1

Chapter 14

Taxation of Personal Income in the United States

2

The Tax Base: Basic Rules for Calculating Taxable Income and Why Much of Income Is Untaxed

Taxable Income is the portion of income received by households that is subject to personal income tax.

Gross Income is income received during the year from all taxable sources.

Adjusted Gross Income (AGI) is Gross Income – allowable adjustments (reimbursed employee business expenses, contributions to special retirement plans, penalties for early withdrawal, and alimony.)

3

Personal Exemptions

Personal Exemptions are pre-set sums of money that taxpayers are allowed to subtract from AGI in the process of calculating taxable income.

In 2003, the personal exemption was $3050 for each person per household.

4

Deductions

These are further reductions from AGI.

Taxpayers may take the standard deduction or they may itemize.

Taxpayers may take whichever amount is greater as they calculate AGI.

5

The Standard Deduction The Standard Deduction is a fixed dollar

amount that may be used to reduce AGI to compute taxable income.

It is adjusted for inflation each year and varies with the filing status of the taxpayer.

For those filing as singles, the standard deduction in 2003 was $4,750, while for married couples filing jointly it was $9,500.

6

Itemized Deductions Itemized Deductions are legally

deductible expenses from AGI to compute taxable income. The most significant of these are the deductions for: home mortgage interest, major medical expenses, charitable contributions, and state and local income and property

taxes.

7

Sources of Income Subject to Tax Gross Income is the sum of:

Wages and Salaries, Interest Income Received, Dividends, Rental Income, Profits from Noncorporate Business Activities, Taxable Pension Benefits, Realized Capital Gains (Special Tax Rates Apply

in Many Cases), Unemployment Compensation and a Portion of

Other Government Payments to Individuals, Alimony Received, and Miscellaneous Income (e.g., Awards and Prizes).

8

Adjustments to Gross IncomeThe sum of:

Moving Expenses Relating to Start of Work, Contributions to Special Retirement Plans and

Medical Savings Accounts, Penalties for Early Withdrawal of Savings, Alimony Paid, A Portion of Self-Employment Tax and Heath

Insurance, Miscellaneous Costs for Employees and Businesses,

and Miscellaneous Education expenses.

9

Calculating Taxable Income Adjusted Gross Income = Gross Income – Adjustments to

Gross Income

Taxable Income = Adjusted Gross Income - Exemptions - Deductions (either Standard or Itemized)

10

Untaxed Income Less than half of total personal income

in the United States is subject to the federal income tax. This can be seen with a simple example. Take a family of four with an income of

$35,000. If they take the personal exemption for each person in the household and the standard deduction for a married couple filing jointly they only have to pay taxes on $13,300. ($35,000 – 4 × $3,050 – $9,500).

11

The Tax Rate Structure

2003 regulations featured six tax brackets for every filing status. A tax bracket is the range of taxable income in which the marginal rate is constant.

 

12

Figure 14.1 Statutory Marginal Tax Rates for the U.S. Personal Income Tax, 2003

13

Taxation of Low-Income Households Low-income households in the U.S. typically

pay no federal income tax and many actually face a negative income tax.

This works because the Earned Income Tax Credit targets money to families with low-income and this credit can easily exceed their federal income tax obligations.

They still face FICA (Social Security) taxes and other state and local taxes.

14

The Effect of Various Credits on the Tax

Rate Structure Some credits, such as the Hope Credit

and the Lifetime Learning credit, have income phase-in and phase-out periods in which households with higher incomes are decreasingly eligible or ineligible for certain tax credits.

This can mean that an individual family has eleven potential tax brackets.

15

Tax Preferences Tax Preferences are exclusions, exemptions,

and deductions from the tax base.

They are referred to as tax loopholes.

They are intentional or unintentional means by which income can be earned but not be subject to the income tax.

16

Justification for Tax Preferences

Tax preferences are usually justified because having the preference:

reduces administrative difficulty,

improves tax equity, or

encourages private expenditures on goods with external benefits.

17

The Administrative Difficulty Justification When a tax provision is difficult to administer

or comply with properly, a provision that partially or fully exempts certain income may be better (in terms of net tax efficiency) than a complicated provision with which it is difficult to comply.

