Push to Pop the Tax Bubble Sparks Debate

On its surface, nothing could be more absurd. No matter how much money a highly paid corporate executive makes, his federal income tax rate will never exceed 28%. Meanwhile, a successful university professor with lower earnings of $100,000 a year must pay an extra $330 in taxes for every additional $1,000 he makes on the lecture circuit.

The apparent unfairness of this “bubble” in the tax code, under which families with taxable income between roughly $75,000 and $210,000 face a 33% tax rate on a portion of their income while those earning more pay a flat 28% but lose some of their basic deductions, has become a staple of Democratic political rhetoric in recent years.

“The highest-income people should be paying the highest tax rate, and not the people who are a step below,” said House Speaker Thomas S. Foley (D-Wash.). “In correcting that, we are not creating a new tax.”

Congress created the confusing bubble in the tax code as part of the sweeping 1986 tax revision. It established a “phantom” tax rate of 33% to enable the government to phase out certain tax benefits for the wealthy while keeping the official top income tax rate as low as possible.

Complaints about the disparity get an especially receptive hearing among congressional lawmakers, whose own salaries--and opportunities for lecture fees and other honorariums--make them all but certain victims of the bubble.

In Washington, though, what’s on the surface doesn’t always reflect reality. Democrats have a good case that the tax system has become less progressive in the last decade--but it’s not because of the bubble.

On the contrary, tax experts explain, the bubble was designed to prevent the wealthy from taking advantage of tax benefits available to everyone else, and it actually helps make the current system more taxing for the rich, not less.

“Many people believe--incorrectly--that taxpayers subject to the 33% rate are being treated unfairly compared to higher-income taxpayers whose marginal rate is 28%,” Sen. Bill Bradley (D-N.J.), one of the key architects of tax reform, pointed out in a recent letter to his Senate colleagues. “In fact, the ‘bubble’ does not reward the rich . . . it enhances the tax system’s progressivity.”

This paradox of the historic 1986 tax revision law is at the center of the current budget negotiations between the White House and Congress. Democrats are intent on trying to exact a greater share of taxes from the wealthy after a decade in which the overall tax burden generally was cut far more for the rich than for the poor and middle class. But rather than saying so explicitly, lawmakers prefer to focus the public’s discontent on an all-too-confusing anomaly in the tax code.

As a result, bursting the bubble has become the minimum price that Democrats are demanding for their acceptance of the Bush Administration’s plan to cut taxes on capital gains--the profits that come from the sale of capital investments such as stocks or real estate. That would boost taxes for those with incomes above $200,000, but it also would give it all back--and more--to many of the same people.

Boosting the top rate to 33% for everyone in the upper bracket would raise about $42 billion over five years, taking all the money from the richest 600,000 taxpayers with incomes above $200,000. On the other hand, a capital gains tax cut, while initially generating tax revenues by encouraging investors to sell some of their assets, would provide more than 60% of its tens of billions in benefits to the 1% of families earning more than $200,000, according to congressional tax specialists.

Moreover, tax analysts say, whatever the economic benefits that might flow from reducing tax rates on capital gains, doing so also would heighten presure among the affluent to escape the higher general tax rates by converting ordinary income into investments. In fact, they contend, the perverse result of such a deal could well be to enhance the very unfairness and capriciousness that Democratic lawmakers say they want to overcome.

Why does the bubble exist? To understand the issue, it helps to go back to the unusual political climate in 1986 that made tax revision possible. With Republicans in control of the White House and the Senate and Democrats dominating the House, few people expected a sweeping overhaul of the tax system to succeed.

All but buried in the tax-writing Senate Finance Committee, the tax reform corpse was revived in May, 1986, with a plan by then-Chairman Bob Packwood (R-Ore.) that eventually created only two basic rates--15% for lower-income taxpayers and 28% for upper-income taxpayers. (The old system had involved 14 brackets, culminating in a top rate of 50%.) To keep a fair share of the tax burden on the affluent, however, the Packwood proposal eliminated or pared many of the loopholes used by the wealthy to slash their tax bills under the old system.

But Congress went even further. Keeping the top rate well under 30% was critically important to the Republicans who were backing tax reform. Making sure that more-affluent taxpayers continued to pay a greater percentage of their income than those with lower income was essential to Democrats.

As frequently is the case, the lawmakers settled on a gimmick that accomplished both goals: Wealthier taxpayers would lose the benefit of today’s $2,050 personal exemption and also give up the advantages of the 15% rate on their first $32,450 in income ($19,400 for singles).

The end result is that the richest taxpayers have no personal exemptions and pay a flat 28% on all their taxable income.

To phase out the tax benefits smoothly, the lawmakers saddled taxpayers in lower brackets (with incomes of roughly $75,000 to $210,000 for a family of four and $45,000 to $100,000 for singles) with a 5% surcharge on the portion of their income that falls within the bubble. Those taxpayers pay a higher marginal rate of 33% on part of their income, but they also retain some of the benefits of the personal exemption and the 15% rate, so that their average tax rate is always lower than the maximum 28%.

The bottom line is that the bubble helps ensure that a person’s effective income tax burden still rises with his income, maintaining the modest progressivity of the federal tax system.

“The irony is that the reformers who built more progressivity into the code are now being attacked for doing the right thing,” said Norman Ornstein, a congressional scholar at the American Enterprise Institute here. “But few people understand that this was not some crazy anomaly put in there to give an extra break to the rich.”

Despite all that, the bubble still has become a symbol of unfairness in the tax code. While Republicans would like to leave income tax rates alone in the current budget negotiations, Democrats believe that the bubble provides them the most powerful lever for extracting a tax increase from the well-to-do.

President Bush is determined to lower capital gains tax rates on long-term investments to 20% because he thinks a change would enhance economic growth. Although most congressional Democrats oppose such a rate cut as a giveaway to the rich, many concede that the White House is likely to get its wish.

So now that Bush is prepared to junk the basic trade-off of lower rates for fewer loopholes that was embodied in the 1986 tax revision law, most Democrats see no reason to preserve it, either. The result may be to impose slightly higher tax rates on the rich, while restoring their favorite tax break--a reduction in tax rates for capital gains.

By eliminating many of the tax breaks that invited abuse and kept hordes of tax lawyers busy helping people and corporations minimize their taxes, the 1986 law significantly improved the progressivity of the tax system.

But it was not enough to overcome the regressive impact of the huge 1981 tax cut--which showered most of its benefits on the affluent and corporate shareholders--and the 1983 Social Security changes, which ushered in a wave of payroll tax increases that landed most heavily on middle-income Americans.

Although the White House and congressional Republicans are searching for other ways to tax high-income Americans that might well enhance progressivity--such as imposing a small tax on stock transactions or further paring back the business-meal deduction--the goal of eliminating the bubble remains at the top of the Democratic agenda.

Meanwhile, Byrle M. Abbin, the top tax specialist in the Washington office of Arthur Andersen, the accounting firm, captures the full irony of today’s debate. “The bubble,” he said, “may be the first tax provision ever repealed simply because it was hard to explain why and how it works.”