I ' ', 

: General Explanations 

1 

· , ' ' 

~ 

of the 

President's Budget Proposals 

Affecting Receipts 

) 

Department of the Treasury 

February 1989 · 

CONTENTS 

General Explanations 

Capital Gains Tax Rate Reduction for 

Individuals. • . . ••.... 

Permanent Research and Experimentation 

Tax Credit •....... 

R&E Expense Allocation Rules 

Energy Tax Incentives. 

1 

17 

23 

27 

Enterprise Zone Tax Incentives 33 

Proposed Child Tax Credit and Refundable Child 

and Dependent Care Tax Credit. . . . 35 

Deduction for Special Needs Adoptions. 39 

Medicare Hospital Insurance (HI) for State and 

Local Employees. . . . . . . . . . 43 

Repeal of the Airport and Airway Trust Fund 

Tax Trigger . .............. . 45 

Extension of the Communications (Telephone) 

Excise Tax . ............. . 47 

Miscellaneous Proposals Affecting Receipts 4 9 II 

Revenue Effects of Proposed Legislation 53 

CAPITAL GAINS TAX RATE REDUCTION FOR INDIVIDUALS 

Current Law 

Under current law, capital gains of individuals are taxed at 

the same rates as ordinary income. Thus, capital gains are 

subject to a 15 percent, 28 percent, or 33 percent marginal rate, 

although the overall rate on all income cannot exceed 28 percent. 

Prior to the Tax Reform Act of 1986 (the "1986 Act"), the tax 

code provided an exclusion for capital gains. The elimination of 

the capital gains exclusion had the effect of increasing the rate 

of tax on capital gains. While the 1986 Act eliminated the 

capital gains exclusion, it did not eliminate the legal 

distinction between capital gains and ordinary income. Thus, the 

tax code retains most of the pre-1987 structure that implemented 

the capital gains tax rate differential. 

Gains or losses from the sale or exchange of capital assets 

held for more than one year are treated as long-term capital 

gains or losses. A taxpayer determines net capital gain by first 

netting long-term capital gain against long-term capital loss and 

short-term capital gain against short-term capital loss. The 

excess of any net long-term capital gain over any net short-term 

capital loss equals net capital gain. Individuals with an excess 

net capital loss may generally take up to $3,000 of such loss as 

a deduction against ordinary income. A net capital loss in 

excess of the deduction limitations may be carried forward 

indefinitely, retaining its character in the carryover year as 

either a short-term or long-term loss. Special rules allow 

individuals to treat losses with respect to a limited amount of 

stock in certain small business corporations as ordinary losses 

rather than as capital losses. · 

A capital asset is defined generally as property held by a 

taxpayer other than (1) inventory, stock in trade, or property 

held primarily for sale to customers in the ordinary course of 

the taxpayer's trade or business; (2) depreciable or real 

property used in the taxpayer's trade or business; (3) rights to 

literary or artistic works held by the creator of such works, or 

acquired from the creator in certain tax-free transactions; 

(4) accounts and notes receivable; and (5) certain publications 

of the government. 

Special rules apply to gains and losses with respect to 

''section 1231 property." Section 1231 property is defined as 

(1) depreciable or real property held for more than 6 months and 

used in a taxpayer's trade or business, but not includable in 

inventory or held primarily for sale in the ordinary course of a 

trade or business; (2) certain pro~erty subject to compulsory or 

involuntary conversion; and (3) special 1231 property, including 

certain interests in timber, coal, domestic iron ore, certain 

livestock, and certain unharvested crops. Gains and losses from 

all transactions involving section 1231 property are netted for 

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each taxable year. Only gains that are not subject to recapture 

as ordinary income are included in the netting. If there is a 

net gain from section 1231 property, all gains and losses from 

section 1231 property are treated as long-term capital gains and 

losses and are combined with the taxpayer's other capital gains 

and losses. If there is a net loss from section 1231 property, 

all transactions in section 1231 property produce ordinary income 

and ordinary loss. However, net gain from section 1231 property 

is converted into ordinary income to the extent net losses from 

section 1231 property in the previous 5 years were treated as 

ordinary losses. 

Depreciation recapture rules recharacterize a portion of 

gain realized upon the disposition of depreciable property as 

ordinary income. These rules vary with respect to the type of 

depreciable property. Under ACRS, for all personal and 

nonresidential rental real property, all previously allowed 

depreciation, not in excess of total realized gain, is recaptured 

as ordinary income. However, if a taxpayer elects straight-line 

depreciation over a longer recovery period, there is no 

depreciation recapture upon disposition of the asset. With 

respect to residential rental property, only the excess of ACRS 

deductions over the straight-line method is recaptured as 

ordinary income. Depreciation recapture also is imputed to a 

partner who sells a partnership interest if recapture would have 

been imposed upon disposition by the partnership of depreciable 

property. There are also recapture rules applicable to 

depletable property. 

Capital gains and losses are generally taken into account 

when ''realized" upon sale, exchange, or other disposition of the 

property. Certain dispositions of capital assets, such as 

transfers by gift, are not generally realization events for tax 

purposes. Thus, in general, in the case of gifts, the donor does 

not realize gain or loss and the donor's basis in the property 

carries over into the hands of the donee. In certain 

circumstances, such as the gift of a bond with accrued market 

discount or of property that is subject to indebtedness in excess 

of the donor's basis, the donor may recognize ordinary income 

upon making a gift. Gain or loss also is not realized on a 

transfer at death. 

The amount of a seller's gain or loss is equal to the 

difference between the amount realized by the seller and the 

seller's adjusted basis (i.e., the cost or other original basis 

adjusted for items chargeable against or added to basis). Under 

various nonrecognition provisi~ns, however, realized gains and 

losses in certain transactions are deferred for tax purposes. 

Examples of such nonrecognition transactions include certain 

like-kind exchanges of property, involuntary conversions followed 

by an acquisition of replacement property, corporate 

reorganizations, and the sale of a principal residence. 

Generally, nonrecognition treatment defers gain or loss for tax 

purposes by providing for a substitution of basis from the old 

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property to the new or for a carryover basis from the old holder 

to the new holder. 

Reasons for Change 

Restoring a capital gains tax rate differential is essential 

to promote savings, entrepreneurial activity, and risk-taking 

investments in new products, processes, and industries that will 

help keep America competitive and economically strong. At the 

same time, investors should be encouraged to extend their 

horizons and search for investments with long-term growth 

potential. The future competitiveness of this country requires a 

sustained flow of capital to innovative, technologically advanced 

activities that may generate minimal short-term earnings but 

promise strong future profitability. A preferential tax rate 

limited to long-term commitments of capital will encourage 

investment patterns that favor innovations and long-term growth 

over short-term profitability. 

A capital gains differential will also provide a rough 

adjustment for taxing inflationary gains that do not represent 

any increase in real income. In addition, the Administration 

believes it is appropriate to provide further capital gains 

benefit to low and moderate income individuals, who less 

frequently make direct investments in capital assets and whose 

capital gains tend to be disproportionately attributable to 

inflation. 

e Investrnent'and Corn etitiveness. The Administration 1s cornrn1tte to rna1nta1n1ng an en anc1ng American leadership in employment growth and entrepreneurial activity. A great 

strength of the American economy has been the rate of new 

business formation, product and process innovation, and 

leadership in new and emerging technologies. This has led to 

record new job creation this decade, a period for which most 

other major industrial economies have suffered stagnant 

employment. 

By reducing the top individual income tax rate to its lowest 

level in more than half a century and by introducing the lowest 

marginal tax rates among the major industrial economies of the 

world, the 1986 Act created strong incentives for individual 

work, savings, and investment that will lead to long-term 

economic growth. These low tax rates are now being emulated by 

our major trading partners -- including especially Canada, the 

United Kingdom, Germany, and Japan -- who wish to get back in 

step with the United States. ·While low marginal tax rates were 

an enormous step forward, the Tax Reform Act of 1986 also raised 

the rate of tax on capital gains. In this area, our major 

competitors now have the upper hand: none of them taxes 

long-term capital gains in full. Restoring a tax differential 

for capital gains will solidify the favorable tax position of the 

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United States relative to the major industrial nations of the 

world. 

Some of the soundest investments in America's future do not 

have immediate payoffs. Thus, it is important to the future 

competitive position of this country that investors look beyond 

short-run profit to an investment's long-term potential. 

Consequently, restoration of a capital gains tax rate 

differential should be tailored to encourage sound, long-term 

investments that require multi-year commitments of capital. 

Moreover, a tax rate differential will promote personal savings 

to finance long-term investment and will ameliorate the built-in 

bias of the income tax against corporate equity financing. 

Inflationarl Gains. Although inflation has been kept low 

under policies o the past eight years, even low rates of 

inflation mean that individuals who sell capital assets at a 

nominal profit are paying tax on a "fictional" element of profit 

represented by inflation. High rates of inflation, such as those 

that existed in the mid and late 1970s, exacerbate the problem. 

An income tax should consider only "real" changes in the value of 

capital assets -- after adjusting for inflation -- in order to 

avoid unintended high effective rates of tax that actually lower 

the real after-tax value of assets. Current law taxation of 

nominal capital gains in full has the perverse result that real 

gains are overstated (and taxed too highly) and real losses are 

understated and, in some cases, actually converted for tax 

purposes from losses to gains. A partial exclusion for long-term 

capital gains provides a rough adjustment for the inflationary 

element of capital gains without creating the complexities and 

additional record-keeping that a precise inflation adjustment 

would require. 

Low and Moderate Income Taxpayers. Low and moderate income 

individuals typically do not directly realize capital gains as 

frequently as those with higher incomes. In 1985, the latest 

year for which detailed tax return data are available, nearly 60 

percent of all returns reported adjusted gross incomes less than 

$20,000, but, as shown on table 1, only 30 percent of the returns 

with net long-term capital gains fell into this group, and their 

gains were only 11.4 percent of the total dollar value of gains 

realized that year. Economic studies of the behavioral reactions 

of-individuals to changes in the taxation of capital gains 

suggest that lower income individuals are much less responsive 

than higher income taxpayers to capital gains tax rate changes, 

thus an extra measure of incentive is required to encourage lower 

income individuals to make direct capital investment in America's 

future. Further, analysis of capital gains realized by 

individuals at different income levels shows that lower income 

individuals are much more likely than higher income individuals 

to have large fractions of their gains represented by inflation. 

For these two reasons -- targeted extra incentive and fairness --

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it is appropriate to provide special capital gains tax relief for 

lower income taxpayers. 

Collectibles. Investment in so-called collectibles, which 

include works of art, stamp and coin collections, antiques, 

valuable rugs, and similar items does relatively little to 

enhance the nation's economic growth or productivity. 

For this reason collectibles do not warrant the preferential 

treatment accorded other capital investments. 

Treatment of Gain on De reciable and De letable Assets. 

Gains an osses rom sa es or ot er ~spos~t~ons of epreciable 

and depletable property should be treated in the same manner as 

other business income or loss and gains or losses from sales of 

other business property(~, inventory). The asymmetrical 

treatment of gains and losses from.such depreciable or depletable 

property provided by pre-1987 law, i.e., the availability of 

capital gain treatment for gains ana-otdinary loss treatment for 

losses, is without justification as a matter of tax policy. 

