FEDERAL TAXPAYER RELIEF ACT OF 1997
by
Jay Wortley, Senior Economist
March 1998
ACKNOWLEDGMENTS

This report was written by Jay Wortley, Senior Economist for the Senate Fiscal Agency. Karen Hendrick word processed and formatted the report for publication.

 
TABLE OF CONTENTS

INTRODUCTION

 
MAJOR TAX REDUCTIONS

MAJOR TAX INCREASES

 
IMPACT ON MICHIGAN TAXES

INTRODUCTION

In the summer of 1997, the Congress passed and the President signed into law the Taxpayer Relief Act (TRA) of 1997. This Act contains many tax cuts for both individuals and businesses. Some of the major tax cuts aimed at individuals include a new child tax credit, expansion of individual retirement accounts (IRAs), lower tax rates on certain capital gains, an increase in the threshold exemption for the estate tax, and creation of education expense tax credits. Some of the more significant tax cuts for businesses include elimination of the alternative minimum tax (AMT) for small corporations, and a reduction in the AMT for other corporations and farmers. These tax decreases were offset in part by some tax increases including extending and modifying the various Federal air transportation excise taxes and increasing the Federal cigarette tax by 10 cents per pack beginning in 2000.

These and other key provisions of the Taxpayer Relief Act of 1997 are described below, along with their overall fiscal impact on Federal revenues. In addition, estimates of the potential impact these Federal changes will have on Michigan's tax revenue are also presented.

Overall Fiscal Impact

According to estimates from the Congressional Budget Office (CBO) and the Joint Committee on Taxation (JCT), the various tax changes contained in the TRA of 1997 will have the following fiscal impacts over the 10-year period from fiscal year (FY) 1997-98 to FY 2006-07:

Table 1 summarizes the estimated impact the Taxpayers Relief Act of 1997 will have on Federal government revenues during each of the next 10 years.
 
Table 1
FEDERAL TAXPAYER RELIEF ACT OF 1997 
NET REVENUE IMPACT:  FY 1997-98 TO FY 2006-07 
(billions of dollars)
Fiscal Year Tax Cuts Tax 
Increases		 Timing 
Changes		 Net Change 
In Revenue
1997-98a) $ (2) $ 8 $ (15) $ (9)
1998-99 (29) 10 12 (7)
1999-00 (36) 13 0 (23)
2000-01 (38) 14 (3) (27)
2001-02 (37) 15 7 (15)
2002-03 (42) 14 (1) (29)
2003-04 (44) 13 0 (31)
2004-05 (47) 14 0 (33)
2005-06 (48) 15 0 (33)
2006-07 (51) 16 0 (35)
Total  $(373) $131 $0 $(242)
a) Includes $1 billion revenue gain from capital gains tax reduction and $1 billion revenue loss due to timing changes, both attributable to FY 1996-97.
Source: Congressional Budget Office, "The Economic and Budget Outlook: An Update", September 1997.
 

Historical Perspective on Net Tax Reduction

While the net reduction in taxes will total $242 billion during the next 10 years, this tax cut is much smaller than the 1981 tax reduction, which was the last time a general tax cut was enacted by the Federal government. To put the 1981 and 1997 tax cuts on a comparable basis, the size of the respective tax cuts during the first five years following their enactment, is calculated as a percentage of gross domestic product (GDP), which measures the size of overall economic activity. The 1981 tax cut exceeded 1.0% of GDP in 1981, the initial year it went into effect, and then grew steadily until reaching about 5.5% in 1985. The 1997 tax reduction will total less than 0.1% of GDP in 1998 and then will increase to only about 0.3% of GDP by 2003.

MAJOR TAX REDUCTIONS

The Taxpayer Relief Act of 1997 is an extensive law that modifies close to 200 provisions in the Federal tax code. These changes vary greatly in terms of the number of taxpayers they affect and their fiscal impact. For example, the new credit for children under 17 will be fairly costly because all taxpayers who have children under 17 years old will be able to claim it. On the other hand, a change restricting like-kind exchanges of certain personal property will affect only a relatively few taxpayers and as a result the loss of revenue associated with it is relatively small. Figure 1 presents the percentage share that each of the major tax cut categories will contribute to the overall tax cut. The child tax credit is by far the largest single component of the total tax reductions as its revenue impact accounts for over 40% of the total reduction in taxes. The next largest tax reduction is made up of the provisions that provide tax incentives to help taxpayers spend more on education.

