Under normal income tax rules, the interest earnings of savings accounts are fully taxable each year. The absence of that annual tax is one of the tax advantages for employer pensions and individual retirement accounts (IRAs). Instituting a tax at a low rate on the earnings of pension funds and IRAS would reduce the size of that advantage. A 5 percent tax rate would raise about $75 billion between 1997 and 2002. (The other tax advantage of pensions and IRAS is the deferral of tax on contributions until retirement, when an employee's marginal tax rate is often lower.)

The tax advantages for pensions and IRAs encourage firms and workers to provide for retirement. Most studies of pensions find that they increase saving; the studies of IRAS are less conclusive. Although the tax advantages promote a public objective, many people receive little or no benefit from them. In 1993, for example, 47 percent of workers neither participated in a pension plan nor contributed to an IRA. The largest pension benefits go to higherpaid workers or to workers with long-term employment at large firms.

Imposing a tax at a low rate on pension and IRA earnings would reduce the tax advantage of saving for retirement through those vehicles. Such a tax would reduce the use of pensions and IRAs and probably result in less retirement saving. The smaller tax advantage for pensions and IRAs would, however, make the tax burden of employees with pensions and IRAS and those without them slightly more equal. It

would also increase taxes relatively more for higherpaid workers.

Taxing pension and IRA earnings would affect more taxpayers than would setting lower limits on employer contributions to pension plans (see REV12). Lowering the contribution limits would increase taxes on a small number of the highest-paid workers and raise taxes substantially for some of them. Taxing pension and IRA earnings would affect workers throughout the income distribution. Moreover, because it would affect so many more workers, it could raise more revenue with a smaller impact for each employee who pays more tax.

Taxing the annual earnings of pension funds and IRAS would encourage fund managers to shift their investments from assets that yield income toward assets that appreciate in value, such as growth stocks and real estate, because they can defer tax on capital gains until realization (see REV-24). To obtain that tax deferral, however, pension funds would have to invest in riskier assets. Although that portfolio shift would reduce the security of workers' retirement funds, it would make it easier for risky enterprises to obtain funding.

In the vetoed Balanced Budget Act of 1995, the Congress proposed to expand access to IRAs and broaden their use beyond retirement saving. Taxing the investment income of IRAs runs counter to the objective of expanding IRA use, but it would also mitigate the revenue loss from such an expansion.

tax.

Under current law, a taxpayer first calculates his or her combined income, which is the sum of adjusted gross income (AGI), nontaxable interest income, and one-half of Social Security and Tier I benefits. If a taxpayer's combined income exceeds a fixed threshold, he or she includes a fraction of benefits in AGI. The thresholds at which up to 50 percent of benefits are subject to tax are $25,000 for single returns and $32,000 for joint returns. The Omnibus Budget Reconciliation Act of 1993 (OBRA-93) imposed a second set of thresholds, $34,000 (single) and $44,000 (joint), above which up to 85 percent of benefits become subject to tax. The additional revenues from the higher thresholds go to the Medicare trust fund, whereas all other revenues from taxing Social Security benefits go to the Social Security retirement and disability trust funds.

About 23 percent of households receiving Social Security pay income tax on some portion of their benefits, and about one-third of those households pay tax on 85 percent of their benefits. Because the thresholds remain fixed over time, as nominal incomes increase, the percentage of households that

pay tax on benefits will grow to 31 percent in 2002. Bills to remove the 85 percent rate were proposed in 1995 but not enacted.

The first option would eliminate the income thresholds entirely and would require all beneficiaries to include 85 percent of their benefits in their adjusted gross income. It would raise $137 billion from 1997 through 2002. Eliminating the income thresholds would cause many more, but not all, Social Security recipients to pay income tax on their benefits. In addition to the thresholds, the tax code through personal exemptions, the regular standard deduction, and an additional standard deduction for the elderly protects the income of lower-income elderly households from being taxed. Eliminating the thresholds on taxing benefits would triple the share of couples and individuals paying tax on their benefits from the current 23 percent to 69 percent.

Eliminating the thresholds would reduce tax disparities among middle-income households. Social Security beneficiaries receive a tax preference not available to other taxpayers because they can exclude a portion of their income--Social Security benefits below the thresholds--from AGI. As a result, the average income tax rate that middle-income elderly

families pay is less than the tax rate that nonelderly families with comparable income pay under current law.

The second option would not change the treatment of couples with combined income above $44,000 and individuals with combined income above $34,000--they would still be taxed on up to 85 percent of their benefits--but it would require all other recipients to include 50 percent of benefits in their adjusted gross income. That option would raise $68 billion from 1997 through 2002. Couples with combined income below $32,000 and individuals with combined income below $25,000 would be added to the beneficiaries whose benefits are subject to tax. Almost all beneficiaries currently taxed on up to 50 percent of their benefits--couples with combined income between $32,000 and $44,000 and individuals with combined income between $25,000 and $34,000--would be unaffected. (Because the taxation of benefits is phased in under current law, some couples with combined income just above $32,000 and singles with income just above $25,000 are now taxed on less than a full 50 percent of their benefits.)

