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Chapter 18Taxation in the United States and Around the
World
Jonathan GruberPublic Finance and Public Policy
Aaron S. Yelowitz - Copyright 2005 © Worth Publishers
Introduction
Taxes play an important role in both the political arena and government policy making.
For example, George H. W. Bush’s 1988 pledge “Read my lips, no new taxes” ultimately isolated many conservatives when he raised taxes in 1990, and was one of the reasons for his 1992 election loss.
Introduction
This lesson begins the study of taxation by setting the institutional and theoretical stage for understanding tax policy. Overview of the types of taxation that exist
in the U.S. at different governmental levels.
Federal income tax. Structure of the income tax and “fairness.” How to measure the tax base.
TYPES OF TAXATION
The five most common types of taxes are those on: Earnings Individual income Corporate income Wealth Consumption
Types of taxationTaxes on earnings
The first kind of tax is on earnings. A payroll tax is a tax levied on income
earned from one’s job. Examples include taxes for Social
Security, Medicare, and Unemployment Insurance.
Types of taxationTaxes on individual income
The second type of taxes is on individual income, which includes broader sources than earnings.
Individual income tax is a tax paid on individual income accrued during the year. Examples include interest earnings and
dividend income. In many cases, the tax applies to family, not
individual, income. Capital gains are earnings from selling
capital assets. Stocks, paintings and houses are all examples.
Types of taxationTaxes on corporate income
A third kind of tax is on corporations. The corporate income tax are taxes
levied on the earnings of corporations. If corporations were not taxed, the
earnings of the owners of capital might otherwise escape taxation.
Types of taxationTaxes on wealth
A fourth type of tax is on accumulated wealth.
Wealth taxes are taxes paid on the value of the assets held by a person or family. Examples of wealth might include real
estate or stocks. Property taxes are a form of wealth tax
based on the value of a house and the land on which it is built.
Estate taxes are a form of wealth tax based on the value of the estate left behind when one dies.
Types of taxationTaxes on consumption
The fifth, and most common source of taxation around the world, is a consumption tax.
Consumption tax is a tax paid on individual or household consumption of goods (and sometimes services).
Sales taxes are taxes paid by consumers to vendors at the point of sale. An excise tax is a tax paid on the consumption of a particular good. Cigarettes and gasoline are examples.
Types of taxation
Payroll, income, and wealth taxes are called direct taxes, because they directly tax individual resources.
Consumption taxes are called indirect taxes, because they tax the use of the resources rather than the resources themselves.
Types of taxationTaxation around the world
Figure 1Figure 1 shows the distribution of tax revenue in the U.S. for different levels of government.
Federal government relies primarily on the individual income tax and the payroll tax (87.3%).
State and localities rely much more on consumption taxes and wealth taxes.
Figure 1 The federal government relies heavily on the individual income tax
and the payroll tax.State and local governments rely more heavily on sales taxes and
property taxes.
Types of taxationTaxation around the world
Figure 2Figure 2 shows similar breakdowns for other nations.
Other countries tend to rely less on the individual income tax, and much more on consumption taxes.
Figure 2
Other countries are more dependent on consumption taxes
than the United States.
Basic structure of the income tax in the United States
Computing the tax base
The federal income tax is the most important source of revenue in the U.S. for the federal government.
The structure of the tax code is laid out for a hypothetical earner, named Jack, in Table 1Table 1.
Table 1
Computing Jack’s income taxGross income $60,000
minus Deductions - $2,000
equals Adjusted gross income (AGI) = $58,000
minus Exemptions - $15,500
minus Itemized (or standard) deduction
- $13,000 (or $9,700)
equals Taxable income = $29,500
Use income tax schedule(Figure 3)
equals Taxes owed = $3,710
minus Credits - $3,000
equals Total tax payment = $710
minus Withholding - $2,000
equals Final payment (refund) due = ($1,290)
The income tax system includes deductions (for actions like
contributing to a 401k).
The income tax system includes exemptions (for family size) and
deductions (standard or itemized).The tax liability is computed from taxable income using the income
tax schedule.
