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Categories of taxation
Taxes on income
– Income tax
– FICA (social security) tax
– Disability tax Taxes on spending
– Sales tax
– Excise tax Taxes on wealth
– Property tax
– Estate and inheritance taxes
Taxes create incentives that distort economic activity
People do less of the activities that are taxed People do more of the activities that are tax-
exempt or subsidized Examples
– mortgage interest deduction encourages home ownership and borrowing, punishes renters
– child credit encourages breeding
– marriage penalty encourages fathers to abandon their families
Tax compliance is a huge additional burden
Tax code is about 4 million words Estimated national compliance cost: $168 billion
plus 6 billion hours of effort 59% of individuals pay tax preparers, 30% use
tax software Public choice theory explains tax complexity
– Politicians have incentive to insert tax provisions that benefit their particular constituency
– No one is looking after the overall cost and complexity of the tax code as a whole
Do corporations pay taxes?
Corporations are subject to income taxes Corporations are not people. Tax burdens
imposed on corporations are borne by Stockholders: lower dividends & capital gains Employees: lower salaries Customers: higher prices
How taxes distort corporate finance
Dividends are taxed twice
– paid out of corporate earnings after tax
– taxable to shareholder recipients
– partly offset by Bush tax reforms Interest paid by corporations
– deductible from corporate taxable income
– taxable to bondholder recipients Tax incentivizes debt finance over equity
Taxes incentivize evasion and avoidance
Evasion is illegal; avoidance is legal Examples of evasion
– Income tax: unreported cash payments
– Sales tax: cash payments, under-reporting
– Property taxes: under-state tax basis
– Death taxes: gifts of cash or gold
Progressive income tax
Most income tax systems are progressive: higher percentage levied on higher incomes
Federal income tax rates, married filing jointly 10% of first $18,150 15% to $73,800 25% to $148,850 28% to $226,850 33% to $405,100 35% to $457,000 39.6% above $457,000
Tax on $100,000 taxable income
10% of $18,500 $1,850
15% of (73,800-18,500) $8,295
25% of (100,000-73,800) $6,550
Total $16,695
Average rate 16,695/100,000 = 16.69%
Marginal rate 25%
– This rate is relevant to incentives to work and save
Tax on $500,000 taxable income
10% of $18,500 $1,850
15% of (73,800-18,500) $8,295
25% of (226,850-73,800) $38,262
28% of (405,100-226,850) $49,910
33% of (457,000-405,100) $17,120
39.6% of (500,000-457,000) $17,028
Total $132,465
Average rate = 132,465/500,000 = 26.49%
Marginal rate = 39.6%
5x increase in income → 8x increase in tax
Progressive taxation, pro and con
“Ability to pay” principle:
– Wealthy person suffers less from extraction of an additional $1 in taxes than does a poor person
– Therefore progressive income taxes impose roughly the same burden on all
Counter-argument
– Interpersonal utility comparison is not possible
– Many high-income people direct large amounts of their income to saving and investing or to charity (T. J. Rodgers)
Tax deductions
Subtract deductions from gross income to get taxable income
Common deductions Mortgage interest Medical expense, but only the portion in
excess of 7.5% of gross income Donations to charity Real estate taxes State income tax (deductible from federal)
Tax credits
Subtracted from tax payable
– Much more valuable than tax deductions, which reduce your tax due by your marginal tax rate times amount of deduction
Examples
– Foreign tax paid
– Earned income credit
– Education credit (?)
Taxes paid by investors
Interest and non-qualified dividends Taxed like wage income
Qualified dividends Taxed at 0%, 15% or 20% Offsets double taxation since corporations
pay dividends out of their after-tax income Capital gains
Held less than one year: ordinary income More than one year: 15% or 20%
Tax deferral
Wage earners are given incentive to save for retirement using tax-deferred accounts
Example: $10,000 saved for 30 years at 5% interest, 25% marginal tax bracket
Tax deferred: 10000x1.0530 = $43,219, then subtract 25%
income tax, leaving $32,415 Not deferred:
7500 after tax income compounded at after-tax rate of 5% x (1-0.25) = 3.75%
7500x1.037530 = $22,631
Pensions
Offered by governments and a decreasing number of private companies
Contributions From employee’s pre-tax income From employer
Employee gets an annuity at retirement Many pension funds have made unrealistic
assumptions
Social security
Almost all wages are subject to FICA (social security) tax
– 6.2% nominally paid by employer
– 6.2% nominally paid by employee
– tax is regressive, no tax on income above $100,000
– self-employed people must pay 12.4% Medicare tax is an additional 2.3% on all
income
Social security
Normal retirement age is 66 (rising to 67) Payments are based on employment history
– Fosters the illusion that your payments are set aside for you to draw on during retirement
– Congress can change payments any time
– Formerly tax free, then 50% subject to income tax, now 85%
Automatic yearly inflation adjustment
Social security
Massive increase in social security tax rates in 1983 led to annual surpluses, which were invested in Treasury securities
Taxes no longer cover payouts – some interest income being used. After that, some rollovers will stop. After that, some bonds will have to be sold prior to maturity.
Social security trust fund is an accounting fiction
– Trust fund money has been spent by the Treasury
401k and IRA
401k offered by most large companies Pre-tax earnings contributed to account Matched by employers in many cases Penalty for withdrawal prior to age 59.5
except in special circumstances Withdrawals must begin by age 70.5
IRA available to workers without an employer program, similar to 401k
Investments allowed in IRA
Shares of stock Bonds Mutual funds, ETFs Sale of covered calls Real estate, gold bullion (?) Not allowed: short sales, option trading other
than sales of covered calls, futures contracts
IRA and 401k pro and con
Pro
– Tax deferral is a significant benefit
– Automatic saving
– Employer matching of 401k contributions is like free money
Con
– Vulnerable to confiscation or taxation by politicians