Historically, the availability of capital gain treatment for 

gains from sales of depreciable assets stems from the 

implementation of excess profits taxes during World war II. Many 

depreciable assets, including manufacturing plants and 

transportation equipment, had appreciated substantially in value 

when they became subject to condemnation or requisition for 

military use. Congress determined that it was unfair to tax the 

entire appreciation at the high rates applicable to wartime 

profits. Accordingly, gains from wartime involuntary conversions 

were taxed as capital gains. The provision was extended to 

voluntary dispositions of assets because it was not practical to 

distinguish condemnations and involuntary dispositions from sales 

forced upon taxpayers by the implicit threat of condemnation or 

wartime shortages and restrictions. These historical 

circumstances offer no justification for returning to the 

pre-1987 treatment of depletable or depreciable assets used in a 

trade or business, given the absence of exceptional wartime gains 

and the low, historically unprecedented (in the post-World War II 

era) statutory tax rates. 

The timing of sales of depreciable or depletable business 

assets is more likely to be determined by the condition of the 

particular asset or by routine business cycles of replacement 

than would be true of capital assets held by investors. As a 

consequence, taxation of gains on sales of depreciable or 

depletable business assets at ordinary rates is less likely to 

affect taxpayer decisions about sales and reinvestment. 

Conversely, taxation of gains on sales of depreciable or 

depletable assets at preferential rates would create an 

undesirable bias toward certain sources of business income. 

Depletion and depreciation deductions provide a current 

benefit in the years in which they are claimed. The effect of 

the recapture rules may be to offset this benefit, in whole or in 

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part, by preventing the conversion of ordinary income into 

capital gain, which was a significant issue under pre-1987 law. 

Such rules are complex, however, and one of the significant 

policy advantages of current law is the greatly reduced 

significance of recapture rules. Excluding gains on depletable 

and depreciable business property from preferential treatment 

would preserve the limited significance of current recapture 

rules. 

Finally, the availability of a capital gain preference prior 

to 1987 for depreciable and depletable business property 

contributed significantly to tax shelter activity. Although the 

passive loss rules adopted in the 1986 Act have limited tax 

shelter benefits, restoration of a capital gain preference for 

depreciable and depletable business property would make tax 

shelter investments more attractive. 

Treatment of Gain on Special Section 1231 Property. Under 

pre-1987 law, gains on dispositions of certain interests in 

timber, coal, iron ore, livestock and unharvested crops, were 

eligible for favorable capital gain treatment without regard to 

whether the property was held for sale in the ordinary course of 

the taxpayer's business. This special treatment violated the 

distinction, which is inherent in the definition of a capital 

asset, between investment property and business property. 

Business income, whether derived from the sale of property used 

in a trade or business or from the sale of property to customers 

in the ordinary course of business, should be taxed as ordinary 

income. The preferential tax rate on capital gains should apply 

only to investment assets.· Gains from dispositions of interests 

in certain natural and agricultural resources should be taxed in 

accordance with these generally applicable rules. 

Description of Proposal 

General Rule. An exclusion would be allowed to individuals 

for 45 percent of the gain realized upon the disposition of 

qualified capital assets. The maximum tax rate applicable to any 

gains on qualified assets would be 15 percent. A qualified asset 

would generally be defined as any asset that qualifies as a 

capital asset under current law and satisfies the phased-in 

holding periods. For example, assuming the holding period is 

satisfied, an individual's residence would be a qualified asset 

and gain on its disposition would be eligible for the lower 

capital gains rate proposed by the budget (and continued rollover 

of gain and the $125,000 one-time exclusion). Disposition of a 

qualified asset by an RIC, REIT, partnership, or other 

passthrough entity would continue to be treated as capital gain 

under the budget proposal and would be eligible for the exclusion 

in the hands of individual investors. 

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Holding Period and Effective Date. To be treated as 

qualified assets eligible for the lower capital gains rate, 

assets will need to satisfy the following holding periods: more 

than 12 months for assets sold in 1989, 1990, 1991, and 1992; 

more than 24 months for assets sold in 1993 and 1994; and more 

than 36 months for assets sold in 1995 and thereafter. 

The proposal would be effective generally for dispositions of 

qualified assets after June 30, 1989. Dispositions of qualified 

assets after that date would be fully protected by the exclusion 

or maximum rate -- that is, there would be no blended rate for 

gains realized in 1989 after June 30. Conversely, gains realized 

on or before June 30, 1989, would not be eligible for the 

exclusion, maximum rate, or any of the other provisions of the 

proposal and would be taxable under current law. 

15 Percent Maximum Rate. A 15 percent maximum tax rate would 

apply to capital gains on qualified assets. This maximum rate 

would apply for purposes of both regular and minimum tax. Thus 

while a taxpayer's ordinary income may be subject to a 33 percent 

marginal rate (due to phase-out of the 15 percent rate or 

personal exemptions), capital gains would not be subject to a 

marginal rate exceeding 15 percent. In some cases, the 

application of a 45 percent exclusion would result in an 

effective tax rate lower than 15 percent; for example, if the 

taxpayer's marginal rate is 15 percent, a 45 percent exclusion 

would result in an effective tax rate of 8.25 percent. 

100 Percent Exclusion for Certain Taxpayers. A taxpayer 

would be eligible for a 100 percent exclusion on sales of 

qualified assets if the taxpayer's adjusted gross income is less 

than $20,000 and the taxpayer is not subject to the alternative 

minimum tax. The $20,000 amount wouldbe calculated taking the 45 

percent capital gains exclusion into account. Thus, if a 

taxpayer's adjusted gross .income is $22,000 (including the full 

amount of gains realized on capital assets), and a 45 percent 

exclusion on. capital gains would reduce the taxpayer's taxable 

income to less than $20,000, the taxpayer would be eligible for 

the 100 percent exclusion. 

The $20,000 figure applies to 

jointly and heads of households. 

taxpayers filing separately would 

exclusion if their adjusted gross 

married taxpayers filing 

Single taxpayers and married 

be eligible for the 100 percent 

incomes are less than $10,000. 

Taxpayers who are subject to the alternative minimum tax 

would not be eligible for the 100 percent exclusion. In making 

this determination, a taxpayer's tentative minimum tax would be 

compared with his regular tax computed using a 45 percent 

exclusion. If the tentative minimum tax exceeds the regular tax, 

the taxpayer has liability under the alternative minimum tax and 

would not be eligible for the 100 percent exclusion. The 

ineligibility for the 100 percent rate would have no other effect 

on the taxpayer. Consideration will given to the need for other 

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rules to restrict the 100 percent exclusion to true low-income 

families. 

Collectibles Not Treated as Qualified Assets. The budget 

proposal would deny capital gain treatment for gains realized 

upon the disposition of collectibles, as defined under the 

individual retirement account (IRA) rules. These rules prohibit 

investments by IRAs in collectibles, which are defined to include 

works of art, rugs, antiques, metals, gems, stamps, alcoholic 

beverages, and most coins. The Secretary of the Treasury is also 

given authority to specify other tangible personal property to be 

treated as collectibles. Proposed regulations define 

collectibles to include musical instruments and historical 

objects. Consideration would also be given to rules denying the 

capital gains preference to sales of corporate stock to the 

extent collectibles had been contributed to the corporation by 

the selling shareholders. 

Definition of Capital Asset and Treatment of Assets used in a 

Trade or Business. The budget proposal would not alter the 

definition of a capital asset; however, gain from the sale, 

exchange, or other disposition of depreciable or depletable 

property used in a trade or business would not be treated as gain 

eligible for the lower capital gains rates. For this purpose, 

depreciable property refers to any property which is of a 

character subject to an allowance under Code sections 167 or 168. 

Thus, gains realized on the disposition of intangible property, 

the cost of which may be recovered through amortization 

deductions (see section 1.167(a)-3), such as sports player 

contracts, would be treated as ordinary income if the intangible 

property is used in the taxpayer's trade or business. The fact 

that cost recovery of an intangible asset may be referred to as 

''amortization'' would not prevent its being treated as depreciable 

property under this provision. Depletable property refers to any 

property of a character that is subject to an allowance for 

depletion, whether cost or percentage depletion. 

Under current law, gains on dispositions of special section 

1231 assets, which include certain interests in timber, coal, 

iron ore, livestock, and unharvested crops, are eligible for 

capital gain treatment regardless of whether the property is held 

for investment or used in the ordinary course of the taxpayer's 

trade or business. Under the budget proposal, gains from such 

assets would not automatically be treated as capital gain 

eligible for the lower rate. Instead, the character of gain upon 

the sale, exchange, or other disposition of such assets would 

depend on generally applicable principles. 

Gains on nondepreciable property that is used in a trade or 

business and is not held for sale in the ordinary course of 

business would be eligible for the lower capital gains rates. 

Losses on such property would also be treated as capital losses. 

Thus, for example, gain or loss realized on the disposition of 

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land that is used in a trade or business and is not held for sale 

to customers would be treated as capital gain or loss. 

Effects of Proposal 

The proposal would restore incentives for investment and risk 

taking that may have been discouraged by elimination of a capital 

gains tax differential in the Tax Reform Act of 1986. The 

proposal would especially encourage long-run investments, which 

would lead to new jobs, the creation of new technologies, and 

economic growth. By more narrowly defining assets eligible for 

preferential treatment and by lengthening the prior-law holding 

period to 3 years, the proposal targets tax benefits to assets 

which are most responsive to a change in tax rate. 

Under the proposal most tax~ayers would be eligible for the 

45 percent or 100 percent exclusions; however, most gains would 

be taxed at the alternate 15 percent rate. The following 

examples illustrate how the proposal would effect typical 

taxpayers. (Taxes have been computed using current law rates and 

other provisions applicable to 1989.) 

Example A. Taxpayer A is a single individual earning $16,000. 

For some years he has been making modest investments in a 

mutual fund that in 1990 reports his share of long-term 

capital gain to be $750. 

Under current law his tax on the $750 capital gain would be 

15% of the full $750 gain, or $112.50. 

Under the proposed general 45 percent exclusion his tax on 

the gain would be 15 percent of $412.50 (after excluding 

$337.50), or $61.88; however because Taxpayer A has adjusted 

gross income that is less then $20,000, he is eligible for 

the special 100 percent long-term capital gains exclusion, 

resulting in a tax of zero, a 100 percent reduction from 

current law tax. 

Example B. Couple B both work and earn $90,000 between them. 

They also have interest income of $3,200 and dividend income 

of $1,800. They have two dependent children and have 

itemized deductions of $7,000. 

In 1995 they sell corporate stock, realizing an $1,800 

capital gain on stock held 15 months and a $3,700 capital 

gain on stock held 38 months. 