Figure 1
 

It is also interesting to note that the tax cuts will have a bigger impact as time goes on because many of the tax reduction provisions are being phased-in, disproportionately, over many years. Figure 2 presents how the tax cuts over the next 10 years will be distributed between the first five years (FY 1997-98 to FY 2001-02) and the second five years (FY 2002-03 to FY 2006-07).  Of the total tax cuts, it is estimated that 38% of the resulting revenue loss will occur during the five-year period from FY 1997-98 to FY 2001-02, and the remaining 62% of the tax cuts will not occur until the five years following FY 2001-02. Brief descriptions of the major tax reductions are presented below, and Table 2 provides a summary of their individual fiscal impacts from FY 1997-98 to FY 2006-07.

 
Figure 2

 

Table 2
FEDERAL TAXPAYER RELIEF ACT OF 1997  
MAJOR CHANGES AND ESTIMATED FISCAL IMPACTS FOR U.S.  
FY 1998 TO FY 2007  
(billions of dollars)
  FY 19981) FY 1999 FY 2000 FY 2001 FY 2002 FY 1997 -  
FY 2002		 FY 2003 -  
FY 2007		 Total  
FY 1997 -  
FY 2007
Tax Cut Provisions:                
Business AMT2) a  ($1) ($2) ($2) ($3) ($8) ($12) ($20)
Capital Gains 7 a  (3) (3) (2) (1) (20) (21)
Child Tax Credit (3) (16) (19) (18) (18) (74) (81) (155)
Education Tax Incentives (3) (8) (9) (10) (10) (40) (59) (99)
Estate Tax a  (1) (1) (2) (2) (6) (28) (34)
Savings Tax Incentives (IRAs)3) a  a  a  a  (1) (1) (19) (20)
Other (3) (3) (2) (2) (2) (12) (12) (24)
Subtotal Tax Cuts ($2) ($29) ($36) ($37) ($38) ($142) ($231) ($373)
                 
Tax Increases:                
Air Transportation Taxes $6 $6 $6 $7 $8 $33 $47 $80
Tobacco Taxes 0 0 1 2 2 5 10 15
Other 2 4 5 5 5 21 15 36
Subtotal Tax Increases $8 $10 $12 $14 $15 $59 $72 $131
                 
Changes In Timing of Taxes ($15) $12 $0 ($3) $7 $1 ($1) $0
                 
Net Tax Changes ($9) ($7) ($24) ($26) ($16) ($82) ($160) ($242)
                 
a = Less than $500 million.                
1) Includes $1 billion gain from capital gains tax cut and $1 billion loss due to timing changes, both attributable to FY 1996-97. 2) Alternative Minimum Tax. 3) Individual Retirement Accounts
Source: Congressional Budget Office, "The Economic and Budget Outlook: An Update", September 1997, and Joint Committee on Taxation, "General Explanation of Tax Legislation Enacted in 1997", December 1997.
 
Capital Gains
 
Tax Rate Reductions. Prior to the Taxpayer Relief Act of 1997, the tax rate on gains realized from the sale of capital assets, held more than 12 months, was capped at 28%. As a result, taxpayers with income levels high enough to put them in the marginal tax rate brackets of 31%, 36%, and 39.6%, received a tax reduction on long-term capital gains, but taxpayers at the 28% and 15% tax brackets did not. Under the Taxpayer Relief Act of 1997, all taxpayers will receive a tax break on long-term capital gains. Taxpayers at the 28% marginal rate, and higher, will pay a maximum tax of 20% on long-term capital gains, and taxpayers at the 15% marginal tax bracket will pay a 10% tax. These lower tax rates will apply to gains realized from assets held for more than 18 months, compared with a holding period of more than 12 months under the old law. These new tax rates will be lowered again in 2001, to 18% and 8%, respectively, for assets held more than five years. In addition, there are some transition rules in effect for assets sold between May 7, 1997, and July 29, 1997, regarding both the holding period changes and the tax rate changes. The recent changes in the tax rates assessed on long-term capital gains are summarized in Table 3.

