THE PERSONAL INCOME TAX Chapter 17

Computation of Federal Personal Income Tax Liability Start with Tax Base Wages and compensation, interest, dividends, capital gain (or loss), business income (or loss), pensions, farm income (or loss), rents, royalties, Social Security benefits, etc. Subtract by “Above-the-line” deductions Trade or business expenses, moving expenses, educator expenses, self-employed health insurance premium payments, student loan payments, tuition and fees, alimony paid, etc. Equals Adjusted Gross Income Subtract Exemptions Phaseout with income Compare Larger of: Standard Deduction or Itemized Deductions Charitable contributions, home mortgage interest, state and local taxes, medical expenses in excess of 10% of AGI, casualty and theft losses, non-reimbursed employee expenses; Differs by filing status Phaseout with income Equals Taxable Income Apply Tax Rate Seven ordinary rates (10%, 15%, 25%, 28%, 33%, 35%, 39.6); differs by filing status; special rates for dividends and capital gains Equals Tax Liability Before Credits Subtract Tax Credits Child tax, additional child tax, EITC, HOPE and Lifetime Learning, electric vehicles, health coverage tax, adoption, mortgage interest, retirement savings contribution, child and dependent care credit, credit for the elderly or the disabled, D.C. First-Time homebuyer’s credit, etc. Phaseout with income Equals Regular Tax Liability Start over to determine AMT tax liability using AMT base. Pay tentative AMT liability in excess of regular tax liability Then Pay Tax or Claim Refund Incur additional compliance, administration, and efficiency costs 17-2

Haig-Simons Income (Comprehensive Income) Income = Consumption +  Net Worth Maximum consumption taxpayers can enjoy without spending down their wealth Anything received that can be used, either now or later, to purchase goods and services Subtract costs of earning income 17-3

Items Included in H-S Income Employer pension contributions and insurance purchases Transfer payments, including Social Security benefits, unemployment compensation, and welfare Capital gains – Realized versus unrealized Income in-kind 17-4

Some Practical and Conceptual Problems Computing income net of business expenses Computing capital gains and losses Valuing in-kind services 17-5

Evaluating the H-S Criterion Equity – treats likes alike Efficiency – treats all forms of income the same so that decisions are made on the basis of economic value, not tax consequences 17-6

Excluded Forms of Money Income Interest on State & Local Bonds Some dividends Capital gains Employer contributions to benefit plans Some types of saving – Individual retirement account (IRA) – Roth IRA – 401(k) plan – Keogh plan – Education savings account Gifts and Inheritances 17-7

Interest on State and Local Bonds Tax break reduces interest rate S&L governments have to pay Market ROR on Taxable Bonds = i p = 15% Individuals MTR = t = 30% Government Tax-Exempt Bond ROR = i g = (1-t)i p = 10.5% Cost of break to Treasury exceeds gain to S&L government i p = 15%t 1 = 30% i g = 10.5% t 2 = 20% i g = 12% If person 2 lends $1,000 Treasury loses $1,000*.15*.20 = $30 and State saves $1,000*.03 = $30 If person 1 lends $1,000 Treasury loses $1,000*.15*.30 = $45 and State saves $1,000*.03 = $

Capital Gains Example 1: Tax is levied only when capital gains are realized P = $100,000 ROR=g = 10% # Years held=20 MTR=.2 $100,000*(1+.1)^20 = $672,750 Capital Gain = $672,750 - $100,000 = $572,750 Tax = $572,750 *.2 = 114,550 Net Gain = $458,200 Example 2: Tax is levied as capital gains accrue regardless of whether realized P = $100,000 g = 10%net g = 10%(1-.2) = 8% $100,000*(1+.08)^20 = $466,096 Capital Gain = $466,096 - $100,000 = $366,096 Taxes deferred are taxes saved Lock-in Effect Gains Not Realized at Death 17-9

Evaluation of Capital Gains Rules No justification under optimal tax literature for preferential treatment of capital gains under H-S criterion Other justifications – Capital gains are unexpected windfalls – Require sacrifice of abstaining from consumption – Needed to stimulate capital accumulation and risk taking – Counterbalance to effect of inflation 17-10

Personal Exemptions Allowable Exemptions – Taxpayer and spouse – Children under 19 (or 24 if in school) – Children and other relatives who pass certain tests (depend on taxpayer for support) – Phase out Why are there exemptions? – Adjust ability to pay for presence of children – Provide tax relief for low-income families 17-11

Deductions Standard versus Itemized Deductibility and Relative Prices – P Z  (1-t)P Z 17-12

Deductions Important Itemized Deductions – Charitable Contributions – Unreimbursed medical expenses > 10% AGI – State and Local Income and Property Taxes – Certain Interest Expenses Interest on consumer debt Interest on qualified education loans Interest on debt incurred to purchase financial assets Interest on home mortgages Interest rules in terms of H-S criterion Tax Arbitrage 17-13

More Deduction Issues Deductions and complexity Deductions versus credits Itemized deduction phase out Standard deduction 17-14