Under current law both gains are subject to full taxation at 

the 33 percent effective marginal tax rate. Tax on the 

$1,800 gain would be $594, and tax on the $3,700 gain would 

be $1,221, for a combined tax of $1,8~5. Under the proposal, 

the gain from the 1995 sale of stock held 15 months will be 

short-term capital gain taxable at ordinary income rates, but 

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the gain from the sale of stock held 38 months is subject to 

the 15 percent maximum alternate capital gains tax rate 

(which for them is more beneficial than the 45 percent 

exclusion). Their tax on the latter gain will be $555.00, 

representing a reduction from current law of $666, or 55 

percent. 

Example c. Taxpayer C is a widow with dividend income of 

$23,000 and $7,000 of taxable pension income. In 1993 she 

sells corporate stock she had purchased over a number of 

years. The most recent purchase had been made more than 

2 years previously. Her realized capital gains total 

$18,000. 

Under current law her tax on that gain would be $5,040 

(28 percent of $18,000), Under the proposal, the 15 percent 

rate cap will lower this capital gains tax to $2,700, a 

reduction of $2,340, or 46 percent. 

Revenue Estimate 

The effect on Federal tax revenues of changes in capital 

gains tax rates is controversial. studies using different data, 

different explanatory variables, and different statistical 

methodologies have reached opposite conclusions on the effect of 

capital gain rate reductions on Federal revenues. 

The Treasury Department estimates that the revenue effect of 

the President's proposal will be positive during the budget 

period, as well as in the long-run, after the phase-in of the 

three-year holding period requirement. The methodology used for 

these estimates is described below in more detail than usual 

since the President's proposal is different from proposals 

previously evaluated and generalizing from previous proposals can 

be misleading. 

The revenue estimate for the budget proposal is generally 

consistent with the Treasury Department's estimate of the capital 

gains tax changes included in the 1986 Act; however, the 

proposal differs significantly from a simple reversal of the 

general increase in capital gains tax rates in the 1986 Act: (1) 

The proposal excludes gains on certain assets whose realizations 

are less responsive to changes in capital gains tax rates; (2) 

the proposal requires a longer holding period for gains to 

benefit from the lower rates; and (3) the proposal has a 

different time pattern between the announcement and effective 

date. Most importantly, in terms of its impact on revenues, the 

proposal creates a much smaller differential between the tax rate 

on capital gains and the tax rate 011 ordinary income than existed 

prior to the 1986 Act. 

As described below, the Treasury revenue estimates assume 

significant behavioral effects as taxpayers adjust their capital 

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gain realizations, their financial portfolios and income sources, 

and the timing of their realizations to the new tax rules. These 

behavioral effects are the subject of continued empirical 

research. studies will differ on the magnitude of these 

behavioral effects, in part due to the scarcity of data on timing 

and on the ultimate conversion of ordinary income to capital gain 

income, and in part due to the responsiveness of taxpayers' 

capital gains realizations to influences other than tax rates. 

The Office of Tax Analysis incorporates all effects believed to 

be important and presents its best estimate of the expected 

effects. 

Table 2 shows the separate revenue effects of the various 

elements of the capital gains proposal. In addition, it shows 

the ''static" and behavioral effects incorporated in the estimate. 

Additional revenues resulting from positive macroeconomic effects 

of the proposal are not included in the revenue estimate. It is 

useful to describe the different effects incorporated in the 

revenue estimate before considering the targeting and 

growth-oriented features that distinguish the budget proposal. 

The revenue estimate is broken into seven different elements. 

Effect of Tax Rate Reduction on the Level of Current Law 

Realizations.. First, a tax loss results from reducing tax rates 

on capital gains that would be realized at current law tax rates; 

i.e., realizations that would have occurred regardless of a 

reduction in tax rates. This is what the "static" revenue 

estimate would be. 

Effect of Increased Realizations. Second, lower tax rates 

will increase taxes due to additional realizations that would not 

otherwise occur in the current year. These "induced'' gains are 

accelerated from realizations in future years, are due tq 

portfolio shifting to capital gain assets from fully taxable 

income sources, or are taxable realizations that would otherwise 

have been tax-exempt because they would have been held until 

death, donated to charities, or realized but not reported. 

The estimate is based on a responsiveness by taxpayers which 

results in additional revenue from induced gains more than 

sufficient to offset the revenue loss from lower rates on current 

gains. The responsiveness of capital gains realizations to 

changes in tax rates is one of the most important revenue 

estimating issues~ The estimate of induced realizations is based 

on a survey of academic and government studies that examine 

taxpayers as a group over a number of ye~rs and other studies 

that examine individual tax returns over several years. With 

respect to the assumed degree of responsiveness of realizations 

to changes in the tax rate, the estimate takes a conservative 

position; there are studies that shew both lower responses as 

well as higher ones. The response is greater in the initial 

years than in the long run due to the unlocking of gains accrued 

before the effective date. 

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The responsiveness of capital gains realizations to a general 

45 percent exclusion from current law would be lower than that 

used to estimate the effect of the 1986 Act, where the top 

effective tax rate on capital gains increased from 20 percent to 

33 percent. Most empirical studies have found that 

responsiveness decreases at lower marginal tax rates. 

Effect of Deferrinf Gains Until After Effective Date. 

Third, the proposal wil induce some taxpayers to defer 

realizations in the first half of 1989 until after the effective 

date of the proposal. With the announcement_of the proposal in 

February and the assumed enactment and effective date of July 1, 

1989, some realizations that otherwise would occur between the 

announcement date and the effective date will be delayed in order 

to benefit from the lower tax rate. The estimate predicts that 

revenue will be lost only over the fiscal year 1989-1990 period 

due to realizations deferred until the effective date. 

Effect of Conversion of Ordinary Income to Capital Gain 

Income. Fourth, the proposal will induce taxpayers to realize 

additional capital gains currently and will encourage taxpayers 

to earn income in the form of lower taxed capital gains. Since 

the advent of preferential tax rates on capital gains in 1922, 

taxpayers have found various ways to convert ordinary taxable 

income into capital gains. Many of the most obvious conversion 

techniques have been stopped, but a capital gains tax rate 

differential will encourage taxpayers to shift to sources of 

income with lower tax rates. 

Methods of converting·ordinary income to capital gain income 

include shifting away from wages and salaries to deferred 

compensation, such as incentive stock options; shifting out of 

fully taxable assets, such as certificates of deposits, to assets 

yielding capital gains; shifting away from current yield assets 

to growth assets, including corporations reducing their dividend 

payout ratios; and investing in tax shelter activities. It is 

assumed that the conversion of ordinary income to capital gain 

income will occur gradually, increasing over the first 5 years. 

The capital gains estimate for the 1986 Act included a large 

revenue gain from stopping the conversion of ordinary income to 

capital gain income by elimination of the differential. In fact, 

most of the revenue gain from reduced income shifting resulted 

from the drop in the top ordinary income tax rate from 50 ~ercent 

to 28 percent. Before the 1986 Act, a 30 percentage point 

differential existed between the top ordinary tax rate and the 

top capital gains tax rate. Under the President's proposal, only 

a 13 percentage point differential will separate .the 15 percent 

maximum rate on capital gains and the top 28 percent statutory 

marginal tax rate on ordinary income and only an 18 percentage 

point differential using the 33 percent effective marginal tax 

rate that applies to certain higher income taxpayers. 

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Effect of Excluding Depreciable Assets and Collectibles. The 

revenue estimate of the proposal is significantly affected by the 

exclusion of depreciable assets and collectibles from the lower 

rate. The 1985 Office of Tax Analysis study of capital gains 

found the responsiveness of capital gain realizations from assets 

other than corporate shares to be relatively low. That is, for 

some classes of assets the additional tax from induced 

realizations will not offset the tax loss from lower tax rates on 

gains that would occur under current law on such assets. By 

restricting the lower rates to more responsive assets, the 

proposal raises an incremental amount of additional net revenue. 

Effect of Phasing In the 3-Year Holdin~ Period Requirement. 

The 3-year holding period requirement is p ased in gradually 

beginning in 1993. Any holding period encourages taxpayers to 

defer realizations until they are eligible for the lower rate. 

During the transition to the 3-year holding period, a one-time 

revenue loss will occur as realizations are deferred. After the 

transition is completed, the 3-year holding period raises revenue 

because it, like the depreciable asset exclusion, tends to limit 

the lower rate to assets more responsive to changes in capital 

gains tax rates. Assets sold after only 1 or 2 years for 

consumption or other purposes, rather than deferred to 3 years, 

would general{y be less responsive to lower tax rates. 

The phase-in of the .3-year holding period will encourage 

many taxpayers to defer realizations that would otherwise occur 

after 1 or 2 years until they become eligible for the lower tax 

rates. In addition, the phase-in will provide an incentive 

during the transition for some taxpayers to accelerate the 

realization of some gains. For instance, taxpayers who might 

realize gains held for 18 months in early 1993 might choose to 

accelerate those gains into calendar year 1992 to be eligible for 

the lower rate as 1-year assets. Thus, the phase-in will 

increase realizations in 1992 and revenues in fiscal years 1992 

and 1993. Due to the two-step phase-in (the jump to 2 years in 

1993 and to 3 years in 1995), the revenue pattern creates 

temporary incremental revenue losses in fiscal years 1994 and 

1996. 

Effect of 100 Percent Exclusion for Low-Income Taxpaters. 

The additional provision to exclude all qualified capita gain 

realiz~tions from tax for taxpayers with low incomes will lose 

approximately $0.3 billion annually. In 1985, taxpayers with 

adjusted gross incomes of less than $20,000 accounted for 11.4 

percent of net long-term capital gain realizations. Some of 

these taxpayers, however, were taxpayers with low adjusted gross 

income due to large tax preferences. The potential cost of this 

feature is reduced by limiting the zero tax rate to individuals 

who are not subject to the alternative minimum tax rate. The 

provision is considered after the initial 45 percent exclusion so 

the revenue loss is due only to the rate reduction from 8.25 

percent (55 percent times 15 percent) to zero, not the full 

reduction from 15 percent to zero. 

-13-
Total Effect of the Proposal. The President's proposal is 

estimated to increase Federal revenues in fiscal years 1989 

through 1993 due to the large induced realizations in the initial 

years from the unlocking of previously accrued gains. During 

fiscal years 1994 through 1996, a one-time revenue loss will 

occur as the 3-year holding period requirement is phased in, 

causing taxpayers to defer short-term realizations. After fiscal 

year 1996, the proposal will increase Federal receipts between $1 

and $2 billion annually. 

These estimates do not include potential increases in the 

rate of macroeconomic growth expected from a lower capital gains 

tax rate. This conforms to the general budget practice of 

including macroeconomic effects of revenue and spending proposals 

in the underlying economic forecast and hence the budget revenue 

and outlay totals but excluding such estimates from budget lines 

showing revenue impacts of any particular proposal. In the case 

of the proposed lower capital gains tax rate, the investment, 

savings, and national income growth will be most significant over 

the longer term. Although not yet estimated, it is likely that 

positive revenues from macroeconomic improvements will be 

significant in the long run. 