This argument is used to justify the provision that allows capital gains taxes to be deferred until gains are realized. (Again, currently up for debate in the Congress).

18

The Equity Justification Tax preferences are often justified with the

argument that they make society fairer.

A college education tax break can be justified as making it easier for lower-income households to send their children to college so that these children may have the same chance in life as children from higher-income households.

19

The External Benefits Justification

Chapter 4 showed that offering a subsidy to a good with an external benefit increases societal welfare.

Tax provisions can be used to implement that subsidy.

20

Excess Burden of Tax Preferences

Unless the tax preference is designed to internalize some externality, excess burden is created with tax preferences.

21

Figure 14.2 Tax Preference and Efficiency

Price

Output of Tax-Preferred Activity per Year

0 Q*

PG A

D = MSB

S = MSC

Net Price

Q1

B

C PG (1 – t) = PN

22

Figure 14.3 Decrease in Excess Burden of Tax Preferences

New NetPrice

0.72 PG

Q2

B’

C’

Pri

ce

(D

olla

rs)

Tax-Preferred Activity per Year 0 Q1 Q*

PG S = MSC

D = MSB

A B

Initial NetPrice

0.50 PG C

23

Tax Preferences in the US Income Tax System In-Kind Income

Fringe Benefits

Transfers

Capital Gains

Interest on State and Local Bonds

Miscellaneous Exclusions and Adjustments

24

The Tax Preference for In-Kind Income Taxpayers who own their own homes and

pay no mortgage or rent get what economists call imputed rent.

This money that they do not have to pay should be treated as income under the Haig-Simons definition.

It is not treated as income, in part because doing so would be nearly impossible to implement.

25

The Tax Preference for Fringe Benefits

Employer paid health insurance, pension funds, and other perks of employment are not taxed.

This tax preference costs the federal government $180 billion annually in lost tax revenue.

26

The Tax Preference for Transfers

Most government welfare payments are tax-exempt.

A portion of Social Security income is taxable if other income is sufficiently high.

27

The Tax Preference for Capital Gains Capital Gains income is not taxed until it is realized.

This tax deferral amounts to a tax preference.

Those capital gains that are realized are taxed at a reduced rate (5% for those in the 15% tax bracket and at 15% for those in the higher tax brackets).

Capital gains taxes are typically forgiven at death.

These amount to substantial preferences and are justified by the fact that many capital gains is not income at all, but simply inflationary gains that should not be taxed under the Haig-Simons definition.

28

The Tax Preferences for Interest on State and

Local Bonds

State and Local bonds are more attractive to investors and this allows these entities to pay lower interest rates.

29

Miscellaneous Exclusions and Adjustments Certain scholarships and fellowships for

academic purposes are not taxable as income.

Earnings contributed to certain savings plans allow for income to be saved pre-tax; that is, not subject to taxation when it is earned (e.g., 401k plans).

For most of these plans, this tax preference is simply a tax deferral and a tax deferred is viewed as a tax lessened.

30

Itemized Deductions Medical Expenses

State and Local Income and Property Taxes

Interest Payments for First and Second Homes

Charitable Contributions

Miscellaneous Deductions

31

Deducting Medical Expenses

Medical expenses and health insurance payments that exceed 7.5% of AGI are deductible.

For practical purposes, one must be quite ill or in a nursing home to benefit from this provision.

32

Deducting State and Local Income and Property Taxes

All income and property taxes paid to state and local governments are deductible.

This makes it somewhat easier for state and local governments to raise their taxes.

33

Deducting Interest Payments on Home

Mortgages The interest paid on the mortgages of first

and second homes is deductible.

Interest on credit cards or loans for automobiles and college loans are not deductible.

This provision has lead to the phenomenon whereby people take out second mortgages to purchase automobiles rather than getting a car loan directly.

34

Deducting Charitable Contributions

Money given to charitable organizations is deductible.

35

Miscellaneous Deductions

If unreimbursed business expenses exceed 2% of AGI, then the excess is deductible.