 

Table 3
LONG-TERM CAPITAL GAINS TAX RATE CHANGES
    Capital Gains Tax Rate
Date Assets Sold Required Holding   
Period Prior   
to Sale (months)		 15%  
Marginal  
Tax Bracket		 28%-39.6%  
Marginal  
Tax Brackets
Old Law      
Before 5/7/97  •More than 12 15% 28%
New Law      
After 5/6/97 & Before 7/29/97  •More than 12 10% 20%
       
After 7/28/97  •More than 12,   
but less than 18		 15% 28%
  •More than 18 10% 20%
After 12/31/2000  •More than 60 (5 years) 8% 18%
Source: Senate Fiscal Agency and Federal Joint Committee on Taxation.
 
 
Gains from Personal Residence. Taxpayers also were granted special tax treatment for gains realized from the sale of a personal residence. This exclusion from taxable income applies to gains of up to $250,000 for single filers and $500,000 for married couples filing a joint return. To qualify, a taxpayer must have owned and used the property as his or her principal residence for at least two years during the five years prior to the date of the sale. This exclusion is allowed each time these qualifications are met, which means a taxpayer could qualify for this exemption, at most, every two years. If a taxpayer fails to meet the two-year requirement due to a change in employment, health, or other unforeseen change in circumstances, then the taxpayer is allowed an exclusion on a pro-rated basis. This new exclusion replaces the old rollover rules that allowed taxpayers to defer the tax on the gain realized from the sale of a principal residence as long as the gain was applied to another residence of greater value within two years from the original sale. Also repealed was the one-time $125,000 exclusion on a sale of a principal residence for taxpayers age 55 and over.

The cost of these changes in the tax on capital gains will be dominated by the reduction in the tax rate. The lower tax on capital gains will in effect reduce the transaction cost of selling assets. As a result, it is estimated by the Federal Joint Committee on Taxation that these tax reductions on capital gains actually resulted in a $1 billion increase in tax revenue in FY 1997 and will generate a $6 billion revenue gain in FY 1998, due to the acceleration in the volume of sales. By FY 2000, the surge in asset transactions will be over, and as a result, tax revenue from capital gains will decline by an estimated $3 billion.

Child Tax Credit
 
A new child tax credit was also enacted into law. Under this credit, taxpayers will be able to claim a tax credit against their income tax equal to $400 in 1998, and $500 for each tax year thereafter, for each child under the age of 17. Qualifying children include a taxpayer's son, daughter, stepson, stepdaughter, grandchild or a foster child a taxpayer is allowed to claim as a dependent. The credit begins to be phased-out if adjusted gross income (AGI) exceeds $110,000 for taxpayers filing a joint return and $75,000 for single and head-of-household tax filers. The income range during which the credit is phased-out varies depending on how many child tax credits the taxpayer can claim.

The child tax credit is expected to result in the largest tax reduction among the tax cuts contained in the Taxpayer Relief Act of 1997. This tax credit will reduce revenue by an estimated $3 billion in FY 1998 and $16 billion in FY 1999, and then level off at about $18 billion to $19 billion in FY 2000 and each year thereafter.
 
Education Tax Incentives
 
The HOPE Scholarship credit, the Lifetime Learning credit, and an individual retirement account for education are new income tax reduction incentives being offered to taxpayers to help offset certain expenses incurred for postsecondary education.
 
HOPE Scholarship Credit. The HOPE credit equals 100% of the first $1,000 and 50% of the next $1,000 of tuition and fees paid during each of the first two years of undergraduate postsecondary education. Therefore, the maximum annual credit is $1,500 per student. In order to qualify, a student must be either the taxpayer, or the taxpayer's spouse or dependent, and must be at least a half-time student. In addition, the HOPE credit cannot be claimed for the same year that a Lifetime Learning credit or education IRA is being claimed. The HOPE credit is phased-out between incomes of $80,000 and $100,000 for joint filers and $40,000 and $50,000 for single filers. The credit amount and the income phase-out levels will be indexed to inflation beginning in 2002.

