.

Sources:  Joseph A. Peachman, *Federal Tax Policy* (Washington Brookings Institutions), 1987; Internal RevenueService, *Statistics of Income*; and U.S. National Center for Health Statistics

	The increasing percentage of decedents liable for estate tax in the period from 1940through the mid-1970s and the similar increasing percentage since 1989 are the result of theinteraction of three factors: a fixed nominal exemption; the effect of price inflation on assetvalues; and real economic growth. The amount of wealth exempt from the Federal estate taxalways has been expressed at a fixed nominal value. If the general price level in the economyrises from one year to the next and asset values rise to reflect this inflation, the "nominal" valueof each individual's wealth will increase. With a fixed nominal exemption, annual increases inthe price level will imply that more individuals will have a nominal wealth that exceeds the taxthreshold. Alternatively stated, inflation diminishes the real, inflation-adjusted, value of wealththat is exempted by a nominal exemption. Thus, even if no one individual's real wealth increased,more individuals would be subject to the estate tax. This interaction between inflation and a fixednominal exemption largely explains the pattern in Table 17.(120) The fixed nominal exemption wasincreased effective for 1977 and again between 1982 and 1987. Prior to 1977 and subsequent to1987, the exemption was unchanged while the economy experienced general price inflation.

	However, even if the exemption were modified annually to reflect general price inflation,one would still expect to see the percentage of decedents liable for estate tax rise because of thethird factor, real growth. If the economy is experiencing real growth per capita, it must beaccumulating capital.(121) Accumulated capital is the tax base of the estate tax. Thus, real growthcan lead to more individuals having real wealth above any given fixed real exempt amount.(122)

**Revenues from the estate, gift, and generation-skipping taxes**

	Table 18 provides summary statistics of the estate and gift tax for selected years.  Totalestate and gift receipts include taxes paid for estate, gift, and generation-skipping taxes as well aspayments made as the result of IRS audits.

**Table 18.-Revenue from the Estate, Gift, and Generation-SkippingTransfer Taxes, Selected Years, 1940-1998**
****Year**Revenues**
**($ millions)****Percentage of total**
**Federal receipts**1940	
1945	

1950	

1955	

1960	

1965	

1970	357
638

698

924

1,606

2,716

3,6446.9
1.4

1.9

1.4

1.7

2.3

1.91975	
1976	

1977	

1978	

1979	4,611
5,216

7,327

5,285

5,4111.7
1.7

2.1

1.3

1.21980	
1981	

1982	

1983	

1984	6,389
6,787

7,991

6,053

6,0101.2
1.1

1.3

1.0

0.91985	
1986	

1987	

1988	

1989	6,422
6,958

7,493

7,594

8,7450.9
0.9

0.9

0.8

0.91990	
1991	

1992	

1993	

1994	11,500
11,138

11,143

12,577

15,2551.12
1.06

1.02

1.09

1.211995	
1996	

1997	

1998	15,087
17,189

19,845

24,0761.12
1.18

1.26

1.40
Sources:  Joint Economic Committee, *The Federal Tax System*: *Facts and Problems*, 1964; Joseph A. Pechman,*Federal Tax Policy* (Washington: Brookings Institution), 1987; Internal Revenue Service, *Statistics of IncomeBulletin*, Fall 1986, and U.S. Office of Management and Budget, *Budget of the United States Government FiscalYear 2000*, and prior years.
	Between 1993 and 1998, estate and gift receipts averaged double digit rates of growth.There are four possible reasons for the rapid growth in these receipts. First, because neither theamount of wealth exempt from the estate and gift tax or the tax rates were indexed, as explainedabove, an increasing number of persons became subject to estate and gift taxes. Second, thetremendous increase in value in the stock market over the past several years increased the valueof estates that would have already been taxable, and increased the number of estates that becametaxable. For example, the Dow Jones Industrial Average ended 1993 at approximately 3750, andended 1998 at approximately 9,000. On average, one-third of the wealth in taxable estatesconsists of publicly traded stocks. Because the value of this component of wealth has more thandoubled during the past five years, one would expect brisk growth in estate tax receipts from thisalone. Third, while the overall population of the United States is growing at about a 1 percentannual rate, the number of persons aged 85 and older is growing at a rate of almost 3.5 percentannually. This also should increase the number of estate tax returns filed. Finally, the unlimitedmarital deduction included in the 1981 Act delayed the payment of estate tax, in most cases, untilthe surviving spouse died. On average, spouses survive their mates by about ten years. Therefore,during the decade of the 1990s, an increase in estate tax receipts is expected as the result offirst-spouse deaths during the 1980s that used the unlimited marital deduction.

	On the other hand, the 1997 Act included provisions that would be expected to reduce thenumber of estates subject to the estate tax.  As explained in Part I, above, the 1997 Act enacted aschedule of increases in the unified credit which will culminate in the unified credit effectivelyexempting $1 million of a decedent's estate from tax beginning for decedents dying in 2006. Given most forecasts of inflation, this change increases the real (inflation adjusted) value of the$600,000 exemption that was available under the estate and gift tax between 1987 and 1997.(123) As explained above, increases in the real value of the unified credit generally would be expectedto reduce the number of estates subject to tax.  The 1997 Act also provided an additionalexemption for certain qualified family-owned business interests and a partial exclusion from theestate tax of the value of land subject to certain qualifying estates, fewer estates would beexpected to be subject to tax.

	Table 19 shows the Joint Committee on Taxation staff present-law estimate of revenuesfrom the estate, gift, and generation-skipping taxes for fiscal years 1999-2008. These estimatesare based on the January 1999 baseline forecast for estate, gift, and generation-skipping taxessupplied by the Congressional Budget Office. Table 19 reports the Joint Committee on Taxationstaff estimates of annual taxable estates and calculates the percentage of all deaths that taxableestates will represent.

**Table 19.-Projections of Taxable Estates and Receipts from Estate, Gift,and Generation-Skipping Transfer Taxes, 1999-2008**
****Year**Exemptionvalue of**
**unified credit******Number of**taxable estates******Percent
**of deaths******Receipts
**($ billions)**1999650,00049,2001.9627.72000675,00051,7002.0328.82001675,00054,2002.1029.82002700,00057,0002.1730.82003700,00059,8002.2532.72004850,00062,8002.3333.82005950,00054,6001.9934.420061,000,00050,4001.8235.720071,000,00052,6001.8737.720081,000,00056,2001.9739.7
Source:  Joint Committee on Taxation staff estimates and calculations based on U.S. Census Bureau estimates ofdeaths in Jennifer Cheeseman Day, *Population Projects of the United States by Age, Sex, Race, and HispanicOrigin: 1995 to 2050*, U.S. Bureau of the Census, Current Population Reports, P25-1130, U.S. GovernmentPrinting Office, Washington, D.C. 1996.
**B.  Comparison of Transfer Taxation in the United States and Other Countries**