The final option would keep the current-law income threshold of $32,000 for couples and $25,000 for individuals, while including up to 85 percent of benefits for all taxpayers above that threshold. The option would raise $5.5 billion from 1997 through 2002. It would, moreover, almost exclusively affect couples with modified income between $32,000 and $44,000, and individuals with income between $25,000 and $34,000.

Increasing the percentage of benefits that are taxable from 50 percent to 85 percent would make the treatment of Social Security roughly similar to that of contributory pension plans. Workers receiving bene

fits from contributory plans pay income tax on the excess of benefits over their own contributions. Social Security actuaries estimate that among workers now entering the labor force, employee-paid payroll taxes will represent 15 percent of expected benefits for high-earning, unmarried workers and a lower percentage for all other workers. Thus, 85 percent is the minimum fraction of benefits in excess of past contributions. However, a lower rate might be appropriate for two reasons. First, benefits will have to be cut or taxes raised at some point in the future to restore the long-run balance of Social Security. Either change would raise taxes as a share of benefits above 15 percent for some workers. Second, keeping the inclusion rate at 50 percent would make the treatment of Social Security equivalent in terms of present value to that of noncontributory pensions, the more common form of pension.

Increasing the tax on benefits would reduce the net benefits of retirees compared with what some people consider to be the implicit promises of the Social Security and Railroad Retirement programs at the time recipients were working. The government has, however, made numerous changes in the Social Security and Railroad Retirement programs over time, including changing the benefit formula, introducing partial taxation of benefits, and raising payroll tax rates to finance the programs.

Increased taxation of Social Security benefits is one way to apply a means test to those benefits. As an alternative to expanding taxation, the government can reduce benefits from those programs by changing the benefit formula (see ENT-39 through ENT-42), reducing cost-of-living adjustments (see ENT-48), or including benefits in a broadly based means test of multiple entitlement programs (see ENT-49).

Life insurance policies often combine features of both insurance and tax-favored savings accounts. In the early years of whole life insurance and similar policies, annual premiums exceed the annual cost of insurance. As the excess premiums accumulate, they earn investment income, which is then available to pay the cost of future insurance, provide part of a death benefit, or provide a disbursement to the policyholder if the policy is voluntarily canceled.

The investment income, sometimes called "inside buildup," receives special tax treatment under current law compared with the interest income from other investments. It is exempt from taxation when used to pay the cost of future life insurance. It is also taxexempt to the beneficiary or, with some tax planning, to the estate of the insured person when it is paid as part of a death benefit. The accumulated investment income is taxable to the policyholder when he or she voluntarily cancels a policy and receives a disbursement. Even when the investment income is ultimately taxable, however, the tax deferral can be favorable to the policyholder. The interest income from other investments, such as taxable bonds, is subject to tax as it accrues, even when interest is not paid to the investor until the bond matures.

Life insurance companies also sell annuities, which likewise have features of both insurance and tax-favored savings accounts. Life annuities promise periodic payments to the annuitant as long as he or she lives. Those payments provide insurance against the possibility that the annuitant will outlive his or her assets. By nature, however, annuities are also saving vehicles because annuity premiums are paid in return for annuity benefits received at a later date. Because premiums are often paid long before benefits are received, the benefits must include a return on

investment in order for an annuity to be financially attractive.

For tax purposes, annuity benefits are divided into two parts--a return of principal and investment income. Only the investment income is subject to tax. Although investment income accrues over the life of a contract, it is not included in taxable income until benefits are paid. As with whole life insurance and other similar policies, such tax deferral can increase the after-tax return to the investor significantly compared with alternative investments such as taxable bonds and certificates of deposit from which interest income is taxable as it accrues.

Tax Investment Income Annually. Under this option, policyholders would include the investment income from life insurance policies and annuities in taxable income as it accrued. Insurance companies would report the accrued investment income to a policyholder or annuitant annually. Life insurance disbursements and annuity benefits would no longer be taxable as they were paid. Making the investment income taxable in that way would raise about $95 billion in 1997 through 2002. Investment income from annuities purchased as part of a qualified pension plan or qualified individual retirement account would still be tax-deferred until benefits were paid.

Taxing the investment income from life insurance and annuities would equalize their tax treatment with the tax treatment of similar investments. The investment income from life insurance and annuities is tax-deferred, but the income from an ordinary savings account or taxable bond is taxed as it accrues. Alternatively, the tax deferral for life insurance and annuities is consistent with the tax deferral currently allowed for capital gains income.