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Copyright © 2002 by Thomson Learning, Inc. Chapter 14 Taxation of Personal Income in the United States Copyright © 2002 Thomson Learning, Inc. Thomson Learning™ is a trademark used herein under license. ALL RIGHTS RESERVED. Instructors of classes adopting PUBLIC FINANCE: A CONTEMPORARY APPLICATION OF THEORY TO POLICY, Seventh Edition by David N. Hyman as an assigned textbook may reproduce material from this publication for classroom use or in a secure electronic network environment that prevents downloading or reproducing the copyrighted material. Otherwise, no part of this work covered by the copyright hereon may be reproduced or used in any form or by any means—graphic, electronic, or mechanical, including, but not limited to, photocopying, recording, taping, Web distribution, information networks, or information storage and retrieval systems—without the written permission of the publisher. Printed in the United States of America ISBN 0-03-033652-X
Copyright © 2002 by Thomson Learning, Inc. The Tax Base: Basic Rules for Calculating Taxable Income and Why Much of Income Is Untaxed Taxable Income is the portion of income received by households that is subject to the personal income tax. Gross Income is all income received during the year from taxable sources. Adjusted Gross Income (AGI) is Gross Income – allowable adjustments (reimbursed employee business expenses, contributions to special retirement plans, penalties for early withdrawal, and alimony.
Copyright © 2002 by Thomson Learning, Inc. Personal Exemptions Personal Exemptions are certain sums of money that a taxpayer is allowed to subtract from AGI in the process of getting taxable income. In 2000 this was $2800 for each person in the household.
Copyright © 2002 by Thomson Learning, Inc. Deductions These are further reductions from AGI. Taxpayers may take the standard deduction or they may itemize. Taxpayers take whichever amount is greater.
Copyright © 2002 by Thomson Learning, Inc. The Standard Deduction The Standard Deduction is a fixed dollar amount that may be used to reduce AGI to compute taxable income. It is adjusted for inflation each year and varies with the filing status of the taxpayer. For those filing as singles the standard deduction in 2000 was $4,400 while for married couples filing jointly it was $7,350.
Copyright © 2002 by Thomson Learning, Inc. Itemized Deductions Itemized Deductions are expenses that are legally deductible from AGI to compute taxable income. The most significant of these are the deductions for home mortgage interest, major medical expenses, charitable contributions, and state and local income and property taxes.
Copyright © 2002 by Thomson Learning, Inc. Untaxed Income Only 45% of total personal income in the United States is subject to the federal income tax. This can be seen with a simple example. Take a family of four with an income of $35,000. If it takes the personal exemption for each person in the household and the standard deduction for a married couple filing jointly they only have to pay taxes on $16,450. ($35,000 – 4 × $2,800 – $7,350).
Copyright © 2002 by Thomson Learning, Inc. The Tax Rate Structure In 2000 there were five tax brackets for every filing status. A tax bracket is the range of taxable income in which the marginal rate is constant.
Copyright © 2002 by Thomson Learning, Inc. Figure 14.1 Statutory Marginal Tax Rates for the U.S. Personal Income Tax, 2000 Marginal Tax Rate (Percent) MTR Taxable Income 0 39.6 ACD 36 31 28 15 C = $132,600 for single taxpayers = $161,450 for married taxpayers filing jointly D = $288,350 for single taxpayers and married taxpayers filing jointly A = $26,250 for single taxpayers = $43,850 for married taxpayers filing jointly B = $63,550 for single taxpayers = $105,950 for married taxpayers filing jointly B
Copyright © 2002 by Thomson Learning, Inc. Taxation of Low-Income Households Low-income households in the U.S. typically pay no federal income tax and many actually face a negative income tax. This works because the Earned Income Tax Credit targets money to families with low- income and this credit can easily exceed their federal income tax obligations. They still face FICA (Social Security) taxes and other state and local taxes.
