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May 7, 2004:

The Honorable Charles E. Grassley:

Chairman:

The Honorable Max S. Baucus:

Ranking Minority Member:

Committee on Finance:

United States Senate:

The Honorable Mark Pryor:

United States Senate:

Subject: Military Personnel: Active Duty Compensation and Its Tax 
Treatment:

The Department of Defense's (DOD) total military compensation package 
for active duty members consists of both cash and noncash benefits. 
Since the late 1990s, Congress and the DOD have increased military cash 
compensation by increasing basic pay and allowances for housing, among 
other things. Military members also receive tax breaks, which are a 
part of their cash compensation. Moreover, active duty personnel are 
offered substantial noncash benefits, such as retirement, health care, 
commissaries, and childcare. In some cases, these noncash benefits 
exceed those available to private-sector personnel.[Footnote 1] DOD 
relies heavily on noncash benefits because it views benefits as 
critical to morale, retention, and the quality of life for service 
members and their families.

To better understand the military compensation system, you asked us to 
provide you information on active duty military compensation and its 
tax treatment. At the outset of this engagement, we agreed to keep you 
periodically informed of the status of our work. In January 2004, we 
briefed your staff on our preliminary observations. Because our work 
identified that the combat zone tax exclusion[Footnote 2] could impact 
some service members, you asked us to focus our work on military cash 
compensation and to do additional work to estimate the effect of the 
combat zone tax exclusion on service members' compensation. We provided 
your staff subsequent briefings that estimated the effect of the combat 
zone exclusion. As requested, we have updated and combined the 
briefings for this report to (1) summarize active duty cash 
compensation and describe how military compensation varies at different 
career points for officers and enlisted members; (2) explain how 
military pay is taxed and any special tax treatment of military 
compensation; (3) estimate the effects of interactions between the 
combat zone exclusion and certain tax credits on military members' 
compensation; and (4) describe the benefits DOD provides active duty 
members as well as specific programs available to members that 
encourage wealth building (see enclosure I). To provide a rough 
estimate of the number of service members in 2003 who suffered a net 
tax loss because of the interactions between serving in a combat zone 
and certain tax credits, we used aggregate data compiled by the Defense 
Manpower Data Center on the number of members who served in a combat 
zone in 2003 and aggregate data on the percentage of spouses not in the 
workforce from the 2002 Active Duty Survey. We believe that the data is 
sufficiently reliable to estimate within a broad range the number of 
people affected. We conducted our review from October 2003 through 
April 2004 in accordance with generally accepted government auditing 
standards.

Results in Brief:

The foundation of military cash compensation is what the DOD calls 
regular military compensation--the sum of basic pay, nontaxable 
allowances for housing and subsistence, and the associated federal tax 
savings. Some members also receive additional cash compensation in the 
form of special pays, incentives, and other allowances. In total, there 
are over 50 of these pays, incentives, and allowances, ranging from 
reenlistment bonuses to clothing allowances and family separation 
allowances. The annual amounts of these pays, incentives, and 
allowances range from a few hundred dollars to thousands of dollars, 
and some of these are also nontaxable. In general, regular military 
compensation progresses steadily with pay grade and years of service. 
For example, a junior enlisted member with 3 years of service might 
earn around $40,000 in cash compensation, while a senior officer with 
22 years of service could earn cash compensation of about $130,000.

Military service brings with it significant tax advantages. Basic pay 
and most other pays are generally subject to federal income tax; 
however, certain allowances are not taxed, such as the basic allowances 
for housing and subsistence.[Footnote 3] DOD considers the federal tax 
advantage as the additional income military members would have to earn 
in order to receive their current take-home pay if their allowances for 
housing and subsistence were taxable. In fact, DOD views the federal 
tax advantage as part of service members' cash compensation when it 
compares military pay with civilian pay. In addition, pay earned--
including basic pay, bonuses, special pays, and allowances--while 
members are serving in one of the 15 designated combat zones is 
excluded from taxes.