Lifetime Learning Credit. The Lifetime Learning credit equals 20% of up to $5,000 of education tuition and fees (increasing to $10,000 in 2002), and therefore, the maximum annual lifetime credit equals $1,000 ($2,000 beginning in 2002) per family, not per student. This credit will apply against tuition and fees incurred in both undergraduate and graduate level courses, as well as any courses to improve an individual's job skills. This credit is not indexed to inflation, but is phased-out at the same income levels as the HOPE credit.
 
Education Individual Retirement Accounts. Contributions of up to $500 can be made by a taxpayer to an education IRA for a student who is under 18 years old. Contributions to an education IRA are not tax deductible, but earnings on the funds in an education IRA are exempt from taxes, and withdrawals from an education IRA are not taxed as long as they are used for qualified educational expenses by the designated beneficiary. The ability to make contributions to an education IRA is phased-out for taxpayers whose AGI falls between $150,000 and $160,000 for joint filers, and $95,000 and $110,000 for other filers.
 
Educational Withdrawals from Other IRAs. The 10% penalty assessed when funds are withdrawn from an IRA before the person reaches age 59-1/2, will be waived if the money is used for qualified higher education expenses for the taxpayer, or the taxpayer's spouse, children, or grandchildren.
 
Student Loan Interest. A new deduction is provided for interest paid on student loans. This deduction will equal $1,000 in 1998, $1,500 in 1999, $2,000 in 2000, and $2,500 in 2001 and beyond. The deduction applies to the interest paid during the first 60 months of actual payments on the loan.
 
These various education tax incentives will reduce Federal tax revenue by an estimated $3 billion in FY 1998, $8 billion in FY 1999, and $9 billion to $10 billion in future years.
 
Tax Incentives to Save
 
Several changes have been made in the amount of money that can be contributed into an individual retirement account (IRA), as well as what the funds can be used for. The purpose of these changes is to make it more attractive for taxpayers to save for the future using IRAs. These enacted changes are described below.
 
Roth IRAs. A new saving instrument created by the TRA of 1997 is the Roth IRA. Nondeductible contributions of up to $2,000 per year can be made to a Roth IRA; however, the $2,000 contribution limit is reduced by the amount of any other contributions to other types of IRAs. The ability to make contributions to a Roth IRA is phased-out for taxpayers with an AGI between $150,000 and $160,000 for joint filers, and between $95,000 and $110,000 for other taxpayers. Qualified withdrawals are tax free and therefore no tax is assessed on the accumulated earnings. Qualified distributions include withdrawals after age 59-1/2, or on death or disability of the taxpayer, and up to $10,000 during the taxpayer's lifetime to be used to acquire a principal residence; however, no qualified distributions can be made until the taxpayer has had a Roth IRA for five years. During 1998, taxpayers will be allowed to transfer funds from a regular IRA into a Roth IRA, if the taxpayer's AGI is not greater than $100,000. The funds withdrawn from the regular IRA will be treated as taxable income, but the 10% penalty that is normally assessed on early distributions from IRAs, will be waived, but only during 1998.
 
Deductible IRAs. Beginning in 1998, a person will not be prohibited from making a deductible contribution to an IRA solely because his or her spouse is an active participant in an employer's retirement plan unless the couple's AGI is in excess of $160,000. In addition, the AGI limits for making deductible IRA contributions for individuals covered by a pension plan have been increased. In 1997, if either spouse was covered by a pension, the couple could make the maximum deductible contribution only if their AGI was less than $40,000, and deductible contributions were phased-out for couples with AGI between $40,000 and $50,000. The ability to make a deductible contribution for single people covered by a pension was phased- out when AGI was between $25,000 and $35,000. Beginning in 1998, these AGI limits will be increased gradually during each of the next 10 years, as shown in Table 4. In 1998, a deductible contribution will be phased-out for taxpayers participating in a pension plan if AGI falls between $50,000 and $60,000 for those filing a joint return, and between $30,000 and $40,000 for single returns. By 2007, the phase-out range will be $80,000 to $100,000 for those filing a joint return and $50,000 and $60,000 for those filing a single return.
 

