«OVERTAXING THE WORKING FAMILY: UNCLE SAM AND THE CHILDCARE SQUEEZE Shannon Weeks McCormack* Today, many working parents are caught in a “childcare ...»
Like § 151’s personal-dependency exemption, § 24’s child tax credit phases out for taxpayers at higher income levels; but the child tax credit phases out far more quickly. In 2015, for instance, a married couple filing jointly begins to lose a portion of the credit once income rises above $110,000, and it loses the credit completely once income exceeds $130,000.39 A single parent begins to lose a portion of the credit once income exceeds $75,000, and she loses the credit completely once income exceeds $95,000.40 The purpose of §§ 151 and 24 is to “reduce the individual income tax burden of... families [and]... better recognize the financial responsibilities of raising dependent children.”41 The availability of the tax relief provided by these sections is not tied to actual expenses incurred and does not depend on whether the expenses are related to the caregiver’s work. A different pair of Code sections provides relief to taxpayers who incur childcare costs, which enables them to earn income. As discussed further in Part II, this distinction between nonworking and working childcare expenses is crucial, and providing tax relief for these two types of costs should be viewed as serving entirely distinct purposes.
35. Id.; see also IRS, Publication 501, Exemptions, Standard Deduction, and Filing Information 8 (2014), http://www.irs.gov/pub/irs-pdf/p501.pdf [http://perma.cc/T264B93K] (indicating when a single parent may file for head of household).
36. Taxpayer Relief Act of 1997, Pub. L. No. 105-34, § 101(a), 111 Stat. 788, 796 (codified as amended at I.R.C. § 24(a) (2012)). In the legislative history of the original version of the bill
passed by the House, lawmakers stated:
The Committee believes that the individual income tax structure does not reduce tax liability by enough to reflect a family’s reduced ability to pay taxes as family size increases. In part, this is because over the last 50 years the value of the dependent personal exemption has declined in real terms by over one-third. The Committee believes that a tax credit for families with dependent children will reduce the individual income tax burden of those families, will better recognize the financial responsibilities of raising dependent children, and will promote family values.
H.R. Rep. No. 105-148, at 309–10 (1997).
37. I.R.C. § 24(a) (2012). The original version of § 24 allowed a $500 credit per child.
§ 101(a), 111 Stat. at 796.
38. I.R.C. § 24(c) defines “qualifying child.”
39. See id.
40. See id.
41. H.R. Rep. No. 105-148, at 309–10.
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B. Tax Relief for Working Childcare Expenses
Section 21 of the Internal Revenue Code allows a taxpayer to reduce her taxable income to reflect childcare expenses that “enable [her] to be gainfully employed.”42 The original version of § 21, enacted in 1954, allowed some taxpayers to deduct up to $600 of these working childcare expenses.43 By 1971, the maximum deduction allowed by any taxpayer was $4,800.44 To illustrate, suppose that the Smiths (married and filing jointly) earned $100,000. Imagine also that the Smiths both work and have two very small boys. Therefore, they spend $3,000 per year for day care. The 1971 version of § 21 allowed the Smiths to reduce their taxable income from $100,000 to $97,000. If the Smiths were in a 30% marginal tax bracket, meaning the rate at which the taxpayer’s next dollar of income would be taxed, this would result in a tax savings of $900 (the product of 30% and the $3,000 reduction in taxable income).
Congress, however, was disturbed by the “upside-down-subsidy effect” created by the original § 21.45 That is, because the tax relief for working childcare expenses took the form of a deduction, wealthier taxpayers benefited more than the less well off. In the example above, the Smiths saved $900 in income taxes as a result of the original § 21 deduction because they earned enough to put them in a 30% marginal tax bracket. Suppose, however, that the Smiths only earned enough to be in a 20% marginal tax bracket but still incurred $3,000 in working childcare expenses. In this case, the tax savings from the original § 21’s deduction would be reduced to $600 (the product of 20% and $3,000), resulting in the upside-down-subsidy effect.
The Code provides for many deductions, each of which, as a matter of mathematics, inevitably results in this upside-down-subsidy effect. Congress, however, was apparently particularly disturbed by this effect in the context
42. I.R.C. § 21(b)(2)(A) defines employment-related expenses as:
amounts paid for the following expenses, but only if such expenses are incurred to enable the taxpayer to be gainfully employed for any period for which there are 1 or more
qualifying individuals with respect to the taxpayer:
(i) expenses for household services, and (ii) expenses for the care of a qualifying individual.
