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Article Excerpt
INTRODUCTION
There is a good chance that the "Brady Bunch" would not pay income taxes even though they have the wherewithal to hire a housekeeper. The exempt level for a married couple with six children who itemize deductions at a rate of 22 percent of income was approximately $90,000 for 2005.
The contours of our tax system with respect to families of different sizes have changed dramatically in the past 15 years. Child credits and the larger earned income credit (EIC) have significantly reduced taxes, or magnified negative tax rates, for lower and moderate income families with children. The growing Alternative Minimum Tax (AMT) has, at the same time, affected families with children in a way perhaps not originally intended. It will do so to a greater extent, absent change, as time goes on. These changes have taken place without, apparently, appealing to standards of horizontal equity--hence, our characterization of this issue as an orphan child. Is our resulting tax system reasonably equitable across family types? And if not, what structural changes would be needed to make it more equitable? Those questions are the object of this paper.
HORIZONTAL EQUITY ACROSS FAMILIES
Horizontal equity suggests that equals before tax should be equals after tax, or, alternatively, that equals should have the same effective tax rates.
One way of measuring equals is through utility analysis. Such an approach is not possible to implement, but it may suggest that when people choose to have children, their costs are compensated by the increase in utility from doing so through the consumption or investment value of their children. In the case of viewing children as consumption, no exemptions, credits or other tax adjustments should be allowed. In the case of viewing children as an investment, income from support by children in old age should be taxed, but a recovery of costs should be allowed. One can extend this argument to the decision to marry as well, although the utility measure is complicated by competing models of marriage, including bargaining models.
Aside from the difficultly in implementing a utility-based measure, such a measure suffers from another problem. Treating children as consumption does not place any weight on the utility of the children. Even from the point of view of the adults, the utility of having children is uncertain. One may have a dutiful child or a "bad seed." Moreover, couples do not have complete control over having children or over marriage and divorce.
We consider instead an ability-to-pay approach. In this approach, families that have the same standard of living should pay the same effective tax rate. Determining equality must adjust for at least two factors. First, children may not require a different expenditure from adults. For example, they may need less food. Second, there are public goods aspects of family consumption as well as economies of scale in home production. For example, additional family members can share kitchens and other common living areas, the family car, telephone service, and entertainment devices.
Such effects have long been recognized in the formulation of equivalence scales for measuring the poverty lines. We adopt such an approach in our analysis. In particular, we use an equivalence index of the form: [(A + PK).sup.e], where A is the number of adults, K is the number of children, P is the ratio of expenditures on a child to that of an adult, and e < 1 is the measure of public goods or scale economies in the household.
For a single adult, [A.sup.e] = 1. If e = 0, all families with the same income should be taxed at the same rate, as all goods are public. If P = 1 and e = 1, a family of four needs four times the income of a family of one, the two families should face the same tax rate, and the exemptions and rate brackets should be four times as large for a family of four as for a family of one. This latter case suggests full income splitting among all family members. The right answer lies in between these measures. If P = 1 and e = 0.5, a family of four needs twice as much income as a family of one. If P = 0.5 and e = 0.5, a married couple with two children needs 173 percent of the income of a family of one.
Our analysis sets both P and e at 0.7 (a married couple with two children needs 235 percent of the income of a family of one), following the estimates in Citro and Michael (1995). At the end of the paper we consider sensitivity analysis.
IMPORTANT FEATURES OF THE TAX STRUCTURE
We cannot consider all of the many features of the tax code that determine tax liability, but rather focus on the main structural features that are relevant to differential treatment of families. These include personal exemptions; standard or itemized deductions; the rate structures for single, head-of-household, and joint returns; the EIC; the child credit; and the AMT. In later sections we also consider the dependent care credit and the benefit of no tax on the additional home production of a non-working spouse. We do not consider the flat rate taxes on capital gains and dividends since rates at the higher income levels where these forms of income are important converge. All calculations are for 2005.
PHILOSOPHIES THAT DRIVE THE DEVELOPMENT OF TAX FEATURES
Potential inequities across family types derive from the objectives of vertical equity, or a progressive tax system, a welfare philosophy, marriage incentives, and other behavioral incentives.
A flat rate tax would tax all families of all incomes at the same rate. Some differences across families are accounted for in basic features of the income tax, which allow personal exemptions and standard deductions that vary across family types and sizes, as well as different rate structures for single, head-of-household and joint returns. Other aspects of the tax code that are driven by vertical equity objectives are the phaseout of personal exemptions, itemized deductions, earned income credits, child credits, dependent care credits, and the AMT, which applies only at higher income levels.
The second feature of the system appears to derive from philosophies underlying the welfare system. Cash assistance in the U.S. welfare system is directed to only certain individuals reflecting an inability to work: dependent children, and the elderly and disabled. When the EIC, a negative income tax, was adopted, it followed this welfare philosophy by initially allowing only benefits for families with children, although all of the families receiving the credit are working families.
It is not clear why this dependency philosophy was applied rather than allowing benefits reflecting needs. Hoffman and Seidman (2003) cite several reasons, but the initial enactment of the EIC in 1975 was done with virtually no debate or notice. One of the rationales advanced for the EIC was to relieve payroll taxes, suggesting benefits should be provided for all workers. Perhaps a more important initial reason for restricting the EIC to families with children was to encourage these families to exit from the welfare system or offer an alternative to welfare expansion, although this argument might suggest the benefit be limited to single parents. Another possible reason was to avoid providing benefits for dependents whose family incomes may be large, students, or for retired individuals with small earnings and income relative to wealth. In 1993, when the credit was increased substantially, a small credit was allowed for families without children, and the targeting...
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