Military Personnel
Active Duty Compensation and Its Tax Treatment Gao ID: GAO-04-721R May 7, 2004The 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. 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, Congress asked us to provide the Chairman and Ranking Minority Member of the Senate Committee on Finance with information on active duty military compensation and its tax treatment. In January 2004, we briefed Congressional staff on our preliminary observations. Because our work identified that the combat zone tax exclusion could impact some service members, Congress 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 Congress 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.
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 general, regular military compensation progresses steadily with pay grade and years of service. 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. 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. 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. 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.
RecommendationsOur recommendations from this work are listed below with a Contact for more information. Status will change from "In process" to "Open," "Closed - implemented," or "Closed - not implemented" based on our follow up work.
Director: Team: Phone:GAO-04-721R, Military Personnel: Active Duty Compensation and Its Tax Treatment
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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.)