There are also credits such as the EITC, child credit, saver’s credit,
and child care credit.Finally, the difference between a
person’s withholding and tax liability determines the payment/refund.
Basic structure of the income tax in the United States
Computing the tax base The first step is computing the tax base for Jack. Gross income is the total of an individual’s
various sources of income. This is $60,000 in Table 1Table 1. It includes wages, interest, dividends, rental
income, etc. Adjusted gross income (AGI) is an individual’s
gross income minus certain deductions. This is $58,000 in Table 1Table 1 for Jack because of an
IRA contribution. These include retirement account contributions,
alimony, and other items.
Basic structure of the income tax in the United States
Computing the tax base The next step it to subtract exemptions and
deductions from AGI. An exemption is a fixed amount a taxpayer can
subtract from her AGI for each dependent member of her household, as well as herself and her spouse.
The standard deduction is a fixed amount that a taxpayer can deduct from his taxable income.
Itemized deductions are an alternative to the standard deduction, whereby a taxpayer deducts the total amount of money spent on various expenses. These include charitable contributions, mortgage
interest on a home, and state and local income taxes.
Basic structure of the income tax in the United States
Computing the tax base
In Table 1Table 1, Jack receives exemptions totaling $15,500 for himself, his wife, and three children.
Jack’s itemized deductions (mainly mortgage interest, state income taxes, and charitable contributions) exceed his standard deduction. Thus, he subtracts $13,000 rather than $9,700. Nationwide, 65% of tax units choose the
standard deduction, while 35% itemize.
Basic structure of the income tax in the United States
Computing the tax base
After subtracting these exemptions and deductions, Jack is left with $29,500 of taxable income.
Taxable income is the amount of income left after subtracting exemptions and deductions from AGI.
The tax base is the net income on which taxes are paid. It is analogous to taxable income.
Basic structure of the income tax in the United States
Tax rates and taxes paid
Figure 3Figure 3 shows the schedule of tax rates that Jack would use to convert taxable income into taxes owed.
The marginal tax rates currently vary between 10% (for taxable income under $14,300) and 35% (for taxable income over $319,100).
Figure 3
Marginal tax rates rise with taxable income, with a current
maximum rate of 35%.
Basic structure of the income tax in the United States
Tax rates and taxes paid To illustrate how dramatically a tax-savy
worker could change his tax base, imagine a married, one-earner couple that: Earned $90,000 Contributed $13,000 to a 401k and
$3,000 to an IRA Took the standard deduction
Their taxable income of $58,100 puts them at the very end of the 15% bracket.
Basic structure of the income tax in the United States
Tax rates and taxes paid
In Jack’s case in Table 1Table 1, his taxable income is $29,500. He owes 10% of the first $14,300 plus 15% of the remaining $15,200.
This comes to $3,710 in taxes.
Basic structure of the income tax in the United States
Tax rates and taxes paid Some taxpayers can reduce their tax liabilities
further. Tax credits are amounts by which taxpayers
are allowed to reduce the taxes they owe to the government through spending, for example, on child care. Child Tax Credit Credit for Child and Dependent Care Expenses Credit for the Elderly or Disabled Hope and Lifetime Learning Credit Work Opportunity Credit
Basic structure of the income tax in the United States
Tax rates and taxes paid With three children, Jack’s credit is $3,000,
reducing the taxes he owes from $3,710 to $710.
During the course of the year, Jack’s employer took money out of his paycheck.
Withholding is the subtraction of estimated taxes owed directly from a worker’s earnings.
A refund is the difference between the amount withheld from a worker’s earnings and his taxes owed if the former is higher.
Jack’s refund is $1,290, because his employer withheld too much during the year.
The coming AMTThe coming AMTtime bombtime bomb
Figure 3Figure 3 is actually a simplified schedule, because it does not include the Earned Income Tax Credit or the Alternative Minimum Tax.
The Alternative Minimum Tax (AMT) is a tax schedule applied to taxpayers with a high ratio of deductions and exemptions to total income.