Copyright © 2002 by Thomson Learning, Inc. The Effect of Various Credits on the Tax Rate Structure Some credits, such as the Hope Credit and the Lifetime Learning credit have income phase-in and phase-out periods in which households with higher incomes are decreasingly eligible or ineligible for certain tax credits. This can mean that an individual family has eleven potential tax brackets.
Copyright © 2002 by Thomson Learning, Inc. Effective Rates for Federal Individual Income Taxes and Total Federal Taxes by Income Quintile, 1998 Income Quintile –10 0 Effective Tax Rate (Percent) Second Lowest Third Fourth Highest 20 Individual Income Taxes A 0 10 Effective Tax Rate (Percent) Second Lowest Third Fourth Fifth 30 20 All Federal Taxes B
Copyright © 2002 by Thomson Learning, Inc. Marginal Tax Rates for a Couple With Two Children in College, One Eligible for a Hope Credit and the Other Eligible for a Lifetime Learning Credit 50 40 30 20 100,000 Marginal Tax Rate (Percent) Annual Income (Dollars) 50,000150,000200,000 10 0 –10 –20 –30 –40 –50 Child Credit Phaseout Range 31 Percent Bracket Begins Personal Exemption Phaseout Begins Child Credit Phasein Ends EITC Phaseout Ends EITC Phaseout Begins 15 Percent Bracket Begins; Child Credit Phase in Begins 28 Percent Bracket Begins Itemized Deduction Phaseout Begins 36 Percent Bracket Begins EITC Phasein Range
Copyright © 2002 by Thomson Learning, Inc. Marginal Tax Rates for a Single Head of Household With Two Children Under Age 17 50 40 30 20 Marginal Tax Rate (Percent) Annual Income (Dollars) 50,000100,000150,000200,000 10 0 –10 –20 –30 –40 28 Percent Bracket Begins Education Credits Phasein Ends EITC Phaseout Begins EITC Phasein Range Itemized Deduction Phaseout Begins Education Credits Phaseout Range 36 Percent Bracket Begins 31 Percent Bracket Begins Personal Exemption Phaseout Begins
Copyright © 2002 by Thomson Learning, Inc. Tax Preferences Tax Preferences are exclusions, exemptions, and deductions from the tax base. They are referred to as tax loopholes. They are intentional or unintentional means by which income can be earned and is not subject to the income tax.
Copyright © 2002 by Thomson Learning, Inc. Justification for Tax Preferences Tax preferences are usually justified because having the preference: Reduces Administrative Difficulty Improves Tax Equity Encourages Private Expenditures on Goods With External Benefits
Copyright © 2002 by Thomson Learning, Inc. The Administrative Difficulty Justification When a tax provision is difficult to administer or comply with properly, it is argued that a provision that partially or fully exempts certain income may be better than a complicated, difficult to comply with provision in terms of net tax efficiency. This argument is used to justify the provision that allows capital gains taxes to be deferred until the gains are realized.
Copyright © 2002 by Thomson Learning, Inc. The Equity Justification Tax preferences are often justified with the argument that they make society fairer. A college education tax break can be justified as making it easier for lower-income households to send their children to college so that these children may have the same chance in life as children from higher-income households.
Copyright © 2002 by Thomson Learning, Inc. The External Benefits Justification Chapter 4 showed that offering a subsidy to a good with an external benefit increases societal welfare. Tax provisions can be used to implement that subsidy.
Copyright © 2002 by Thomson Learning, Inc. Excess Burden of Tax Preferences Unless the tax preference is designed to internalize some externality, excess burden is created with tax preferences.
