The US Personal Income Tax & how taxes affect behavior

1. The US Personal Income Tax & how taxes affect behavior Today: Calculating the federal personal income tax liability The marriage penalty How are labor decisions affected by taxes?

2. The US Personal Income Tax • About 45% of federal revenues are generated through personal income taxes • Federal taxes are easy and simple to understand, right?

3. Federal personal income tax liability

4. Digesting federal income 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. 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 • 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 Phase-out with income 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 Six ordinary rates (10%, 15%, 25%, 28%, 33%, 35%); differs by filing status; special rates for dividends and capital gains 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

5. More on simplicity • The Tax Reform Act of 1986 (TRA86) tried to simplify the tax system • Increased standard deduction • Fewer people needed to itemize deductions • Personal exemption increased substantially  Fewer people needed to file tax returns • Since 1986 • Tax laws became more complicated • About 15,000 changes to the tax code

6. More on simplicity • Is the tax code too complex? • Some support a flat income tax • Same tax rate to everyone and each component of income • No deductions • Little room for personal exemptions and business expenses • Criticism of flat income tax • Move tax burden from rich to middle class

7. Other features of the US tax system • Exemptions • $3,650 per family member is 2009 • Deductions • Standard deduction • $5,700 per single filer in 2009 • $11,340 per joint filer in 2009 • Fixed amount, no documentation needed • Itemized deductions • Unreimbursed medical expenses above 7.5% of AGI • State and local income and property Taxes • Certain interest expenses • Charitable contributions

8. Marginal tax rates Source: http://www.irs.gov/formspubs/article/0,,id=150856,00.html

9. Marginal tax rates Source: http://www.irs.gov/formspubs/article/0,,id=164272,00.html

10. Inflation issues • Notice that the ranges on the marginal tax rate tables increase from year to year • About 3.5-4% from 2006-2007 tax years • Increases account for inflation • Taxes are on real income, so to speak • Alternative minimum tax (AMT) • Not automatically adjusted for inflation  More Americans are subject to the AMT each year when Congress does not adjust for inflation • What used to be a policy on the rich, is now a policy that affects many upper-middle income Americans

11. The marriage penalty • We examine the marriage issue further • There are many reasons that people in the United States decide NOT to marry • Costly to divorce if the marriage does not work out well • Many low-income people may lose benefits • People receiving public assistance may lose qualification for these programs if they marry someone who is working • Tax burden may increase as a married couple than as if they lived together unmarried

12. Example of the marriage penalty: Taxes • Suppose a simple case • Only taxable income determines taxes that have to be paid • See what happens to tax burden when some couples get married

13. Recall marginal tax rates, 2007 Source: http://www.irs.gov/formspubs/article/0,,id=164272,00.html

14. Example 1, single • Cameron has $80,000 in taxable income • Tax burden: $16,510.75 total • 10% of $7,825 • 15% of $24,025 • 25% of $45,250 • 28% of $2,900 • Erin has $80,000 in taxable income • Tax burden: $16,510.75 total • 10% of $7,825 • 15% of $24,025 • 25% of $45,250 • 28% of $2,900 As single people, Cameron and Erin pay a total of $33,021.50 in taxes

15. Example 1, married • Cameron and Erin get married • Total taxable income is $160,000 • Tax burden: $33,792.50 total • 10% of $15,650 • 15% of $48,050 • 25% of $64,800 • 28% of $31,500 • $771 more than the total paid if they are single

16. Example 2, single • Pat has $30,000 in taxable income • Tax burden: $4,108.75 total • 10% of $7,825 • 15% of $22,175 • Shannon has $200,000 in taxable income • Tax burden: $52,068.25 total • 10% of $7,825 • 15% of $24,025 • 25% of $45,250 • 28% of $83,750 • 33% of $39,150 As single people, Pat and Shannon pay a total of $56,177 in taxes

17. Example 2, married • Pat and Shannon get married • Total taxable income is $230,000 • Tax burden: $55,100 total • 10% of $15,650 • 15% of $48,050 • 25% of $64,800 • 28% of $67,350 • 33% of $34,150 • $1,077 less than the total paid if they are single

18. Why the difference? • Look at marginal tax rates and the cut-offs

19. Example 1: Cameron/Erin, $80K each More income is taxed in the 28% bracket after they get married

20. Example 2: Pat $30K/Shannon $200K As a married couple, less income is taxed in the 28% and 33% brackets; more in the 25% bracket

21. Two reasons that this happens • When there is one person that earns almost all of the income, more money is usually subject to the lower marginal rates • Notice that the two lowest brackets vary by a factor of two • At the higher brackets, the income ranges converge • Notice that the 35% bracket is the same whether or not you are married

22. Current tax rate schedule Source: http://www.irs.gov/pub/irs-drop/rp-09-50.pdf

23. Changes in behavior due to taxation • Although taxation typically is on income, it is indirectly based on other types of decisions • Labor decisions • Saving decisions

24. Labor decisions • Taxes reduce the marginal wage that a person receives • How do taxes alter people’s behavior?

25. Labor supply without taxes D |Slope| = w Income per week E1 G iii ii i Income Leisure Work 0 T F Hours of leisure per week time endowment

26. Fewer hours worked after labor tax for this person D |Slope| = w Income per week H E1 G iii ii |Slope| = (1-t)w Hours of work after tax E2 G’ i I 0 T F Hours of leisure per week Hours of work before tax

27. More hours worked after labor tax for this person This may happen to people that are poor and have no social safety net. Example: Suppose that you need an income of at least K to survive. D Income per week H E1 G iii E3 ii K Hours of work after tax i J 0 T F Hours of leisure per week Hours of work before tax

28. Effects of Taxation Kink points are in red D |Slope| = w Income per week |Slope| = (1-t3)w E1 N (1-t1)$5,000 + (1-t2)$5,000 E4 (1-t1)$5,000 |Slope| = (1-t1)w |Slope| = (1-t2)w P 0 T F Hours of leisure per week Hours of work before tax

29. Empirical literature • Who responds to changes in tax rates? • Women • Example: Tax Reform Act of 1986 (TRA86) • Marginal tax rates for high incomes were decreased significantly • Women with husbands earning a lot increased their work by a lot (on average) • Women with husbands earning moderate amounts increased their work by a smaller amount (on average) • For more, see Eissa (2001)

30. Summary: Changes in behavior • Theory is unclear as to how people change their labor decisions when taxes change • Empirical evidence shows that women with high-earning husbands increase their labor supply significantly when marginal tax rates decrease

31. Wrapping up the quarter • No class on Monday • Memorial Day, enjoy the day off • Next Wednesday is review day • Bring your questions • I will answer questions until 1:45 or you are done asking questions, whichever comes first • Tuesday, June 8, Noon-2:30 pm • Scheduled time for final exam • Office hours will remain as scheduled through June 7

32. End of lecture material Thank you for your attention this quarter. I will answer your questions for the final on Wednesday, for those of you that want to come. Good luck on the final and have a great summer!