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The coming AMTThe coming AMTtime bombtime bomb
The AMT was motivated, back in 1969, by the fact that 155 high-income households in 1966 paid no income taxes whatsoever, by legally taking advantage of the existing tax law.
The complicated AMT calculation excludes many exemptions and deductions. The AMT figures are not indexed for inflation, meaning that many middle-income households will eventually be subject to it if there are not changes in the law.
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MEASURING THE FAIRNESS OF TAX SYSTEMS
Tax fairness is an important concern to citizens worldwide. For example, Margaret Thatcher’s
proposed “poll tax” in 1990, which levied a flat charge equally on all individuals regardless of income, caused riots.
Yet, notions of what is fair vary across people.
There are several common concepts used to measure fairness.
Measuring the fairness of tax systems
Average and marginal tax rates First, there are two key concepts to
describe the set of tax rates on income. A marginal tax rate is the percentage
that is paid in taxes on the next dollar earned. In the example with the worker who earned
$90,000, the marginal tax rate was 15%. An average tax rate is the percentage of
total income is that is paid in taxes. This workers average tax rate was 8.9%.
Measuring the fairness of tax systems
Effective versus statutory rates Another important distinction is
between statutory and effective tax rates.
Statutory tax rates are tax rates laid out in the legal tax schedule.
Effective tax rates are tax rates an individual actually pays. The two diverge because of the host of
exemptions and deductions from taxable income, which reduces the tax base.
Measuring the fairness of tax systems
Vertical and horizontal equity Two distributional goals are frequently cited in
measuring tax fairness. Vertical equity is the principle that groups
with more resources should pay higher taxes than groups with fewer resources. Could be motivated by utilitarian SWF, that calls
for redistribution. Horizontal equity is the principle that similar
individuals who make different economic choices should be treated similarly by the tax system. In reality, horizontal inequities are hard to define,
because the person endogenously made a choice to earn more or less.
Measuring the fairness of tax systems
Measuring vertical equity There are fairly standard ways of
measuring vertical equity. A progressive tax system is one in which
effective average tax rates rise with income.
A proportional tax system is one in which effective average rates do not change with income, so that everyone pays the same proportion of their income in taxes.
A regressive tax system is one in which effective average tax rates fall with income.
The political process ofThe political process ofmeasuring tax fairnessmeasuring tax fairness
Most analysts would agree that to be vertically equitable, the tax system should be progressive.
Yet, politicians often choose a notion of fairness that fits their agenda.
In the debate over tax cuts in 2003, Democrats argued that 44% of the tax reductions went to the top 1% of taxpayers, while Republicans pointed out that these taxpayers already paid 38% of all income taxes – roughly proportional to the tax cut.
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DEFINING THE INCOME TAX BASE
In the U.S., and elsewhere, there are a variety of deductions, exemptions, and credits that cause the tax base to be smaller than total income.
What is the theoretically appropriate income tax base, and why is it deviated from?
Defining the income tax baseThe Haig-Simons comprehensive income
definition The Haig-Simons comprehensive
income definition defines taxable resources as the change in an individual’s power to consume during the year.
It is best viewed as a measure of ability to pay – regardless of the actual choices in terms of consumption and savings.
In reality, the U.S. tax system deviates from this definition in many ways, for example, the exclusion of employer-provided health insurance.
Defining the income tax baseThe Haig-Simons comprehensive income
definition
The Haig-Simons definition improves both vertical and horizontal equity.
In terms of vertical equity, those who have more resources (even through untaxed channels) have higher income.
In terms of horizontal equity, people who are the same in terms of underlying resources pay the same amount regardless of the form in which they spend their resources.
Defining the income tax baseDeviations from Haig-Simons
Implementing this idealized definition is challenging, however, for two reasons. Defining a person’s power to consume Dealing with work-related expenditures
Defining the income tax baseDeviations due to ability-to-pay
considerations First, it is challenging to define an
individual’s ability to pay taxes. Various shocks affect ability to pay, and
are used to justify deductions in the actual tax system: Property and casualty losses Medical expenditures State and local income taxes
Defining the income tax baseDeviations due to ability-to-pay
considerations Although these affect ability to pay, they
may be choices to some extent. Individuals have some control over
medical expenditures, and some of this deduction may represent consumption.
