Transcript Slide 1

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
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Haig-Simons Income (Comprehensive
Income)
• Income = Consumption + DNet 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
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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
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Some Practical and Conceptual
Problems
• Computing income net of business expenses
• Computing capital gains and losses
• Valuing in-kind services
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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
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Excluded Forms of Money Income
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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 = ip = 15%
• Individuals MTR = t = 30%
• Government Tax-Exempt Bond ROR = ig = (1-t)ip = 10.5%
Cost of break to Treasury exceeds gain to S&L government
• ip = 15%
t1 = 30% ig = 10.5%
t2 = 20% ig = 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 = $30
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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
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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
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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
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Deductions
• Standard versus Itemized
• Deductibility and Relative Prices
– PZ  (1-t)PZ
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Deductions
• Important Itemized Deductions
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Charitable Contributions
Unreimbursed medical expenses > 10% AGI
State and Local Income and Property Taxes
Certain Interest Expenses
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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
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More Deduction Issues
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Deductions and complexity
Deductions versus credits
Itemized deduction phase out
Standard deduction
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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?
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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)
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Rate Structure
Official Statutory Tax Rate Schedule (2013)
Single Returns
Marginal
Taxable Income Tax Rate %
$0-$8,925
10.0
$8,926-$36,250
15.0
$36,251-$87,850
25.0
$87,851-$183,250
28.0
$183,251-$398,350
33.0
$398,351-$400,000
35.0
$400,001 and over
39.6
Joint Returns
Marginal
Taxable Income Tax Rate %
$0-$17,850
10.0
$17,851-$72,500
15.0
$72,501-$146,400
25.0
$146,401-$223,050
28.0
$223,051-$398,350
33.0
$398,351-$450,000
35.0
$450,001 and over
39.6
Source: www.irs.gov
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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
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Flat Income Tax
• Features of Flat income tax
– Applies same tax rate to everyone and each component of income
– Limited deductions
• Arguments in favor
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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]
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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
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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%
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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
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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
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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
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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
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Tax Liabilities Under a Hypothetical System
Lucy
Individual
Income
Individual
Tax
$1,000
$ 100
Ricky
29,000
12,100
Ethel
15,000
5,100
Fred
15,000
5,100
Family Tax
with
Individual
Filing
Joint
Income
Joint Tax
$12,200 $30,000 $12,600
10,200
30,000
12,600
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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
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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
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Treatment of International Income
• Global versus territorial systems
• Equity
• Efficiency
– Production decisions
– Residential decisions
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State Income Taxes
• State income taxes similar to federal tax
• Lower marginal tax rates
• Including state tax rates when assessing
overall marginal tax rates
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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”
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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 highincome 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
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