The complex interactions between the combat zone exclusion and certain 
tax credits (principally the Earned Income Tax Credit and the 
Additional Child Tax Credit) appear to be creating unintended 
consequences. Specifically, some low-income-earning service members 
who serve in a combat zone are worse off for tax purposes, while some 
higher-income-earning members are better off because they become 
eligible for a tax credit that is normally targeted to low-income 
workers. Low-income members with children qualify for refundable tax 
credits that can not only offset all of their tax liability but can 
also leave them with payments from the government. The combat zone 
exclusion can actually cause a reduction or elimination of these 
payments to some service members. For example, over certain income 
ranges the amount of Earned Income Tax Credit that a taxpayer earns 
increases as his or her income increases. Service in a combat zone 
reduces the amount of earned income that a member reports for tax 
purposes and, thus, can reduce or eliminate the refunded portion of the 
member's credit. These members actually suffer a net loss in tax 
benefits because they receive no offsetting advantage from the 
exclusion. Our analysis suggests that some of the roughly 430,000 
members serving in a combat zone in 2003--between 5,000 and 10,000 
members in one-earner households--suffered a net loss of tax 
benefits.[Footnote 4] Data limitations make it difficult to produce a 
comprehensive estimate of the number of members who suffered a net loss 
of tax benefits. In particular, it is more difficult to make a reliable 
estimate of the number of members with working spouses who had net 
losses of tax benefits. However, we believe that number is not likely 
to be much higher than several thousand and could be less than that. 
Additionally, the number of members losing tax benefits could be larger 
in 2004 depending on the how many service members are in a combat zone 
and how long they are there. The amount of the tax benefit loss varies 
considerably, with a maximum of about $4,500 or $3,200, for enlisted 
and officer members, respectively. In general, the members losing tax 
benefits tend to be those who are serving in a combat zone longer than 
6 months; who are in the lower pay grades; who are married with 
children; and who have little to no investment or spousal income. On 
the other hand, some other low-income members earned larger earned 
income tax credits by serving in a combat zone than they otherwise 
would have. Moreover, it appears that a large number of service members 
who had incomes exceeding the normal upper limit for Earned Income Tax 
Credit eligibility and who served in a combat zone for at least 6 
months could become eligible to receive that credit as a result of this 
income exclusion. DOD is aware of service members who are disadvantaged 
and advantaged by these tax provisions, and it is seeking remedies that 
would require changing the rules of the tax credits so that income 
earned in a combat zone would not be excluded when calculating 
eligibility for the tax credits.

Benefits are a substantial portion of noncash military compensation. 
DOD offers a wide range of benefits to active duty members, including 
health care, retirement, education assistance, and installation-based 
benefits--that is, services found on military installations, such as 
commissaries and child care. While the value of benefits to members 
varies depending on the members' needs, the cost to provide such 
benefits is substantial.[Footnote 5] Some of the benefits DOD provides 
encourage wealth building over a service member's career. Military 
retirement--a lifetime annuity generally provided to members who serve 
20 years or more--is one of the primary wealth-building programs 
available to military members. However, DOD estimates that less than 
half of officers and only about 15 percent of enlisted members will 
become eligible for retirement. In addition, other savings programs are 
offered, such as the Thrift Savings Plan and the Savings Deposit 
Program. Since 2001, service members can contribute a percentage of 
their basic pay, before taxes, to be invested in one or more of the 
specific funds offered through the Thrift Savings Plan; about 21 
percent of the active duty military participate. Service members 
deployed to a combat zone or other qualified areas can contribute to 
the Savings Deposit Program, earning a guaranteed 10 percent interest 
on their investment. However, less than 1 percent of the active duty 
force participates. Service members may also be eligible to participate 
in the Department of Veterans Affairs no-money down, mortgage-backed 
loan program. Moreover, military members can take advantage of a number 
of wealth-building tax provisions available to citizens, such as 
deductions for mortgage interest and tax credits for elective 
retirement accounts contributions.

Matter for Congressional Consideration:

If the Congress wishes to remedy the unintended tax consequences 
associated with the combat zone exclusion, it should consider revising 
the rules of the Earned Income Tax Credit and the Additional Child Tax 
Credit with respect to income earned in a combat zone.

Scope and Methodology:

Our audit work focused on military cash compensation and its tax 
treatment for active duty service members. To summarize the components 
of active duty military members' compensation, we reviewed policies, 
publications, and regulations governing military compensation. We 
interviewed officials from the Office of the Secretary of Defense and 
the Defense Manpower Data Center. We compiled 2003 data for basic pay 
tables, basic allowances for housing and subsistence rates, special pay 
amounts, incentive pay amounts, and allowance pay amounts. To describe 
how military compensation varies at different career points for 
officers and enlisted members, we created notional junior and senior 
enlisted service members and officers. We assigned these hypothetical 
service members typical years of service for their pay grades, 
locations across the United States, numbers of dependents, and special 
pays typical of their pay grades and locations. We discussed our 
examples with officials from the Office of the Under Secretary of 
Defense for Personnel and Readiness to ensure that our profiles were 
reasonable. We identified benefits offered to active duty military 
members and some associated values by reviewing past GAO reports, DOD 
documents, and the fiscal year 2002 DOD Actuarial Valuation Report.

