1. Chapter 33
Personal Income Taxes

2. Chapter Outline HOW INCOME TAXES WORK ISSUES IN INCOME TAXATION
INCENTIVES AND THE TAX CODE
THE TAX DEBATE OF THE 1990s AND BEYOND

3. Where Personal Income Taxes Fit
In 2002 the federal government collected $1,853 billion in taxes.
$858 billion of that was collected from the personal income tax.
The remainder was collected in payroll taxes (for Social Security and Medicare), corporate income taxes, tariffs and other taxes.

4. Federal Taxes

5. How Income Taxes Work
When people get a new job they fill out a W-4 which is used to calculate withholding (an estimate as to how much tax you are going to owe on the earned income). This money is taken out of a paycheck and sent, by the employer to the federal government.
The estimate is reconciled with actual income taxes owed with the Income Tax Return filed by April 15th of the following year.

6. The Vocabulary of Income Taxes
Adjusted Gross Income (AGI)
total net income from all sources
Exemptions
an amount by which AGI is reduced that is determined by the size of the family
Deductions
amounts by which AGI is reduced; the greater of either the standard deduction (the minimum level of deduction)or itemized deductions (deductions for particular expenses on which the government does not want taxes paid)
Taxable Income
AGI-Exemptions-Deductions

7. More Vocabulary Filing Status Marginal Tax Rate Tax Credits
the type of household for tax purposes (Single, Married Filing Jointly, Married Filing Separately and Single Head of Household)
Marginal Tax Rate
the percentage of each dollar in that bracket that must be paid in tax
Tax Credits
The reductions off of the amount of tax owed.

8. How the Pieces Fit Together: 2002 Tax Year

9. Issues in Income Taxation: Fairness
Horizontal Equity
equal people should be treated equally
Vertical Equity
people across the income scale are treated fairly with regard to ability to pay
Progressive Income Tax
with higher income you pay a higher rate of tax. The marginal tax rate rises from 10%, 15%, 25%, 28%, 33%, 35%, and higher as taxable income rises.

10. Issues in Income Taxation: The Equity-Simplicity Tradeoff
Economists want a tax code to be neutral (a characteristic of a tax code that implies that it does not favor particular forms of income or expenditure).
For neutrality to happen taxes must often be complicated. Consider capital gains (any profit you have from asset sales) as an example. It order to tax capital gains in a neutral way to other income you have to make capital gains tax rules very complicated.

11. Capital Gains To be neutral you should To be simple you should
not tax the gains that exist only because of inflation,
tax each year based on the paper increases or decreases in value (called on accrual) rather than when the asset is sold (called on realization)
tax the capital gains on assets of those who have died before they sold their assets.
To be simple you should
tax all gains,
tax only on realization,
Forgive capital gains taxes on death (because locating the paperwork is difficult.
What we do
Tax all gains on realization while forgiving gains for those who have died.
The tax rate is lower for capital gains than for ordinary income.

12. Incentives in the Tax System
Whether the income tax discourages or encourages work or savings boils down to the income effect and the substitution effect of that tax policy.
Income effect
The effect on work or saving just accounting for the tax money taken away.
Substitution effect
The effect on work or saving just accounting for the change in the relative value of working or saving.

13. Empirical Evidence on Incentives
Work
Most economists have found that there is nearly no impact of tax rates on number of hours worked. Some estimate that it takes an 8% increase in the marginal tax rate to reduce work by 1%.
Saving
There are differing estimates of the impact but most economists agree that an increase in taxes reduces savings slightly. One estimate has a 2.5% decrease in the after-tax interest rate decreasing savings by 1%.

14. Taxes for Social Engineering
Tax Incentives exist to induce people to
Save for college.
Send their children to college.
It is uncertain whether these tax provisions cause people to go to college.

15. Who Pays the Federal Income Taxes
the bottom half of taxpayers pays only 5% of the income tax while the top half pays the remaining 95%.
the top 10% of taxpayers accounts for 63% of federal income taxes paid
The top 5% of taxpayers accounts for more than half of federal income taxes paid

16. Who Pays Income Taxes: A Graphical Portrayal
Higher income earners pay a higher percentage of the income than they receive in income. The red line indicates perfect equality and the income line is closer to equality than the tax line.

17. Tax Debates
The tax debates between Republicans and Democrats tend to boil down to whether tax cuts should go to
The people who pay federal income taxes.
The people who “need” the money.
An across-the-board tax cut
will go almost entirely to people in the top 50% of income earners and more than half will go the top 5%.
will change the after-tax income distribution in favor of high-income taxpayers.