Higher state and local tax payments could reflect greater amenities and local public goods.
Thus, full deductions for both are hard to justify with the Haig-Simons definition.
Defining the income tax baseDeviations due to the costs of
earning income The other key problem is that some
expenditures are not for consumption but reflect the cost of earning a living.
Yet, defining legitimate business expenses is difficult – for example, part of a business lunch represents consumption, but how much? Currently, the tax code allows for 50%
of the expenses of such a meal to be deducted.
What are appropriateWhat are appropriatebusiness deductions?business deductions?
More generally, there are a many difficulties in defining appropriate or inappropriate business deductions.
A high school geography teacher claimed a $5,047, six-month, 18-country world tour as a business expense. He claimed visiting these exotic places
aided him in his teaching. The tax court disallowed the deduction,
concluding that “any educational benefit gained from these experiences was de minimis.”
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What are appropriateWhat are appropriatebusiness deductions?business deductions?
In another case, a man claimed $30,000 worth of business expenses for selling amphetamines, cocaine, and marijuana in 1981.
Although the IRS disallowed the deductions, a tax court overturned the decision.
After he was allowed to claim the deductions for business expenses, he was sentenced to four years in prison for possessing cocaine with intent to distribute it.
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What are appropriateWhat are appropriatebusiness deductions?business deductions?
Finally, before 1996, U.S. companies were at a disadvantage in international business because other countries allowed their companies to write off as a business expense the cost of bribing foreign officials.
After 1996, this was no longer deductible.
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EXTERNALITY/PUBLIC GOODS RATIONALES FOR DEVIATING
FROM HAIG-SIMONS Some activities yield external benefits
to society, which gives a rationale for deviating from the Haig-Simons income definition.
Two major deviations that are justified on such grounds are charitable giving and home ownership.
Externality/Public goods rationales for deviating from Haig-Simons:
Charitable giving The private market is likely to
underprovide charitable support for many public goods because of the free-rider problem.
Because charitable contributions are tax-deductible, the relative price of giving $1 to charity is $(1-).
The tax treatment yields a benefit (providing a public good) at the cost of deviating from the H-S definition.
Externality/Public goods rationales for deviating: Spending crowd-out versus
tax subsidy crowd-in An alternative to this tax subsidy would
be direct provision of the public good by the government.
Why, then, does the government choose to deviate from the Haig-Simons definition of income rather than increase government spending?
Externality/Public goods rationales for deviating: Spending crowd-out versus
tax subsidy crowd-in The first reason relates to crowd-out. If the government provides the good
directly, it may crowd-out private charitable giving. By providing a tax subsidy, both the income and substitution effects lead to greater private giving. This “crowds-in” private giving.
Externality/Public goods rationales for deviating: Spending crowd-out versus
tax subsidy crowd-in At the same time, the tax subsidy gives a
tax break to those who would have already supported the public good without the break.
Marginal impacts are changes in behavior the government hopes to encourage through a given tax incentive.
Inframarginal impacts are tax breaks the government gives to those whose behavior is not changed by new tax policy.
Externality/Public goods rationales for deviating: Spending crowd-out versus
tax subsidy crowd-in For example, imagine that $1 million
would be given to the homeless without any tax breaks.
If the government allowed deductibility for charitable giving, and =50%, suppose that giving went up to $1.5 million. Giving has gone up. Yet, for those who were giving before, the
tax break simply rewards them for what they were already doing.
Externality/Public goods rationales for deviating: Spending crowd-out versus
tax subsidy crowd-in The marginal impact is the $500
thousand increase in giving. The inframarginal impact is the $500
thousand in new tax deductions for those already giving.
The most cost-efficient tax breaks have large marginal impacts from those who change their behavior; in those cases small government expenditure can deliver large externalities.
