Chapter 12: Low-Income Assistance Chapter 8 Income Taxes Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

Chapter 8: Income Taxes Introduction Mechanics of the U.S. income tax Concepts underlying the income tax Issues in taxing capital income Issues in taxing labor income

Chapter 8: Income Taxes Tax Revenue from the Major Federal Taxes % of GDP % of Fed Revenue % of GDP % of Fed Revenue Household Income Taxes9.6%48%7.5%43% Payroll Taxes6.7%30%6.5%37% Corporate Income Taxes2%10%2.3%13% Excise Taxes0.8%4%0.6%3% Estate and Gift Taxes0.3%1%0.2%1% Customs Duties (Tariffs)0.2%1%0.2%1% Other Revenue0.4%2%0.3%2% TOTAL20%100%17.5%100% Table 8.1

Chapter 8: Income Taxes Determining Your Income Tax Total Income$100,000 - Adjustments- $4,000 = Adjusted Gross Income (AGI)= $96,000 - Personal Exemptions- $14,000 - Itemized (or Standard) Deductions- $12,000 = Taxable Income= $70,000 Tentative Tax$10,188 - Credits- $2,000 = Tax= $ Withholding- $7,000 = Payment (or Refund)= $1,188 Table 8.2

Chapter 8: Income Taxes Standard Deduction$10, OR -- Itemized Deductions State and income and property tax payments$9,000 Home mortgage interest payments$1,000 Charitable contributions$2,000 Medical expenses in excess of 7.5% of AGI$0 TOTAL$12,000 Table 8.3 Determining Your Income Tax

Chapter 8: Income Taxes Taxable IncomeTax Rate $0 to $16,05010% $16,050 to $65,10015% $65,100 to $131,45025% $131,450 to $200,30028% $200,300 to $357,70033% Over $357,70035% Table 8.4 Example tax schedule for married couples filing jointly, Marginal tax rate increases through six tax brackets. Determining Your Income Tax

Chapter 8: Income Taxes Table 8.5 Your tax as a percentage of your income Total Income$100,000 Adjusted Gross Income (AGI) $96,000 Taxable Income$70,000 Tax Bracket (Marginal Tax Rate)25% Tentative Tax$10,188 Tentative Tax as a Percent of Taxable Income14.6% Final Tax $8.188 Final Tax as a Percent of Taxable Income11.7% Final Tax as a Percent of AGI8.5% Final Tax as a Percent of Total Income8.2% Determining Your Income Tax

Chapter 8: Income Taxes The Alternative Minimum Tax (AMT) Determining Your Income Tax Replaces the regular income tax for a subset of high-income households The AMT is not indexed Marriage penalty Marriage bonus Different tax schedules for married couples and single persons

Chapter 8: Income Taxes Ability-to-pay Concepts Underlying the Income Tax An income tax taxes households according to their ability-to-pay If the ratio of tax to taxable income stays constant as taxable income rises, the schedule is proportional. Proportional, Progressive, Regressive If the ratio of tax to taxable income rises as taxable income rises, the schedule is progressive. If the ratio of tax to taxable income falls as taxable income rises, the schedule is regressive.

Chapter 8: Income Taxes Proportional, Progressive, Regressive Taxable IncomeTaxTax as a % of Taxable Income L$16,050$1,60510% H$32,100$4, % Table 8.6 Taxable IncomeTaxTax as a % of Taxable Income L$25,000$1,0004% H$50,000$6,00012% Table 8.7

Chapter 8: Income Taxes Comprehensive Income Table 8.8 January 1 Assets$20,000 Bank Account ($10,000), Corporate Stock ($10,000) January 1 Liabilities (Debt)$5,000 January 1 Wealth$15,000 Sources of Income Jan. 1 – Dec. 31$40,000 Interest ($1,000), Dividends ($1,000), Wage Income ($38,000) Uses of Income Jan. 1 – Dec. 31$40,000 Consumption ($36,000), Increase in Wealth (4,000) December 31 Assets$24,000 Bank Account ($14,000), Corporate Stock ($10,000) December 31 Liabilities (Debt)$5,000 December 31 Wealth$19,000

Chapter 8: Income Taxes Gifts or inheritances received by a household The exclusion from tax of employer-paid health insurance The deferral of tax on contributions to certain retirement accounts The income tax differs from a comprehensive income tax. Exclusion of interest from state and local bonds The deferral of tax on unrealized capital gains Comprehensive Income

