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17-1
Chapter 17 Personal Income Taxation
Ch. 16 on Optimal Personal Income taxation: -finding a balance between equity and efficiency
17-6
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
17-7
Items Included in H-S Income
Employer pension contributions and insurance purchase
Transfer payments, including Social Security benefits, unemployment compensation, and welfare
Capital gains Realized versus unrealized
Income in kind Imputed rent
17-8
Some Practical and Conceptual Problems
Computing income net of business expenses Computing capital gains and losses Computing imputed income from durables Valuing in-kind services
17-9
Evaluating the H-S Criterion
Equity – treats likes alike Efficiency – treats all forms of income the
same; decisions made on the basis of economic value not tax consequences
17-10
Excludable 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
17-11
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
17-13
Important Itemized Deductions
Unreimbursed medical expenses > 7.5% 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
Charitable Contributions
17-14
More Deduction Issues
Deductions and complexity Deductions versus credits Itemized deduction phaseout Standard deduction
17-15
Impact on the Tax Base
Impact of Subtractions from AGI on the Tax Base, 2004
32%
68%
Subtractions from AGI Taxable Income
17-16
Tax Expenditures
What are tax expenditures? Annual tax expenditure budget Technical problems with measuring tax
expenditures Incentive effects Defining income Philosophical objections
17-18
The Simplicity Issue
Tax Reform Act of 1986 (TRA86) Economic Growth and Tax Relief
Reconciliation Act of 2001 (EGTRRA)
17-19
Rate Structure
Official Statutory Tax Rate Schedule (2006)Single Returns Joint Returns
Taxable Income Marginal Tax Rate
Taxable Income Marginal Tax Rate
$0-$7,550 10% $0-$15,100 10%
$7,550-$30,650 15 $15,100-$61,300 15
$30,650-$74,200 25 $61,300-$123,700 25
$74,200-$154,800 28 $123,700-$188,450 28
$154,800-$336,550 33 $188,450-$336,550 33
$336,550 and over 35 $336,550 and over 35
17-20
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
17-21
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]
17-22
Taxes and Inflation
Tax Indexing How inflation can affect taxes
Bracket creep Deductions and exemptions set in nominal terms Taxation of nominal capital gains Taxation of nominal interest
17-23
Coping with the Tax/Inflation Problem
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; repeal would have a larger impact on low-income families
17-24
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
17-25
AMT as a Mass Tax
Why has AMT become more important? AMT not adjusted for inflation Cuts in regular tax
Problems with AMT Fairness Efficiency Simplicity
17-26
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
17-27
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 $12,600Ricky 29,000 12,100
Ethel 15,000 5,100
10,200 30,000 12,600Fred 15,000 5,100
17-28
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 reduces (but does not eliminate) marriage penalty and adds “tax dowry”
17-29
Analyzing the Marriage Tax
Advantages to using the family as taxable unit Fairer treatment of nonlabor 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
17-30
Treatment of International Income
Global versus territorial systems Equity Efficiency
Production decisions Residential decisions
17-31
State Income Taxes
State income taxes similar to federal tax Lower marginal tax rates Including state tax rates when assessing
overall marginal tax rates
17-32
Politics and Tax Reform
Disagreements among experts Any change will hurt someone Tax system with low rates and broad base is
not stable politically
17-33
Interest on State and Local Bonds
ip = 15% t = 30%
ig = 10.5% ig = (1-t)ipip = 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
17-34
Capital Gains
P = $100,000 g = 10%
$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
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
17-35
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
17-36
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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