Such term shall not include any amount paid for services outside the taxpayer’s household at a camp where the qualifying individual stays overnight.
I.R.C. § 21(b)(2)(A).
43. H.R. Rep. No. 83-1337, at A61 (1954). For a full discussion of the early history of then-section 214 see Alan L. Feld, Deductibility of Expenses for Child Care and Household Services: New Section 214, 27 Tax L. Rev. 415 (1972).
44. I.R.C. § 214(c) (1971) (repealed 1976); S. Rep. No. 94-1236, at 48–51 (1976).
45. See S. Rep. No. 94-938, at 132–33 (1976).
Uncle Sam and the Childcare Squeeze 569 February 2016] of the childcare deduction. Initially, Congress attempted to mitigate this effect by phasing down the deductible expenses allowed as the taxpayer’s income rose.46 But in 1976, Congress responded more directly to the perceived upside-down-subsidy problem and amended § 21, replacing the deduction with a tax credit for a percentage of working childcare expenses.47 The 1976 version of § 21 allowed a taxpayer to claim a credit equal to 20% of childcare expenses that enabled her to be gainfully employed.48 Thus, all taxpayers incurring $3,000 of working childcare expenses (such as the Smiths) could subtract $600 from their tax bill. The original credit, therefore, eliminated the upside-down-subsidy effect created by § 21’s original deduction by allowing all taxpayers to reduce their taxable income by the same percentage of working childcare costs.
In changing the working childcare deduction to a credit, Congress explicitly rejected income-based “phaseouts.”49 First, Congress believed the phaseout was no longer necessary since the upside-down-subsidy effect of the deduction was eliminated.50 Further, Congress thought the phaseout inappropriate because working childcare expenses were “cost[s] of earning income”51 and, therefore, not the type of expenses that should ever be subject to phaseouts, a concept that the Article discusses further at Part IV.52 Nevertheless, in 1981, perhaps having lost sight of § 21’s history, Congress amended that provision to include income phaseouts.53 Currently, a taxpayer—for example, a married couple filing jointly with children, or a single custodial parent—may deduct 35% of working childcare expenses if the taxpayer earns $15,000 or less.54 Once the taxpayer’s income rises above the $15,000 threshold, the percentage of creditable working childcare expenses is reduced. Taxpayers earning over $43,000 may credit only 20% of
46. Specifically, the maximum $4,800 deduction was reduced by one dollar for every two dollars a taxpayer’s income exceeded $35,000. Staff of Joint Comm. on Taxation, 94th Cong., Summary of the Tax Reform Act of 1976 (H.R. 10612, 94th Cong., Public Law 94-455) 20–21 (Comm. Print. 1976).
48. Tax Reform Act of 1976, Pub. L. No. 94-455, § 504(a)(1), 90 Stat. 1520, 1563.
49. S. Rep. No. 94-938, at 133 (“The committee views qualified child care expenses as a cost of earning income and believes that an income ceiling on those entitled to the allowance has minimal revenue impact, if the allowance is in the form of a credit. Therefore, it considers it appropriate and feasible to eliminate the income phaseout and to allow all taxpayers to claim such expenses regardless of their income level.”).
50. Id. at 132 (“One method for extending the allowance of child care expenses to all taxpayers, and not just to itemizers, would be to replace the itemized deduction with a credit against income tax liability for a percentage of qualified expenses. While deductions favor taxpayers in the higher marginal tax brackets, a tax credit provides more help for taxpayers in the lower brackets.”).
51. Id. (“The committee believes that [working childcare] expenses should be viewed as a cost of earning income for which all working taxpayers may make a claim.”).
52. See infra Section IV.A.
53. Economic Recovery Tax Act of 1981, Pub. L. No. 97-34, 95 Stat. 172, 198.
54. I.R.C. § 21(a)(2) (2012).
570 Michigan Law Review [Vol. 114:559 these expenses and the percentage remains at 20% for all income levels exceeding this threshold.55 Considering that in 2014, the poverty level for a family with two children was $23,850,56 these phaseouts are extremely steep.