36

Deductions versus Credits

A tax credit directly reduces taxes owed, while a tax deduction reduces the amount of income subject to tax.

Generally, for an equal cost to government revenues, a credit favors low-income earners while a deduction favors high-income earners.

37

Tax Expenditures Item Projected

Revenue Loss (in billions)

Exclusion of Employer Pension Contributions 123

Employer Contributions for Medical Insurance 120

Deduction of Mortgage Interest 68

Deduction of State and Local Taxes (not home property) 51

Capital Gains 54

Step-Up Basis of Capital Gains at Death 29

Exclusion of Social Security Pension Benefits for Retirees 19

Deduction of Charitable Contributions 34

Exclusion of Interest on Public-Purpose State and Local Government Debt

27

Deduction of State and Local Property Taxes on Homes 22

38

The Alternative Minimum Tax

The Alternative Minimum Tax (AMT) prevents high-income earners from having so many deductions and credits that they owe little tax.

39

Issues in Income Tax Policy

The Flat Tax

Capital Gains Taxes

Bracket Creep

The Marriage Penalty

A National Sales Tax

40

The Flat Tax At various times, politicians have

responded to the anger citizens have concerning the complicated nature of the federal income tax by recommending a flat tax.

Such a tax would allow few, if any, tax preferences and would tax the entire tax base at the same rate.

41

The Economic Impact of a Flat Tax Depending on the proposal, a flat tax would

generally reduce excess burden associated with tax preferences.

Depending on the size of the personal exemption, it would dramatically lower taxes paid by the upper end of the tax scale.

If the flat tax eliminated the EITC, it would dramatically raise the net income tax paid by those at the lower end of tax scale.

42

Capital Gains Taxes Inflation and Capital Gains: Inflation raises the price of assets.

Economists see this as taxing a gain that does not exist. All else equal, this provision overtaxes long-term capital gains income. 

Taxation of Capital Gains on Realization: This provision allows people to decide when or whether they will pay taxes on capital gains. They can defer the tax by deferring the gain.

The Stepped-up Basis on Death: This provision means that the taxes that would be owed on capital gains are forgiven at death.

The latter two provisions lead to a “lock-in effect” where people are encouraged to hold assets rather than sell them.

43

Bracket Creep Prior to 1986, tax brackets were not subject to

inflation indexation, which meant that inflation caused people to owe more taxes each year on the same real income. This is called bracket creep.

The AMT has not been indexed for inflation.

Tax brackets are indexed by the CPI. Economists generally agree the CPI over-estimates inflation by around 1 percentage point. This has the effect of lowering real taxes owed each year.

44

The Marriage Tax

People who are married pay more in taxes than they would if they were not married and simply living together, based on the same income levels. This is called the marriage tax.

Married couples earning $50,000 where each party earns $25,000 a year pay more than $1000 more in tax because they are married than if they filed separately.

45

A National Consumption or Sales Tax Another policy option that has been

suggested is to convert the system to a national sales tax or a national consumption tax. A sales tax would operate just like most

sales taxes in the states that have them. A consumption tax would operate just like

the current income tax, except that reinvested capital gains would not be considered income and contributions to savings plans would be deductible.

46

Income Taxes and Economic Growth

Evidence suggests that countries that rely heavily on income taxes grow more slowly than those that rely on consumption taxes.

Evidence also suggests that a decrease in the marginal tax rate by 5% leads to a .2 to .5 percentage point increase in real growth.

47

Effective Rates for Federal Individual Income Taxes and Total Federal Taxes by Income Quintile, 1998

48

Marginal Tax Rates for a Couple With Two Children in College, One Eligible for a Hope Credit and the

Other Eligible for a Lifetime Learning Credit

49

Marginal Tax Rates for a Single Head of Household With Two Children Under Age 17

50

State Income Taxes All but seven states have income taxes (AK, FL, NV, SD,

TX, WA, and WY).

Most have progressive rate structures though some (CA, MA, MI, and PA) have proportional structures.

Income taxes account for 40% of state revenues

Most states start with the Federal Adjusted Gross Income and then use their own system of deductions and exemptions.