	Among developed countries, an inheritance tax is more common than the type of estatetax that is imposed in the United States. An inheritance tax generally is imposed upon the amountof wealth the transferee or donee receives rather than on the total wealth of the transferor. That is,the funds the heir receives in a bequest determines the tax imposed. The United States alsoimposes a generation-skipping tax in addition to any estate or gift tax liability on certain transfersto generations two or more younger than that of the transferee. This effectively raises themarginal tax rates on affected transfers. Countries that impose an inheritance tax do not havesuch a separate tax but may impose higher rates of inheritance tax on bequests that skipgenerations. Among developed countries, Australia and Canada impose neither an estate tax noran inheritance tax.(124)

	Because the U.S. estate and gift tax exempts transfers between spouses, provides aneffective additional exemption of $650,000 (in 1999) through the unified credit, and exempts$10,000 of gifts per year per donee, the United States may have a larger exemption (a largerzero-rate tax bracket) than many other developed countries.(125) However, because most othercountries have inheritance taxes, the total exemption depends upon the number and type ofbeneficiaries. While the effective exemption may be larger, with the exception of transfers tospouses, which are untaxed, marginal tax rates on taxable transfers in the United States generallyare greater than those in other countries. This is particularly the case when comparing transfers toclose relatives, who under many inheritance taxes face lower marginal tax rates than do otherbeneficiaries. On the other hand, the highest marginal tax may be applied at a greater level ofwealth transfer than in other countries. It is often difficult to make comparisons between the U.S.estate tax and countries with inheritance taxes because the applicable marginal tax rate dependson the pattern of gifts and bequests.

	It is difficult to assess the extent to which the practice of any of the foreign transfer taxesis comparable to the practice of transfer taxation in the United States. For example, in the UnitedStates, transfers of real estate generally are valued at their full and fair market value. In Japan,real estate is assessed at less than its fair market value. Land is assessed for inheritance taxpurposes according to a valuation map known as *Rosen Ka.* The *Rosen Ka* values range from 25to 80 percent of fair market value.(126)  It is also unclear to what extent transferors may be able toexploit legal loopholes under the various systems imposed by other countries. Again, using Japanas an example, prior to 1988, a transferor could reduce inheritance tax liability by adoptingchildren to increase the number of legal heirs.(127)  Such adoptees of convenience would receivenominal compensation for agreeing to be an adoptive child. The larger the number of children,the greater the total exemption for inheritance taxes in Japan, even if not all children receive abequest. This legal loophole was said to be widely recognized and exploited by wealthyfamilies.(128)

	Table 20 compares total revenue collected by OECD countries from estate, inheritance,and gift taxes to total tax revenue and to gross domestic product (GDP) to attempt to compare theeconomic significance of wealth transfer taxes in different countries.  Among these selectedOECD countries, Belgium, France, Greece, and Japan collect more such revenue as a percentageof GDP than does the United States.  Switzerland and the Netherlands collect modestly lessrevenue from such taxes as a percentage of GDP than does the United States. The remaining 17countries in Table 20 collect substantially less revenue from such taxes as a percentage of GDPthan does the United States.  As a percentage of tax revenue, only Japan relies more heavily onits inheritance tax as a revenue source, although Belgium, France, and Switzerland each collected0.8 of one percent of total tax revenue from estate, inheritance, and gift taxes.

**Table 20.-Revenue from Estate, Inheritance and Gift Taxesas a Percentage of Total Tax Revenue andGDP in OECD Countries, 1996**
******Country****Percentage oftotal tax revenue****Percentage of GDP**
Australia

Austria

Belgium

Canada

Denmark

Finland

France

Germany

Greece

Iceland

Ireland

Italy

Japan

Luxembourg

Netherlands

New Zealand

Norway

Portugal

Spain

Sweden

Switzerland

Turkey

United Kingdom

United States
0.00

0.12

0.81

0.00

0.43

0.47

0.88

0.30

1.88

0.29

0.55

0.17

1.70

0.28

0.68

0.01

0.25

0.21

0.52

0.16

0.87

0.06

0.62

1.06
0.00

0.05

0.37

0.00

0.23

0.23

0.40

0.11

0.36

0.09

0.19

0.07

0.48

0.12

0.29

0.00

0.10

0.07

0.18

0.08

0.30

0.01

0.22

0.30
Note:  Data not directly comparable to data reported in Table 18.  The OECD attempts to collect standardized dataacross member countries.  OECD data includes tax revenue collected by the States as well as the FederalGovernment.  Therefore data in OECD reports for the United States may not perfectly correspond to data asreported by OMB.
Source:  Organization for Economic Cooperation and Development, *Revenue Statistics, 1965-1997*(Paris: OCED),1998.

	The United States is a wealthy country, with higher average household wealth than mostof the countries surveyed. While exemption levels are higher in the United States than most othercountries, a significant amount of accumulated wealth still may be subject to estate and gifttaxation as compared to the other countries. The data in Table 20 do not reveal the extent towhich estate, inheritance, and gift taxes fall across different individuals within each country. Inthe United States, as reported in Table 17, above, of the 2.3 million deaths in 1997, only 42,901or 1.85 percent of decedents, gave rise to any estate tax liability. Similar data were not availablefor the other countries in this survey.

**C.  Economic Issues Related to Transfer Taxation**
**Taxes on income versus taxes on wealth**

	Income taxes, payroll taxes, and excise and other consumption taxes generally taxeconomic activity as it occurs. Income and consumption represent ongoing, current economicactivity by the taxpayer.(129) Accumulated wealth, on the other hand, does not correspond to anyongoing, current economic activity.(130) Wealth depends upon previous economic activity either bythe current wealth holder or other individuals. For example, current wealth can result fromaccumulated saving from income or from bequests received.

	Taxes on wealth are not directly comparable to taxes on income. Because wealth is theaccumulation of flows of saving over a period of years, taxes on wealth are not directlycomparable to taxes on income or consumption which may represent only current, rather thanaccumulated, economic activity. For example, assume that a taxpayer receives wage income of$10,000 per year, saves all of this income, and the savings earn an annual return of 5 percent. Atthe end of five years, the accumulated value of the taxpayer's investments would be $58,019.Assume that the wealth is transferred at the end of the fifth year. If a 10-percent tax wereimposed on wage income, one would conclude that a burden of $1,000 was imposed annually. Ifa 10-percent tax were imposed on the transfer of wealth, one would conclude that a burden of$5,801.90 was imposed at the end of the fifth year. If, after paying the wage tax, the taxpayer hadinvested the remaining $9,000 each year to earn 5 percent, the taxpayer's holding would be$52,217.10 at the end of five years. This is the same value that would remain under the wealthtax ($58,019.00 less $5,801.90). Thus, it is misleading to say that the burden of the wage tax is$1,000 in each year while the burden of the transfer tax is $5,801.90 in the fifth year.

