CHAPTER 17

The Personal Income Tax

McGraw-Hill/Irwin

Copyright 2010 by the McGraw-Hill Companies, Inc. All rights reserved.

Computation of Federal Personal Income Tax Liability

Wages and compensation, Trade or business expenses, interest, dividends, capital gain moving expenses, educator (or loss), business income (or expenses, self-employed loss), pensions, farm income (or health insurance premium loss), rents, royalties, Social payments, student loan Security benefits, etc. payments, tuition and fees, alimony paid, etc.

Tax Base - Above-the-line Phase-out deductions Child tax, additional child tax, EITC, with income Adjusted Gross Income Learning, Six HOPE and Lifetime ordinary rates (10%, 15%, 25%, health coverage electric vehicles, - Exemptions 28%, 33%, 35%); tax, adoption, mortgage interest, differs by filing retirement savings contribution, - Larger of standard deduction credit, status; special child and dependent care or itemized deductions rates for the elderly credit disabled, Start over Taxable Incomefor dividends or theto determine AMT and capital gains D.C. First-Time homebuyers credit, tax liability using AMT base. etc.; Phase-out with income tax rate Pay tentative AMT liability in excess of regular tax liability Tax liability before credits - Tax credits Regular tax liability
Pay tax or claim refund

Charitable contributions, home mortgage interest, state and local taxes, medical expenses in excess of 7.5% of AGI, casualty and theft losses, nonreimbursed employee expenses; Phase out with income; Differs by filing status

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Haig-Simons Income (Comprehensive Income)

Income = Consumption + DNet 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

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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
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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

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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

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

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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

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More Deduction Issues

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

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Impact on the Tax Base

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Tax Expenditures
What are tax expenditures? Annual tax expenditure budget Technical problems with measuring tax expenditures
Incentive effects Defining income Philosophical objections

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The Simplicity Issue

Tax Reform Act of 1986 (TRA86)
However, gains to simplification have been lost since then

Additional Confusion: Sunset Provisions

Example: Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA)

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Rate Structure
Official Statutory Tax Rate Schedule (2009)

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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

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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]
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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

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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
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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
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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

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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
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Tax Liabilities Under a Hypothetical System

Individual Income Individual Tax Family Tax with Individual Filing Joint Income Joint Tax

Lucy Ricky Ethel Fred

$1,000 29,000 15,000 15,000

$ 100 12,100 5,100 5,100 10,200 30,000 12,600 $12,200 $30,000 $12,600

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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
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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
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Treatment of International Income

Global versus territorial systems Equity Efficiency
Production decisions Residential decisions

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State Income Taxes

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

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Politics and Tax Reform

Disagreements among experts Any change will hurt someone Tax system with low rates and broad base is not stable politically

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Interest on State and Local Bonds

Tax 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

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Capital Gains
Example 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 = $458,200

Example 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

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Evaluation of Capital Gains Rules

No justification under optimal tax literature for preferential treatment of capital gains under HS 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
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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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Taxation of Nominal Interest

Real after-tax rate of return: r = (1 t)i Let t = 25%, i = 16%, = 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%

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