Table 4
ADJUSTED GROSS INCOME RANGES FOR  
PHASING OUT IRA DEDUCTIBLE CONTRIBUTIONS
Tax Years Single Taxpayers Married Taxpayers
Old Law $25,000-35,000 $40,000-50,000
New Law    
1998 $30,000-40,000 $50,000-60,000
1999 31,000-41,000 51,000-61,000
2000 32,000-42,000 52,000-62,000
2001 33,000-43,000 53,000-63,000
2002 34,000-44,000 54,000-64,000
2003 40,000-50,000 60,000-70,000
2004 45,000-55,000 65,000-75,000
2005 50,000-60,000 70,000-80,000
2006 50,000-60,000 75,000-85,000
2007 & After
 50,000-60,000 85,000-100,000
Source: Federal Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in 1997.
 
Early Withdrawals. In addition to waiving the 10% penalty for early distributions from IRAs to cover educational expenses, penalty-free early distributions are now also allowed under certain circumstances for taxpayers buying a house. Beginning in 1998, an early distribution, subject to a lifetime limit of $10,000, can be made by taxpayers, penalty free, as long as they have not owned a principal residence in the prior two years.

The fiscal impact of these changes in IRAs will be close to zero in the first few years and then grow over time due to three main factors: 1) the income levels at which deductible contributions are phased-out are being increased gradually over the next 10 years, 2) people will not be making qualified tax-free withdrawals from Roth IRAs for at least five years, and 3) revenue reductions that will occur during the first few years as taxpayers increase the amount of deductible contributions they make to regular IRAs, will be offset in part as people pay taxes on the funds they will move from deductible IRAs to Roth IRAs.
 
Estate Tax
 
Under the Taxpayer Relief Act of 1997, the exemption allowed under the estate tax is being raised from the current $600,000 to $1,000,000. This increase will be phased-in between 1998 and 2006, with the largest increases occurring during the final three years of this period. The law has also been changed to reduce the estate tax on family-owned businesses. These changes to the Federal estate tax will reduce Federal revenue by an estimated $1 billion in FY 1999 and FY 2000, and by $2 billion in FY 2001 and FY 2002.
 
Alternative Minimum Tax for Businesses
 
Changes were made in the alternative minimum tax (AMT) to provide tax relief to corporations and small businesses. First, for assets placed in service after December 31, 1998, corporations will be able to calculate depreciation for the AMT using the same asset lifetimes as used for calculating depreciation for the regular tax. This should significantly reduce the AMT because the longer lifetimes previously required to be used when calculating depreciation for the AMT were generating a large amount of the AMT revenue. Second, small corporations will be exempt from the AMT. A small corporation is any corporation that for its first tax year following 1996 averaged annual gross receipts of less than $5 million during the preceding three-year period. In subsequent years, these small corporations will continue to be exempt from the AMT as long as their average annual gross receipts do not exceed $7.5 million in the three years prior to the current tax year. Third, farmers are now allowed to use the installment method of accounting for AMT purposes and this will reduce their tax liability. These changes in the AMT applied to businesses will reduce revenue about $1 billion in FY 1999 and then $2 billion in FY 2000 to FY 2002.
 
MAJOR TAX INCREASES
 
A portion of the amount being granted in tax reductions, is being offset by increases in other taxes. These increases are concentrated in two major areas: 1) extending the air transportation excise taxes, and 2) increasing the Federal tax on cigarettes.
 
Air Transportation Taxes
 
The Federal air transportation excise taxes were scheduled to expire on September 30, 1997, but the new law extends them for another 10 years through September 30, 2007. In addition to extending these taxes, the new law also made some significant changes to these taxes. These changes are summarized below.
 