**Wealth taxes, saving, and investment**

	Taxes on accumulated wealth are taxes on the stock of capital held by the taxpayer. As atax on capital, issues similar to those that arise in analyzing any tax on the income from capitalarise. In particular, there is no economic consensus on the extent to which the incidence of taxeson the income from capital is borne by owners of capital in the form of reduced returns orwhether reduced returns cause investors to save less and provide less capital to workers, therebyreducing wages in the long run. A related issue is to what extent individuals respond to increases(decreases) in the after-tax return to investments by decreasing (increasing) their saving. Againthere is no census in either the empirical or theoretical economics literature regarding theresponsiveness of saving to after-tax returns on investment.(131)

	Some economists believe that an individual's bequest motives are important tounderstanding saving behavior and aggregate capital accumulation. If estate and gift taxes alterthe bequest motive, they may change the tax burdens of taxpayers other than the decedent and hisor her heirs. It is an open question whether the bequest motive is an economically importantexplanation of taxpayer saving behavior and level of the capital stock. For example, theoreticalanalysis suggests that the bequest motive may account for between 15 and 70 percent of theUnited States' capital stock.(132) Others question the importance of the bequest motive in nationalcapital formation.(133) Nor has direct empirical analysis of the existence of a bequest motive led toa consensus.(134) Theoretically, it is an open question whether estate and gift taxes encourage ordiscourage saving and there has been no empirical analysis of this specific issue. By raising thecost, in terms of taxes, of leaving a bequest, potential transferors may be discouraged fromaccumulating the assets necessary to make a bequest. On the other hand, some individualspurchase additional life insurance in order to have sufficient funds to pay the estate tax withoutdisposing of other assets in their estate.

	Regardless of any potential effect on aggregate saving, the transfer tax system may affectthe composition of investment. In particular, some observers note that the transfer tax systemmay impose special cash flow burdens on small or family-owned businesses. They note that if afamily has a substantial proportion of its wealth invested in one enterprise, the need to pay estatetaxes may force heirs to liquidate all or part of the enterprise or to encumber the business withdebt to meet the estate tax liability. If the business is sold, while the assets generally do not ceaseto exist and remain a productive part of the economy, the share of business represented by smallor family-owned businesses may be diminished by the estate tax. If the business borrows to meetestate tax liability, the business's cash flow may be strained. There is some evidence that manybusinesses may be constrained by the capital markets in the amount of funds they can borrow. Ifthey are so constrained, they may reduce the amount of investment they undertake, to thedetriment of the economy at large.(135) Undercapitalization may be prevalent among smallbusinesses. A recent study suggests that reduction in estate taxes may have a positive effect on anentrepreneur's survival.(136)

	Others argue that potential deleterious effects on investment by small or family-ownedbusinesses are limited.  As a result of the Taxpayer Relief Act of 1997, certain small businessescan obtain an effective exemption of up to $2.6 million per married couple, and other legitimatetax planning can further reduce the burden on such enterprises.  Some have argued that estate taxreturns report a small fraction of the value of decedents' estates.(137)

**Wealth taxes and labor supply**

	As people become wealthier, they generally choose to consume more leisure time. Some,therefore, suggest that, by reducing the potential wealth of heirs, transfer taxes may have aneffect on labor supply. Over 100 years ago, Andrew Carnegie opined that "the parent who leaveshis son enormous wealth generally deadens the talents and energies of the son, and tempts him tolead a less useful and less worthy life than he otherwise would...."(138) While in theory increases inwealth should reduce labor supply, empirically economists have not found strong support for thisproposition.(139)

**Wealth taxes, the distribution of wealth, and fairness**

	Some suggest that, in addition to their role in producing Federal revenue, the transfertaxes may help prevent an increase in the distribution of wealth. There are relatively few analysesof the distribution of wealth holdings.(140) Conventional economic wisdom holds that the GreatDepression of the 1930s and the second world war substantially reduced the concentration ofwealth in the United States, and that there has been no substantial change in the succeedingdecades. Most analysts assign no role to tax policy in the reduction in wealth concentrationwhich occurred between 1930 and 1945. Nor has any analyst been able to quantify what role taxpolicy might have played since the second world war.(141)

	Others note that the income tax does not tax all sources of income. They suggest that byserving as a "backstop" for income that escapes income taxation, the transfer taxes may helppromote overall fairness of the U.S. tax system. Others counter that to the extent that muchwealth was accumulated with after-(income)-tax dollars, as an across-the-board tax on wealth,transfer taxes tax more than just those monies that may have escaped the income tax. In addition,depending upon the incidence of such taxes, it is difficult to make an assessment regarding thetransfer taxes' contribution to the overall fairness of the U.S. tax system.

	Even if transfer taxes are believed to be borne by the owners of the assets, an additionalconceptual difficulty is whether the tax is borne by the generation of the transferor or thegeneration of the transferee. The design of the gift tax illustrates this conceptual difficulty. A taxis assessed on the transferor for taxable gifts. Assume, for example, a mother makes a gift of $1million to her son and incurs a gift tax liability of $500,000. From one perspective, the gift taxcould be said to have reduced the mother's current economic well-being by $500,000. However,it is possible that, in the absence of the gift tax, the mother would have given her son $1.5million, so that the gift tax has reduced the son's economic well-being by $500,000. It also ispossible that the economic well-being of both was reduced. Of course, distinctions between thedonor and donee generations may not be important to assessing the fairness of transfer taxes ifboth the donor and donee have approximately the same income.(142)

**Federal estate taxation and charitable bequests**

	The two unlimited exclusions under the Federal estate tax are for bequests to a survivingspouse and for bequests to a charity.  Because the marginal tax rates under the estate tax rangefrom 37 percent to 55 percent, while marginal income tax rates range from 15 to 39.6 percent, theafter-tax cost of a charitable bequest is lower than the after-tax cost of a charitable gift madeduring one's lifetime.(143)  Some analysts have suggested that the charitable exclusion creates astrong incentive to make charitable bequests and that changes in Federal estate taxation couldalter the amount of funds that flow to charitable purposes.  A limited number of studies haveexamined the effects of estate taxes on charitable bequests.  Most of these studies have concludedthat, after controlling for the size of the estate and other factors, deductibility of charitablebequests encourages taxpayers to provide charitable bequests.(144)  Some analysts interpret thesefindings as implying that reductions in estate taxation could lead to a reduction in funds flowinginto the charitable sector.  This is not necessarily the case, however.  Some charitable bequestsmay substitute for lifetime giving to charity, in part to take advantage of the greater value of thecharitable deduction under the estate tax than under the income tax that results from the lowermarginal income tax rates and limitations on annual lifetime giving.  If this is the case,reductions in the estate tax could lead to increased charitable giving during the taxpayer's life.

**Federal estate taxes and State revenues**

	As explained in Part I, above, the State death tax credit acts as a revenue sharingprovision with States that impose "pick-up" or "make-up" estate taxes.  The State death tax crediteffectively cedes revenue to those States that impose such taxes without increasing the aggregatetax burden imposed upon an estate. Repeal of the Federal estate tax would eliminate this sourceof revenue sharing.  The burden of estate taxation would rest with the States.

