The PEP and Pease Provisions of the Federal Individual Income Tax
CRS Report for Congress
The PEP and Pease Provisions of the Federal
Individual Income Tax
Gregg A. Esenwein
Specialist in Public Finance
Government and Finance Division
Summary
The personal exemption phaseout (PEP provision) and the limitation on itemized
deductions (Pease provision) were enacted as part of the Omnibus Budget
Reconciliation Act of 1990. In 2001, the Economic Growth and Tax Relief
Reconciliation Act enacted a phased-in repeal of these provisions beginning in 2006.
Repeal of these provisions greatly reduces the complexity of the federal individual
income tax. Repeal of these provisions, however, will reduce federal revenues by
approximately $33 billion over the next five years. In addition, the tax benefits from
repeal of these two provisions are highly concentrated in the upper end of the income
spectrum.
This paper will be updated as legislative action warrants or as new data become
available.
In October 1990, Congress passed the Omnibus Budget Reconciliation Act of 1990
(OBRA90), an assortment of spending cuts and tax increases that was expected to reduce
the federal budget deficit by an estimated $496 billion over five years. On November 5,
At the time, it was estimated that OBRA90’s tax increases would raise, on a net
basis, $146.3 billion. This represented only about 29% of the estimated total five-year
deficit reduction. Two of these provisions, the phaseout of the personal exemption and
the limitation on itemized deductions, accounted for approximately 20% of the net tax
increase under OBRA90. Although the spending reductions constituted the vast majority
of this deficit-reduction package, it was OBRA90’s tax increases that were the focus of
most of the debate.
In May 2001, Congress passed the Economic Growth and Tax Relief Reconciliation
Act (EGTRRA). On June 5, 2001, EGTRRA became P.L. 107-15 after it was signed by
President George W. Bush. EGTRRA contained provisions for a phased-in repeal of the
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personal exemption phaseout and the limitation on itemized deductions beginning in
Personal Exemption Phaseout (PEP)
Prior to OBRA90, provisions in the Tax Reform Act of 1986 (TRA86) had created
an individual marginal income tax rate structure that consisted of two statutory marginal
tax rates, 15% and 28%. TRA86, however, also created a 5% surcharge on the taxable
income of certain high-income taxpayers, which effectively created a third marginal tax
rate of 33% (28% statutory rate plus the 5% surcharge) and produced an anomaly that
came to be known as the tax rate “bubble.”
Because the surcharge was phased out as incomes increased, marginal tax rates rose
to 33% but then fell back to 28% and, hence, created the tax rate “bubble.” Ostensibly,
the surcharge was created to phase out the tax benefits of the 15% tax bracket and the
personal exemptions for high-income taxpayers. In reality, the surcharge was adopted so
that TRA86 would not change the distribution of the tax burden relative to its distribution
under pre-1986 tax law, would meet the needed revenue targets, and yet would allow
TRA86 to be characterized as having only two statutory marginal income tax rates.
OBRA90 created an explicit three-tiered statutory marginal rate structure and
eliminated the tax “bubble” by repealing the 5% tax surcharge. Although OBRA90
eliminated the 5% tax surcharge, it instituted a new and explicit approach to phasing out
the tax benefits of the personal exemption for high-income taxpayers.
This new phaseout of the tax benefits of the personal exemption (PEP) was
structured as follows. Each personal exemption was phased out by a factor of 2% for each
$2,500 (or fraction of $2,500) by which a taxpayer’s adjusted gross income (AGI)
exceeded a given threshold amount. In 1991, the threshold amount for a joint return was
set at $150,000; for a single return the threshold was $100,000; and for heads of
households the threshold was set at $125,000.
For example, in 1991, a joint household whose AGI was $183,000 would lose 28%
of their total personal exemptions claimed. The AGI amount in excess of the threshold
in this instance would be $33,000 — $183,000 AGI less $150,000 threshold limit. The
$33,000 excess divided by $2,500 would produce a factor of 13.2, which when rounded
up would equal 14. This figure is multiplied by 2% to arrive at the final disallowance
amount of 28%. Hence, if the family had claimed two personal exemptions, which at
$2,150 each would total $4,300, they would be allowed to deduct only $3,096 ($4,300
total personal exemptions less the $1,204 disallowance, which is 28% of the total).
For tax years after 1991, these threshold amounts were to be indexed for inflation.
Under OBRA90 provisions, the PEP rules were originally scheduled to expire after 1995.
Continued budgetary pressures, however, led to the passage of a second round of tax
increases in 1993. Under provisions of the Omnibus Budget Reconciliation Act of 1993
(OBRA93), the PEP provisions were made permanent.
By 2006, indexation had increased the PEP phaseout threshold amount for a joint
return to $225,750; for a single return to $150,000; and for heads of households to
$188,150.