Office of Tax Policy 

-14-
\n 

I 

Table 1 

Distribution of Net Long Term Capital Gains 

For Returns With Long Term Capital Gains in 1985 

(In Percent) 

Adjusted Gross Income Class 

Less than $10,000 

$10,000 to $19,999 

$20,000 to $29,999 

$30,000 to $49,999 

$50,000 to $99,999 

$100,000 to $199,999 

$200,000 or more 

TOTAL 

Department of the Treasury 

Office of Tax Analysis 

Source: 1985 IRS Statistics of Income 

Distribution of 

Returns With 

Long Term Gains 

14.6% 

15.6 

15.6 

24.9 

21.3 

5.5 

2.4 

100.0% 

Percentage of 

Distribution of Total Returns With 

Long Term Gains Long Term Gains 

8.0% 4.4% 

3.4 6.2 

3.7 9.6 

8.3 13.7 

16.1 31.2 

14.1 61.1 

46.4 80.7 

100.0% 9.9% 

February 9, 1989 
Table 2 

Revenue Effects of The President's Capital Gains Proposal 

Fiscal Years 1989-1999 

Fiscal Years ($billions) 

Budget Period 

Effects of Proposal 19891 1990 I 1991 I 19921 19931 19941 1~9sJ 

Effect of Tax Rate Reduction on Existing Gains 

Projected For Current Law Realizations ...•..••..•......•..•.••.•.•...•..•........ -1.6 -11.9 -17.6 -19.1 -20.2 -21.0 -21.5 

Effect of Increased Realizations ......•••.•••...••.••..•..••..•.••..•.•.•..•..........•.. 2.4 17.1 21.8 21.8 21.5 22.3 22.3 

Effect of Delaying Gains Until the Effective Date .....•..•.••.•.•..•..••..•....... -0.2 -1.2 0.0 0.0 0.0 0.0 0.0 

Longer Run* 

19961 19971 19981 1999 

-22.0 -22.5 -23.0 -23.5 

22.9 23.4 23.9 24.5 

0.0 0.0 0.0 0.0 

"' Effect of Conversion of Ordinary Income to Capital Gain Income .•.....••. 0.0 -0.1 -0.6 -1.3 -1.9 -2.5 -2.5 -2.6 -2.6 -2.7 -2.8 I 

Effect of Excluding Depreciable Assets and Collectibles •.••.......•..••...... 0.2 1.2 1.7 1.9 2.1 2.1 2.3 2.4 2.4 2.5 2.5 

Effecl of Phased in Three Year Holding Period .•...•..•.••..•.•....•............. 0.0 0.0 0.0 0.4 1.0 -7.4 -2.3 -11.7 -0.1 1.5 1.5 

Effect of 100% Exclusion for Certain Low Income Taxpayers .......•...•... -0.0 -0.3 -0.3 -0.3 -0.3 -0.3 -0.3 -0.3 -0.3 -0.3 -0.3 

TOTAL REVENUE EFFECT OF PROPOSAL j:~:r:~m~~~:[i~:~~~~l!+~~illi~:~:~~:~~:~~~2~mi:~:~:t:~:r~~§J~~~:~[~~:~g~g~!Jili~ili~:~~§illi1~ilim~g~m~m~~~~r4n~mm~P.i:~~ili~ilim:I1~~i~:~:~1~1:~[~[*§ill~ 

Department of the Treasury 

Office of Tax Analysis 

February 9, 1989 

Notes: These estimates include changes in taxpayor behavior but do not include potential increases in the level of macroeconomic growth. 

D.:tails may not add due to rounding. 

Dis.1ggregated effects are st:Jcked in sequence . 

. *Longer run estimates assume 1994 growth extends past the budget forecast period. 
PERMANENT RESEARCH AND EXPERIMENTATION TAX CREDIT 

Current Law 

Present law allows a 20 percent tax credit for a certain 

portion of a taxpayer's ''qualified research expenses.'' The 

portion of qualified research expenses that is eligible for the 

credit is the increase in the current year's qualified research 

expenses over the base amount. The base amount is the taxpayer's 

average annual amount of qualified research and experimentation 

(R&E) expenditures over the prior three years (or if the taxpayer 

has not been in existence for three years, the average of the 

expenditures for its years in existence). This base, however, is 

subject to the limitation that it can never be less than 50 

percent of current qualified expenditures. 

In general, qualified expenditures consist of (1) ''in-house'' 

expenditures for wages and supplies used in research; (2) 65 

percent of amounts paid by the taxpayer for contract research 

conducted on the taxpayer's behalf; and (3) certain time-sharing 

costs for computers used in research. Restrictions further limit 

the credit to expenditures for research that is technological in 

nature and that will be useful in developing a new or improved 

business component. In addition, certain research is 

specifically excluded from the credit, including research 

performed outside the United States, research relating to style, 

taste, cosmetic, or seasonal design factors, research conducted 

after the beginning of commercial production, research in the 

social sciences, arts, or humanities, and research funded by 

persons other than the taxpayer. 

The credit is available only for research expenditures paid 

or incurred in carrying on a trade or business of the taxpayer. 

With one exception, relating to certain research joint ventures, 

the "trade or business test" for purposes of the credit is the 

same as for purposes of the business deduction provisions of 

section 162. As a result, new corporations and corporations 

entering a new line of business cannot claim the credit for 

qualified R&E expenses until the expenses relate to an ongoing 

trade or business. 

Present law also provides a separate 20 percent tax credit 

("the University Basic Research Credit") for corporate funding· of 

basic research through grants to universities and other qualified 

organizations performing basic research. The University Basic 

Research Credit is measured by the increase in spending from 

certain prior years. This basic research credit applies to the 

excess of (1) 100 percent of corporate cash expenditures 

(including grants or contributions) paid for university basic 

research over (2) the sum of a fixed research floor plus an 

amount reflecting any decrease in nonresearch giving to 

-17-
universities by the corporation as compared to such giving during 

a fixed base period (adjusted for inflation). A grant is tested 

first to see if it constitutes a basic research payment; if not, 

it may be tested as a qualified research expenditure under the 

general R&E credit. 

The R&E credit is aggregated with certain other business 

credits and made subject to a limitation based on tax liability. 

The sum of these credits may reduce the first $25,000 of regular 

tax liability without limitation, but may offset only 75 percent 

of any additional tax liability. Taxpayers may carry credits not 

usable in the current year back three years and forward fifteen. 

The amount of any deduction for research expenses is reduced 

by 50 percent of the amount of the tax credit taken for that 

year. 

The research credit (including the University Basic Research 

Credit) expires on December 31, 1989. 

Reasons for Change 

The tax credit for research is intended to create an 

incentive for technological innovation. Although the benefit to 

the country from such innovation is unquestioned, the market 

rewards to those who take the risk of research and experimentation are not sufficient to support the level of research 

activity that is socially desirable. The credit is intended to 

reward those engaged in research and experimentation of unproven 

technologies. 

The credit cannot induce additional R&E expenditures unless 

it is available at the time firms are planning R&E projects and 

projecting costs. R&E activity, by its nature, is long-term, and 

taxpayers should be able to plan their research activity knowing 

whether the credit will be available. Thus, if the credit is to 

have the intended incentive effect, the R&E credit should be made 

permanent. 

It is now widely acknowledged that the present incremental 

credit with a base equal to a moving average of previous 

expenditures amounts to an effective rate of credit which is much 

lower than the 20 ~ercent statutory rate. (A credit's effective 

rate is the effective reduction in price for an additional 

expenditure undertaken by a firm and is a measure of the credit's 

incentive effect.) The credit's low effective rate is primarily 

attributable to the moving base, since additional R&E in one year 

increases the base and thereby decreases the credit in subsequent 

years. Thus, R&E generating one dollar of credit in the first 

-18-
year will cause a 33.3 cent reduction in credit in each of the 

following three years, so that the credit's only benefit to a 

firm is a deferral rather than a reduction in taxes. 

In some situations the moving base can actually turn the 

effective rate of credit negative, so that the credit encourages 

a firm to reduce R&E expenditures. This occurs both when a firm 

is growing slowly and current R&E expenditures are below the base 

and when a firm is growing quickly and is subject to the 50 

percent base limitation. For firms with R&E expenditures below 

the base, negative effective rates of credit result because 

increases in R&E expenditures yield no current credit but reduce 

credits in future years. For firms subject to the base 

limitation, negative effective rates of credit result because 

each 50 cents of credit earned in the current year is followed by 33.3 cents less credit in each of the following three.years. 

Under the current credit structure, the availability of the 

credit, the amount of credit, and the revenue loss from the 

credit are. positively related to the rate of inflation. 

High rates of R&E growth in the early 1980s (due both to real 

growth and to inflation) minimized the problem of the limited 

availability of the current credit to firms performing R&E, 

because inflation kept many slow-growing firms from falling below 

the base. A slowdown in R&E growth in the late 1980s, however, 

has made it increasingly apparent that an increase in the 

availability of the credit would improve its effectiveness. 

Under current law, a new firm or a firm entering a new line 

of business may not earn credits until qualified expenses are 

incurred "in carrying on" a trade or business. Since it may be 

several years between initial research expenditures and the sale 

of products resulting from such expenditures, the tax system puts 

start-up firms at a competitive disadvantage vis-a-vis 

established firms who are already "carrying on'' a trade or 

business. 

Under present law, alternative sources of Federal government 

support for research receive different tax treatment. A tax 

credit is economically equivalent to a grant (but administered 

through the tax system). However, a firm's research costs funded 

through grants are not deductible while 50 percent of research 

costs offset by credits are deductible. Grants and tax credits 

should receive similar tax treatment. 

Description of Proposal 

The proposed R&E credit would retain the incremental feature 

of the present credit and its 20 percent rate, but would make the 

credit permanent and modify calculation of the base amount. The 

new base would be a fixed historical base equal to the average of 

-19-
the firm's qualified R&E expenditures for the years 1983 through 1987, and would be indexed annually by the average increase in 

gross national product (GNP). Firms also would have the option 

of a separate seven percent credit for expenditures which exceed 

75 percent of the base amount. In addition, for the first year 

the base would receive a one-time upward adjustment of two 

percent. As with current law, all firms would be subject to a 50 

percent base limitation. 

Under the proposal, the "trade or business" test would be 

made less stringent so that new firms and firms entering new 

lines of business could claim the credit without regard to the 

trade or business test if the taxpayer intended to use the 

results of the research in the active conduct of a present or 

future trade or business. The credit would not be available, 

however, fot research undertaken for investment rather than 

business purposes. Thus, research intended solely to be licensed 

to unrelated parties for use in their businesses would not be 

eligible for the credit. In addition, the liberalized trade or 

business rules would apply only to in-house research and not to 

research contracted out to unrelated parties. 

Finally, a taxpayer's section 174 research deductions would 

be reduced by the total amount of credit taken. 

The proposal would apply to expenditures for research and 

experimentation on or after January 1, 1990. · 

Effects of Proposal 

The proposed credit has the following advantages: (1) it 

makes the credit permanent; (2) it increases the incentive of the 

R&E credit; (3) it increases the percentage of R&E-performing 

firms that are eligible for the credit; (4) it eliminates the 

relationship between the availability of the credit and the rate 

of inflation; (5) it extends to new firms R&E incentives which 

had previously been available only to established firms; and (6) 

it rationalizes the tax treatment of alternative funding sources 

for research. 