Externality/Public goods rationales for deviating: Spending crowd-out versus
tax subsidy crowd-in In determining whether to give tax
subsidies or use direct spending, the government implicitly must weigh the following tradeoff:
If the first term is larger, the government gets more bang-per-buck from the tax subsidy.
d pr iva te char ity
d tax break
d pr iva te char ity
d governm en t
_
_
_ 1
Externality/Public goods rationales for deviating: Spending crowd-out versus
tax subsidy crowd-in Empirical evidence suggests that the
elasticity of charitable giving with respect to the tax subsidy is around -1. With this elasticity, the marginal effect of the
tax subsidy is equal to the inframarginal effect, or $1 in reduced government revenue leads to $1 in increased charitable spending.
Evidence also suggests $1 direct government spending raises overall spending by 30-90¢.
On this basis, subsidizing private giving is a more efficient way of providing charitable resources.
Externality/Public goods rationales for deviating: Consumer sovereignty vs.
imperfect information Tax subsidization may also be preferred
because it preserves consumer sovereignty. The preferences of the legislators may not be the same as those of the citizens.
A disadvantage is that the private sector may not be able to ensure efficient distribution of charitable spending.
Externality/Public goods rationales for deviating from
Haig-Simons: Housing Another deviation from the H-S definition,
justified on externality grounds is the tax subsidy to homeownership.
A mortgage is an agreement to use a certain property, usually a home, as security for a loan. The interest payments from such a
mortgage are tax deductible, while rental payments for an apartment are not.
The mortgage interest deduction leads to forgone revenue of $70 billion per year for the federal government.
Externality/Public goods rationales for deviating from
Haig-Simons: Housing Does homeownership have positive
externalities? Although there are certainly positive
correlations between homeownership and good neighborhood outcomes (e.g., more political activism, etc.), these findings may be the result of “selection bias.”
By selection bias, we mean that homeowners are better neighbors in ways that are unobservable to researchers. For example, those who own homes may be more inclined to social connection and better maintenance regardless of their ownership status.
Externality/Public goods rationales for deviating from
Haig-Simons: Housing A large body of evidence suggest the tax
subsidy does increase housing consumption, but along the intensive margin (how much housing to consume) rather than the extensive margin (whether to own or rent).
Most arguments about positive externalities rely on the extensive margin; thus the current structure of the subsidy does little to address this issue.
Thus, there is no clear rationale for deviating from the Haig-Simons income definition for housing.
Externality/Public goods rationales for deviating from Haig-Simons: Tax
deductions vs. tax credits Another consideration that arises when
deviating from the Haig-Simons income definition is whether a tax deduction or tax credit is more appropriate.
Tax deductions are amounts by which taxpayers are allowed to reduce their taxable income through spending on charitable donations or home mortgage interest. The effective price of the activity is
lowered from $1 to $(1-).
Externality/Public goods rationales for deviating from Haig-Simons: Tax
deductions vs. tax credits Tax credits allow taxpayers to reduce
the amount of tax they owe to the government by a certain amount. If the individual’s expenditure is below
the amount of the credit, the effective price of the activity is lowered from $1 to $0. If the expenditure is above, the effective price is $1.
Externality/Public goods rationales for deviating from Haig-Simons: Tax
deductions vs. tax credits In deciding whether a deduction or credit is
more appropriate, the trade-off the government faces is between a system that subsidizes all giving partially (the deduction) or some giving fully and some not at all (the credit).
On efficiency grounds, the appropriate instrument will depend on: The nature of the demand for the subsidized
good. And whether it is important to achieve some
minimal level of behavior (e.g., health coverage or housing consumption).
Externality/Public goods rationales for deviating from Haig-Simons: Tax
deductions vs. tax credits On equity grounds, however, tax credits
are more equitable than deductions. The value of deductions rises with a
person’s marginal tax rate, making them regressive.
Credits are equally available for all incomes, so they are progressive.
Externality/Public goods rationales for deviating from Haig-Simons: Tax
deductions vs. tax credits In reality, a tax credit may not be very
progressive if those with low tax liabilities cannot have the excess of the credit refunded.
A tax credit is refundable if it is available to individuals even if they pay few or no taxes.
