Breaks for Middle Class or Rich? : ‘Fairness’ Issue Foremost in Reconciling of Tax Bills

Only a day after the Senate overwhelmingly passed its tax revision bill last month, Rep. Richard A. Gephardt (D-Mo.) was already on the warpath.

Gephardt, a member of the House Ways and Means Committee who makes no secret of his presidential ambitions, denounced the Senate plan as unfair to the middle class and promised that Democrats would crack down harder on the wealthy. “We want to make a stand,” Gephardt vowed, “on the outcome for the middle-class taxpayer and the lower-middle-income taxpayer.”

Gephardt may get his chance later this month when congressional tax writers try to negotiate a final compromise between the Republican-sponsored Senate version of tax overhaul and the bill passed last year by the Democratic-controlled House. Democrats in the House promise to make the new tax code more “progressive” than the Senate-passed bill, which they argue is too favorable to the rich.

More Myth Than Reality

But that widely shared perception of the Senate tax bill is more myth than reality. The House package, in fact, is more generous to upper-income taxpayers than the Senate plan.

On the surface, the Senate’s maximum tax rate of 27% looks much more attractive to the rich than the 38% top rate approved by the House. At the same time, however, the Senate bill would wipe out two key aspects of the current tax code--the capital gains preference and real estate tax shelters--that enable many wealthy taxpayers to avoid large tax obligations.

“Both bills have their virtues, but you can’t set up the House plan as automatically ‘fairer’ than the Senate version,” said Joseph Minarik, a tax analyst at the Urban Institute. “If you look at what people actually pay, the Senate plan is certainly more progressive than the system we have now.”

By taxing corporations more heavily, the House plan provides a larger average tax cut for the middle class--those earning between $20,000 and $50,000--than the Senate bill. But the House bill also gives a bigger tax reduction to the wealthy, largely because it caps the tax on capital gains at 22% and maintains many of the advantages of tax shelters. Taxpayers in the $100,000 to $200,000 bracket can look forward to an average tax cut of $810 in the Senate bill but $2,049 in the House bill.

House Democrats’ Challenge

The challenge now facing House Democrats, said California Rep. Robert T. Matsui (D-Sacramento), a Ways and Means Committee member, is “to try to regain the high road. We’ve got to press for a little more progressivity in the rate structure so that the middle class realizes that Democrats can look out for their interests, too.”

But in the process of helping the middle class at the expense of the wealthy, the Democrats could find that the peculiar calculus of tax overhaul will force them to restore some of the most valuable tax breaks for the rich.

If they push to raise the top tax rate well above the Senate bill’s 27%, for instance, the political demands to restore a tax preference for capital gains--profits on investments held more than six months--are likely to prove overwhelming. Otherwise, the maximum tax rate on capital gains, now only 20%, could take an unacceptable leap upward.

Senate Democrats already have felt this pressure. When Sen. George J. Mitchell (D-Me.) proposed an amendment on the Senate floor to impose a 35% top rate on high-income taxpayers, he felt compelled to sweeten it by limiting the top rate on capital gains to 27%. His amendment failed despite the sweetener.

IRA Deductions

House Democrats may also try to salvage most of the deduction for individual retirement account contributions, a tax break that is widely considered a middle-class tax preference. The Senate bill would prohibit the IRA deduction for workers covered by employer pension plans, while the House bill would limit the deduction only for those covered by 401(k) retirement plans--a much smaller group.

But the IRA deduction actually most helps wealthy taxpayers. Taxpayers with total incomes above $100,000 received more than four times the average tax savings from IRA deductions than those earning between $30,000 and $50,000 and 30 times the average benefit of those earning less than $30,000.

The capital gains tax break, which the House-passed bill would retain, provides nearly three-quarters of its tax benefit--or more than $27 billion--to the 0.5% of all taxpayers who earn more than $200,000. Similarly, tax shelter benefits of at least $10 billion a year flow almost exclusively to individuals with incomes exceeding $100,000--and, although the House bill trims them, only the Republican-sponsored Senate bill wipes them out.

