Sunday, March 9, 2003

An analysis published today in the Raleigh News and Observer focuses on how the marital status of a taxpayer, and whether a taxpayer is raising children will impact the amount of taxes he or she pays to the federal treasury.

The report is the third in a four-part analysis by Raleigh securities lawyer Nicholas D. Thomas that examines how the U.S. Income Tax Code affects economic and personal choices we make in our daily lives.

Last week Thomas looked at some of the economic choices -- owning a home versus renting, charitable giving, savings, earnings -- that have significant tax consequences. This week, he looks at how the tax code treats taxpayers differently depending on whether they are married or not and whether they have minor children at home or not.

Marriage Penalties and Bonuses

Thomas says that the so-called "marriage penalty" exists on at least two levels in the income tax code.

First, for taxpayers with modest incomes, the most significant marriage penalty lies in the standard deduction. At present, a single person gets a $4,700 standard deduction, while a married couple gets $7,850. So simply by virtue of being married, two working taxpayers end up paying tax on an additional $1,550.

For taxpaying couples with higher incomes, the marriage penalty grows out of the progressive nature of our tax system. And to understand that, you need to know a bit of tax history.

Before 1969, the tax code treated the income of married couples as if each partner earned half of the income. The problem was that single taxpayers protested. Their complaint: Given the progressive rate structure of the code, a single person earning, say, $50,000 paid more tax on that money than a married couple earning the same amount (because each spouse would be presumed to earn $25,000, which was taxed in a lower bracket).

In 1969, the federal government, in an effort to eliminate the penalty on single taxpayers, responded by creating two separate tax schedules -- one for single taxpayers and one for married couples. That effort, however, backfired and ended up penalizing married couples under certain circumstances.

Under today's code, two married people earning roughly equivalent incomes (assuming those incomes are high enough) suffer a marriage penalty because, simply put, their joint income is taxed at a higher rate than it would be if they were single filing separately.

On the other hand, for those married couples where one spouse earns all or most of the income and the other earns little or none, the post-1969 system provides a marriage "bonus," with the married taxpayer paying less tax than his or her unmarried counterpart. There is a good deal of talk in the current administration about eliminating the tax penalty -- in the form of the lesser-earning spouse being permitted to deduct a certain amount from his or her income but no provision for eliminating the disparity in the standard deduction. But no change has taken place yet.

Therefore, as it stands, except for couples where one partner earns all the income (and a substantial income at that), Thomas says that the code essentially discourages marriage.

Price tag on children

The code has several provisions granting limited favorable treatment for taxpayers with children.

The first is a child tax credit. For the year 2002, it is $600 for families whose income does not exceed $110,000. And that is a credit, not a deduction; it's an amount families can deduct directly from their tax bill.

Second, children can generally be counted as dependents. And for the tax year 2002, each dependent qualifies a taxpayer for a $3,000 "dependency exemption," which represents $3,000 you can deduct from your taxable income.

In addition, taxpayers with modest incomes may be eligible for a dependent-care credit, which reimburses them for a small percentage of the cost of child care. And because children are family members for income tax purposes, their medical expenses, including insurance and orthodontia, may qualify a taxpayer for a medical expense exemption if the family's total medical expenses exceed 7.5 percent of its income.

But, Thomas points out, if the question is whether the code encourages taxpayers to have children, it helps to look at the actual cost of raising children. According to a study by the U.S. Department of Agriculture, using 2001 dollars, it costs low-income families (less than $39,000 per year) between $6,400 and $7,400 per year (depending on age) to raise a child. Middle-income families (up to $65,000 per year) pay between $9,000 and $10,100. Upper-income families (more than $65,000 per year) pay between $13,400 and $14,600.

So even at best, considering the child tax credit and the dependency exemption, the code reimburses parents for no more than 25 percent of the actual cost of raising a child. Considering that most low-income families pay very little income tax, meaning the dependency exemption does them little or no good, the government is reimbursing only about 10 percent of the cost of raising a child.

From these facts, Thomas concludes that while the government does not actively discourage having children, and although it provides some assistance for parents, from an income tax point of view, having children is a highly inefficient economic behavior.

Should you adopt?

In general, once a child is adopted, he or she is treated as a child of the family in question, and the information from the preceding section applies.

So the only real question is whether the code encourages or discourages the act of adoption.

Under current law, adoptive parents with family incomes of less than $150,000 are entitled to a tax credit of up to $10,000 for each child they adopt (before 2002, the figure was $5,000). The credit covers not only the cost of the adoption itself, but also the professional fees and travel expenses involved in the adoption process. Keep in mind this is a credit -- money subtracted from your tax bill -- not just an exemption or deduction.

The actual cost of adoption, both domestic and international, typically ranges between $7,500 and $17,000, plus travel expenses. So the adoption tax credit can cover all or most of the costs of adoption. This is one instance where it seems the code can be said to affirmatively encourage a behavior.