To explain how military pay is taxed and any special tax treatment of 
military compensation, we reviewed DOD policies and regulations and the 
Internal Revenue Services' 2003 Armed Forces Tax Guide publication. To 
estimate the federal tax advantage of the exclusion of the housing and 
subsistence allowances from taxation, we estimated the tax liability 
for hypothetical members according to current tax rules as if the 
members' housing and subsistence allowances were taxable. We present 
the pre-tax value of this tax advantage--that is, the additional income 
the members would have to earn in order to receive their current take 
home pay if their allowances were taxable.

To estimate certain effects of the combat zone exclusion on military 
members' taxes, we estimated the number of members negatively affected 
and the number who may become eligible for Earned Income Tax Credit by 
the combat zone tax exclusion. For more detailed information on how we 
estimated the combat zone effect, see enclosure II.

To describe programs available to members that encourage wealth 
building, we reviewed documents and interviewed officials from the 
Office of the Secretary of Defense and the Department of Veterans 
Affairs. In addition, we also reviewed other documents to identify tax 
provisions that encourage wealth building for citizens.

Agency Comments:

In providing oral comments on a draft of this report, DOD 
representatives from the Office of the Under Secretary of Defense for 
Personnel and Readiness stated that they generally concurred with the 
content of the report. Technical comments were incorporated as 
appropriate. DOD officials told us that they have been seeking to 
remedy the unintended tax consequence related to the combat zone tax 
exclusion. We also received comments on the tax-related sections of our 
draft from Internal Revenue Service (IRS). In providing oral comments, 
IRS representatives from the Office of the Commissioner, Wage and 
Investment Division and the Office of Legislative Affairs said that the 
IRS could administer a change in law that would include combat pay in 
earned income for purposes of computing eligibility for the Earned 
Income Tax Credit.  Since earned income used for computing Earned 
Income Tax Credit is not reported anywhere on the IRS form 1040 or 
Schedule EIC, IRS would modify the Earned Income Tax Credit worksheets 
and related instructions to account for the combat zone pay.  In 
addition, they would work with DOD to develop a process for identifying 
and processing returns from taxpayers who would be affected by this 
provision.  The representatives noted that, although at the outset the 
process would likely be primarily manual, IRS would explore options for 
automation. The IRS officials also provided technical comments relating 
to the child tax credit, which we incorporated as appropriate, and made 
the point that changes to the treatment of income earned in a combat 
zone for the purposes of the two credits could affect other tax 
benefits, such as the dependent care credit and the exclusion for 
employer-provided benefits under a dependent care assistance program, 
depending on the specific wording of the changes. We also spoke to the 
Department of Treasury staff about the tax-related sections of our 
briefing documents and incorporated their technical comments as 
appropriate.

As arranged with your office, unless you publicly announce its contents 
earlier, we plan no further distribution of this report until 30 days 
from its issue date. At that time, we will send copies of this report 
to the Secretary of Defense and the Commissioner of the Internal 
Revenue Service. We will also make copies available to appropriate 
congressional committees and to other interested parties on request. In 
addition, the report will be available at no charge on our Web site at 
http://www.gao.gov.

If you or your staff have any questions about this report, please 
contact Derek Stewart, (202) 512-5559, or James White, (202) 512-5594, 
or e-mail them at stewartd@gao.gov or whitej@gao.gov, respectively. Key 
contributors to this report were Lori Atkinson, Jennifer Gravelle, John 
Pendleton, Sonja Ware, and James Wozny.

Signed by: 

Derek B. Stewart:

Director, Defense Capabilities and Management:

James R. White,

Director, Strategic Issues:

Enclosure I: Active Duty Military Compensation and Its Tax Treatment: 

[See PDF for image]

[End of figure]

Enclosure II: Methodology for Estimating Tax Effects of the Combat Zone 
Exclusion:

This enclosure describes the data and methodology we used to estimate 
(1) the extent of net loss of tax benefits from the combat zone 
exclusion and (2) the number of higher-income members who become 
eligible to earn the earned income tax credit as a result of service in 
a combat zone.