Copyright © 2002 by Thomson Learning, Inc. Figure 14.2 Tax Preference and Efficiency Price Output of Tax-Preferred Activity per Year 0 Q1Q1 Q* PGPG AB C D = MSB Net Price S = MSC P G (1 – t) = P N
Copyright © 2002 by Thomson Learning, Inc. Figure 14.3 Decrease in Excess Burden of Tax Preferences Price (Dollars) New Net Price Tax-Preferred Activity per Year 0Q1Q1 Q* PGPG S = MSC D = MSB A Q2Q2 B Initial Net Price 0.72 P G 0.50 P G B’ C’ C
Copyright © 2002 by Thomson Learning, Inc. Tax Preferences in the US Income Tax System In-Kind Income Home Production Fringe Benefits Transfers Capital Gains Interest on State and Local Bonds Miscellaneous Exclusions and Adjustments
Copyright © 2002 by Thomson Learning, Inc. The Tax Preference for In-Kind Income Taxpayers who own their own homes and pay no mortgage or rent get what economists call imputed rent. This money that they do not have to pay should be treated as income under the Haig-Simons definition. It is not in part because doing so would be nearly impossible to implement.
Copyright © 2002 by Thomson Learning, Inc. The Tax Preference for Home Production Improvements that taxpayers perform on their house increases their net worth. This increase in value is not taxed. Again, it would be impossible to implement a system by which home production was taxed.
Copyright © 2002 by Thomson Learning, Inc. The Tax Preference for Fringe Benefits Employer paid health insurance, pension funds, and other perks of employment are not taxed. This costs the federal government $180 billion annually in lost tax revenue.
Copyright © 2002 by Thomson Learning, Inc. The Tax Preference for Transfers Most government welfare payments are tax-exempt. A portion of Social Security income is taxable if other income is sufficiently high.
Copyright © 2002 by Thomson Learning, Inc. The Tax Preference for Capital Gains Capital Gains income is not taxed until it is realized. This tax deferral amounts to a tax preference. Those capital gains that are realized are taxed at a reduced rate (10% for those in the 15% tax bracket and at 20% for those in the higher tax brackets). Capital gains taxes are typically forgiven at death. These amount to substantial preferences and are justified by the fact that much of capital gains is not income at all but simply inflationary gains that should not be taxed under the Haig-Simons definition.
Copyright © 2002 by Thomson Learning, Inc. The Tax Preferences for Interest on State and Local Bonds State and Local bonds are more attractive to investors and this allows these entities to pay lower interest rates.
Copyright © 2002 by Thomson Learning, Inc. Miscellaneous Exclusions and Adjustments Certain scholarships and fellowships for academic purposes are not taxable as income. Earnings contributed to certain savings plans allow for income to be saved pre-tax. For most of these plans this tax preference is simply a tax deferral and a tax deferred is viewed as a tax lessened.
Copyright © 2002 by Thomson Learning, Inc. Itemized Deductions Medical Expenses State and Local Income and Property Taxes Interest Payments for First and Second Homes Charitable Contributions Miscellaneous Deductions
Copyright © 2002 by Thomson Learning, Inc. Deducting Medical Expenses Medical expenses and health insurance payments that exceed 7.5% of AGI are deductible. For practical purposes, one must be quite ill or in a nursing home to benefit from this provision.
Copyright © 2002 by Thomson Learning, Inc. Deducting State and Local Income and Property Taxes All income and property taxes paid to state and local governments are deductible. This makes it somewhat easier for state and local governments to raise their taxes.
Copyright © 2002 by Thomson Learning, Inc. Deducting Interest Payments on Home Mortgages The interest paid on the mortgages of first and second homes is deductible. Interest on credit cards or loans for automobiles and college loans are not. This provision has lead to the phenomenon whereby people take out second mortgages to purchase automobiles rather than getting a car loan directly.
Copyright © 2002 by Thomson Learning, Inc. Deducting Charitable Contributions Money given to charitable organizations is deductible.
Copyright © 2002 by Thomson Learning, Inc. Miscellaneous Deductions If unreimbursed business expenses exceed 2% of AGI, then the excess is deductible.
Copyright © 2002 by Thomson Learning, Inc. The Alternative Minimum Tax The Alternative Minimum Tax (AMT) prevents high-income earners from having so many deductions and credits that they owe little tax.