Exemptions and Deductions Impact on the Tax Base 17-15

Tax Expenditures What are tax expenditures? Annual tax expenditure budget Technical problems with measuring tax expenditures – Incentive effects – Defining income – The decision not to tax is not equivalent to a government expenditure Why are tax expenditures to popular? 17-16

The Simplicity Issue The U.S. personal income tax has always been complicated Additional Confusion: Sunset Provisions that require given changes in laws to expire at specific dates in the future – Make long-term planning difficult – Example: Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) 17-17

Rate Structure Official Statutory Tax Rate Schedule (2013) Source:

Effective versus Statutory Rates Statutory rates differ from effective rates – Tax system treats some forms of income preferentially – Tax shifting – Excess burden and administrative costs 17-19

Flat Income Tax Features of Flat income tax – Applies same tax rate to everyone and each component of income – Limited deductions Arguments in favor – Reduces excess burden – Reduces incentive to cheat – Greater simplicity – Equity Arguments against – Shifts burden from rich to middle class – Simplicity an illusion Altig et. Al. [2001] 17-20

Taxes and Inflation Tax Indexing How inflation affects taxes – Bracket creep – Deductions and exemptions set in nominal terms – Taxation of nominal capital gains – Taxation of nominal interest 17-21

Taxation of Nominal Interest Real after-tax rate of return: r = (1 – t)i – π Let t = 25%, i = 16%, π = expected inflation rate = 10% r = (1 -.25)(.16) -.10 =.02 = 2% Now assume expected rate of inflation and nominal interest rate both increase by 4 percentage points r = (1 -.25)(.20) -.14 =.01 = 1% 17-22

Tax Indexing Ad hoc reductions in tax rates Indexing of parts of tax code [1981] Should indexing be maintained? – No – ad hoc adjustments force legislature to reexamine the entire tax code – Yes – desirable to have a stable and predictable tax code and fewer opportunities for legislative mischief 17-23

The Alternative Minimum Tax Brief history of the AMT Computing the tax base under AMT – Add AMT tax preferences to regular taxable income – Subtract AMT exemption – Alternative minimum tax income (AMTI) Computing Tentative AMT – Apply AMT tax rate schedule to AMTI Taxpayer pays higher of tentative AMT or regular income tax liability 17-24

Why does the AMT affect so many taxpayers? Why has AMT become more important? – Cuts in regular tax liability relative to the AMT Problems with AMT – Fairness – Efficiency – Simplicity 17-25

Choice of Unit and the Marriage Tax Three principles – The income tax should embody increasing marginal tax rates – Families with equal income should, other things being the same, pay equal taxes – Two individuals’ tax burdens should not change when they marry; the tax system should be marriage neutral No tax system can adhere to all three simultaneously 17-26

Tax Liabilities Under a Hypothetical System Individual Income Individual Tax Family Tax with Individual Filing Joint Income Joint Tax Lucy$1,000$ 100 $12,200$30,000$12,600 Ricky29,00012,100 Ethel15,0005,100 10,20030,00012,600 Fred15,0005,

Brief History of Marriage Tax in the United States Pre-1948 taxable unit was individual 1948 family became taxable unit – Income splitting 1969 New tax rate schedule for unmarried people created 1981 New deduction for two-earner married couples added 1986 Two-earner deduction eliminated 2001 law reduced (but did not eliminate) marriage penalty 17-28

Analyzing the Marriage Tax Advantages to using the family as taxable unit – Fairer treatment of non-labor income (bedchamber transfers of property) – Family a bedrock institution of society Disadvantages of using the family as taxable unit – Given high divorce rates, bedchamber transfers of property may not be significant – Defining the family Efficiency issues – Does tax system affect marriage and divorce rates? – Labor supply 17-29

Treatment of International Income Global versus territorial systems Equity Efficiency – Production decisions – Residential decisions 17-30

State Income Taxes State income taxes similar to federal tax Lower marginal tax rates Including state tax rates when assessing overall marginal tax rates 17-31

Tax Arbitrage Assume Caesar pays taxes at a 35% rate and can borrow all he wants at a 15% interest rate Let Cesar borrow $1,000 Each year he pays $150 in interest (=.15*1,000) Interest payment reduces taxable income $150 and saves $52.50 in taxes (=.35*150) His net payment of interest is $150 - $52.50 = $97.50 for an effective interest rate of $97.50/$1,000 = 9.75% If he can invest in state & local bonds at 11%, the tax system has created a “money machine” 17-32

Chapter 17 Summary The Haig-Simons criterion of income is the next change in the individual’s power to consume. The U.S. federal tax system is far removed from the Haig-Simons criterion Computing federal income tax liability involves determining the total income base, taxable income – the tax base minus deductions and exemptions - and tax liability – taxable income times a tax rate – Tax expenditures are forgone revenues due to preferential tax treatment The alternative minimum tax was designed to ensure that high- income earners who use tax shelters pay some federal income tax, although it affects millions of middle-class earners Currently, joint tax liabilities can increase or decrease upon marriage Taxes due are roughly independent of whether the income is earned at home or abroad 17-33