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

17-2

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

17-3

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

17-4

Some Practical and Conceptual Problems

• Computing income net of business expenses• Computing capital gains and losses• Valuing in-kind services

17-5

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

17-6

Excluded 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

17-7

Interest on State and Local BondsTax 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

17-8

Capital GainsExample 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 = $458,200Example 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

17-9

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

17-10

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

17-11

Deductions

• Standard versus Itemized• Deductibility and Relative Prices– PZ (1-t)PZ

17-12

Deductions• Important Itemized Deductions– Charitable Contributions– Unreimbursed medical expenses > 10% 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

17-13

More Deduction Issues

• Deductions and complexity• Deductions versus credits• Itemized deduction phase out• Standard deduction

17-14

Exemptions and DeductionsImpact 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?

17-16

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)

17-17

Rate Structure

Official Statutory Tax Rate Schedule (2013)

Source: www.irs.gov17-18

Marginal MarginalTaxable Income Tax Rate % Taxable Income Tax Rate %

$0-$8,925 10.0 $0-$17,850 10.0$8,926-$36,250 15.0 $17,851-$72,500 15.0$36,251-$87,850 25.0 $72,501-$146,400 25.0$87,851-$183,250 28.0 $146,401-$223,050 28.0$183,251-$398,350 33.0 $223,051-$398,350 33.0$398,351-$400,000 35.0 $398,351-$450,000 35.0$400,001 and over 39.6 $450,001 and over 39.6

Single Returns Joint Returns

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

17-19

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]

17-20

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

17-21

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%

17-22

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

17-23

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

17-24

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

17-25

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

17-26

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

17-27

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

17-28

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

17-29

Treatment of International Income

• Global versus territorial systems• Equity• Efficiency– Production decisions– Residential decisions

17-30

State Income Taxes

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

overall marginal tax rates

17-31

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”

17-32

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 high-income 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

17-33