Public Finance Seminar Spring 2019, Professor Yinger

1. Public Finance SeminarSpring 2019, Professor Yinger Income Taxes

2. Public Finance SeminarIncome Taxes Class Outline • Income Taxes • Design of the Federal Tax • Link to State Income Taxes • Design of Local Income Taxes • Selected Issues in Federal Tax Policy

3. Income Taxes The Federal Income Tax • We start with the federal income tax because most state taxes are linked to it. • We will discuss the broad issues in the design of the federal income tax. • Then we will turn to state and local income taxes.

4. Income Taxes Federal Income Tax Design Comprehensive Income - Exclusions = Adjusted Gross Income - Exemptions - Deductions (Itemized or Standard) = Taxable Income × Tax Table = Gross Tax - Tax Credits = Net Tax

5. Income Taxes Exclusions & Exemptions • Exclusions • Interest income on municipal bonds • Implicit rent on owner-occupied housing • Exemptions (Eliminated by the 2017 Tax Cuts and Jobs Act, TCJA) • Personal exemptions ($4,050) • Exemptions for dependents • Exemptions for age and some categories of disability

6. Income Taxes Deductions • Itemized Deductions • Mortgage interest on primary residence (and some secondary) • Property taxes on primary residence (and some secondary) • State income taxes (or state sales taxes) • Charitable contributions • Excess medical expenses • Standard Deduction • Fixed amount (used by most taxpayers) • $12,600 for joint return(increased to $24,000 by TCJA). Limited to $10,000 by TCJA

7. Income Taxes

8. Income Taxes Tax Calculations • Tax Tables • Separate tables for married and single (but a marriage penalty for equal-earning couples—more later). • Alternative minimum tax to ensure that average tax rate does not fall too low. Exemptions increased a lot by TCJA. • Tax Credits • Earned income tax credit (more later).

9. Marginal Rate 39.6% 37.0% 10% $18,650 $470,700 $9,525 $500,000 Taxable Income Income Taxes Tax Table, Joint Returns, 2017 (2018)

10. Income Taxes Marginal to Average Rates • Translation from marginal to average rates is complicated. • Marginal rate tables are highly misleading due to phase outs. • All the other features of the tax code affect average rates. • Deductions are particularly powerful at the highest income levels.

11. Income Taxes

12. Income Taxes

13. Itemized Deductions, AMT T Y Zero Income Amount (Exemptions+ Standard Deduction) ? After 2017 TCJA? 0 Comprehensive Income EITC Income Taxes Possible Average Rate Figure

14. Income Taxes Source: IRS. Note that negative rates form the EITC cannot be identified in the IRS data.

15. Income Taxes State Income Taxes • State income taxes are less progressive than the federal income tax. • States worry about scaring away high-income residents, although I have not seen any evidence that this is a large effect. • State top rates go as high as 13.3 % (California), and 8 states have a flat rate; minimum taxed income varies widely. • Seven states do not have an income tax, and two states only tax investment income. • For more, see: http://www.taxpolicycenter.org/statistics/state-individual-income-tax-rates-2000-2018

16. Income Taxes Tax Reform Act of 1986 (TRA) • TRA was a remarkable bi-partisan reform that closed loopholes (favored by liberals) and lowered marginal rates (favored by conservatives). • These two are linked—broadening the base makes lower rates possible. • This reform also shifted the burden from individuals to corporations. • Since TRA loopholes have been added at a rapid rate!

17. Income Taxes Link to State Income Taxes • Most state income taxes either • A. use federal taxable income and their own tax tables, or • B. set their tax as a percentage of federal tax. • The “A” states gained from base broadening in the 1986 TRA. • The “B” states lost from the shift away from individual income taxes in TRA.

18. Income Taxes Progressivity in State Taxes • The “A” States, the ones with federal taxable income, have less progressive rate structures than the federal tax. • These taxes are less progressive than they seem because of federal (or federal and state) deductibility of income taxes paid—but TCJA lowered this effect a lot. • Progressivity is limited by the ability of rich individuals to move to another state in response to a high state income taxes—but this effect appears to be small.

19. Income Taxes The Tax Cuts and Jobs Act of 2017 (TCJA) • The same issues arise with TCJA. Possible revenue raisers for states: • “Personal Exemption Elimination • The federal tax bill will repeal personal exemptions. Ten states currently couple their state personal exemption with the federal personal exemption. Given that the federal personal exemption was eliminated, these states could see a revenue gain, absent a change in state law. • Alternative Inflation Measure • The legislation eliminates the use of the traditional CPI-U (consumer price index for all urban consumers) measure for inflationary adjustments to the tax system. Instead, the bill imposes the slower growing, chained CPU measure. This will affect tax brackets, the standard deduction, the Earned Income Tax Credit (EITC) phasein/phaseout thresholds. • Modifications to Other Deductions • Modifications to the deduction for home mortgage interest, nondisaster casualty losses, and moving expenses have been estimated to increase federal revenues. This would also increase revenues in the states that incorporate these changes.” • See: http://www.ncsl.org/research/fiscal-policy/federal-tax-reform-and-the-states.aspx

