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Wednesday, May 4, 2011

Deficit Reduction: The Economic and Tax Revenue Effects of Personal Exemption Phaseout (PEP) and Limitation on Itemized Deductions (Pease)

Thomas L. Hungerford
Specialist in Public Finance

The Omnibus Budget Reconciliation Act of 1990 (OBRA90; P.L. 101-508) created two provisions, the personal exemption phaseout (PEP) and the limitation on itemized deductions (often called “Pease”), that raised taxes on high-income taxpayers. Many observers complained that these provisions were nothing more than a “back door” tax rate increase. A decade later, the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA; P.L. 107-16) was enacted (part of what became known as the “Bush tax cuts”), which included the phased-in repeal of both PEP and Pease between 2006 and 2009. PEP and Pease were completely eliminated in 2010. Both tax provisions, however, were to be reinstituted beginning with the 2011 tax year, but the reintroduction was postponed until the 2013 tax year by the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (P.L. 111-312). The projected revenue loss of the two-year postponement is $20.7 billion.

In the debate over the fate of the Bush tax cuts (leading up to the passage of P.L. 111-312), most Members of Congress took one of two positions: allowing the Bush tax cuts to expire for the richest 2% or 3% of taxpayers or permanently extending all of the Bush tax cuts. It is possible that similar positions will be staked out in 2012 as the expiration of the Bush tax cuts (including the reintroduction of PEP and Pease) nears and congressional debate heats up. Tax policy is currently being discussed in debates over deficit reduction. In the FY2012 budget submission, the Obama Administration proposes allowing the Bush tax cuts to expire for high-income taxpayers after 2012; the proposal of Representative Paul Ryan of the House Budget Committee, the Path to Prosperity, proposes to reduce tax rates and broaden the tax base.

Various criteria have been offered for determining a good tax system, including simplicity, equity, and efficiency. The issues associated with PEP and Pease are how these two tax provisions affect the tax system in meeting these criteria. PEP and Pease affect the tax system along three dimensions. The first is the effect on the complexity of the tax code. The second is how economic efficiency is affected. Last is the effect PEP and Pease have on equity.

The reintroduction of PEP and Pease could increase tax revenues by about $10 billion per year. Both tax provisions, however, have been referred to as back door tax rate increases on higherincome taxpayers that do not appear on any tax table. While these provisions would somewhat increase the complexity of the individual income tax, the burden of this complexity would be eased by the use of paid tax preparers and tax preparation software. These provisions could distort economic decision making, but any distortions would likely be relatively small. PEP and Pease would slightly reduce income inequality, but could affect taxpayers with children more than taxpayers without children, and thus could be perceived as unfair.

Date of Report: April 29, 2011
Number of Pages: 13
Order Number: R41796
Price: $29.95

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