	All States and the District of Columbia impose estate, gift, or inheritance taxes.  MostStates impose only "pick-up" estate taxes. A few States also impose additional estate orinheritance taxes.  In those States that impose only a "pick-up" estate tax, such taxes currentlyimpose no incremental burden on the estate.  With the repeal of the Federal estate tax, these taxeswould now impose a burden on estates.  This may create sentiment to repeal these State leveltaxes, but repeal of the State level taxes may require States to increase other taxes to make up forthe loss of the implicit  revenue sharing provided under present law.
**FOOTNOTES**
1.   This document may be cited as follows: Joint Committee on Taxation,*Present Law andBackground on Federal Tax Provisions Relating to Retirement Savings Incentives, Health andLong-Term Care, and Estate and Gift Taxes*(JCX-29-99), June 15, 1999.
2.   For a detailed comparison of Roth IRAs and deductible IRAs, see Joint Committee onTaxation *Description and Analysis of Tax Proposals Relating to Individual Savings and IRAs*(JCS-2-97), March 3, 1997.
3.   Early distribution of converted amounts may also accelerate income inclusion ofconverted amounts that are taxable under the 4-year rule applicable to 1998 conversions.
4.   Pursuant to the Taxpayer Relief Act of 1997, qualified plans maintained by State andlocal governments are not subject to the nondiscrimination rules applicable to other qualifiedplans.
5.   Under present law, an employee is treated as highly compensated if the employee (1)was a 5-percent owner of the employer at any time during the year or the preceding year or (2)either (a) had compensation for the preceding year in excess of $80,000 (for 1999) or (b) at theelection of the employer had compensation for the preceding year in excess of $80,000 (for1999) and was in the top 20 percent of employees by compensation for such year.  A nonhighlycompensated employee is an employee other than a highly compensated employee.
6.   Qualified plans are subject to regulation under Federal labor laws (Title I of ERISA) aswell as under the Internal Revenue Code. The ERISA rules generally relate to the rights of planparticipants, reporting and disclosure, and the obligations of plan fiduciaries.
7.   Annual benefits may in some cases exceed this dollar limitation under grandfather andtransition rules contained in the Tax Equity and Fiscal Responsibility Act of 1982 and otherlegislation.
8.   State and local governments may not maintain section 401(k) plans, but can maintainsimilar arrangements.  As described below, educational institutions may maintain tax-shelteredannuities, which operate in a manner similar to section 401(k) plans, i.e., they allow employeesto make elective contributions.  Similarly, many State and local governments maintain section457 plans (described below) which in practice operate like section 401(k) plans.  These plans arenot subject to the nondiscrimination rules applicable to section 401(k) plans.
9.   As with qualified plans, State and local governmental tax-sheltered annuities are notsubject to nondiscrimination rules.
10.   For a more detailed discussion of medical savings accounts see section I.D. of PartTwo, below.
11.   In addition, an excise tax applies if a contribution is made by any person to aneducation IRA established on behalf of a beneficiary during any taxable year in which anycontributions are made by anyone to a qualified State tuition program on behalf of the samebeneficiary.
12.   The national income and product accounts measure the flow of goods and services(product) and income in the economy. Two common measures of the size of the economy are thegross domestic product ("GDP") and the gross national product ("GNP"). GDP measures the totalvalue of the output of the U.S. economy. GNP measures the total annual value of goods andservices produced by U.S. residents, i.e., their gross income. GDP is greater than GNP by thepayment of factor income to the rest of the world (such as profits to foreign owners of U.S. basedbusinesses), but is less than GNP by the amount of factor income received from the rest of worldby U.S. residents (such as wages paid to U.S. workers who work abroad). Examining the incomemeasure, GNP, is useful in understanding the trade-off between consumption tomorrow andconsumption today. GNP may be measured in several ways. One way is to measure GNP byexpenditure on final product in the economy. By this measure,

	(1) GNP = C + I + G + (X-M).

	Equation (1) is an accounting identity which states that gross national product equals thesum of consumption expenditures (C), investment expenditures on plant, equipment, inventory,and residential construction (I), governmental purchases of goods and services (G), and netexports (exports less imports of goods and services or X-M).

	An alternative is to measure GNP by the manner in which income created in the economyis disposed of. By this measure,

	(2) GNP = C + S + T.

	Equation (2) is another accounting identity which states that gross national product equalsthe sum of consumption expenditures, saving by consumers and businesses (S), and net taxpayments to the government (T) (net tax payments are total tax receipts less domestic transfer,interest, and subsidy payments made by all levels of government).

	Because both measures of GNP are simple accounting identities, the right hand side ofequation (1) must equal the right hand side of equation (2). From this observation can be derivedan additional national income accounting identity,

	(3) I = S + (T-G) + (M-X)

