Chapter 17 Personal Income Taxation

1. Chapter 17 Personal Income Taxation • Ch. 16 on Optimal Personal Income taxation: -finding a balance between equity and efficiency

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. Deductions • Standard versus Itemized • Deductibility and Relative Prices • PZ (1-t)PZ

13. 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

14. More Deduction Issues • Deductions and complexity • Deductions versus credits • Itemized deduction phaseout • Standard deduction

15. Impact on the Tax Base

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

18. The Simplicity Issue • Tax Reform Act of 1986 (TRA86) • Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA)

19. Rate Structure

20. 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

21. 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]

22. 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

23. 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

24. 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

25. 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

26. 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

27. Tax Liabilities Under a Hypothetical System

28. 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 and adds “tax dowry”

29. Analyzing the Marriage Tax • Advantages to using the family as taxable unit • Fairer treatment of nonlabor 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

30. Treatment of International Income • Global versus territorial systems • Equity • Efficiency • Production decisions • Residential decisions

31. State Income Taxes • State income taxes similar to federal tax • Lower marginal tax rates • Including state tax rates when assessing overall marginal tax rates

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

33. Interest on State and Local Bonds ip = 15% t = 30% ig = 10.5% ig = (1-t)ip 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

34. Capital Gains P = $100,000 g = 10% $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 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

35. 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

36. 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.”

37. Taxation of Nominal Interest Real after-tax rate of return: r = (1 – t)i – π Let t = 25%, i = 16%, π = 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%