Stable tax laws that encourage research allow taxpayers to 

undertake research with greater assurance of tax consequences. A 

permanent R&E credit (including the University Basic Research 

Credit) permits taxpayers to establish and expand research 

facilities without the fear that tax rules will suddenly change. 

The proposal would increase the credit's incentive effect by 

replacing the current credit's moving-base with a fixed-base 

structure. The critical feature of this "fixed'' base is that a 

firm's current spending will have no effect on future credits. 

Thus, unlike the current credit, a dollar of credit earned in the 

current year does not reduce credits in the following year. 

-20-
The proposal would also significantly increase the percentage 

of R&E-performing firms eligible for the credit. This increase 

is achieved through the design of the primary and alternative 

bases, which results in a larger number of firms with R&E 

expenditures above the base. Since the credit base is indexed to 

GNP, the amount of the credit allowable to any firm and the cost 

of the credit to the government no longer depends on the rate of 

inflation. In this way, the credit is provided only for real 

increases in R&E spending. 

The proposal greatly expands the number of firms eligible for 

the credit by allowing new firms and firms beginning a new line 

of business to claim the credit for qualified R&E expenses that 

relate to the active conduct of a present or future trade or 

business. The proposal would allow expenditures of new firms and 

firms entering new lines of business to claim the credit without 

regard to the trade or business test if the taxpayer intends to 

use the results of the research in the active conduct of a 

present or future trade or business. Thus, a firm that intends 

merely to lease or license the results of research would continue 

to be ineligible for the credit. 

Finally, the proposal disallows a deduction for R&E expenses 

to the extent of R&E credits taken. Disallowing a deduction for 

R&E expenses to the extent of R&E credits would provide similar 

tax treatment for all sources of Federal suppo~t for R&E. For 

example, assume Firm A conducts $100 in qualifying research and 

receives $20 from the government as a 20 percent matching grant. 

Under current law, Firm A is entitled to deduct only the $80 R&E 

expenses it actually incurred. By contrast, Firm B conducts $100 

of research and receives $20 of tax credit rather than a $20 

grant. Under current law, Firm B is entitled to deduct $90 of 

R&E expense ($100 expenditure minus 50 percent of the R&E credit) 

even though the $20 tax credit to Firm B is equivalent to $20 

grant received by Firm A. Under the proposal, Firm B would be 

allowed to deduct $80, the same amount as firm A. 

Revenue Estimate 

1990 

-0.4 

Fiscal Years 

1991 1992 

~illionsr-

-0.7 -1.0 

-21-

1993 

-1.2 

Office of Tax Policy 

R&E EXPENSE ALLOCATION RULES 

Current Law 

Research and experimentation (R&E) allocation rules generally 

expired on May 1, 1988. Under those rules, u.s. firms were 

allowed to deduct 64 percent of their expenses for R&E performed 

in the United States from their u.s. income. (The technical 

terminology is that 64 percent of the expenses were allocated to 

u.s. source income.) The remaining 36 percent of expenses were 

allocated between U.S. and foreign source income on the basis of 

either gross sales or gross income. (The amount allocated 

to foreign source income on the basis of gross income had to be 

at least 30 percent of the amount allocated to foreign source 

income on the basis of gross sales.) 

Since expiration of the R&E allocation rules, R&E expenses 

have been allocated between u.s. and foreign source income under 

detailed 1977 Treasury regulations, which were designed to match 

R&E expenses with the foreign and domestic source income 

related to the expenses. 

Reasons for Change 

The current allocation regulations do not provide sufficient 

incentives for u.s.-based research activity. In fact, a return 

to the 1977 Treasury regulations might actually reduce R&E 

expenditures in the United states from their current leVels and 

might shift some research from the United States to overseas. To 

encourage U.S.-based R&E, more favorable allocation rules are 

needed. 

The Tax Reform Act of 1986 increased the significance of the 

allocation rules for many taxpayers by expanding the number of 

U.S. firms that have excess foreign tax credits and by increasing 

the size of such excess credits. Firms derive greater tax 

benefits by using these credits to offset their current u.s. tax 

liability rather than carrying them forward or deducting them. 

Firms can use more of their foreign tax credits to offset their 

u.s. tax liability to the extent that R&E expenses are allocated 

to U.S. source income rather than to foreign source income. The 

proposal would allow more R&E expenses to be allocated to u.s. 

source income. 

The new rules should be made permanent because after more 

than 10 years of instability, taxpayers need certainty. 

Temporary rules for allocating R&E expenses were passed in 1981, 

1984, 1985, 1986, and 1988. U.S. firms need permanent rules so 

they can be certain of the long-term tax ramifications of their 

R&E expenses. Stable tax laws would encourage growth in U.S. 

research activity. 

-23-
Description of Proposal 

The proposal would permit 67 percent of R&E expenses to be 

allocated to u.s. source income. The remaining 33 percent would 

be allocated on the basis of either gross sales or gross income. 

No limitation would be placed on the allocation to U.S. source 

income under the gross income method. 

The proposal would apply retroactively to the expiration of 

the earlier rules, generally May 1, 1988. 

Effects of Proposal 

The proposal would result in greater tax savings than current 

law for u.s. firms from their U.S.-based R&E expenses. current 

law allocates more R&E expenses to foreign source income and less 

to u.s. source income than the proposal. The higher allocation 

to foreign source income under current law reduces the amount of 

foreign tax credits that firms can use to offset their u.s. tax 

liability. Because many firms have excess foreign tax credits, 

the existing allocation regulations can reduce firms' U.S.-based 

R&E expenditures. 

The difference in the effects of the current regulations and 

the proposal is best illustrated by an example. Assume that 

before deductions a firm has $1,075 in u.s. source income and 

$1,075 in foreign source income. Assume also that the firm has 

$100 in R&E expenses and $500 in foreign tax credits. Assume 

under current law, $25 of expenses are allocated to u.s. source 

income and $75 to foreign source income. Thus, for u.s. tax 

purposes, the firm is considered to have $1,050 ($1,075- $25) in 

U.S. source income and $1,000 ($1,075 - $75) in foreign source 

income. Assuming the firm pays tax at a 34-percent rate, the 

firm would have a U.S. tax liability af $697 [($1,050 + $1,000) 

* .34]. But the firm can offset $340 ($1,000 * .34) of its u.s. 

tax liability by using its foreign tax credits. Thus, the firm 

would have to pay U.S. tax of $357 ($697- $340). The firm could 

carryover the remaining $160 ($500 - $340) in foreign tax 

credits. 

Under the proposal, $75 of R&E expenses would be allocated to 

u.s. source income and $25 to foreign source income. (The 

example assumes that the amount of foreign tax paid is unaffected 

.bY changes in u.s. allocation rules.) Thus, for U.S. tax 

purposes, the firm would be considered to have $1,000 ($1,075 -

$75) in U.S. source income and $1,050 ($1,075 - $25) in foreign 

source income. The firm would still have a u.s. tax liability of 

$697 [($1,000 + $1,050) * .34]. But the firm would now be able 

to offset $357 ($1,050 * .34) of its u.s. tax liability by using 

its foreign tax credits. Thus, the firm would only have to pay 

U.S. tax of $340 ($697- $357). The firm would carryover the 

remaining $143 ($500 - $357) in foreign tax credits. 

-24-
The net result is that the proposal would reduce the amount 

of U.S. tax that the firm must pay by $17. 

Revenue Estimate 

1990 

-1.7* 

Fiscal Years 

1991 1992 

--T$ billions) 

-0.7 -0.8 

1993 

-0.9 

*The FY 1990 revenue los~ includes the retroactive application of 

this proposal. 

Office of Tax Policy 

-25-

ENERGY TAX INCENTIVES 

Current Law 

Summary. Current law provides incentives for domestic oil 

and gas exploration and production by allowing the expensing of 

intangible drilling costs ("IDCs") and the use of percentage 

depletion. These two incentives are subject to certain 

limitations and their benefits are included as preferences in the 

alternative minimum tax ("AMT"). Current law does not provide 

any further tax incentives for either exploratory drilling or 

tertiary enhanced recovery techniques. 

Exploratora Drilling vs. Develolment Drilling. The search 

for new oil an gas reserves typica ly begins with certain 

preliminary tests (~, geological and geophysical tests) 

designed to determine the likelihood of discovering commercial 

quantities of hydrocarbons. If such tests suggest that oil and 

gas may be present, further tests may be conducted. New oil and 

gas reserves, however, are typically identified only by 

exploratory drilling (i.e., drilling in a property not previously 

drilled and not locatea-next to another producing property). 

About 55 percent of exploratory well drilling expenditures result 

in dry holes. A dry hole results if commercially recoverable oil 

and gas is not found. A taxpayer is allowed to expense all costs 

of a dry hole upon abandonment of the dry hole. If exploratory 

drilling is successful in locating oil and gas in commercial 

quantities, additional drilling, termed development drilling, is 

done to recover the maximum amount of oil and gas. Current law 

does not provide any special incentive for exploratory drilling. 

Tertiar Enhanced Recover Techni ues. Tertiary enhanced 

recovery tee n1ques 1ncrease ava1 a e reserves by producing oil 

and gas that cannot be recovered economically with conventional 

pumping or water flooding. Tertiary enhanced recovery projects 

use steam, C02, or chemical injectants. Current law does not 

provide any special incentive for these projects. 

Intangible Drilling Costs (IDCs). Current law generally 

requires the capitalization of expenditures for permanent 

improvements or betterments made to increase the value of any 

property. An excepti~n to·the capitalization requirement permits 

the expensing of roes paid in connection with the drilling of 

oil, gas, and geothermal wells. IDCs include amounts paid for 

labor, fuel, repairs, and site preparation. roes do not include 

geological and geophysical costs (''G&G costs'') and surface casing 

costs (~, the cost of casings, valves, pipelines, and other 

facilit1es required to control, transport, or store the oil and 

gas). Costs that do not qualify as roes must be capitalized and 

recovered through depreciation or depletion. 

-27-
Percentage Depletion. Cost recovery with respect to oil and 

gas propert1es is allowed by means of depletion deductions. The 

depletion deduction may be calculated under the cost depletion 

method or, with significant restrictions, under the generally 

more favorable percentage depletion method. Under cost 

depletion, the amount of the depletion deduction is equal to the 

portion of the taxpayer's basis equal to the percentage of total 

oil or gas reserves produced during the year. Cost depletion 

deductions may not exceed the taxpayer's basis in the property. 

Under percentage depletion, the amount of the depletion 

deduction is equal to a statutory percentage of gross income from 

the property (15 percent in the case of oil and gas production). 

Percentage depletion deductions over the life of a property may 

exceed the cost of the property. Independent producers and 

royalty owners may use percentage depletion, but only with 

respect to 1,000 barrels of production per day. Percentage 

depletion with respect to oil and gas is not permitted for 

retailers or refiners of oil or gas products. Percentage 

depletion is also unavailable for oil and gas properties that 

have been transferred after they have been "proven'' (i.e., shown 

to have oil or gas reserves). The percentage depletion-aeduction 

may not exceed either 50 percent of the taxpayer's net income 

from the property or 65 percent of the taxpayer's net taxable 

income for the year. 