Chapter 8: Income Taxes The Deferral of Tax on Unrealized Capital Gains Table 8.9 January 1 Assets$20,000 Bank Account ($10,000), Corporate Stock ($10,000) January 1 Liabilities (Debt)$5,000 January 1 Wealth$15,000 Sources of Income Jan. 1 – Dec. 31$41,000 Interest ($1,000), Dividends ($1,000), Wage Income ($38,000), Capital Gain ($1,000) Uses of Income Jan. 1 – Dec. 31$41,000 Consumption ($36,000), Increase in Wealth (5,000) December 31 Assets$25,000 Bank Account ($14,000), Corporate Stock ($11,000) December 31 Liabilities (Debt)$5,000 December 31 Wealth$20,000

Chapter 8: Income Taxes December 31 Assets$25,000 Bank Account ($25,000), Corporate Stock ($0) December 31 Liabilities (Debt)$5,000 December 31 Wealth$20,000 Table 8.10 The Deferral of Tax on Unrealized Capital Gains Only realized capital gains are subject to income tax. Tax on unrealized capital gain is deferred until the stock is sold. Suppose you sell the stock and deposit the $11,000 into your bank account.

Chapter 8: Income Taxes The Taxation of Nominal Rather than Real Capital Income pii–pTax Ruleti–ti–t–p 10%4% 25% tax on i1%3% 28%12%4%25% tax on i3%9%1% 38%12%4%25% tax on (i-p)1%11%3% Table 8.11 Nominal versus real interest rates There is an impact on savings and capital gains.

Chapter 8: Income Taxes Credits versus Deductions Spending on X DeductionTax Bracket Tax Savings H$1,000 35%$350 L$1,000 15%$150 Table 8.12 With a tax deduction, Congress has no control over the size of the assistance or how assistance varies with household income. Both are determined by the household’s tax bracket

Chapter 8: Income Taxes Credits versus Deductions Spending on X Credit RateCredit Tax Savings H$1,00025%$250 L$1,00025%$250 H$1,00035%$350 L$1,00015%$150 H$1,00015%$150 L$1,00035%$350 With a tax credit, both vary with household income. Table 8.13 Target low income households with a refundable tax credit.

Chapter 8: Income Taxes Encouraging Home Ownership Mortgage Interest Payment DeductionTax Bracket Tax Savings H$1,000 35%$350 L$1,000 15%$150 Table 8.14 There is a tax deduction for mortgage interest payments This policy gives a much larger assistance to high-income households than low-income households. Should a deduction or credit have a ceiling or a floor?

Chapter 8: Income Taxes The deduction of state and local tax payments The deduction for home mortgage interest payments The deduction for medical expenses in excess of 7.5% of AGI Various important itemized deductions, exemptions, and credits exist under the U.S. income tax Personal exemptions and the child tax credit Particular Deductions. Exemptions, and Credits

Chapter 8: Income Taxes A tax deduction is given for saving in the year it occurs Capital income is exempt from tax as it is earned Tax is deferred until the capital gains are realized Retirement savings incentives Nominal, not real, capital gains are taxed Issues in Taxing Capital Income Capital gains Business income Depreciation The corporate income tax Business can incorporate to benefit from limited liability

Chapter 8: Income Taxes The U.S. estate and gift tax The Estate Tax A bequest is the estate (wealth) that will be given to heirs after a person’s death A unified transfer tax coordinates the taxation of a person’s estate at death with gifts given prior to death. Taxing gifts and inheritances received under the income tax Should wealth be taxed annually or periodically?

Chapter 8: Income Taxes Exclude capital income from the income tax Household taxation plus progressivity creates a dilemma for a second-earner Household taxation, progressivity, and the second earner Issues in Taxing Labor Income Both the Social Security and the Medicare payroll taxes are regressive A labor income tax The payroll tax

Chapter 8: Income Taxes Summary Mechanics of the U.S. income tax Concepts underlying the income tax Issues in taxing labor income Issues in taxing capital income

Chapter 8: Income Taxes Preview of Chapter 9: Consumption Taxes A household consumption tax The flat tax and the X-tax A retail sales tax compared to a value-added tax Replacing the income tax with a consumption tax A consumption tax vs. a labor income tax Which tax is fairest? Pollution, transportation, and health taxes