	This is the basis for the statement that national investment equals private saving (S), pluspublic saving (T-G), and net imports (M-X). 
13.   This ignores the relatively small amount of unilateral transfers to foreigners. For amore detailed discussion of foreign trade and domestic saving and investment, see JointCommittee on Taxation, *Background and Issues Relating to the Taxation of Foreign Investmentin the United States* (JCS-1-90), January 23, 1990. 
14.   For instance, see Hatsopoulos, Krugman, and Summers, "U.S. Competitiveness:Beyond the Trade Deficit," *Science*, 15 July 1988, vol. 241, pp. 299-307. 
15.   See, for instance, Martin Feldstein and Charles Horioka, "Domestic Saving andInternational Capital Flows," *Economic Journal*, vol. 90 (June 1980), pp. 314-329. 
16.   See Phillippe Bacchetta and Martin Feldstein, "National Saving and InternationalInvestment," in Douglas Bernheim ad John Shoven (eds.), *National Saving and EconomicPerformance*, (Chicago: The University of Chicago Press), 1991.
17.   Organization for Economic Co-Operation and Development, *National Accounts,1960-1989*, vol. 1, 1991. 
18.   The data on international saving rates in the text and in Table 4 are not directlycomparable to the data in Tables 2 and 3 because such data are not always compiled consistentlyacross nations. For example, in computing household saving rates, the OECD subtractshousehold interest expense from income to determine U.S. household disposable income. TheBureau of Economic Analysis does not make a similar adjustment in defining householddisposable income. Also, while the source of the international comparisons draws on data fromthe OECD, which attempts to provide data on an internationally comparable basis, the data arenot fully comparable. For example, in computing household saving rates, the definition of thehousehold sector is not identical across all countries. In particular, except in Japan, France, andItaly, private nonprofit institutions are included in the household sector. See, Andrew Dean,Martine Durand, John Fallon, and Peter Hoeller, "Saving Trends and Behaviour in OECDCountries," OECD, Economics and Statistics Department Working Paper, No. 67, June 1989. 
19.   See, Lawrence H. Summers, "Capital Taxation and Accumulation in a Life CycleGrowth Model," *American Economic Review*, 71, September 1981. 
20.   See, David A. Starrett, "Effects of Taxes on Saving," in Henry J. Aaron, HarveyGalper, and Joseph A. Pechman (eds.), *Uneasy Compromise: Problems of a HybridIncome-Consumption Tax* (Washington: Brookings Institution), 1988. 
21.   See, Michael Boskin, "Taxation, Saving, and the Rate of Interest," *Journal of PoliticalEconomy*, 86, April 1978. 
22.   See, George von Furstenberg, "Saving," in Henry Aaron and Joseph Pechman (eds.),*How Taxes Affect Economic Behavior* (Washington: Brookings Institution), 1981. 
23.   See the discussion in William G. Gale and John Karl Scholz, "IRAs and HouseholdSaving," *American Economic Review*, 84, December 1994, and Steven F. Venti and David A.Wise, "Tax Deferred Accounts, Constrained Choice, and Estimation of Individual Saving,"*Review of Economic Studies*, 53, August 1996. 
24.   Patrick J. Bayer, B. Douglas Bernheim, and John Karl Scholz, "The Effects ofFinancial Education in the Workplace: Evidence from a Survey of Employers," National Bureauof Economic Research, Working Paper #5655, July 1996.
25.   B. Douglas Bernheim, Daniel M. Garrett, and Dean M. Maki, "Education and Saving:The Long-Term Effects of High School Financial Curriculum Mandates," National Bureau ofEconomic Research, Working Paper #6085, July 1997.
26.   See, Richard H. Thaler, "Psychology and Savings Policies," *American EconomicReview*, 84, May 1984. 
27.   Daniel Feenberg, and Jonathan Skinner, "Sources of IRA Saving," in LawrenceSummers (ed), *Tax Policy and the Economy*, vol. 3, (Cambridge: Massachusetts Institute ofTechnology Press), 1989. 
28.   Jane Gravelle, "Do Individual Retirement Accounts Increase Savings?" *Journal of**Economic Perspectives*, 5, Spring 1991. 
29.   Calculations by the Joint Committee on Taxation staff based on Social SecurityAdministration, *Annual Statistical Supplement to the Social Security Bulletin, 1998*, November1998, Table 3.E.3.
30. *Statistical Abstract of The United States 1997*, Table 1200, p. 725. 
31. *Statistical Abstract of The United States 1997*, Table 780, p. 513. 
32.   Social Security benefit recipients with modified AGI exceeding certain limits have toinclude up to 85 percent of their benefits in income. The Joint Committee on Taxation staffprojects that in 1999, 33 percent of all elderly will include some portion of Social Securitybenefits in taxable income.
33.   Earnings are indexed by the rate of wage growth. Highest career earnings are definedas the average of the highest five years of earnings. 
34.   This measure is calculated only for those individuals who worked a significant amountduring the five years preceding retirement. 
35.   Susan Grad, "Earnings Replacement Rates of New Retired Workers," *Social SecurityBulletin*, 53, October 1990.
36.   Alan L. Gustman and Thomas L. Steinmeiner, "Effects of Pensions on Savings:Analysis with Data from the Health and Retirement Study."  National Bureau of EconomicResearch, Working Paper #6681, August 1998.  Replacement rates in this study are measuredrelative to pre-retirement earnings of the household.
37.   The reported replacement rates measured replacement income in terms of nominaldollars.  If the calculation were to account for future inflation, the authors estimated that real(inflation adjusted) replacement rates averaged 60 percent across all of the households in thesample and 66 percent of the real value of the pre-retirement earnings for the median 10 percentof households.  See, Gustman and Steinmeier, "Effects of Pensions on Savings," pp. 18-19.
38.   James F. Moore and Olivia S. Mitchell, "Projected Retirement Wealth and SavingsAdequacy in the Health and Retirement Study," National Bureau of Economic Research,Working Paper # 6240, October 1997.  Moore and Mitchell estimate that the necessary savingrate falls to 7 percent per year if the household would defer retirement until age 65.  Moore andMitchell measure "pre-retirement consumption" by reference to replacement rates of less than100 percent.  Thus, if a 100-percent replacement rate were the goal, an even greater saving ratewould be necessary.
39.   Social Security Administration, *Annual Statistical Supplement to the Social SecurityBulletin, 1998, November 1998*, Table 3.E.2.
40.   For a discussion of the legislative history of social security coverage, see Committeeon Ways and Means, *1998 Green Book* (WMCP 105-7), May 19, 1998, pp. 6-11.
41. *EBRI Databook on Employer Benefits*, Fourth Edition 1997.  Table 10.2 on page 84reports that in 1975, 31 million employees were participants in private sector pension plans.  By1993 this number had expanded to 45 million employees.  Among all civilian workers, thepercentage participating in a pension plan has grown from 44 percent in 1979 to 51 percent in1993 (Table 10.4, p. 86).
42.   Some private-sector employees contribute to 403(b) tax-sheltered annuities instead of401(k) plans.
43.   Gustman and Steinmeier, "Effects of Pensions on Savings," pp. 8-9.
44.   J.R. Woods, "Pension Coverage Among Private Wage and Salary Workers:Preliminary Findings from the 1988 Survey of Employee Benefits," *Social Security Bulletin*, 52,p.17.
45.   J.A. Turner and D. Beller, *Trends in Pension*, (Washington, D.C.: U.S. Department ofLabor), 1989, pp. 65 and 357.
46.   "Gross financial assets" reports only the "asset side" of the family's balance sheet. That is, these figures do not net out the value of any of the family's financial liabilities such asmortgage or consumer debt.  "Gross financial assets less retirement assets" subtracts IRA anddefined contribution plan asset balances from reported gross financial assets.  Neither figureincludes a calculation of the value of any accrued defined benefit pension plan benefits.
47.   Congressional Budget Office, "Baby Boomers in Retirement: An Early Perspective,"September 1993, p. xiv. Also see, Joyce Manchester, "Baby Boomers in Retirement: An EarlyPerspective," in Dallas Salisbury and Nora Super Jones (eds.), *Retirement in the 21st Century:Ready or Not?* (Washington: Employee Benefits Research Institute), 1994. 
48.   B. Douglas Bernheim, "Adequacy of Savings for Retirement and the Role ofEconomic Literacy," in Dallas Salibury and Nora Super Jones (eds.), *Retirement in the 21stCentury: Ready or Not?* (Washington: Employee Benefits Research Institute), 1994.  Also seeLaurence Kotlikoff and Alan J. Auerbach, "U.S. Fiscal and Savings Crises and Their Impact forBaby Boomers" in the same volume.  Bernheim and Kotlikoff and Auerbach project potentialconsumption paths of baby boomers based on their current accumulation of assets andconsumption behavior.  Both studies conclude that baby boomer saving is, on average,inadequate for that generation to maintain its standard of living in retirement.  Bernheimestimates that, holding constant their participation in qualified plans, baby boomer non-retirement plan saving is at one-third the rate necessary to maintain pre-retirement consumption.