Alternative Minimum Tax (AMT). An alternative minimum tax is 

imposed on certain taxpayers. This tax is calculated with 

respect to alternative minimum taxable income ("AMTI"), which is 

calculated by making certain adjustments and adding tax 

preference items to regula~ taxable income. Both roes and 

percentage depletion deductions are preference items for both 

corporate and non-corporate taxpayers, and thus are included in 

AMTI. 

The percentage depletion tax preference item is the amount by 

which the depletion deduction claimed for regular tax purposes 

exceeds the taxpayer's basis in the property at the end of the 

taxable year (disregarding the depletion deduction for the year). 

Treating such amounts as a preference item in computing AMTI may 

reduce or eliminate the benefit of permitting percentage 

depletion for certain taxpayers. 

The IDC tax preference is the amount by which a taxpayer's 

''excess IDCs" claimed with respect to successful wells exceed 65 

percent of his net income from oil, gas, or geothermal 

properties. The "excess roes" are the amount by which the roc 

deductions claimed for the year exceed the deductions that would 

have been claimed had the IDCs been capitalized and either 

amortized over 120 months or recovered through cost depletion. 

Thus, for AMT purposes, the IDC deduction for incremental IDC 

expenditures in excess of the net income limit is reduced to 

zero. 

-28-
Reasons for Change 

The sharp reduction in world oil prices and the increasing 

levels of oil imports may raise both energy security and national 

security concerns. our increased dependence on foreign oil may 

leave the nation vulnerable to potential foreign supply 

disruptions. The Administration supports an energy policy that 

is designed to address these concerns by improving our long-term 

energy security and strengthening the domestic oil industry. 

An increase in domestic oil and gas reserves would improve 

our energy security. The level of proven domestic reserves is 

closely related to the level of domestic exploratory drilling. 

The level of domestic exploratory drilling, however, has fallen 

by 70 percent from recent levels, largely due to uncertainty 

concerning low world oil prices. In addition, over the same time 

period, development drilling has increased 20 percent, resulting 

in a substantial decline in domestic oil and gas reserves. 

Special tax incentives are appropriate to encourage higher levels 

of exploratory drilling which may lead to increased domestic 

reserves. 

Current law limits the incentive effects of IDC expensing and 

percentage depletion, particularly for independent producers, 

which have historically drilled a majority of our exploratory 

wells. Current rules for the use of percentage depletion by 

independent producers limit the use to properties acquired by or 

transferred to an independent producer before the property is 

shown to have oil or gas reserves (the "transfer rule"). 

The transfer rule discourages the transfer of producing wells 

that are uneconomic in the· hands of current owners to owners that 

may be more efficient, more willing to bear current losses, or 

better able to use the tax benefits of current depletion. Repeal 

of the transfer rule would encourage the continued operation of 

such properties by small producers with lower overhead. By 

keeping marginal wells in production, U.S. oil production would 

be maintained without additional drilling costs. Current law 

also provides that percentage depletion may not exceed 50 percent 

of the net income of a property calculated before depletion. At 

current oil and gas prices, the 50 percent net income limitation 

may significantly reduce the benefits of percentage depletion for 

production from properties generating a small amount of net 

income. Raising the net income limitation to 100 percent would 

allow some oil producers to claim greater depletion deductions, 

thus encouraging them to operate marginal properties. Moreover, 

raising the limit might also encourage added investment in 

exploratory drilling projects. In addition, the current 

alternative minimum tax (AMT) severely limits the incentive 

effects of !DC expensing, particularly for independent producers. 

The level of exploratory drilling and domestic reserves would 

be increased by providing a program of temporary IDC credits, 

less restrictive rules for the use of percentage depletion, and 

AMT relief, all targeted to exploratory drilling in general and 

-29-
to independent prod11cers in particular. A temporary tax credit 

for new tertiary enhanced recovery projects would encourage the 

recovery of known energy deposits that are currently too costly 

to produce. 

Description of Proposal 

Four incentives are proposed to encourage exploration for new 

oil and gas fields and the reclamation of old fields. Two 

proposals would provide temporary tax credits. The temporary tax 

credits would be phased out if the average daily U.S. wellhead 

price of oil is at or above $21 per barrel for a calendar year. 

First, a temporary 10 percent tax credit would be allowed for 

the first $10 million of expenditures (per year per company) on 

exploratory intangible drilling costs and a 5 percent credit 

would be allowed for the balance effective January 1, 1990. 

Second, a temporary 10 percent tax credit, effective January 1, 

1990, will be allowed for all capital expenditures on new 

tertiary enhanced recovery projects (i.e., projects that 

represent the initial application of tertiary enhanced recovery 

to a property). 

These tax credits could be applied against both the regular 

tax and the alternative minimum tax. However, the credits, in 

conjunction with all other credits and net operating loss 

carryforwards, could not eliminate more than 80 percent of the 

tentative minimum tax in any year. Unused credits could be 

carried forward. 

Third, the proposal would eliminate the "transfer rule," 

which discourages the transfer of proven properties to 

independent producers and royalty owners, and would increase the 

percentage depletion deduction limit for independent producers to 

100 percent of the net income of each property. These changes 

would increase the availability to independent producers of the 

percentage depletion tax incentive. The proposed effective date 

of each change would be Januar"y 1, 1990. 

Fourth, the proposal would eliminate 80 percent of current 

AMT preference items generated by exploratory roes incurred by 

independent producers effective January 1, 1990. Thus, 

independent producers would be allowed to deduct 80 percent 

(rather than zero, as under current law) of exploratory excess 

roes in excess of the net income limit for purposes of the AMT. 

As under current law, the net income limit would be equal to 65 

percent of oil and gas net income determined without regard to 

excess roc deductions. 

-30-
Effects of Proposal 

The proposed new incentive program for the oil and gas industry 

would encourage exploration for new oil and gas fields and the 

reclamation of old fields. The incentives would strengthen the 

financial health of the smaller independent producers in 

particular. The incentives would help the nation achieve greater 

energy independence and greater national security. 

Revenue Estimate 

10 percent credit 

for exploratory 

1990 

drilling -0.2 

10 percent credit 

for tertiary enhanced recovery * 

Eliminate the 

transfer rule and 

increase the net 

income allowance 

to 100 percent for 

percentage depletion 

by independent 

producers and royalty 

owners * 

Eliminate 80 percent of exploratory 

IDC tax preferences 

from minimum tax for 

independent producers -0.1 

*-$50 million or less. 

Fiscal Years 

1991 1992 1993 

---rrbilliOilS) 

-0.3 -0.3 -0.4 

* * * 

* * * 

-0.1 -0.1 -0.1 

Office of Tax Policy 

-31-

ENTERPRISE ZONE TAX INCENTIVES 

Current Law 

Existing Federal tax incentives generally are not targeted to 

benefit specific geographic areas. Although the Federal tax law 

contains incentives that may encourage economic development in 

economically distressed areas, they are not limited to use with 

respect to such areas. 

Among the existing general tax incentives that aid 

economically distressed areas is the targeted jobs tax credit. 

This credit, which provides an incentive to employers to hire 

economically disadvantaged workers, pften is available to firms 

locating in economically distressed areas. An investment credit 

also is allowed for certain investment in low-income housing or 

the rehabilitation of certain structures. Another type of tax 

incentive permits the deferral of capital gains taxation upon 

certain transfers of low-income housing and certain exchanges of 

business or investment property for property of the same kind. 

As a final example of a general tax incentive benefitting 

economically distressed areas, state and local governments are 

permitted to issue a limited number of tax-exempt private 

activity bonds that provide low-cost financing for businesses to 

begin or expand their ventures. 

Reasons for Change 

Despite sustained national prosperity and growth, certain 

areas have not kept pace. To help these areas share in the 

benefits of continued economic growth, this Administration 

proposes enterprise zones to stimulate local government and 

private sector revitalization of economically distressed areas. 

Enterprise zones would encourage private industry investment 

and job creation in economically distressed areas by removing 

regulatory and other barriers inhibiting growth. They would also 

promote growth through selected tax incentives to reduce the 

risks and costs of expanding in severely depressed areas. 

Enterprise zones would let business and innovation bloom in 

places where there has been little hope and little opportunity. 

A new era of public/private partnerships is needed to help 

distressed cities and rural areas help themselves. The 

enterprise zone initiative will help determine the effectiveness 

of selected Federal tax incentives and reduced Federal 

regulations in stimulating the private and local public 

investment needed to revitalize economically deprived areas. 

-33-
Description of Proposal 

The proposed enterprise zone initiative would include 

selected Federal employment and investment tax credits. These 

tax credits will be offered in conjunction with Federal, state, 

and local regulatory relief. Up to 70 zones will be selected 

between 1990 and 1993. 

There would be both capital-based and employment-based tax 

credits, although the details of the tax credits have not been 

specified. The extent of the tax subsidies will vary, with 

larger subsidies in the early years that decline over time. 

Total Federal revenue losses will gradually rise, however, as 

more zones are designated. 

The willingness of states and localities to "match'' Federal 

incentives will be considered in selecting the special enterprise 

zones to receive these additional Federal incentives. 

Revenue Estimate 

1990 

-150 

Fiscal Years 

1991 1992 

~mi1lionsr-

-200 -300 

-34-

1993 

-400 

Office of Tax Policy 
PROPOSED CHILD TAX CREDIT AND 

REFUNDABLE CHILD AND DEPENDENT CARE TAX CREDIT 

Current Law 

The Internal Revenue Code provides assistance to low-income 

working parents through both the earned income tax credit (EITC) 

and the child and dependent care tax credit. 

Earned Income Tax Credit. Low-income workers with minor 

dependents may be eligible for a refundable income tax credit of 

up to 14 percent of the first $6,500 in earned income. The . 

maximum amount of the EITC is $910. The credit is reduced by an 

amount equal to 10 percent of the excess of adjusted gross income 

(AGI) or earned income (whichever is greater) over $10,240. The 

credit is not available to taxpayers with AGI over $19,340. Both 

the maximum amount of earnings on which the credit may be taken 

and the income level at which the phase-out region begins are 

adjusted for inflation (1989 levels are shown). 

Earned income eligible for the credit includes wages, 

salaries, tips and other employee compensation, plus the amount 

of the taxpayer's net earnings from self-employment. Eligible 

individuals may receive the benefit of the credit in their 

paychecks throughout the year by electing advance payments. 

Child and Dependent Care Credit. Taxpayers may also be 

eligible for a nonrefundable income tax credit if they incur 

expenses for the care of a qualifying individual in order to 

work. A qualifying individual is (1) a dependent who is under 

the age of 13 for whom the taxpayer can claim a dependency 

exemption; (2) the spouse of the taxpayer if the spouse is 

physically or mentally incapable of caring for himself or 

herself; or (3) a dependent of the taxpayer who is physically or 

mentally incapacitated and for whom the taxpayer can claim a 

dependency exemption or could claim as a dependent except that he 

or she has more than $1,500 in income. 

To claim the child and dependent care credit, taxpayers must 

be married and filing a joint return or be a head of household. 

