«OVERTAXING THE WORKING FAMILY: UNCLE SAM AND THE CHILDCARE SQUEEZE Shannon Weeks McCormack* Today, many working parents are caught in a “childcare ...»
204. Staff of U.S. Dep’t of the Treasury & Joint Comm. on Internal Revenue Taxation, 93rd Cong., Estimates of Federal Tax Expenditures 5 (Comm. Print 1973).
205. In explaining reasons for repealing the credit, the proposal explains “[t]he dependent care credit is complex and overlaps with other tax provisions that provide tax benefits for families” and that “[c]onsolidating redundant and complex family tax benefits, such as the dependent care credit, into an increased child credit and standard deduction would result in significant simplification.” Comm. on Ways & Means Majority Tax Staff, 113th Cong., Tax Reform Act of 2014 Discussion Draft 13 (Comm. Print. 2014). This reflects a fundamental misunderstanding of the tax laws. As discussed in Part I, tax relief for working expenses and nonworking expenses serve entirely different purposes in the tax law.
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B. A Blueprint for Enacting Meaningful Reform
Congress should do five things to reform the tax laws so that working childcare costs are treated like other costs of earning income.
First, lawmakers should replace the percentage credit in § 21 with a deduction. In general, the law allows taxpayers to deduct (not credit) the costs of earning income.206 Thus, § 21’s percentage credit mechanism stands working childcare costs apart from other costs of earning income and seems to invite misunderstanding by lawmakers who may assume that the credit (like many other credits) serves nontax related purposes.207 As discussed, this misconception may partially explain why the dollar limitations found in § 21 have not been changed for well over a decade.208 Thus, treating working childcare expenses the same as other costs of earning income, in addition to promoting consistency in the Code, would provide an important and apparently needed signal to Congress that these costs cannot be repealed without compromising the accurate calculation of net income.
Second, the proposed deduction for working childcare costs should be an “above-the-line” deduction used to calculate a taxpayer’s adjusted gross income (AGI) (an essential figure needed to calculate one’s tax liability that will be discussed below). There are two types of deductions in the tax law, colloquially referred to as “above-the-line” and “below-the-line” deductions.
Generally, consumptive personal expenditures fall below the line and do not reduce a taxpayer’s AGI.209 By contrast, most expenses that are “ordinary and necessary” to one’s trade or business, such as business-related moving expenses210 and meal and entertainment expenses,211 to which working childcare costs can easily be analogized, may be deducted above the line,212 thereby reducing a taxpayer’s AGI.
206. Compare supra Section II.B (discussing the tax law’s tendency—and need—to allow taxpayers to deduct the cost of doing business from the calculation of their income), with supra Section II.A (explaining why purely consumptive expenses are generally not deductible).
207. See supra note 182 (discussing credits with nontax related goals).
208. See supra notes 53–59 and accompanying text.
209. See I.R.C. § 62(a) (2012) (listing above-the-line deductions and not including most personal deductions). But see id. § 62(a)(10) (allowing alimony, a purely personal expense, to be deducted above the line).
210. Id. §§ 62(a)(15), 217.
211. Id. §§ 62(a)(1), 162(a).
212. Unreimbursed expenses incurred by an employee fall “below the line,” under § 62(a)(2)(A), in order to subject him to certain limitations that are inapplicable to above-theline deductions. Id. § 62(a)(2)(A). Thus, to the extent an employee incurs deductible expenses that are not reimbursed under his employer’s reimbursement plan, those expenses will not be used to calculate adjusted gross income. Id. This likely reflects skepticism that employee expenses that an employer is unwilling to reimburse are truly nonconsumptive expenditures.
Clearly, this reasoning in no way implicates the working childcare deduction, and it would be patently absurd to allow parents engaged in their own trade or businesses (for example, the solo law practice) to deduct working childcare costs above the line while having employeeparents (like lawyers working for a law firm) deduct costs below the line.