20. Income Taxes The Tax Cuts and Jobs Act of 2017 (TCJA) 2 • Possible revenue losers for states: • “Standard Deduction • Twelve states conform to the federal standard deduction [and will lose revenue from its increase]. For states that use federal taxable income as their starting points, the increase in the standard deduction will decrease revenues unless actions are taken to decouple. • Pass-Through Deduction • The new law will allow a new deduction of 20 percent of qualified business income from certain pass-through entities [with income limits]. The deduction is only allowed in computing and reducing taxable income, not federal AGI, so only the few states that conform to FTI would be affected by this change, which would reduce revenues unless they decouple from this provision or switch to federal AGI as a starting point. • [This provision may encourage some business entities to switch from the corporate to the individual income tax.] State corporate income tax is already declining rapidly as a revenue source for states, so this could potentially add to that trend with more businesses moving to the individual tax code. Some tax experts have speculated that states may consider eliminating the corporate income tax entirely and look at broader taxes imposed on all forms of business entities, such as Ohio’s commercial activity tax or Texas’ margin tax.” • See: http://www.ncsl.org/research/fiscal-policy/federal-tax-reform-and-the-states.aspx

21. Income Taxes State Reponses • Some states have responded to TCJA by changing their tax code. • To offset the loss of itemized deductions for state taxes, New York passed an optional employer-base payroll tax as an alternative to the state income tax. • With this approach, state income taxes are paid by the employer but the incidence probably falls on the worker. • As a result, the worker’s income is equivalent to income after state taxes and hence to income with a deduction for state taxes. • However, some experts caution against major changes in state taxes. • See: Burman and Sammartino, http://www.taxpolicycenter.org/taxvox/state-responses-tcjas-salt-deduction-limit-may-be-costly-and-favor-high-income-residents and Leachman and Mazerov https://www.cbpp.org/research/state-budget-and-tax/how-should-states-respond-to-recent-federal-tax-changes

22. Income Taxes Local Income Taxes • A few cities (e.g. Baltimore, Detroit, New York) have income taxes of their own, usually linked to their state tax. • Most local income taxes are limited to wages and salaries and take the form of either • an earnings tax (with legal incidence on workers) • a payroll tax (with legal incidence on firms)

23. Income Taxes Commuter Taxes • A few cities (e.g. Newark, San Francisco, Cleveland, Philadelphia) collect taxes on the wages and salaries earned by non-residents within the city. • Payroll taxesdo this automatically.

24. Income Taxes Commuter Taxes, 2 • Commuter taxes only work if cities have access to them but suburbs do not. • The first claim on taxable resources goes to the jurisdiction of residence. So if a city passes an income tax, the suburbs can pass one and claim all the taxes paid by their commuting residents—with no increase in the tax on those residents! • This happened in Pittsburgh.

25. Income Taxes Commuter Taxes, 3 • Commuter taxes have the advantage that they can help satisfy the benefit principle—people who benefit from the services in the city where they work help pay for these services. • Commuter taxes have the disadvantage that they may encourage firms (not households) to leave a city, although the evidence on this effect is mixed.

26. Income Taxes Selected Issues in Federal Tax Policy • The “Marriage Penalty” • The EITC • Tax Deductions for Homeownership

27. Income Taxes The Marriage Penalty • The U.S. tax code has several tax schedules. The main two are: • Tax rates for single people. • Tax rates for married people filing joint returns, which have wider tax brackets (e.g. $0 to $15,000 for the first bracket instead of $0 to 10,000). • The idea is not to penalize people for getting married. • But neither the brackets nor the standard deduction are doubled for two people who get married.

28. Income Taxes The Marriage Penalty, 2 • The result: Marriage penalties and marriage bonuses. • A “marriage penalty” is defined as a situation in which a couple pays more income tax filing jointly than they would if they had remained single. • A “marriage bonus” is defined as a situation in which a couple pays less tax filing jointly than they would if they had remained single. • Marriage bonuses are more common.

29. Income Taxes The Marriage Penalty, 3 • Couples most likely to face a marriage penalty are those in which the spouses have similar incomes. • Couples most likely to receive a marriage bonus are those in which one spouse earns most or all of the couple’s income. • Recent legislation reduced marriage penalties and increased marriage bonuses by • Raising the standard deduction for couples to twice that for single filers • Setting the income range of 10 and 15% tax brackets (but not higher ones) for couples to twice that for individuals. • These changes became permanent a few years ago.

30. Income Taxes The Marriage Penalty, 4 • Marriage penalties and bonuses are not good policy, but they are expensive to eliminate. • Keeping the marriage penalty reductions is estimated to cost more than $130 billion over 7 years. • Fixing other sources of these penalties (such as high-income brackets that are not twice as wide for joint returns) would cost even more. • These policies cut taxes by about 1 percent across all income levels, which means they are worth more in dollar terms to the richest taxpayers.