The recent raising of the child credit from $600 to $1,000 raised this refundability issue.
Externality/Public goods rationales for deviating from Haig-Simons: Tax
expenditures Tax expenditures are government
revenue losses attributable to tax law provisions that allow special exclusions, exemptions, or deductions from gross income, or that provide a special credit, preferential tax rate or deferral of liability.
The government measures how much tax revenue is lost by excluding health insurance from taxable compensation, or allowing deductibility of charitable contributions.
Externality/Public goods rationales for deviating from Haig-Simons: Tax
expenditures Table 2Table 2 shows the major tax
expenditures. Overall, in 2005, the government is
projected to lose $740 billion through all tax expenditures, the largest of which is the exclusion of employer-provided health insurance.
Table 2
Top 10 Federal Government Tax Expendituresby Estimated 2005 Revenue Impact (billions of $)
Tax ExpenditureRevenue Impact
Exclusion of employer contributions for medical insurance $113.0
Deductibility of home mortgage interest 69.7
Exclusion of pension contributions and earnings: employer plans
61.7
Exclusion of pension contributions and earnings: 401(k) plans
58.9
Deductibility of state and local taxes 46.2
Preferential treatment of capital gains income 30.2
Child credit 29.9
Deductibility of charitable contributions 29.7
Exclusion of interest on state and local bonds 26.4
Exclusion of interest on life insurance savings 22.1
Total of all tax expenditures $740.0
Overall, “tax expenditures” amount to $740 billion in lost
tax revenue.
Employer health insurance, mortgage interest, and
retirement plans are key.
THE APPROPRIATE UNIT OF TAXATION
The problem of the “marriage tax” Choosing the appropriate unit of
taxation is a difficult task as well. Should the government impose taxes on family income or individual income?
It is not possible to design a tax system that achieves the following three goals: Progressivity. Across-Family Horizontal Equity. Across-Marriage Horizontal Equity (e.g.,
marriage neutrality).
The appropriate unit of taxation
The problem of the “marriage tax” The example in Table 3Table 3 illustrates this
problem.
Table 3
Tax liabilities under hypothetical system
Individual Income
Individual Tax
Family Tax withIndividual
FilingJoint
IncomeJoint Tax
Hillary $140,000 $32,000 $33,000 $150,000 $35,000Bill 10,000 1,000
George 75,000 13,000 26,000 150,000 35,000Laura 75,000 13,000
Both households have the same total income.
If they file individually, then Hillary and Bill pay
substantially more in this case.
The appropriate unit of taxation
The problem of the “marriage tax” Taxing on an individual basis violates the
concept of horizontal equity across families, because Hillary and Bill pay more than George and Laura.
Taxing on a family basis violates the marriage neutrality criterion, because both families pay more in taxes married than they did when they were single.
The marriage tax is the rise in the joint burden on two individuals from becoming married.
The appropriate unit of taxation
Marriage taxes in practice Note that it is possible to remove the
marriage tax if the standard deduction for married couples is large enough.
But this is still not marriage neutral. In reality, some couples face marriage
taxes and other marriage bonuses. There is no evidence that the “marriage penalty” does discourage marriage.
The appropriate unit of taxation
Marriage taxes in practice Why the concern about marriage taxes?
Horizontal equity. The tax might discourage marriage. The high marginal tax rate on the
secondary earner. This last problem could be solved with
a secondary earner deduction.
The appropriate unit of taxation
Marriage taxes in practice The U.S. is fairly unique in have a tax
system based on family income. 19 OECD countries tax husbands and
wives individually. 5 OECD countries offer marriage
subsidies through family taxation with income splitting – which lowers the tax burden with a progressive tax schedule.
Only 2 other OECD nations have pure family taxation system similar to the U.S.
Recap of Taxation in the United States and Around the
World Types of Taxation Basic Structure of the Income Tax in
the United States Measuring the Fairness of Tax Systems Defining the Income Tax Base Externality/Public Goods Rationales for
Deviating from Haig-Simons The Appropriate Unit of Taxation