Copyright © 2002 by Thomson Learning, Inc. Deductions versus Credits A tax credit directly reduces taxes owed while a tax deduction reduces the amount of income subject to tax. Generally, for an equal cost to government revenues, a credit favors low-income earners while a deduction favors high-income earners.
Copyright © 2002 by Thomson Learning, Inc. Tax Expenditures Item Projected Revenue Loss (in billions) Exclusion of Employer Pension Contributions 88.83 Employer Contributions for Medical Insurance75.01 Deduction of Mortgage Interest58.81 Deduction of State and Local Taxes (not home property)40.24 Accelerated Depreciation of Machinery and Equipment27.74 Step-Up Basis of Capital Gains at Death27.09 Exclusion of Social Security Pension Benefits for Retirees24.50 Deduction of Charitable Contributions24.46 Exclusion of Interest on Public-Purpose State and Local Government Debt 22.95 Deduction of State and Local Property Taxes on Homes22.18
Copyright © 2002 by Thomson Learning, Inc. Issues in Income Tax Policy The Flat Tax Capital Gains Taxes Bracket Creep The Marriage Penalty A National Sales Tax
Copyright © 2002 by Thomson Learning, Inc. The Flat Tax At various times, politicians have responded to the anger citizens have concerning the complicated nature of the federal income tax by recommending a flat tax. Such a tax would allow few, if any, tax preferences and would tax the entire tax base at the same rate.
Copyright © 2002 by Thomson Learning, Inc. The Economic Impact of a Flat Tax Depending on the proposal, a flat tax would generally reduce excess burden associated with tax preferences. Depending on the size of the personal exemption, it would dramatically lower taxes paid by the upper end of the tax scale. If the flat tax eliminated the EITC, it would dramatically raise the net income tax paid by those at the lower end of tax scale.
Copyright © 2002 by Thomson Learning, Inc. Capital Gains Taxes Inflation and Capital Gains: Inflation raises the price of assets. Economists see this as taxing a gain that does not exist. All else equal, this provision overtaxes long-term capital gains income. Taxation of Capital Gains on Realization: This provision allows people to decide when or if they will pay taxes on capital gains. You can defer the tax by deferring the gain. The Stepped-up Basis on Death: This provision means that the taxes that would be owed on capital gains are forgiven at death. The latter two provisions lead to a “lock-in effect” where people are encouraged to hold assets rather than sell them.
Copyright © 2002 by Thomson Learning, Inc. Bracket Creep Prior to 1986 tax brackets were not subject to inflation indexation, which meant that inflation caused people to owe more taxes each year on the same real income. This is called bracket creep. The AMT has not been indexed for inflation. Tax brackets are indexed by the CPI. Economists generally agree the CPI over- estimates inflation by around 1 percentage point. This has the effect of lowering real taxes owed each year.
Copyright © 2002 by Thomson Learning, Inc. The Marriage Penalty and Bonus People who are married and earn about the same level of income pay more in taxes than they would if they were not married and simply living together. This is called the marriage penalty. Married couples earning $50,000 where each party earns $25,000 a year pay more than $1000 more in tax because they are married. Conversely, people who are married with only one spouse earning all or most of the income pay less than they would if they were not married and living together. This is called the marriage bonus.
Copyright © 2002 by Thomson Learning, Inc. A National Consumption or Sales Tax Another policy option that has been suggested is to convert the system to a national sales tax or a national consumption tax. A sales tax would operate just like most sales tax in the states that have them. A consumption tax would operate just like the current income tax except reinvested capital gains would not be considered income and contributions to savings plans would be deductible.
Copyright © 2002 by Thomson Learning, Inc. Income Taxes and Economic Growth Evidence suggests that countries that rely heavily on income taxes grow more slowly than those that rely on consumption taxes. Evidence also suggests that a decrease in the marginal tax rate by 5% leads to a.2 to.5 percentage point increase in real growth.
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