Democratic Paradox

“The paradox is that many of the Democrats over here are going around pounding the table for benefits that go largely to the well-to-do,” said a Ways and Means Committee aide. “In politics, though, the problem is that perception often becomes more important than reality.”

Senate tax writers hope they can change the perception. “I wouldn’t want to be in the House situation,” a top Senate Finance Committee staff member said. “All we have to do is point out the hypocrisy of their own bill.”

Recognizing the dilemma, Ways and Means Committee Chairman Dan Rostenkowski (D-Ill.) and many other Democrats have begun moving away from the soak-the-rich argument to focus on boosting corporate taxes as a means of financing larger individual tax cuts.

“There’s been a subtle but crucial shift in Democratic rhetoric on this issue,” said Norman Ornstein, a political analyst at the American Enterprise Institute. “Instead of populist attacks on the wealthy who are getting away with murder, the goal has become grabbing money from corporations to target it for the middle class.”

Effect on Business

Indeed, the House tax package hits corporations much harder than the Senate plan. The House boosts taxes on business by about $140 billion over five years, versus a $100-billion increase under the Senate bill. Although the figures are not strictly comparable because they cover different time periods and rely on slightly different economic assumptions, there is no doubt the House plan is tougher on many business tax preferences.

In negotiations with the Senate, House members will focus on tax breaks for defense contractors, the oil industry and natural resource firms that are preserved in the Senate measure. “It’s going to be the middle class versus McDonnell Douglas,” Matsui said. “That’s a no-lose situation for us.”

Senate tax writers, however, have the advantage of championing tax rates much lower than those in the House bill. Although families earning between $75,000 and $185,000 could wind up paying rates of 32% or even higher on some of their income because of complexities in the Senate bill, the nominal top rate of 27% would be the lowest in more than half a century.

Low Rates Called Key

“Low rates are the driving force behind the tax overhaul effort,” Ornstein said. “You don’t win too many political brownie points with income distribution tables.”

Some House Democrats now say they realize that, just as former President Richard M. Nixon was able to open the door to China because no one could call him soft on communism, the bill of the Republican Senate attacks personal tax breaks for the wealthy that Democrats would not dare have touched.

Rostenkowski recently acknowledged that he finds many of the Senate individual tax provisions more “worthy” than the equivalent House provisions. “Every item is open to negotiation,” he said.

Minarik of the Urban Institute said: “The Senate bill just isn’t as vulnerable as some people think on the progressivity issue. I think that’s why most Democrats have not tried to score any points out of it.”

Problem for Democrats

Indeed, the tables may be turned. Because Senate Republicans actually went further than the House in cracking down on tax breaks for the wealthy, it may be difficult for Democrats to extract much partisan advantage out of the maneuvering over the final version of tax overhaul.

“Never in their wildest dreams did the Democrats think the Senate would go so far,” said conservative political analyst Kevin Phillips. “Now, instead of blaming the Republicans in the Senate for killing tax reform, they are scrambling to make sure Democrats get some of the credit, too.”

COMPARING THE TAX CUTS Personal tax cuts under the Senate and House versions of the tax bill in the first year in which they are fully effective--1987 for the House bill and 1988 for the Senate bill.

Senate bill House bill Average change in Average change in after-tax income after-tax income Gross income Percent Amount Percent Amount

$0-10,000 +0.9% +$43 +1.0% +$52 10-20,000 +1.4 +181 +1.5 +208 20-30,000 +0.9 +186 +1.0 +214 30-40,000 +0.4 +129 +1.0 +301 40-50,000 +0.9 +337 +1.2 +442 50-75,000 +0.6 +305 +1.2 +603 75-100,000 +0.9 +564 +1.2 +816 100-200,000 +0.8 +810 +1.9 +2,049 200,000 plus +1.4 +5,892 +1.9 +8,003 Total +0.9 +215 +1.3 +291

Source: Joint Tax Committee