Domestic Ticket Tax. The previous 10% tax assessed on the price of tickets on domestic flights was changed, effective October 1, 1997, to a 9% tax plus a $1 tax on each segment of the flight (one takeoff and one landing). This tax will change to an 8% tax plus a $2 tax on each flight segment effective October 1, 1998. On October 1, 1999, the tax on the price of a domestic flight becomes 7.5%, and then on January 1, 2002, the flat tax increases to $3 per flight segment. These taxes are slightly different for flights that begin or end in a rural airport.
 
International Departure Tax. Prior to October 1, 1997, passengers on international flights departing the U.S. were assessed a $6 per person tax. Under the new law, this tax is increased to $12 per person and is expanded to include both departing and arriving international flights. In addition, this tax will be indexed to inflation beginning in 1999.
 
These changes in the Federal air transportation taxes will generate $33 billion from FY 1997-98 to FY 2001-02, which is about $4 billion more than if they had just been extended without any modifications. During the entire 10 years from FY 1997-98 to FY 2006-07, these air transportation taxes will generate an estimated $80 billion.
 
Cigarette Tax
 
The Federal excise tax on cigarettes will increase from the current 24 cents to 34 cents per pack, effective January 1, 2000, and then effective January 1, 2002, the tax will increase to 39 cents per pack. Proportionate tax increases will also be placed on other tobacco products. Tobacco companies will be allowed to credit the amount paid under these increases against any payments they may be required to make under the pending tobacco industry liability settlement. This increase in the cigarette tax will generate an estimated $1 billion in FY 1999-2000, $2 billion in FY 2001-02, and a total accumulated increase of $15 billion by the end of FY 2006-07.
 
IMPACT ON MICHIGAN TAXES
 
A number of the recently enacted changes in Federal taxes will have an impact on tax collections in Michigan. This impact will occur for basically two reasons:  

Federal tax changes that do not impact AGI or change taxpayer behavior, such as the child tax credit, will not directly affect Michigan's tax revenue.
 
The Federal tax changes that are expected to have the most significant impact on Michigan's taxes, are described below and their estimated fiscal impacts are summarized in Table 5.
 
 
Table 5
TAXPAYER RELIEF ACT OF 1997  
IMPACT ON MICHIGAN REVENUE  
(dollars in millions)
Federal Tax Change FY 1998 FY 1999 FY 2000
Income Tax:      
Capital Gains Tax Cut  $17.6 ($9.1) ($6.3)
Increase IRA Deductions & Roth IRAs  (3.4) (3.2) (3.5)
Education IRAs  (1.4) (6.0) (8.0)
IRA Withdrawals for Education, No Penalty  1.2 3.2 3.3
Student Loan Interest Deduction  (0.3) (1.0) (1.2)
Subtotal Income Tax  $13.7 ($16.1) ($15.7)
Cigarette Tax Increase  $0.0 $0.0 ($6.2)
Estate Tax Exemption Increase  $0.0 ($3.8) ($4.3)
Total Revenue Change  $13.7 ($19.9) ($26.2)
General Fund/General Purpose Revenue  11.0 (16.7) (18.4)
School Aid Fund Revenue  2.7 (3.2) (7.1)
Source: FY 1997-98 and FY 1998-99: Consensus estimates adopted at the January 14, 1998, Consensus Revenue Estimating Conference; FY 1999-2000: Estimates prepared by the Senate Fiscal Agency.
 
Capital Gains: The reduction in the Federal income tax rate on capital gains is an example of a change in Federal tax policy that will lead to changes in taxpayer behavior, which in turn will affect tax revenue in Michigan. The lowering of the Federal income tax rate assessed on capital gains, has decreased the transaction cost of liquidating a capital asset. As a result, this has initially resulted in an acceleration in the selling of assets to realize gains. This increase in the selling of capital assets will generate an increase in capital gain income in FY 1997-98. Most of this increase will be from gains that would have otherwise been realized at a later time. As a result, capital gain realizations are expected to be lower than they otherwise would have been in FY 1998-99 and FY 1999-2000. This change in the pattern of capital gain realizations will boost income tax revenue in Michigan by an estimated $18 million in FY 1997-98, but then reduce revenue by an estimated $9.1 million in FY 1998-99 and $6.3 billion in FY 1999-2000.
 