Estimating the Extent of Net Loss of Tax Benefits:

The tax effect of the combat exclusion is the difference between what a 
member's tax liability would have been with no time spent in a combat 
zone and his or her actual tax liability after having spent one or more 
months in a combat zone. The only conditions under which this tax 
effect can be negative is if (1) the service member's tax liability 
would have been negative if he or she spent no time in a combat zone 
and (2) the member's actual liability was a smaller negative value, 
zero, or positive after service in a combat zone. The first of these 
conditions is met if the member would have been able to earn refundable 
tax credits that more than offset his or her precredit tax liability. 
The second condition is met if the combat zone exclusion reduces the 
member's earned income to such an extent that the refunded portion of 
the member's tax credit is reduced or eliminated.[Footnote 6]

Due to significant data limitations, we were not able to make a precise 
estimate of the number of service members negatively affected by the 
combat zone exclusion in 2003. Nevertheless, the limited data available 
from DOD permitted us to estimate the rough order of magnitude of this 
number. The only way to make precise estimates of the two different tax 
liabilities (both in and out of the combat zone) for each member that 
served in a combat zone in 2003 would be to match personnel data from 
DOD with tax records from IRS for each of those members. We could not 
follow this approach because IRS records for 2003 would not be 
available to us for months. Given the time frames of this report, the 
only data we were able to use were Defense Manpower Data Center's 
aggregate numbers of service members in each enlisted and officer grade 
that were deployed in combat zones during 2003 and the limited data 
that DOD could provide us on relevant characteristics of service 
members, aggregated at the grade level. After discussing the 
reliability of the combat zone data with agency officials, we 
determined the data to be sufficiently reliable for our purposes.

Our overall estimation approach involved two steps. The first step was 
to compute the two tax liabilities for an extensive set of hypothetical 
service members. These hypothetical computations identified every 
combination of pay level, family size, and length of service in a 
combat zone during 2003 that could have resulted in a negative tax 
effect. The second step in our methodology was to use data on the 
characteristics of all active military personnel, by pay grade, as well 
as data on the number of service members from each pay grade that were 
deployed in a combat zone during 2003 to estimate the number deployed 
members who had income and family characteristics consistent with the 
hypothetical cases that showed negative effects.

Data from the DOD's Selected Military Compensation Tables (current as 
of October 2003) allowed us to make reliable estimates of the percent 
of married service members within each pay grade with one, two, three, 
and four or more children. The data indicated that the number of single 
service members with children in each grade was negligible, and so we 
excluded this subpopulation from our analysis. The same data source 
enabled us to determine the basic pay of service members, by pay grade 
and years of service. However, we did not have data on three other 
types of taxable income that we needed for our estimates: special pays, 
investment income, and spousal income.[Footnote 7] In the absence of 
the special pay and investment income data we used ranges of 
assumptions for the amounts of each of these types of income that each 
service member earned. These ranges of assumptions are reflected in the 
range that we provide for our end results. To deal with the lack of 
data on spousal income, we separated the service member population into 
two groups--those with spouses in the labor force and those 
without.[Footnote 8] The lack of data on spousal income does not affect 
our estimates for members without spouses in the labor force. 
Consequently, we could more easily estimate, at least within a broad 
range, the number of members in that group who were negatively affected 
by service in the combat zone. In contrast, we did not feel that we 
could reliably specify a range for the number of members with working 
spouses who were negatively affected; however, as we explain below, we 
were able to assess a rough order of magnitude for this group.

By combining the family and pay grade data listed above, we were able 
to estimate the number of all service members within a particular pay 
grade and with a specific number of years of service who had nonworking 
spouses and various numbers of children.[Footnote 9] We also had DOD 
data that allowed us to determine what percent of members in each pay 
grade were deployed in a combat zone for one month, what percent were 
deployed for two months, etc., for all possible lengths of stay in a 
combat zone. By assuming that the distribution of family 
characteristics across the deployed members within a particular pay 
grade and years-of-service category was the same as the distribution 
across all members (deployed or not) within that same grade and 
category, we were able to estimate the number of members with 
nonworking spouses who had the specific combinations of pay, family 
characteristics, and months of service in a combat zone that would have 
resulted in a net loss of tax benefits.