Two-parent households, with only one earner, do not qualify for 

the credit unless the non-working spouse is disabled or a 

full-time student. 

The amount of employment-related expenses that is eligible 

for the credit is subject to both a dollar limit and an earned 

income limit. Employment-related expenses are limited to $2,400 

for one qualifying individual and $4,800 for two or more 

qualifying individuals. Further, employment-related expenses 

cannot exceed the earned income of the taxpayer, if single, or 

for married couples, the earned income of the spouse with the 

lower earnings. 

-35-
Taxpayers with AGI of $10,000 or less are allowed a credit 

equal to 30 percent of eligible employment-related expenses. For 

taxpayers with AGI of $10,000 to $28,000, the credit is reduced 

by one percentage point for each $2,000, or fraction thereof, 

above $10,000. The credit is limited to 20 percent of 

employment-related dependent care expenses for taxpayers with AGI 

above $28,000. 

Reasons for Change 

Current law does not adequately provide for the child care 

needs of low-income working families. Many low-income families 

do not incur a federal income tax liability and as a consequence 

are unable to claim the child and dependent care credit. 

Further, many low-income families rely on relatives and neighbors 

to provide care for their children, and thus these families can 

not claim the child and dependent care credit. The EITC, while 

refundable, does not adjust for differences among working 

families in the costs of providing care according to the age of 

the dependent child. Pre-school children generally require more 

extensive care than older children who may be in a school setting 

for much of the day. 

Description of Proposal 

Proposed Child Tax Credit. Low-income families, containing 

at least one worker, would be entitled· to take a new tax credit 

of up to $1,000 for each dependent child under age four. For 

each child under the age of four, families could receive a credit 

equal to 14 percent of earned income, with a maximum credit equal 

to $1,000 per child. Initially, the credit would be reduced by 

an amount equal to 20 percent of the excess of AGI or earned 

income {whichever is greater) over $8,000. As a consequence, the 

credit would not be available to families with AGI or earned 

income greater than $13,000. In subsequent years, both the 

starting and end-points of the phase-out range would be increased 

by $1,000 increments. In 1994, credit would phase-out between 

$15,000 and $20,000. 

The credit would be refundable and would be effective for 

tax years beginning January 1, 1990. Families would have the 

option of receiving the refund in advance through a payment added 

to their paycheck. 

Refundable Child and De endent Care Credit. The existing 

child an epen ent care tax ere 1t wou e made refundable. 

Families could not claim both the new child credit and the child 

and dependent care credit with respect to the same child but 

could choose the larger of the two credits. The refundable child 

and dependent care credit would be effective for tax years 

beginning January 1, 1990. 

-36-
Effects of the P•oposal 

The p•oposal would inc•ease the •esou•ces available to 

low-income families, bette• enabling them to choose the 

child-ca•e a••angements which best suit thei• needs and 

co••espond to thei• pe•sonal values. About 2.5 million wo•king 

families with child•en unde• the age of fou• will initially be 

eligible fo• the new child tax c•edit. When the p•oposal is 

fully implemented, eligibility will be expanded to app•oximately 

1 million additional families. These families will also have the 

option of claiming the •efundable child and dependent ca•e 

c•edit, although they will not be able to claim both c•edits with 

•espect to the same child. In addition, low-income pa•ents of 

child•en between the ages of fou• and twelve would benefit f•om 

the •efundabilty of the child and dependent ca•e c•edit if they 

incur child-care expenses in order to work. 

Consider, for example, a single working mother of two 

children, ages three and six years old. The mother earns $10,000 

a yea• and has no other sources of taxable income. She pays a 

neighbor $20 a week to care for her younger child. Her older 

child is enrolled in a latchkey program during the school year 

and a neighborhood park program during the summer at a total cost 

of $500 per year. In total, she spends $1,540 a year for child 

care in order to work. Under current law, she is not entitled to 

claim the child and dependent care credit. At a 30 percent 

credit rate on dependent care expenses, the credit would be $462. 

However, she has no tax liability as·a consequence of the 

standard deduction and personal exemptions, and therefore cannot 

claim the credit. 

Under the proposal, the mother would be able to claim the 

proposed child tax credit. In 1990, she would be entitled to a 

credit equal to $600. (A mother in similar circumstances in 1992 

would be entitled td the full $1,000 credit.) In addition, the 

mother would be able to claim the child and dependent care tax 

credit of $150 based on the expenses associated with the day care 

of her older child. In total, she would be entitled to a·refund 

of $750. 

Revenue Estimate 

Fiscal Years 

1990 1991 1992 1993 

( $ billions) 

Revenue loss * * * .1 

·outlays' . 2 1.8 2 . 2 2 • 4 

* $50 million or less. 

1 Increased outlays attributable to refunds payable to eligible 

individuals with no tax liability. 

Office of Tax Policy 

-37-

DEDUCTION FOR SPECIAL NEEDS ADOPTIONS 

Current Law 

Expenses associated with the adoption of children are not 

deductible under current law. However, expenses associated with 

the adoption of special needs children are reimbursable under the 

Federal-State Adoption Assistance Program (Title IV-E of the 

Social Security Act). Special needs children are those who by 

virtue of special conditions such as age, physical or mental 

handicap, or combination of circumstances, are difficult to place 

for adoption. The Adoption Assistance Program includes several 

components. One of these components requires states to reimburse 

families for costs associated with the process of adopting 

special needs children. The Federal government shares 50 percent 

of these costs up to a maximum Federal share of $1,000 per child. 

Reimbursable expenses include those associated directly with the 

adoption process such as legal costs, social service review, and 

transportation costs. Some children are also eligible for 

continuing Federal-State assistance under Title IV-E of the 

Social Security Act. This assistance includes Medicaid. Other 

children may be eligible for continuing assistance under 

State-only programs. 

Reasons for Change 

The Tax Reform Act of 1986 (the ''1986 Act'') repealed the 

deduction for adoption expenses associated with special needs 

children. Under prior law, a deduction of up to $1,500 of 

expenses associated with the adoption of special needs children 

was allowed. The 1986 Act provided for a new outlay program 

under the existing Adoption Assistance Program to reimburse 

expenses associated with the adoption process of these children. 

The group of children covered under the outlay program is 

somewhat broader than the group covered by the prior deduction. 

The prior law deduction was available only for special needs 

children assisted under Federal welfare programs. Aid to 

Families with Dependent Children (AFDC), Title IV-E Foster Care, 

or Supplemental Security Income (SSI). The current adoption 

assistance outlay program provides assistance for adoption 

expenses for these special needs children as well as special 

needs children in private and State-only programs. 

Repeal of the special needs adoption deduction may have 

appeared to some as a lessening of the Federal concern for the 

adoption of special needs children. 

-39-
An important purpose of the Adoption Assistance Program is to 

enable families in modest circumstances to adopt special needs 

children. In a number of cases the children are in foster care 

with the prospective adoptive parents. The prospective parents 

would like to formally adopt the child but find that to do so 

would impose a financial hardship on the entire family. 

While the majority of eligible expenses are expected to be 

reimbursed under the continuing expenditure program, the 

Administration is concerned that in some cases the limits may be 

set below actual cost in high cost areas or in special 

circumstances. Moreover, inclusion in the tax code of a 

deduction for special needs children may alert families who are 

hoping to adopt a child to the many forms of assistance provided 

to families adopting a child with special needs. 

Description of Proposal 

The proposal would permit the deduction from income of 

expenses incurred associated with the adoption of special needs 

children up to a maximum of $3,000 per child. Eligible expenses 

would be limited to those directly associated with the adoption 

process that are eligible for reimbursement under the Adoption 

Assistance Program. These include court costs, legal expenses, 

social service review, and transportation costs. Only expenses 

for adopting children defined as eligible under the rules of the 

Adoption Assistance Program would be allowed. Expenses which 

were deducted and reimbursed would be included in income in the 

year in which the reimburs~ment occurred. 

Effects of Proposal 

The proposal when combined with the current outlay program 

would assure that reasonable expenses associated with the process 

of adopting a special needs child do not cause financial hardship 

for the adoptive parents. The proposed deduction would 

supplement the current Federal outlay program. In addition, the 

proposal highlights the Administration's concern that adoption of 

these children be specially encouraged and may call to the 

attention .of families interested in adoption the various programs 

which help families adopting children with special needs. 

There is currently uncertainty regarding whether Federal and 

State reimbursements are income to the adopting families. The 

proposal would clarify the treatment of reimbursements by making 

them includable in income but also deductible, up to $3,000 of 

eligible expenses per child. Additionally, qualified expenses up 

to this limit would be deductible even though not reimbursed. 

-40-
While the costs of adoption of a special needs child are only 

a small part of the total costs associated with adoption of these 

children, the Administration believes that it is important to 

remove this small one-time cost barrier that might leave any of 

these children without a permanent family. 

Revenue Estimate 

1990 

----:::-;--

Fiscal Years 

($ millions) 

1991 1992 

---=-3 ---=-3 

* less than $500,000 

-41-

1993 

---=-3 

Office of Tax Policy 

MEDICARE HOSPITAL INSURANCE (HI) FOR STATE AND LOCAL EMPLOYEES 

·current Law 

State and local government employees hired on or after 

April 1, 1986, are covered by Medicare Hospital Insurance and 

their wages are subject to the Medicare tax (1.45 percent on both 

employers and employees). Employees hired prior to April 1, 

1986, are not covered by Medicare Hospital Insurance nor are they 

subject to the tax. 

Reasons for Change 

State and local government employees are the only major group 

of employees not assured Medicare coverage. A quarter of state 

and local government employees are not covered by voluntary 

agreements nor by law. However, eighty-five percent of these 

employees receive full Medicare benefits through their spouse or 

because of prior work in covered employment. Over their working 

lives, they contribute only half as much tax as is paid by 

workers in the private sector. Extending coverage would assure 

that the remaining 15 percent have access to Medicare and would 

eliminate the inequity and the drain on the Medicare trust fund 

caused by those who receive Medicare without fully contributing. 

Description of Proposal 

As of October 1, 1989, all state and local government 

employees would be covered by Medicare Hospital Insurance. 

Effects of Proposal 

An additional 2 million state and local government employees 

would be contributing to Medicare. Of these, roughly 300,000 

employees would become newly eligible to receive Medicare 

benefits subject to satisfying the minimum 40 quarters of covered 

employment. 

Revenue Estimate 1 

Fiscal Years 

1990 1991 1992 1993 1994 

($ biTITons)--

1.8 1.9 1.9 1.9 1.9 

1 Net of income tax offset. 

Office of Tax Policy 

-43-

REPEAL OF THE AIRPORT AND AIRWAY TRUST FUND TAX TRIGGER 

Current Law 

The Airport and Airway Safety and Capacity Expansion Act 

of 1987 established a trigger that would reduce by 50 percent 

several of the airport and airway trust fund taxes. The trigger 

would take effect in calendar year 1990 if the 1988 and 1989 

appropriations for the capital programs funded by these taxes 

were less than 85 percent of authorizations. The trigger would 

reduce by 50 percent the 8 percent air passenger tax, the 5 percent air freight tax, and the 14 cents per gallon noncommercial 

aviation fuels tax. It would also substantially reduce the 

aviation gasoline tax. 