49.   For a brief review of this literature see Daniel B. Radner, "The Retirement Prospects ofthe Baby Boom Generation," *Social Security Bulletin*, 61, 1998, pp. 3-19.
50.   The Code also provides an exclusion for amounts received under workmen'scompensation acts for personal injuries or sickness and damages received on account of personalinjuries or sickness (sec. 104).
51.   This limit does not apply to collectively bargained plans, or plans maintained by 10 ormore employers.
52.   Elective contributions under a qualified cash or deferred arrangement that is part of acafeteria plan are subject to employment taxes.
53.   Prop. Treas. Reg. 1.125-2 Q&A-5(a).
54.   Prop. Treas. Reg. 1-125-2 Q&A-7(b).
55.   Prop. Treas. Reg. 1-125-2 Q&A-7(c).
56.   Prop. Treas. Reg. 1-125-2 Q&A-7(b).
57.   Self-employed individuals include more than 2-percent shareholders of S corporationswho are treated as partners for purposes of fringe benefit rules pursuant to section 1372.
58.   The Public Health Service Act provides that health maintenance organizations mayoffer high deductible plans (as defined under the Internal Revenue Code provisions relating toMSAs).  Thus, providing they are otherwise eligible, an individual with a high deductible planthrough an HMO is eligible for an MSA.
59.   This exclusion does not apply to expenses that are reimbursed by insurance orotherwise.
60.   The exclusion still applies to expenses for continuation coverage or coverage while theindividual is receiving unemployment compensation, even if for an individual who is not aneligible individual.
61.   Permitted coverage, as described above, does not constitute coverage under a healthinsurance plan for this purpose.
62.   See discussion in part II.D., below.
63. 63  The 90-day period is not a waiting period.  Thus, for example, an individual can becertified as chronically ill if the licensed health care practitioner certifies that the individual willbe unable to perform at least 2 activities of daily living for at least 90 days.  The certification ofan insured as a chronically ill individual may occur at any time, and is intended to take intoaccount the sum of continuous prior days when the insured was chronically ill and future dayswhen the insured is expected to remain chronically ill.
64. 64  For purposes of determining whether an individual is chronically ill, the number ofactivities of daily living that are taken into account under the contract may not be less than five. For example, a contract could require that an individual be unable to perform (without substantialassistance) two out of any five of the listed activities.  By contrast, a contract does not meet thisrequirement if it required that an individual be unable to perform two out of any four of the listedactivities.  This requirement does not apply to the determination of whether an individual is achronically ill individual either (1) by virtue of severe cognitive impairment, or (2) if the insuredsatisfies a standard (if any) that is not based upon activities of daily living, as determined underregulations prescribed by the Secretary of the Treasury in consultation with the Secretary ofHealth and Human Services.
65. 65  The rule limiting such services provided by a relative or a related corporation does notapply for purposes of the exclusion for amounts received under a long-term care insurancecontract, whether the contract is employer-provided or purchased by an individual.  Thelimitation is unnecessary in such cases because it is anticipated that the insurer will monitorreimbursements to limit opportunities for fraud in connection with the performance of servicesby the taxpayer's relative or a related corporation.
66. 66  Similarly, within certain limits, in the case of a rider to a life insurance contract,charges against the life insurance contract's cash surrender value that are includible in income aretreated as medical expenses (provided the rider constitutes a long-term care insurance contract).
67.   The dollar cap is also reduced by amounts received with respect to a chronically illindividual under a life insurance contract.
68.   HIPAA also enforces these requirements through the Employee Retirement IncomeSecurity Act and the Public Health Service Act, and imposes similar and additional requirementson health insurance issuers.
69.   In the case of a church plan, this correction is generally extended to 270 days after thedate of mailing by the Secretary of the Treasury of a notice of default with respect to a failure tocomply with the group health plan requirements.
70.   Congressional Budget Office analysis of 1996 Current Population Survey.
71.   Figures do not include deductions for long-term care expenses.
72.   Internal Revenue Service figures.
73.   General Accounting Office, *Medical Savings Accounts, Results From Surveys ofInsurers*, GAO/HEHS 99-31 (December 1988).
74.   Prior to 1976, separate tax rate schedules applied to the gift tax and the estate tax. 
75.   The unified credit operates to effectively exempt from estate and gift tax the first$650,000 in cumulative taxable transfers in 1999.  For transfers in excess of $650,000, estate andgift tax rates begin at 37 percent.  The effective exemption is increased to $1 million in 2006 andthereafter.
76.  Thus, if a taxpayer has made cumulative taxable transfers in excess of the amountnecessary to phase out the benefits of the graduated rates, his or her average transfer tax ratewould approach but never reach 55 percent.
77.  P.L. 105-34 (August 5, 1997).
78.   For purposes of the 50-percent and 25-percent tests, the value of the property isdetermined without regard to its current-use value.
79.   The term "qualified heir" means a member of the decedent's family, which includeshis or her spouse, lineal descendants, parents, aunts, uncles, and their descendants.
80.   A direct skip is any transfer subject to estate or gift tax of an interest in property to askip person (e.g., a transfer from grandparent to grandchild). A taxable termination is atermination (by death, lapse of time, release of power, or otherwise) of an interest in propertyheld in trust unless, immediately after such termination, a non-skip person has an interest in theproperty, or unless at no time after the termination may a distribution (including a distributionupon termination) be made from the trust to a skip person. A taxable distribution is a distributionfrom a trust to a skip person (other than a taxable termination or a direct skip). 
81.   The term "death taxes" is used to refer to taxes that are imposed at the time of thedeath of an individual. As used herein, the term includes taxes with other names. Such taxesinclude "inheritance taxes" and "estate taxes." An "inheritance tax" is a tax on the right to receiveproperty at death from an individual and generally is measured by the amount that a particularlegatee receives from the decedent. An "estate tax" is a tax on the right to transfer property atdeath and generally is measured by the total amount passing at the time of the decedent's death.Historically, inheritance taxes were imposed by States, while estate taxes were imposed by theFederal Government. 
82.   Act of July 6, 1797, 1 Stat. 527. 
83.   Act of June 30, 1802, 2 Stat. 148. 
84.   Act of July 1, 1862, 12 Stat. 432, 483; Act of July 15, 1870, 16 Stat. 256. 
85.   War Revenue Act of 1898, 30 Stat. 448, 464 (July 4, 1898). 
86.   See quotation in Paul, Randolph E., Taxation in the United States, p. 88 (Boston,1954). 
87.   Act of September 8, 1916, 39 Stat. 756. 
88.   This rule is contained in section 2043 of present law. 
89.   This rule is contained in section 2037 of present law. 
90.   Act of March 3, 1917, 39 Stat. 1000. 
91.   These rules are now contained in sections 2041 and 2514 of present law. 
92.   This rule is now contained in section 2038 of present law. 
93.   This rule is now contained in section 2011 of present law. The size of the credit has notchanged even though the Federal estate tax rates subsequently have been changed several times. 
94.   Revenue Act of 1932, 47 Stat. 169 (June 6, 1932). 
95.   This rule is now contained in section 2036(a) of present law. 
96.   Act of May 10, 1934, 48 Stat. 680. 
97.   Act of August 30, 1935, 49 Stat. 1014. 
98.   Revenue Act of 1940, 54 Stat. 516. 
99.   Act of September 20, 1941, 55 Stat. 687. 