In the case of members with working spouses, we followed an approach 
similar to that just described; however, due to the lack of data on 
spousal income, there is greater uncertainty surrounding each member's 
household income and, thus, greater uncertainty about whether the 
member was negatively affected. Through our computations for 
hypothetical taxpayers, we determined that only members in grades E-1 
through E-6 with working spouses were likely to be negatively affected, 
and the large majority of those would be affected only if their spouses 
earned less than $6,000 in 2003. We estimate that up to about 25,000 
members with working spouses were in a combat zone for long enough 
periods in 2003 to have the potential to be negatively affected if 
their spouses' incomes were sufficiently low. We do not have actual 
data on the number of spouses with income low enough to have a negative 
effect. However, we believe that likely only a small percentage of them 
actually were negatively affected.

Estimating the Number of Higher-Income Members Who Become Eligible for 
the Earned Income Tax Credit:

To estimate the number of higher-income members who become eligible for 
the Earned Income Tax Credit, we follow the same general approach 
described above. However, instead of using tax rules and data on 
income, family size, and lengths of stays in combat zones to identify 
those members whose specific circumstances would result in a negative 
tax effect, we used the same information to identify those members who 
would not qualify for the Earned Income Tax Credit under normal 
circumstances, but who do qualify when they are deployed for a 
sufficient length of time in a combat zone.

As was the case with our estimates of the net loss of tax benefits, we 
cannot make a reliable estimate for members with working spouses. 
Although, we cannot make an estimate for the population of members 
without children, those members can qualify for an Earned Income Tax 
Credit of up to $400, but only if they are over 25 years old. We have 
no information on the age of members deployed in 2003, so we cannot 
determine how many of these members would qualify.

(350425):

FOOTNOTES

[1] U.S. General Accounting Office, Military Personnel: Active Duty 
Benefits Reflect Changing Demographics, but Opportunities Exist to 
Improve, GAO-02-935 (Washington, D.C.: Sept. 18, 2002). 

[2] The combat zone exclusion allows service members to exclude income 
earned for each month served in one of the 15 designated combat zones. 
Members who serve a minimum of 1 day in a combat zone are eligible to 
receive the combat zone exclusion for the respective month. For 
officers, the combat zone exclusion was limited to $5,958 per month in 
2003. Enlisted members' exclusion is not limited. 

[3] Although the allowances for housing and subsistence are the primary 
nontaxable allowances and account for most of service members' tax 
benefit, some members may receive other nontaxable allowances, such as 
the family separation allowance--that is, additional money provided to 
service members as compensation for being away from their spouses and/
or children. 

[4] Our estimates are based on information provided by DOD on the 
number of households with a spouse not in the labor force, the amount 
of military members' pay, and the 2003 deployment rates. They are also 
based on the assumption that deployed personnel in each pay grade have 
the same household characteristics as the total population of service 
members in each grade. These estimates are imprecise because we did not 
have information such as total family income, deductions, and other tax 
credits. See enclosure II for further details on our methodology. 

[5] According to a recent Congressional Budget Office report, noncash 
benefits in 2002 cost an average of $56,000 per active duty service 
member. However, this cost includes noncash compensation that service 
members receive while on active duty and estimated accrued cost of 
deferred compensation for the following noncash benefits: health care 
for service members, their dependents, and retirees; veterans' 
services; and other benefits, such as the Social Security Old-Age and 
Survivors Insurance and Disability Insurance programs. Also, this cost 
includes installation-based services for active duty members. 
Congressional Budget Office, Military Compensation: Balancing Cash and 
Noncash Benefits (Washington, D.C.: Jan. 16, 2004). 

[6] The only refundable tax credits that are likely to be widely used 
by members of the military are the earned income tax credit and the 
additional child tax credit. Over certain income ranges, the amount of 
credit that a taxpayer earns increases with earned income. Income 
earned in a combat zone is not included as earned income for the 
purpose of computing these credits. Consequently, there are cases where 
the combat zone exclusion reduces the refunded portion of the credits 
that members would otherwise have earned.

[7] We did not need information on nontaxable allowances because they 
have no effect on tax liabilities either in or out of a combat zone 
and, therefore, had no effect on our estimates.

[8] The July 2002 Status of Forces Survey of Active-Duty Members showed 
the percent of members with spouses not in the labor force. This survey 
percent is provided by broad pay grade groups, rather than for each 
individual grade (e.g., there was a single percent for all members in 
pay grades E1 to E3). 

[9] An important assumption that we made when combining these data is 
that the work status of a member's spouse was independent of the number 
of children that the member has. (The available data showed the percent 
of members by aggregated pay grade levels with a spouse not in the 
labor force and, separately, showed the percents of members in each 
grade with various numbers of children. The data did not show the joint 
occurrence of a nonworking spouse and a specific number of children.)