Reasons for Change 

Given congressional action for 1988 and 1989, the trigger 

would take effect and reduce by 50 percent these airport and 

airway trust fund taxes. The receipts from these taxes are 

required to modernize airport and airway facilities in the 

United States in the early ~990s. 

Description of Proposal 

The proposal would repeal the tax reduction trigger, 

resulting in increased airport and airway trust fund receipts of 

$1.2 billion in 1990 and increased governmental receipts (net of 

income and employment tax offsets) of $0.9 billion. 

Effects of Proposal 

Repealing the trigger is required for the accumulation of 

funds for the modernization of airport and airway facilities 

in the United States in the early 1990s. 

Revenue Estimate 1 

1990 

0.9 

Fiscal Years 

1991 1992 

rsl5111ions) 

1.6 1.7 

1993 

1.8 

1 Net of income tax offsets. The estimates shown are relative to 

current services receipts which assume continuation of trigger 

rates through 1994. 

.office of Tax Policy 

-45-

EXTENSION OF THE COMMUNICATIONS (TELEPHONE) EXCISE TAX 

Current Law 

The Omnibus Budget Reconciliation Act of 1987 extended the 

communications excise tax until the end of 1990. The tax is 

imposed at a rate of three percent on local and toll (longdistance) telephone service and on teletypewriter exchange 

service. 

Reasons for Change 

The communications excise tax was originally enacted in 1914 

and has been imposed continuously since 1932, even though it has 

been scheduled to expire continuously since 1959. Allowing the 

tax to expire would reduce Federal tax receipts by approximately 

$2.5 billion annually. 

Description of Proposal 

The proposal would permanently extend the three percent 

Federal communications excise tax. The tax rate is substantially 

less than the ten percent rate that was in effect between 1954 

and 1972, and as low or lower than the rate in effect for any 

year since 1932 (except for 1980-82). The base of the tax would 

not be broadened. 

Effects of Proposal 

Extension of the communications excise tax would maintain 

a revenue source that has been in existence continuousli since 

1932, and would avoid the disruption that would occur if the tax 

were allowed to expire and then were reenacted. 

Revenue Estimate 1 

1990 

0 

1 Net of income tax offset. 

Fiscal Years 

1991 1992 

($billions) 

1.6 2.6 

-47-

1993 

2.8 

Office of Tax Policy 

MISCELLANEOUS PROPOSALS AFFECTING RECEIPTS 

Current Law 

Internal Revenue Service (IRS) Enforcement Initiative. IRS 

currently allocates some of its funding for tax law enforcement. 

Increase Nuclear Regulatory Commission (NRC) User Fees. 

The proportion of the NRC's costs incurred in regulating nuclear 

power plants will decline from 45 percent in 1989 to 33 percent 

in 1990. 

Initiate Federal Emergency Management Agency (FEMA) User 

Fees. The costs that FEMA incurs as NRC's agent in regulating ~evacuation plans of nuclear power plants are financed through 

general revenues. 

Increase District of Columbia (D.C.) Ern lo er Contributions 

to the C1v1 Serv1ce Ret1rernent System CSRS). The D.C. govern 

rnent contributes 7 percent of wages and salaries to CSRS and D.C. 

employees contribute an additional 7 percent. 

Initiate Federal Marine Fishing Licenses and Fees. The costs 

of Federal efforts to conserve and manage the Nation's marine 

fishery resources are financed through general revenues. 

Extend Reimbursable Status to Amtrak. The Technical and 

Miscellaneous Revenue Act of 1988 exempts public commuter railroads from paying the full railroad unemployment tax rate in 

1989 and 1990 and permits them to reimburse the unemployment 

fund for the actual costs of their employees. The exemption 

does not extend to Amtrak. 

Eliminate Superfund Petroleum Tax Differentials. The 

superfund petroleum tax is 8.2 cents per barrel for domestic 

crude oil and 11.7 cents per barrel for imported products. 

Other Proposals. Pay raise proposals; extending customs 

processing fee; establish a fee for U.S. Travel and Tourism 

Administration; user fee on taxpayer telephone information 

services. 

Reasons for Change 

Internal Revenue Service (IRS) Enforcement Initiative. The 

gap between taxes owed and taxes voluntarily paid contributes to 

the Federal deficit and undermines the system of voluntary 

compliance. 

-49-
Increase NRC User Fees. Costs of regulating the nuclear 

power industry should be fully borne by the users of the 

services. 

Initiate FEMA User Fees. Costs of regulating the evacuation 

plans of the nuclear power industry should be borne by the users 

of the services, as are the general regulatory costs. 

Retirement 

the employer 

by the D.C. 

Initiate Federal Marine Fishing Licenses and Fees. The 

costs of Federal conservation and management of marine fishery 

resources should be paid by the commercial fishermen who directly 

benefit from the services. 

Extend Reimbursable Status to Amtrak. The reimbursement 

arrangement ensures that commuter railroads use the public 

subsidies they receive to hold down fares rather than paying 

for the high unemployment costs of private freight railroads. 

Amtrak is in much the same position as the commuter railroads. 

Eliminate Superfund Petroleum Tax Differentials. The 

current tax differential could subject the united States to 

retaliation or possible compensatory damage payments under the 

General Agreement on Tariffs and Trade (GATT). 

Description of Proposal 

IRS Enforcement Initiative. Increase IRS funding for tax 

law enforcement. 

Increase NRC User Fees. Increase fees to cover 100 percent 

of NRC's regulatory costs, effective October 1, 1989. 

Initiate FEMA User Fees. Recover 100 percent of regulatory 

costs through user fees, effective October 1, 1989. 

Increase D.C. Employer Contributions to CSRS. The D.C. 

government will pay retirement cost-of-living adjustments (COLAs) 

to its retirees and their survivors. The initial annual payment 

would begin in 1991 because of a proposed budget COLA freeze for 

government annuitants in 1990. 

Licenses and Fees. Establish 

a perm1t an va orem fee on commerc1a sa es, effective 

January 1, 1990. Applicable only to fishermen who fish in the 

fishery conservation zone (3 to 200 miles offshore) or who fish 

for federally managed species. 

-50-
Extend Reimbursable Status to Amtrak. Require Amtrak to 

reimburse the unemployment fund for actual costs of their 

employees rather than paying the full railroad industry 

unemployment tax. 

Eliminate Superfund Petroleum Tax Differentials. Equalize 

the excise taxes through a slight increase in the tax rate on 

domestic crude oil and a slight decrease in the rate on imported 

petroleum products. 

Other Proaosals. Additional changes affecting receipts 

include the A ministration's pay raise proposals; extension 

of the customs processing fee, which is scheduled to expire 

September 30, 1990, at current rates; and the establishment 

of a fee for the u.s. Travel and Tourism Administration (USTTA). 

A user fee on taxpayer telephone information services is proposed for 1991; a design evaluation will be conducted in 1989 

and 1990 that will include an actual demonstration of the 

technologies and systems capabilities. 

Effects of Proposal 

IRS Enforcement Initiative. Ensure that taxpayers correctly 

report their income for tax purposes and improve collection of 

past due taxes. 

Increase NRC User Fees. Users of NRC regulatory services 

pay the full costs of regulation. 

Initiate FEMA user Fees. Users of FEMA regulatory services 

pay the full costs of regulation. 

Increase D.C. Employer Contributions to CSRS. Requires the 

D.C. government to bear more of the retirement costs of its 

employees. 

Initiate Federal Marine Fishing Licenses and Fees. Requires 

users of Federal fishery research, conservation, and management 

services to pay the costs of the services. 

Extend Reimbursable Status to Amtrak. Helps to reduce the 

Amtrak operating deficiency and prevents public funds intended 

to subsidize public commuter railroad fares from unintentionally 

cross-subsidizing high unemployment freight railroads. 

Eliminate Superfund Petroleum Tax Differentials. Achieves a 

system of excise taxes on petroleum that is consistent with GATT. 

-51-
Revenue Estimates 

IRS Enforcement Initiative 

Increase NRC User Fees 

Initiate FEMA User Fees 

Increase D.C. Government 

CSRS Contributions 

Initiate Federal Marine Fishing 

Licenses and Fees 

Extend Reimbursable status to 

Amtrak 

Eliminate Superfund Petroleum 

Differential 

Other Proposals 

$50 million or less. 

1990 

0.3 

0.3 

* 

0.0 

* 

- * 

0.0 

- 0.1 

-52-

Fiscal Years 

1991 1992 

TIDillions) 

0.6 

0.3 

* 

* 

0. 1 

- * 

0.0 

0. 1 

0.7 

0. 3 

* 

* 

0. 1 

* 

0.0 

0. 1 

1993 

0.7 

0.3 

* 

* 

0.1 

* 

0.0 

0.2 

Office of Tax Policy 
REVENUE EFFECTS OF PROPOSED LEGISLATION 

' "' "' ' 

REVENUE EFFECTS OF PROPOSED LEGISLATION 

PROPOSAL 

Capital Gains Tax Rate Reduction for Individuals ..........................•.....•.. 

Permanent Research and Experimentation Tax Credit ........................... . 

R&E Expense Allocation Rules .......•................................ ~ .................... . 

Energy Tax Incentives ...........................................................•.•.......•..•• 

Enterprise Zone Tax Incentives ....................................................•.•...... 

Proposed Child Tax Credit and Refundable Child and Dependent 

Care Tax Credit 11 ..............•.....................•.............................•........... 

Deduction for Special Needs Adoption ................................................. .. 

Medical Hospital Insurance (HI) for State and Local 

Employeas .......................................................................... ,. ....•......... 

Repeal of the Airport and Airway Trust Fund Tax Trigger ···············:········ 

Extension of the Communication (Telephone) Excise Tax, .......•.•........•... 

Miscellaneous Proposals Affecting Receipts ......................................... . 

TOTAL REVENUE EFFECTS OF PROPOSALS 

Department of the Treasury 

Office of Tax Analysis 

• = less than $50 million 

1989 I 1990 I 1991 I 1992 I 1993 

0.7 4.8 4.9 3.5 2.2 

-0.4 -0.7 -1.0 -1.2 

-1.7 -0.7 -0.8 -0.9 

-0.3 -0.4 -0.4 -0.5 

-0.2 -0.2 -0.3 -0.4 

-• -• -• -0.1 

-• -• -• -• 

1.8 1.9 1.9 1.9 

0.9 1.6 1.7 1.8 

1.6 2.6 2.8 

-· 0.6 1.2 _Lg 1Jl 

t~~millililHRf~ili~~1~1!!!1l1m1~~:§~~~~11~1%f~~1illi~~g:ill!~!~]l~!~t~l}ktW:§1l{~ill1~iill1~ili~~~Zi~l 

February 9, 1989 

11 Refundable tax credits involving refunds which exceed tax liability are shown as increased outlays. Outlays will increase 

by $0.2 billion in FY90, $1.8 billion in FY91, $2.2 billion in FY92, $2.4 billion in FY93, and $2.8 billion in FY94. 

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