1. Chapter 35 Personal Income Taxes Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

2. 35-2 Chapter Outline HOW INCOME TAXES WORK ISSUES IN INCOME TAXATION INCENTIVES AND THE TAX CODE THE TAX DEBATE OF THE 1990s AND BEYOND

3. 35-3 You Are Here

4. 35-4 Where Personal Income Taxes Fit In 2008 the federal government collected $2,524 billion in taxes. $1,146 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.

5. 35-5 Federal Taxes

6. 35-6 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 15 th of the following year.

7. 35-7 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

8. 35-8 More Vocabulary Filing Status –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.

9. 35-9 The Alternative Minimum Tax Began in the 1960s Intended to insure that high income earners could not use deductions to avoid taxes. The point at which it begins is not indexed for inflation Will affect 40% of taxpayers in 2010 Adds a high level of complication

10. 35-10 The Impact of the AMT

11. 35-11 How the Pieces Fit Together: 2008 Tax Year AGI Adjusted Gross Income = Wages+Salaries+Tips+Inter est+ Dividends+Business Profit+ Rents (received)+Capital Gains+other income. - Exemptions Exemptions=$3,500*(the number of people in the household + the number of people over 65 + the number of people who are blind) - Deductions The Bigger of Itemized Deductions=medical expenses in excess of 7.5% of AGI + interest paid on a home mortgage + unreimbursed business expenses in excess of 2% of AGI + charitable donations state and local income and property taxes. standard deduction = ($5,450 for a single person and $10,900 for a married couple) = Taxable Income => Tax Table Taxes Owed - Credits Credits=Earned Income Tax Credit +College Tuition Credit+ Child Care Credit+Dependent Child Credit = What You Owe Compare to Alt. Min. Tax =>

12. 35-12 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. Issues in Income Taxation: Fairness

13. 35-13 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.

14. 35-14 Capital Gains To be neutral 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.

15. 35-15 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.

16. 35-16 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%.

17. 35-17 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.

18. 35-18 Who Pays Federal Income Taxes? the bottom half of taxpayers pays only 3% of the income tax while the top half pays the remaining 97%. the top 10% of taxpayers accounts for 74% of federal income taxes paid The top 5% of taxpayers accounts for more than half of federal income taxes paid

19. 35-19 Who Pays Income Taxes: A Graphical Portrayal Higher income earners pay a higher percentage of the income than they receive in income. The blue line indicates perfect equality and the income line (AGI) is closer to equality than the tax line.

20. 35-20 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. Eliminating or altering the Alternative Minimum Tax –The AMT needs to be altered before it affects a majority of taxpayers. –Will (by definition) affect only higher income taxpayers.