An estimated 5,000 to 10,000 military members fighting in Iraq and Afghanistan last year received combat-zone tax exclusions that had a surprising effect: lowered family incomes.

Some families saw a net loss in tax benefits of more than $4,000 because wartime tax exclusions disqualified them for more valuable tax breaks, including the Earned Income Tax Credit.

Higher numbers of military families than last year could see the same sort of tax benefit loss in 2004, say congressional auditors.

A Defense Department proposal to address the problem this spring failed to clear the White House’s Office of Management and Budget. Treasury officials said it would lower tax revenues and therefore opposed it.

“We will continue to work [the issue] and try again next year,” said Charles S. Abell, principal deputy undersecretary of defense for personnel and readiness, in a Wednesday phone interview.

The notion that combat-zone tax exclusions actually can lower overall tax breaks for low-income military families sounds “counterintuitive,” Abell said. So when the first complaints from servicemembers surfaced in January, he was skeptical. Visits with deployed forces, however, found a growing problem and staff analysis confirmed it.

“I would ask folks like the senior enlisted advisers about this, saying ‘I don’t get it.’ They’d come back and say, ‘Yeah, troops are telling us this, and tax advisers in units are agreeing with them,’” said Abell.

Victims of the net loss in tax benefits typically are lower-grade enlisted or junior officers who serve seven months or more in combat zones during the tax year, are married with children and have little or no other family income, either from spouses or investments.

Even some members whose spouses work see net losses in tax benefits, according to a new General Accounting Office report on the issue. Those numbers, however, are harder to estimate and likely don’t exceed several thousand, GAO said.

Combat-zone tax exclusions remain a welcomed benefit to most servicemembers fighting the global war on terrorism. Income earned in war zones, including basic pay, bonuses and special pays, are fully tax exempt for enlisted personnel. Officer combat tax exclusions are capped with the first $5,958 in monthly earning excluded in 2003.

But in a letter report to the Senate Finance Committee this month, GAO confirmed “unintended consequences” when combat-zone tax exclusions cross with other tax breaks such as the Earned Income Tax Credit.

EITC lowers tax liabilities for 21 million working Americans. It not only can wipe out tax bills but refundable tax credits can put government payments in their pockets. The maximum credit in 2003 was $4,204 for a taxpayer with two or more qualifying children, $2,547 for a taxpayer with one child and $382 for a taxpayer without a child.

To qualify for EITC, earned and adjusted gross income must be less than $33,692 ($34,692 if married filing jointly) with more than one qualifying child, $29,666 ($30,666 if married filing jointly) with one child and $11,230 ($12,230 if married filing jointly) without a child.

Combat zone tax exclusions affect eligibility for EITC by lowering servicemembers’ taxable income. Because low-income military families don’t pay income taxes anyway, the combat tax exclusion can eliminate tax credits that otherwise would put cash in their pockets.

“These members actually suffer a net loss in tax benefits because they receive no offsetting advantage from the [combat zone] tax exclusion,” explained the report (GAO-04-721R).

Combat zone tax exclusions also bring positive unintended consequences. Servicemembers who usually earn too much to qualify for EITC see their combat tax exclusions lower taxable income to a point where they can draw refundable tax credits.

“This thing works in a perverse way,” said Abell. When combat tax exclusions are combined with EITC, senior enlisted personnel and, in some cases, even full colonels can qualify for tax credits. These more extreme windfalls occur when senior enlisted members or officers serve only part of the year in a combat zone, leaving them with just enough taxable income to qualify for low-income tax credits.

To end this “inversion,” said Abell, the Defense Department drafted a legislative proposal this spring that would have set aside combat-zone tax exclusions for the purpose of calculating EITC or other special tax credits.

“I was just trying to say, ‘Look, when you devised Earned Income Tax Credit you never envisioned combat-zone tax exclusions. So why don’t we exempt these tax exclusions from calculations for Earned Income Tax Credit?’ Everybody’s happy. My colonels don’t qualify and my privates do.”

Trying to apply the change retroactively would have been more difficult, Abell said, and was not part of the department’s proposal. As it was, Treasury officials did their own cost analysis and disagreed with DOD that the change would have no impact on government revenues.

Given that “the administration and Congress were having a fuss over extending tax cuts,” Abell said, “it … fell at the wrong time.”

OMB shelved the proposal. Defense officials will look for a way to offset any revenue loss, Abell said, and push the issue again next year.

“We’ll be back and we’ll try to craft it better next time,” he said.

— Comments are welcomed. Write to Military Update, P.O. Box 231111, Centreville, VA 20120-1111, e-mail or visit: www.militaryupdate.

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