McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

CHAPTER 17

THE PERSONAL THE PERSONAL INCOME TAXINCOME TAX

17-2

Computation of Federal Personal Income Tax Liability

Tax Base- “Above-the-line” deductions

Adjusted Gross Income

- Exemptions- Larger of standard deduction or itemized deductions

Taxable Income• tax rate

Tax liability before credits- Tax credits

Regular tax liability

Wages and compensation, interest, dividends, capital gain (or loss), business income (or

loss), pensions, farm income (or loss), rents, royalties, Social

Security benefits, etc.

Trade or business expenses, moving expenses, educator

expenses, self-employed health insurance premium

payments, student loan payments, tuition and fees,

alimony paid, etc.

Phase-out with income

Charitable contributions, home mortgage interest, state and

local taxes, medical expenses in excess of 7.5% of AGI,

casualty and theft losses, non-reimbursed employee

expenses; Phase out with income; Differs by filing status

Six ordinary rates (10%, 15%, 25%, 28%, 33%, 35%);

differs by filing status; special

rates for dividends and capital gains

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.; Phase-out with income

Start over to determine AMT tax liability using AMT base. Pay tentative AMT liability in excess of regular tax liability

Pay tax or claim refund

17-3

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

17-4

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

17-5

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

17-6

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

17-7

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

17-8

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

17-9

Deductions

Standard versus Itemized

Deductibility and Relative Prices

PZ (1-t)PZ

17-10

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

17-11

More Deduction Issues

Deductions and complexity Deductions versus credits Itemized deduction phaseout Standard deduction

17-12

Impact on the Tax Base

Impact of Subtractions from AGI on the Tax Base, 2004

32%

68%

Subtractions from AGI Taxable Income

17-13

Tax Expenditures

What are tax expenditures? Annual tax expenditure budget Technical problems with measuring tax

expenditures Incentive effects Defining income Philosophical objections

17-14

The Simplicity Issue

Tax Reform Act of 1986 (TRA86) Economic Growth and Tax Relief

Reconciliation Act of 2001 (EGTRRA)

17-15

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

17-16

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

17-17

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]

17-18

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

17-19

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

17-20

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

17-21

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

17-22

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

17-23

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

17-24

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”

17-25

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

17-26

Treatment of International Income

Global versus territorial systems Equity Efficiency

Production decisions Residential decisions

17-27

State Income Taxes

State income taxes similar to federal tax Lower marginal tax rates Including state tax rates when assessing

overall marginal tax rates

17-28

Politics and Tax Reform

Disagreements among experts Any change will hurt someone Tax system with low rates and broad base is

not stable politically

17-29

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

17-30

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

17-31

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

17-32

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.”

17-33

Taxation of Nominal Interest

Real after-tax rate of return: r = (1 – t)i – π

Let t = 25%, i = 16%, π = 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%