Uncle Sam and the Childcare Squeeze 599 February 2016] “Above-the-line” deductions also include a somewhat motley assortment of other costs such as certain expenses of performing artists,213 elementary and secondary school teachers,214 and alimony.215 While a coherent theory for determining what expenses should be used to calculate AGI seems lacking from this list, one can form a better opinion of how working childcare expenses should be characterized by considering the importance of the AGI amount. AGI is calculated by subtracting above-the-line deductions from one’s gross income.216 AGI, in turn, determines the extent to which the personal exemption amount,217 various “below-the-line” deductions, and credits218 may be claimed to reduce one’s tax liability. In most instances, as one’s AGI increases, one’s ability to claim these tax reductions decreases.219 For example, a taxpayer may deduct medical expenses and casualty losses to personal property caused by fire, storm, or other unexpected events to the extent that each of these expenses or losses exceeds 10 percent of his AGI.220 The higher his AGI, the higher the floor.
It is essential that taxpayers be allowed to reduce their AGI to reflect working childcare expenses. As this Article shows, because parents may only deduct a fraction of their working childcare costs, their income is overstated.
By failing to allow any of these costs to reduce adjusted gross income (at least those that are directly incurred, as opposed to diverted through a dependent-care FSA), working parents will also be entitled to deduct fewer below-the-line costs than similarly situated families that do not require childcare, further exacerbating the problem.
Consider, for instance, Families A, B, and C and suppose the following:
Mrs. A earns $150,000 each year while Mr. A cares for their two small children; both Mr. and Mrs. B together earn $170,000 and directly pay a day care $20,000 to care for their children while they work, entitling them to § 21’s percentage credit; and Mr. and Mrs. C collectively earn $170,000 but divert the $20,000 they need for childcare to a dependent-care FSA, entitling them to § 129’s exclusion. Suppose finally that each of these families incurs $25,000 of medical expenses and suffers a $20,000 casualty loss, each which
213. Id. § 62(a)(2)(B).
214. Id. § 62(a)(2)(D).
215. Id. § 62 (a)(10).
216. Id. § 62(a) (defining AGI).
217. Id. § 151(d)(3) (providing phaseout of the personal exemption amount based on AGI). For a discussion of the personal exemption, see supra Section I.A.
218. See, e.g., id. §§ 21, 24 (providing credits that phase out based on AGI).
219. See, e.g., id. § 67(a) (creating overall limitation that certain below-the-line deductions may be claimed only to the extent they exceed 2 percent of AGI); id. § 68 (creating an overall limitation on ability to claim most personal deductions based on AGI); id. § 165(c), (h) (providing deduction for casualty losses to the extent expenses exceed 10 percent of AGI); id.
§ 213(a) (providing deduction for medical expenses to the extent expenses exceed 10 percent of AGI). But see id. § 170 (providing that charitable contributions may be deducted up to a 50 percent of AGI ceiling, thus allowing wealthier taxpayers to deduct more than less well-off taxpayers).
220. See, e.g., id. §§ 165(c), (h), 213(a).
600 Michigan Law Review [Vol. 114:559 may be deducted to the extent the expenses or losses exceed 10 percent of the taxpayer’s AGI.
After childcare costs are paid, each family has $150,000 income at their disposal. Nonetheless, each taxpayer’s adjusted gross income will be different. Family A will have adjusted gross income of $150,000, which seems to correctly reflect net income. B will have adjusted gross income of $170,000 because working childcare expenses may not be deducted above the line.
And C will have adjusted gross income of $165,000 because $5,000 of the expenses diverted to the FSA may be excluded under § 129.221 As a result, the extent to which each of these similarly situated families may claim the “below-the-line” medical and casualty loss deductions will be different, as will each family’s final tax liability. The following chart quantifies these
221. Id. § 129(a).
222. A few notes about Table 1: The numbers are based on 2015 tax rates, and the Table assumes a $4,000 personal exemption amount. See Rev. Proc. 2014-61, 2014-47 I.R.B., 866, http://www.irs.gov/pub/irs-irbs/irb14-47.pdf [http://perma.cc/9ZDP-LPVZ].
