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DEMOS EXERT PRESSURE TO BURST TAX `BUBBLE’

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The anomaly known as "the bubble" in federal personal income tax rates is trembling under the pressure of the budget summit.

The bubble has been in the code for four years, since it helped win approval for the Tax Reform Act of 1986. At the time, some called it "the phantom third rate." It was hard to explain, affected relatively few taxpayers and got short shrift in most summaries of the bill.Stated simply, the bubble is an unprecedented step-up step-down kink in the top tax rate, which rises with filers' incomes from 28 percent to 33 percent and drops back down to 28 percent.

Backers have argued that, without the bubble, the landmark 1986 overhaul would have raised less money and placed more of the total federal tax burden on those less able to afford it.

But four years after the tax reform summer, the bubble's importance to the 1986 bill is little remembered - or valued. Instead, attention has focused on its oddity and apparent unfairness: It allows a billionaire to pay a lower marginal rate (the tax due on the last dollar of income) than an ordinary couple with two good jobs.

Since President Bush's June 26 acknowledgment that new tax revenues will be needed as part of a budget-summit deal, Democrats have become increasingly aggressive about targeting the bubble. They are characterizing it as a symbol of the Reagan era's lowering of tax rates for the wealthy.

Republicans, for their part, have been adamant in rejecting top-rate increases of the magnitude Mitchell proposed. Bob Packwood of Oregon, ranking GOP member of the Senate Finance Committee, says he would rather see the summit fail utterly than give in on that point.

The current 33 percent top rate is not really a rate, according to Packwood and others, because it eventually falls away. They call it "a 5 percent add-on." The Democrats, they say, are proposing not to "fix" the bubble, but to increase the top rate for the wealthiest to 33 percent.

The 1986 tax bill was built on a simple tradeoff: lower tax rates in return for fewer deductions and other tax breaks, such as preferential treatment of capital gains.

By adding the bubble to the measure, the Senate kept the bill from losing money - even while it lowered the nominal top rate to 28 percent from 50 percent.

Democrats now hope to have both ends of the tax reform bargain their way. They want to continue taxing capital gains as ordinary income while also pushing the top rate back up to 33 percent or more.

Republicans want the reverse: lower rates on capital gains without any increase in the top rate.

The debate is often tortuous, in large measure because the bubble is so difficult to explain.

Technically, the 1986 law established two nominal rates for taxable income: 15 percent and 28 percent. By law, everyone pays 15 percent on the first portion of his taxable income (up to a certain "break-point") and 28 percent on the rest.

This break-point rises each year to account for inflation. For income received in 1989 it was roughly $19,000 for individuals and $30,000 for joint filers.

But those with higher incomes eventually reach a second break-point. When a taxpayer exceeds this income level, the rates work to gradually offset the savings he is getting by paying 15 percent on the first portion of his taxable income.

If his income is high enough, eventually all the benefits of the lower rate are offset. He then begins to lose the benefits of the personal exemption, as well.

Several million U.S. taxpayers (individuals or households) now earn enough to pay at least some tax at 33 percent (putting them "in the bubble").

Only about 600,000 filers have enough taxable income to take the step back down to 28 percent. But their income is large enough that the consequences of that step down are substantial. According to the Joint Committee on Taxation, keeping the top rate at 33 percent would be worth more than $44 billion to the Treasury from fiscal 1991 through fiscal 1995.