31. Income Taxes The Marriage Penalty, 5 • Tax reductions, tax changes, and the marriage penalty. LA Whittington, J Alm. National Tax Journal, 2001. • https://www.taxpolicycenter.org/taxvox/tpc-releases-updated-marriage-penalty-and-bonus-calculator-2018-including-tcja

32. Income Taxes The Earned Income Tax Credit • The largest “welfare” program in the U.S., called the Earned Income tax Credit, is run through the income tax. • The EITC provides a tax credit based on income, up to maximum, with a higher credit for families with children. • It was implemented in 1975 and has been greatly expanded since. • The EITC is “refundable,” which means that it is paid even to households with no tax liability.

33. Income Taxes The Earned Income Tax Credit, 2 • The EITC increases with income up to a certain amount, then holds steady up to another income level, then phases out. • For example, the EITC for a single parent with 2 children in 2017 was • 40% of earned income up to an income of $14,040 • Exactly $5,616 for incomes between $14,040 and $18,340. • Phased out between incomes of $18,340 and $45,007. • See: http://www.taxpolicycenter.org/statistics/eitc-parameters

34. Income Taxes

35. Income Taxes The Earned Income Tax Credit, 3 • The EITC’s principal goal is to help low-income households by rewarding work. • The EITC increases the incentive to work in the phase-in range. • However, the EITC discourages work in its phase-out range, which involves more workers. • Stretching the phase-out range would weaken this work disincentive for those currently affected, but would also bring in more workers and raise the program’s cost.

36. Income Taxes The Earned Income Tax Credit, 4 • Many studies look at the work impact of the EITC. My reading of this literature is that it • Encourage some people in the phase-in to take jobs. • Encourages some secondary earners in the phase-out range to stop working. • Has little impact on hours worked for those with jobs.

37. Income Taxes The Earned Income Tax Credit, 5 • The EITC may also discourage marriage. • The design of the program creates a huge marriage penalty. • But empirical studies find little change in marriage rates due to this penalty.

38. Income Taxes The Earned Income Tax Credit, 6 Using Differences in Knowledge across Neighborhoods to Uncover the Impacts of the EITC on Earnings. R Chetty, JN Friedman, E Saez. American Economic Review, 2013. Effective policy for reducing inequality? The earned income tax credit and the distribution of income. HW Hoynes, AJ Patel. Journal of Human Resources, 2018. Income, the earned income tax credit, and infant health. H Hoynes, D Miller, D Simon. American Economic Journal: Economic Policy, 2015,

39. Income Taxes The Earned Income Tax Credit, 7 State Earned Income Tax Credits and the Production of Child Health: Insurance Coverage, Utilization and Health Status. R.A. Baughman and N. Duchovny. National Tax Journal, March 2016. This study exploits across-state variation in the EITC to study the impact of income on health. A higher EITC leads to more private insurance and less public insurance. It also leads to “significant improvements in health status for older children, and effect consistent with higher family income.”

40. Income Taxes Deductions for Homeownership • The U.S. tax code gives 4 major benefits to homeowners: • 1. Homeowners who itemize deductions are allowed to deduct interest paid on their mortgage. • 2. Homeowners who itemize deductions are allowed to deduct their property taxes. Now limited by TCJA.

41. Income Taxes Deductions for Homeownership, 2 • 3. The implicit rent on a house, unlike the return on other investments, is excluded from taxable income. • 4. When a homeowners sells her house, she may exclude up to $500,000 of capital gains if she (a) has maintained the home as her principal residence in two out of the preceding five years and (b) has not claimed this exclusion for the sale of another home during the previous two years.

42. Income Taxes Deductions for Homeownership, 3

43. Income Taxes Deductions for Homeownership, 4 • Because these deductions favor high-income individuals, they mainly lead to larger homes or second-homes, not more homeownership. • Because they lead to larger homes, they actually raise the price of housing. • Many low-income homeowners do not itemize deductions and therefore do not benefit from these deductions at all.

44. Income Taxes Deductions for Homeownership, 5

45. Income Taxes Deductions for Homeownership, 6 • Possible Reforms: • 1. Replace the mortgage interest and property tax deductions with a tax credit. • This would give benefits to low-income homeowners, even if they do not itemize. • This would eliminate the extra subsidy to high-income homeowners. • Moving to a credit of up to $1,400 for property taxes instead of a deduction, for example, would shift about half of the benefits to the bottom two-fifths of the income distribution, with no impact on federal revenue.

46. Income Taxes Deductions for Homeownership, 7

47. Income Taxes Deductions for Homeownership, 8 • Possible Reforms: • 2. Lower the limit on the allowable size of a home mortgage; TCJA did this. • Right now, homeowners can deduct interest on up to $1 million of mortgage debt,. • Lowering this limit to $400,000 would lower the subsidy to the highest-income individuals. • Recent estimates indicate that this change would have increased federal revenue by $30 billion between 2008 and 2012 and would yield nearly $60 billion over the subsequent five years. But these are overstatements because of TCJA.

48. Income Taxes Deductions for Homeownership, 9 • Homeownership and the American dream. LS Goodman, C Mayer. Journal of Economic Perspectives, 2018. • Implications of US tax policy for house prices, rents, and homeownership. K Sommer, P Sullivan. American Economic Review, 2018