Deductible IRAs and Roth IRAs: The numerous changes in individual retirement accounts also will have an impact on Michigan income tax collections. The effects on Michigan's income tax revenue from these changes will be caused by changes in both AGI and taxpayer behavior. Increasing the income limits for taxpayers to make contributions to deductible IRAs will encourage people to increase their participation in deductible IRAs, which will reduce both AGI and income tax revenue in Michigan. The new Roth IRAs will not have an immediate direct impact on revenue because contributions are not tax exempt; however, the new Roth IRA will attract some individuals who would otherwise contribute to a deductible IRA. To the extent that this change in taxpayer behavior occurs, the new Roth IRAs will partially offset the potential reduction in income tax revenue from deductible IRAs over the next few years. The direct impact of Roth IRAs will not be felt for several years because investment earnings are exempt from taxation when qualified withdrawals are made. It is estimated that the expansion of deductible IRAs and the new Roth IRAs will result in a net reduction in Michigan income tax revenue of $3.4 million in FY 1997-98. Participation in both of these types of IRAs will grow over time, but the net impact is not expected to change much in FY 1998-99 and FY 1999-2000.
 
Education IRAs: The new Education IRAs allow taxpayers to contribute up to $500 annually for any one beneficiary, but the tax break does not occur until the funds are withdrawn and used for education expenses. Therefore, as time goes on, the participation in and use of Education IRAs are expected to continue to grow, which means that the impact on Michigan's income tax revenue will also grow over time. In FY 1997-98, Michigan's income tax revenue will decline an estimated $1.2 million due to withdrawals from Education IRAs. This loss in revenue will increase to $6.0 million in FY 1998-99, and $8.0 million in FY 1999-2000, as the use of these IRAs increases.
 
Student Loan Interest Deduction: The new deduction for interest paid on student loans will also have a negative impact on Michigan income tax revenue because it will reduce AGI. In FY 1997-98, the deduction of interest on student loans will reduce income tax revenue $0.3 million, and in FY 1998-99 and FY 1999-2000, the revenue loss will be about $1 million each year.
 
Penalty-Free IRA Withdrawals: Partially offsetting some of these reductions in income tax revenue will be the impact from the provision allowing taxpayers to withdraw funds from an existing IRA for education purposes and to purchase a house in some instances. These withdrawals will be penalty free, but they will be counted as taxable income, and therefore, will have a positive impact on Michigan income tax revenue. These IRA early withdrawal provisions will increase income tax revenue by an estimated $1.2 million in FY 1997-98, and about $3 million in FY 1998-99 and FY 1999-2000.
 
Estate and Cigarette Tax Changes: In addition to the Federal tax changes that will affect Michigan's income tax revenue, two other Federal tax changes will affect the State's cigarette tax and estate tax revenues. Michigan's estate tax is linked to the Federal estate tax, but legislation will be needed to assure that Michigan's tax is consistent with these latest changes at the Federal level. If Michigan adopts the increase in the estate tax exemption, fewer people will be subject to the Michigan estate tax, and Michigan's estate tax revenue will decline. This loss in revenue will amount to an estimated $3.8 million in FY 1998-99 and $4.4 million in FY 1999-2000. The Federal tax on cigarettes is scheduled to increase 10 cents per pack beginning on January 1, 2000. This tax increase will push up the price of cigarettes and result in a slight drop in the number of packs of cigarettes purchased. As a result, the revenue from Michigan's cigarette tax, which is $0.75 per pack, will decline by an estimated $6.2 million in FY 1999-2000.
 
Overall Impact on Michigan Tax Revenue
 
In FY 1997-98, the positive effect of the acceleration in capital gain realizations will offset the net loss in revenue due to the new IRA provisions, and as a result, it is estimated that Michigan income tax revenue will increase $13.7 million. In FY 1998-99, the falloff in capital gain realizations will produce a decline in income tax revenue, which coupled with the growing net losses from the IRA provisions, and the loss in estate tax revenue, will result in a loss in Michigan tax revenue of an estimated $19.9 million. The same factors, combined with an expected drop in cigarette tax revenue, will reduce Michigan tax revenue by an estimated $26.2 million in FY 1999-2000.