While Family C has earned $170,000, it has diverted $20,000 into an FSA. Section 129 allows it to exclude $5,000 of that amount, bringing its gross income down to $165,000. I.R.C.
The child tax credit, discussed supra in Section I.A., will be completely phased out for each of these taxpayers. See id. § 24(a)–(b).
Family C receives a $200 credit as a result of the interplay between §§ 129 and 21.
Because § 129 only allows taxpayers to exclude $5,000 but § 21 allows a credit up to $6,000 in Uncle Sam and the Childcare Squeeze 601 February 2016] As this example illustrates, the tax liabilities of working Families B and C are over 20 percent higher than the tax liability of single-earner Family A, even though each of these families has the same disposable income after accounting for working childcare costs. This chasm is, of course, created largely by the working families’ inability to reduce their taxable incomes to reflect most of their childcare costs. But this chart also shows how the failure to allow deductions above the line whittles away other deductions. For instance, Family B’s medical and casualty loss deductions are, respectively, 20 percent and 40 percent lower than that of Family A. This disparity can be corrected by allowing deductions for working childcare costs to fall above the line.
Finally, transforming the percentage credit to an above-the-line deduction would enable the relief provided by § 21 to be equated with the relief provided by § 129’s FSA exclusion and eliminate the strange situation in which Family B is taxed more than Family C, despite being in economically identical positions. As a result, § 129’s FSA exclusion would be rendered duplicative of the new deduction and could be omitted to simplify the current system.223 Third, the new deduction should not phase out. As discussed in Section I.B.1, § 21’s credit “phases out” as income levels rise. But the Code does not phase out deductions for costs of earning income because to do so would be to misunderstand the reason behind allowing these deductions—namely, to accurately measure a taxpayer’s net income. One cannot phase out a deduction based on income level when that deduction is needed to accurately calculate income in the first place.
Nor is a phaseout appropriate to limit the upside-down-subsidy effect, discussed in Part I.B, which occurs as a result of a deduction. While it is a worthy goal to temper this effect when caused by deductions of purely consumptive expenses, it cannot be modified for costs of earning income, at least so long as the United States continues to (as it always has) tax net income progressively. Put differently, deductions for the cost of earning income will inevitably result in the greatest tax savings for taxpayers in the highest marginal tax brackets; but these deductions cannot be altered because they are needed to calculate net income. Comparing the richer widget salesman to the struggling one, the former will receive more value when he deducts the costs of widget parts, for traveling to widget conventions, and for taking potential widget purchasers to lunch. There is no reason to be more concerned about this fact in the context of working childcare costs.
Fourth, the proposed deduction should not include the “earned income limitation” found in both §§ 21 and 129. Currently, §§ 21 and 129 provide that a single taxpayer may not credit expenses that exceed her taxable income for the year and that a couple filing jointly may not credit or exclude expenses, Family C may claim the additional $1,000 as a percentage credit. Because the phased down percentage is 20%, a credit of $200 is allowed. See id. §§ 21, 129.
223. Specifically Code § 129 could be revised to apply only to in-kind benefits, such as when an employer provides employees discounted on-site day care.
602 Michigan Law Review [Vol. 114:559 expenses that exceed the income of the lowest wage earner.224 To illustrate, suppose Harry earned $100,000 this year while Sally earned $5,000, incurring $6,000 in working childcare expenses. Although the dollar limitations of § 21 would allow a percentage credit for $6,000 of expenses,225 Harry and Sally, assuming they are married and filing jointly, are limited to a percentage credit of $5,000 expenses, Sally’s salary. The rationale is probably that the tax law should only encourage taxpayers to work outside the home when that work will enhance efficiency, apparently defined as work that produces annual income exceeding the annual cost of childcare. But this rationale is shortsighted. Even small resume gaps can drastically hinder the ability of an individual to return to the workforce.226 At the same time, infant and preschool care is by far the most expensive care.227 Thus, a nonprimary wage earner caring for an infant or preschool-aged child might rationally choose to work in a position that does not cover her current childcare costs in order to preserve future earning capacity. The Code’s judgment that this represents inefficient behavior is shortsighted.