100.   The $60,000 deathtime and the $30,000 lifetime exemptions remained at these levelsuntil the Tax Reform Act of 1976 when the estate and gift taxes where combined into a singleunified tax that could be reduced by a unified credit which replaces the two exemptions. 
101.   Act of October 21, 1942, 56 Stat. 798. 
102.   Revenue Act of 1948, 62 Stat. 110. 
103.   This rule is now contained in section 2042 of present law. 
104.   P.L. 85-866 (September 2, 1958). 
105.   This rule has been subsequently modified, and is now contained in section 6166 ofpresent law. 
106.   P.L. 94-455 (October 4, 1976).
107.   These rules are contained in sections 2001 and 2501 of present law. 
108.   This rule is now contained in section 2035 of present law. 
109.   These rules are now contained in section 2032A of present law. 
110.   This rule is now contained in section 2518 of present law. 
111.   Crude Oil Windfall Profits Act of 1980 (P.L. 96-223 (April 2, 1980)). 
112.   P.L. 97-34 (August 13, 1981).
113.   This rule in now contained in section 2056 of present law. 
114.   P.L. 99-514 (October 22, 1986).  The rules added by the Tax Reform Act of 1986 arecontained in sections 2601 - 2654 of present law.
115.   P.L. 100-203.
116.   These rules are contained in sections 2701- 2704 of present law. 
117.   P.L. 103-66 (August 10, 1996). 
118.   P.L. 105-34 (August 5, 1997).
119.   See description of changes made to the estate tax in 1976 in Part I.B., above.
120.   The 1988 percentage of decedents liable for estate tax of 0.87 may overstate the nadirachieved by the increase in the unified credit to an exemption equivalent amount of $600,000.This is because the 1981 legislation also increased the marital exemption to an unlimitedexemption. (See Part I.B., above.) An increase in the marital exemption would be expected toreduce the percentage of decedents liable for the estate tax, both permanently and during atemporary period following the increase. The permanent effect results from some marriedcouples having neither spouse liable for estate tax. The temporary reduction in the percentage ofdecedents liable for estate tax arises as follows. A married couple may have sufficient assets tobe subject to the estate tax. During the transition period in which husbands and wives first takeadvantage of the unlimited marital exemption, the number of decedents liable for estate tax fallsas the first spouse to die takes advantage of the expanded marital deduction, despite the fact thatthe surviving spouse subsequently dies with a taxable estate. In the long run, the number of newcouples utilizing the unlimited marital deduction may be expected to approximately equal thenumber of surviving spouses becoming taxable after their decedent spouse had claimed theunlimited marital deduction.
121.   The following analysis assumes that the capital accumulated is physical or businessintangible capital. Real per capita GNP could grow if individuals accumulated more knowledgeand skills, or what economists call "human capital." Accumulation of human capitalunaccompanied by the accumulation of physical or business intangible capital would notnecessarily lead to increasing numbers of decedents becoming liable for estate tax. 
122.   This analysis assumes that the capital accumulation is held broadly. If the growth inthe capital stock were all due to a declining number of individuals doing the accumulating, thenthe distribution of wealth would be becoming less equal and real growth could be accompaniedby a declining percentage of decedents being liable for estate tax. 
123.   If the inflation rate were to be 3 percent for each year between 1997 and 2006; theinflation-adjusted value of $600,000 in 2006 would be approximately $783,000.
124.   For a survey of the transfer tax systems of 28 countries see Joint Committee onTaxation, *Issues Presented by Proposals to Modify the Tax Treatment of Expatriation*(JCS-17-95), June 1, 1995, pp. C-1 through C-17. In Australia, the transferee receiving assetswith accrued capital gains transferred at death retains the transferor's basis in the assets(carryover basis). In Canada, gains accrued on assets held by a taxpayer at the time of his or herdeath are treated as realized and taxable as income to the taxpayer. Assets transferred to a spouseare untaxed but retain the decedent spouse's basis (carryover basis). 
125.   Joint Committee on Taxation, *Issues Presented by Proposals to Modify the TaxTreatment of Expatriation*.
126.   Thomas A. Barthold and Takatoshi Ito, "Bequest Taxes and Accumulation ofHousehold Wealth: U.S.-Japan Comparison," in Takatoshi Ito and Anne O. Kreuger (eds.), *ThePolitical Economy of Tax Reform*(Chicago: The University of Chicago Press), 1992, pp.250-251.
127.   Adoption by another did not cause an adoptee to lose his or her legal right to be anheir of his or her biological parents.
128.   Barthold and Ito, "Bequest Taxes and Accumulation of Household Wealth," p. 249.
129.   Economists call income and consumption "flow" concepts. In simple terms, a flowcan only be measured by reference to a unit of time. Thus, one refers to a taxpayer's annualincome or monthly consumption expenditures. 
130.   Economists call wealth a "stock" concept. A stock of wealth, such as a bank account,may generate a flow of income, such as annual interest income. 
131.   For a more detailed discussion of the incidence of taxes on the income from capitaland the responsiveness of saving to after-tax rate of returns, see Joint Committee on Taxation,*Methodology and Issues in Measuring Changes in the Distribution of Tax Burdens* (JCS-7-93),June 14, 1993, pp. 44-46. 
132.   See, Laurence J. Kotlikoff and Lawrence H. Summers, "The Role of IntergenerationalTransfers in Aggregate Capital Accumulation," *Journal of Political Economy*, 89, August, 1981.Also see, Laurence J. Kotlikoff, "Intergenerational Transfers and Savings," *Journal of EconomicPerspectives*, 2, Spring, 1988. For discussion of these issues in the context of wealth transfertaxes see, Henry J. Aaron and Alicia H. Munnell, "Reassessing the Role for Wealth TransferTaxes," *National Tax Journal*, 45, June, 1992. For recent attempts to calculate the share of theaggregate capital stock attributable to the bequest motive, see Barthold and Ito, "Bequest Taxesand Accumulation of Household Wealth," and William G. Gale and John Karl Scholz,"Intergenerational Transfers and the Accumulation of Wealth," *Journal of EconomicPerspectives*, 8, Fall 1994, pp. 145-160. Gale and Scholz estimate that 20 percent of the nation'scapital stock can be attributed to "intentional transfers" (including inter vivos transfers, lifeinsurance, and trusts) and another 30 percent can be attributed to bequests, whether planned orunplanned.
133.   Franco Modigliani, "The Role of Intergenerational Transfers and Life Cycle Saving inthe Accumulation of Wealth," *The Journal of Economic Perspectives*, 2, Spring, 1988. In thisarticle, Modigliani argues that 15 percent is more likely an upper bound. 
134.   See, B. Douglas Bernheim, "How Strong Are Bequest Motives? Evidence Based onEstimates of the Demand for Life Insurance and Annuities," *Journal of Political Economy*, 99,October 1991, pp. 899-927. Bernheim finds that social security annuity benefits raise lifeinsurance holdings and depress private annuity holdings among elderly individuals. He interpretsthis as evidence that elderly individuals choose to maintain a positive fraction of their resourcesin bequeathable forms. For an opposing finding, see Michael D. Hurd, "Savings of the Elderlyand Desired Bequests,"*American Economic Review*, 77, June 1987, pp. 298-312. Hurdconcludes that "any bequest motive is not an important determinant of consumption decisionsand wealth holdings.... Bequests seem to be simply the result of mortality risk combined with avery weak market for private annuities." (p. 308). 
135.   Steven M. Fazzari, R. Glenn Hubbard, and Bruce C. Petersen, "Financing Constraintsand Corporate Investment," *Brookings Papers on Economic Activity*, 1988, pp. 141-195. 
136.   Douglas Holtz-Eakin, David Joulfaian, and Harvey S. Rosen, "Sticking It Out:Entrepreneurial Survival and Liquidity Constraints," *Journal of Political Economy*, 102,February 1994, pp. 53-75. Holtz-Eakin, Joulfaian, and Rosen study the effect of receipt of aninheritance on whether an entrepreneur's business survives rather than whether an on-goingbusiness taxed as an asset in an individual's estate survives. They find that "the effect ofinheritance on the probability of surviving as an entrepreneur is small but noticeable: a $150,000inheritance raises the probability of survival by about 1.3 percentage points," and "[i]f enterprisesdo survive, inheritances have a substantial impact on their performance: the $150,000 inheritance... is associated with a nearly 20-percent increase in an enterprise's receipts" (p.74).

