Understanding Personal Income Tax: Computation, Deductions, Rates, and Exemptions

1. CHAPTER 17 THE PERSONAL INCOME TAX

2. Computation of Federal Personal 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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

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

10. 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

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

12. Impact on the Tax Base

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

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

15. Rate Structure

16. 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

17. 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]

18. 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

19. 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

20. 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

21. 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

22. 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

23. Tax Liabilities Under a Hypothetical System

24. 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”

25. 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

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

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

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

29. 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

30. 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

31. 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

32. 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.”

33. 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%