Chapter 18: Introduction to Taxation

1. Chapter 18: Introduction to Taxation • This lecture discusses a few institutional and theoretical issues 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.

2. 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.

3. Figure 2 Other countries are more dependent on consumption taxes than the United States.

4. Figure 3 Marginal tax rates rise with taxable income, with a current maximum rate of 35%. Be clear: even a taxpayers with TI of $400,000 pays 10% on her first $14,300, 15% on the next $43,800, etc.

5. A Set of Important Taxation Concepts:Measuring the fairness of tax systems • A marginal tax rate is the percentage that is paid in taxes on the next dollar earned. • An average tax rate is the percentage of total income is that is paid in taxes. • Most think a progressive tax system is fairest, in that it respects the ability to pay. • 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.

6. Measuring the fairness of tax systemsEffective 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 • There are many exemptions and deductions from taxable income, which reduces the tax base. • As we will discuss next chapter, the burden of some taxes can be shifted.

7. Measuring the fairness of tax systemsVertical 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.

8. Defining the income tax base: The 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. • In practice it is very difficult to implement the Haig-Simons income concept. Problems include • Adjusting for an individual’s ability to pay (property and casualty losses, medical expenses, state and local taxes); the costs of earning income; and difficult to value items (imputed rent on owner-occupied housing).

9. 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. • 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.

10. Tax deductions vs. tax credits • Tax credits are more equitable than deductions. • The value of deductions (such as for home mortgage interest or charitable contributions) rises with a person’s marginal tax rate, making them regressive. • Credits are equally available for all incomes, so they are progressive. • 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.

11. THE APPROPRIATE UNIT OF TAXATIONThe 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 (i.e., uses the family as the unit of taxation). • Across-Marriage Horizontal Equity (e.g., marriage neutrality).

12. The appropriate unit of taxationMarriage 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. • There is no empirical evidence that the “marriage penalty” does discourage marriage. • But people might still be concerned about the “optics” of the tax system providing a financial incentive for some not to marry.

13. The appropriate unit of taxationMarriage taxes in practice • The U.S. is unusual in that it has 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. • Ireland and Norway…