The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) which
was signed into law on June 7, 2001, contained provisions for a phased-in repeal of the
personal exemption phaseout. Under EGTRRA, the PEP provisions are to be phased out
over a five-year period starting in this year. For 2006 and 2007, the personal exemption
phaseout is scheduled to be reduced by one-third and, for 2008 and 2009, it is scheduled
to be reduced by two-thirds. Finally, the PEP provisions are to be repealed for tax years
after 2009.1
Congress cited three main reasons for the repeal of the PEP provisions.2 First, the
personal exemption phaseout was too complex. Second, the phaseout constituted a
hidden way of raising marginal income tax rates, and thus undermined respect for the tax
system. Third, the phaseout imposed excessively high effective marginal tax rates on
families. At the time, the Joint Committee on Taxation (JCT) estimated that the phaseout
of the PEP provision would reduce federal revenues by $8 billion over the 2006 through
Limitation on Itemized Deductions (Pease Provision)
OBRA90 also contained the so-called Pease provision limiting the amount of
itemized deductions high-income taxpayers could claim in any given year. (This
provision takes its name from former Representative Don Pease of Ohio who was its
author.) Under this provision, for tax years starting in 1991, otherwise allowable itemized
deductions were reduced by 3% of the amount by which a taxpayer’s AGI exceeded
$100,000 (for married couples filing separate returns the AGI limit was set at $50,000).
For example, if a taxpayer’s AGI were $110,000 then his otherwise allowable
deductions would be reduced by $300 ($110,000 less $100,000 threshold times 3%). This
provision effectively raises the marginal income tax rate of affected taxpayers by
approximately one percentage point. (A dollar of income in excess of the $100,000 AGI
threshold is taxed as if it were $1.03, since in addition to the extra dollar of income the
taxpayer loses $0.03 of itemized deductions.)
Allowable deductions for medical expenses, casualty and theft losses, and investment
interest were not subject to the limitation. Also, total deductions subject to the limit
cannot be reduced by more than 80%. For tax years after 1991, the $100,000 AGI
threshold was indexed for inflation. This provision, like the PEP provision, was
1 All of the changes in EGTRRA (including the PEP and Pease provisions) will expire (sunset)
after 2010. Congress included the sunset in EGTRRA to avoid a Byrd rule (Section 313 of the
1974 Congressional Budget Act, as amended) violation in the Senate. The Byrd rule prohibits
“extraneous matter” in reconciliation legislation. Under the rule, extraneous matter includes,
among other things, language that would cause an increase in the budget deficit (or reduce budget
surpluses) in a fiscal year beyond those covered by the reconciliation legislation. As a result of
the Byrd rule, EGTRRA contained language providing for the expiration of all of its provisions
at the end of calendar year 2010, since the years after 2010 were outside the reconciliation budget
window.
2 Joint Committee on Taxation, JCS-1-03, General Explanation of Tax Legislation Enacted in the
originally scheduled to expire after tax year 1995. As mentioned earlier, however,
continued budgetary pressures led to the passage of a second round of tax increases in
By 2006, indexation for inflation had increased the AGI threshold at which otherwise
allowable itemized deductions are limited to $150,500.
As was the case with the PEP provision, EGTRRA contained a provision for the
phased-in repeal of the Pease provision. Under, EGTRRA, the Pease provision is
scheduled to be repealed over a five-year period. For tax years 2006 and 2007, the overall
limit on otherwise allowable itemized deductions is reduced by one-third, for tax years
2008 and 2009 the limit is reduced by two-thirds, and for tax years after 2009 the limit is
repealed.
Complexity was the main reason cited by Congress for the repeal of the Pease
provisions. The JCT estimated that the phased-in repeal of the Pease provision would
reduce federal revenues by $25 billion over the five-year period.
Issues
Some of the complexity of the current tax system can be traced to the attempt to
accurately measure real net economic income. However, this is not the case with the PEP
and Pease provisions. The PEP and Pease provisions were adopted as a means of raising
additional revenue without having to explicitly raise marginal income tax rates. They
were also designed so that the resultant tax increases were borne by taxpayers at the upper
end of the income spectrum.
Hence, while repealing the PEP and Pease provisions unambiguously reduces the
complexity of the tax system, it will also reduce federal revenues and affect the
distribution of the tax burden. In total, the JCT estimated that repealing both the PEP and
Pease provisions would reduce federal revenues by $33 billion over the five-year budget
horizon.
Repeal of these provisions will also affect the distribution of the federal income tax
burden. Although no official estimates of the distributional effects of repealing the PEP
and Pease provisions are available, non-governmental estimates show that the tax
reductions from repeal of these two provisions are highly concentrated in the upper end
of the income spectrum.3
These estimates indicate that in 2010 the tax benefits from repeal of these two
provisions accrue to only 3.3% of all taxpayers, and that those taxpayers have incomes
in excess of approximately $150,000. The largest average tax reductions, around
$19,000, accrue to taxpayers with incomes in excess of $1 million.
3 Urban-Brookings Tax Policy Center, “Effects of the PEP/Pease Repeal,” Table T05-0023,
[http://www.taxpolicycenter.org/ T axModel/tmdb/T MT emplate.cfm].