	These results do not necessarily imply that the aggregate economy is made better off byreceipt of inheritances. Survival of the entrepreneur may not be the most highly valuedinvestment that could be made with the funds received. 
137.   See George Cooper,*A Voluntary Tax? New Perspectives on Sophisticated TaxAvoidance*, (Washington, D.C.: The Brookings Institution), 1979. Also, see B. DouglasBernheim, "Does the Estate Tax Raise Revenue?" in Lawrence H. Summers (ed.), *Tax Policyand the Economy*, 1, (Cambridge, Mass.: The MIT Press), 1987; and Alicia H. Munnell withNicole Ernsberger, "Wealth Transfer Taxation: The Relative Role for Estate and Income Taxes,"*New England Economic Review*, November/December 1988. These studies pre-date theenactment of chapter 14 of the Internal Revenue Code. The purpose of chapter 14 is to improvereporting of asset values in certain transfers. 
138.   Andrew Carnegie, "The Advantages of Poverty," in *The Gospel of Wealth and OtherTimely Essays*, Edward C. Kirkland (ed.), (Cambridge, MA: The Belknap Press of HarvardUniversity Press), 1962, reprint of Carnegie from 1891. 
139.   For a review of this issue, see John Pencavel, "Labor Supply of Men: A Survey," inOrley Ashenfelter and Richard Layard (eds.), *Handbook of Labor Economics*, vol. I, (New York,NY: North-Holland Publishing Co.) 1986. For a direct empirical test of what some refer to as the"Carnegie Conjecture," see Douglas Holtz-Eakin, David Joulfaian, and Harvey S. Rosen, "TheCarnegie Conjecture: Some Empirical Evidence," *Quarterly Journal of Economics*, 108, May1993, pp. 413-435. Holtz-Eakin, Joulfaian, and Rosen assess the labor force participation offamilies that receive an inheritance. They find that "the likelihood that a person decreases his orher participation in the labor force increases with the size of the inheritance received. Forexample, families with one or two earners who received inheritances above $150,000 [in1982-1985 constant dollars] were about three times more likely to reduce their labor forceparticipation to zero than families with inheritances below $25,000. Moreover, ... highinheritance families experienced lower earnings growth than low inheritance families, which isconsistent with the notion that inheritance reduces hours of work" (pp. 432-433).
140.   For some exceptions, see Martin H. David and Paul L. Menchik, "Changes in CohortWealth Over a Generation," *Demography*, 25, August 1988; Paul L. Menchik and Martin H.David, "The Effect of Income Distribution on Lifetime Savings and Bequests," *AmericanEconomic Review*, 73, September 1983; and Edward N. Wolff, "Estimate of Household WealthInequality in the U.S., 1962-1983," *The Review of Income and Wealth*, 33, September 1987. 
141.   See Michael K. Taussig, "Les inegalites de patrimoine aux Etats-Unis," in Kessler,Masson, Strauss-Khan (eds.) *Accumulation et Repartition des Patrimoines*. Taussig estimatesshares of wealth held by the top 0.5 percent of wealth holders in the United States for variousyears between 1922 and 1972. Wolf, in "Estimate of Household Wealth Inequality in the U.S.,1962-1983," does not attribute any movements in wealth contribution directly to tax policy, butrather to the changes in the relative values of housing and corporate stock.
142.   Researchers have found that the correlation of income between parents and children isless than perfect. For analysis of the correlation of income among family members acrossgenerations, see Gary R. Solon, "Intergenerational Income Mobility in the United States,"*American Economic Review*, 82, June 1992, and David J. Zimmerman, "Regression TowardMediocrity in Economic Stature," *American Economic Review*, 82, June 1992. 
143.   Economists note that when expenditures on specified items are permitted to bededucted from the tax base, before the computation of tax liability, the price of the deductibleitem is effectively reduced by a percentage equal to the taxpayer's marginal tax rate.  Assume,for example, a decedent has a $1 million taxable estate and that the marginal, and average, estatetax rate were 40 percent.  This means that the estate tax liability would be $400,000.  A net of$600,000 would be available for distribution to heirs.  If, however, the decedent had providedthat his estate make a charitable bequest of $100,000, the taxable estate would equal $900,000and the estate tax liability would be $360,000.  By bequeathing $100,000 to charity, the estate'stax liability fell by $40,000. The net available for distribution to heirs after payment of the estatetax and payment of the charitable bequest would be $540,000.  The $100,000 charitable bequestonly reduced the amount of funds available to be distributed to heirs by $60,000.  Economistssay that the $100,000 charitable bequest "cost" $60,000, or that the "price" of the bequest was 60cents per dollar of bequest.  More generally, the "price" of charitable bequest equals (1 - *t*), where*t* is the estate's marginal tax rate.
144.   For example, see Charles T. Clotfelter, *Federal Tax Policy and Charitable Giving*(Chicago: University of Chicago Press), 1985; David Joulfaian, "Charitable Bequests and EstateTaxes, *National Tax Journal*, 44, June 1991, pp. 169-180; and Gerald Auten and DavidJoulfaian, "Charitable Contributions and Intergenerational Transfers," *Journal of PublicEconomics*, 59 January 1996, pp. 55-68.  Each of these studies estimates a tax price elasticity inexcess of 1.6 in absolute value.  This implies that for each 10-percent reduction in the tax price,where the tax price is defined as one minus the marginal tax rate, there is a greater than 16-percent increase in the dollar value of charitable bequests.  Such a finding implies that charitiesreceive a greater dollar value of bequests than the Treasury loses in forgone tax revenue.

	Not all studies find such responsiveness of charitable bequests to the marginal estate taxrate.  Thomas Barthold and Robert Plotnick, "Estate Taxation and Other Determinants ofCharitable Bequests," *National Tax Journal*, 37, June 1984, pp. 225-237, estimated that marginaltax rates had no effect on charitable bequests.******************************************************************