Further, § 21 was soon amended to include dollar limitations. Currently, creditable working childcare expenses are limited to $3,000 for one child and $6,000 for two or more children.57 Thus, the maximum credit allowed for all taxpayers earning over $43,000 is $1,200 (20% of $6,000). If a taxpayer’s marginal tax rate is 30%, this equates to a $4,000 deduction, compared to the $4,800 deduction allowed by the 1971 version of § 21.58 Congress has, therefore, not only failed to adjust § 21 for inflation—the dollar limitations found in § 21 have not been changed for well over a decade59— but has also allowed today’s version of § 21 to provide working families with a non-indexed dollar tax savings that is less than the non-indexed savings allowed four decades ago. It is, therefore, not particularly surprising that § 21 allows working families tax relief for only a small fraction of the childcare costs they actually incur. Part II explores this reality in greater detail.
Before proceeding to that discussion, however, an additional section of the Code provides another method parents may use to reduce their taxable income to reflect working childcare costs. In 1981, Congress added what is now § 129 to the Code.60 While § 21 provides tax relief to taxpayers who directly incur working childcare expenses, § 129 provides tax relief to taxpayers who, as a result of their employment, receive childcare services or other benefits that lessen the costs of childcare.61 For instance, an employer might provide its employees on-site day care for free or at a discounted cost. Ordinarily, the fair-market value of those services (or the value of the discount) would be included in the taxpayer’s income.62 Section 129, however, allows taxpayers to exclude up to $5,000
55. See id.
56. 2014 Poverty Guidelines, 79 Fed. Reg. 3593, 3593 (Jan. 22, 2014), http://www.gpo.gov/fdsys/pkg/FR-2014-01-22/pdf/2014-01303.pdf [http://perma.cc/K5NQ-CNQA].
57. I.R.C. § 21(c).
58. A deduction reduces a taxpayer’s taxable income, which is then used to calculate the taxpayer’s tax liability using applicable tax rates. If a taxpayer is in a 30% marginal tax rate— that is, his next dollar of income will be taxed at a rate of 30%—a $4,000 reduction in his taxable income will result in a tax savings of $1,200 (30% of the $4,000). Thus, a $1,200 credit (which provides a dollar-for-dollar reduction from tax liability) produces the same tax savings as a $4,000 deduction.
59. In 2001, the limits were adjusted to their current levels. See Economic Growth and Tax Relief Reconciliation Act of 2001, Pub. L. No. 107-16, 115 Stat. 38, 49.
60. Economic Recovery Tax Act of 1981, Pub. L. No. 97-34, 95 Stat. 172, 199–200 (codified as amended at I.R.C. § 129).
61. Compare I.R.C. § 21, with I.R.C. § 129.
62. 26 C.F.R. § 1.61-2(d)(1) (2015) (“If services are paid for in exchange for other services, the fair market value of such other services taken in payment must be included in income as compensation.”).
Uncle Sam and the Childcare Squeeze 571 February 2016] worth of employer-provided dependent-care assistance—for example, employer-provided childcare—from their taxable income.63 Section 129 also allows an employer to establish dependent-care flexible-spending accounts (FSAs), into which employees may divert up to $5,000 of their earnings free from taxation, so long as those funds are used to cover working childcare costs.64 To illustrate, recall the Smith family discussed above. Suppose that rather than paying $3,000 directly to their sons’ day care, the Smiths decide to take advantage of their employer’s dependent-care flexible-spending plan and set aside $3,000 of their $30,000 earnings. Section 129 allows the Smiths to exclude that “earmarked” $3,000, reducing their taxable income to $27,000. If the Smiths are in a 30% marginal tax bracket, this results in a $900 tax savings (the product of 30% and $3,000).
Unlike § 21, § 129 does not provide phaseouts and does not change dollar limitations based on number of children. But like § 21, the dollar limitations provided in § 129 are likely to represent only a small fraction of the childcare costs incurred by working families.
Several things are worth noting before discussing the currently high cost of childcare. First, § 129 inevitably results in the upside-down-subsidy effect Congress attempted to eliminate in 1976 when it changed the mechanism of tax relief provided in § 21 from a deduction to a percentage credit.65 While the Smiths, who are presumptively in a 30% marginal tax bracket, will enjoy $900 in tax savings as a result of excluding the $3,000 set aside in the dependent-care FSA, a taxpayer who earns only enough to be in a 20% marginal tax bracket will enjoy a lesser $600 savings from setting aside the same amount.