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Copyright © 2002 by Thomson Learning, Inc. Chapter 14 Taxation of Personal Income in the United States Copyright © 2002 Thomson Learning, Inc. Thomson Learning™ is a trademark used herein under license. ALL RIGHTS RESERVED. Instructors of classes adopting PUBLIC FINANCE: A CONTEMPORARY APPLICATION OF THEORY TO POLICY, Seventh Edition by David N. Hyman as an assigned textbook may reproduce material from this publication for classroom use or in a secure electronic network environment that prevents downloading or reproducing the copyrighted material. Otherwise, no part of this work covered by the copyright hereon may be reproduced or used in any form or by any means—graphic, electronic, or mechanical, including, but not limited to, photocopying, recording, taping, Web distribution, information networks, or information storage and retrieval systems—without the written permission of the publisher. Printed in the United States of America ISBN 0-03-033652-X

Chapter 14- TAXATION OF PERSONAL INCOME IN THE UNITED STATES

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Page 1: Chapter 14- TAXATION OF PERSONAL INCOME IN THE UNITED STATES

Copyright © 2002 by Thomson Learning, Inc.

Chapter 14

Taxation of Personal Income in the United States

Copyright © 2002 Thomson Learning, Inc. Thomson Learning™ is a trademark used herein under license.

ALL RIGHTS RESERVED. Instructors of classes adopting PUBLIC FINANCE: A CONTEMPORARY APPLICATION OF THEORY TO POLICY, Seventh Edition by David N. Hyman as an assigned textbook may reproduce material from this publication for classroom

use or in a secure electronic network environment that prevents downloading or reproducing the copyrighted material. Otherwise, no part of this work covered by the copyright hereon may be reproduced or used in any form or by any means—graphic, electronic, or mechanical, including, but not limited to, photocopying, recording, taping, Web distribution, information networks, or information storage and retrieval

systems—without the written permission of the publisher. Printed in the United States of America

ISBN 0-03-033652-X

Page 2: Chapter 14- TAXATION OF PERSONAL INCOME IN THE UNITED STATES

Copyright © 2002 by Thomson Learning, Inc.

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 the personal income tax.

Gross Income is all income received during the year from 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.

Page 3: Chapter 14- TAXATION OF PERSONAL INCOME IN THE UNITED STATES

Copyright © 2002 by Thomson Learning, Inc.

Personal Exemptions

Personal Exemptions are certain sums of money that a taxpayer is allowed to subtract from AGI in the process of getting taxable income.

In 2000 this was $2800 for each person in the household.

Page 4: Chapter 14- TAXATION OF PERSONAL INCOME IN THE UNITED STATES

Copyright © 2002 by Thomson Learning, Inc.

Deductions

These are further reductions from AGI. Taxpayers may take the standard

deduction or they may itemize. Taxpayers take whichever amount is

greater.

Page 5: Chapter 14- TAXATION OF PERSONAL INCOME IN THE UNITED STATES

Copyright © 2002 by Thomson Learning, Inc.

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 2000 was $4,400 while for married couples filing jointly it was $7,350.

Page 6: Chapter 14- TAXATION OF PERSONAL INCOME IN THE UNITED STATES

Copyright © 2002 by Thomson Learning, Inc.

Itemized Deductions

Itemized Deductions are expenses that are legally deductible 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.

Page 7: Chapter 14- TAXATION OF PERSONAL INCOME IN THE UNITED STATES

Copyright © 2002 by Thomson Learning, Inc.

Untaxed Income

Only 45% 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 it takes 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 $16,450. ($35,000 – 4 × $2,800 – $7,350).

Page 8: Chapter 14- TAXATION OF PERSONAL INCOME IN THE UNITED STATES

Copyright © 2002 by Thomson Learning, Inc.

The Tax Rate Structure

In 2000 there were five tax brackets for every filing status. A tax bracket is the range of taxable income in which the marginal rate is constant.

 

Page 9: Chapter 14- TAXATION OF PERSONAL INCOME IN THE UNITED STATES

Copyright © 2002 by Thomson Learning, Inc.

Figure 14.1 Statutory Marginal Tax Rates for the U.S. Personal Income Tax, 2000

Mar

gin

al T

ax R

ate

(Per

cen

t)

MTR

Taxable Income 0

39.6

A C D

36 31 28

15

C = $132,600 for single taxpayers = $161,450 for married taxpayers filing jointly

D = $288,350 for single taxpayers and married taxpayers filing jointly

A = $26,250 for single taxpayers = $43,850 for married taxpayers filing jointly

B = $63,550 for single taxpayers = $105,950 for married taxpayers filing jointly

B

Page 10: Chapter 14- TAXATION OF PERSONAL INCOME IN THE UNITED STATES

Copyright © 2002 by Thomson Learning, Inc.

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.

Page 11: Chapter 14- TAXATION OF PERSONAL INCOME IN THE UNITED STATES

Copyright © 2002 by Thomson Learning, Inc.

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.

Page 12: Chapter 14- TAXATION OF PERSONAL INCOME IN THE UNITED STATES

Copyright © 2002 by Thomson Learning, Inc.

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

Income Quintile – 10

0

10

Eff

ec

tiv

e T

ax

Ra

te (

Pe

rce

nt)

Second

Lowest

Third

Fourth

Highest 20

Individual Income Taxes

A

0

10

Eff

ec

tiv

e T

ax

Ra

te (

Pe

rce

nt)

Second

Lowest Third

Fourth

Fifth

30

20

All Federal Taxes

B

Page 13: Chapter 14- TAXATION OF PERSONAL INCOME IN THE UNITED STATES

Copyright © 2002 by Thomson Learning, Inc.

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

50

40

30

20

100,000

Ma

rgin

al

Ta

x R

ate

(P

erc

en

t)

Annual Income (Dollars)

50,000 150,000 200,000

10

0

–10

–20

–30

–40

–50

Child Credit Phaseout Range

31 Percent Bracket Begins

Personal Exemption Phaseout Begins

Child Credit Phasein Ends

EITC Phaseout Ends

EITC Phaseout Begins

15 Percent Bracket Begins; Child Credit Phase in Begins

28 Percent Bracket Begins Itemized Deduction Phaseout Begins

36 Percent Bracket Begins

EITC Phasein Range

Page 14: Chapter 14- TAXATION OF PERSONAL INCOME IN THE UNITED STATES

Copyright © 2002 by Thomson Learning, Inc.

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

50

40

30

20

Ma

rgin

al

Ta

x R

ate

(P

erc

en

t)

Annual Income (Dollars)

50,000 100,000 150,000 200,000

10

0

–10

–20

–30

–40

28 Percent Bracket Begins

Education Credits Phasein Ends

EITC Phaseout Begins

EITC Phasein Range

Itemized Deduction Phaseout Begins

Education Credits Phaseout Range

36 Percent Bracket Begins

31 Percent Bracket Begins Personal Exemption

Phaseout Begins

Page 15: Chapter 14- TAXATION OF PERSONAL INCOME IN THE UNITED STATES

Copyright © 2002 by Thomson Learning, Inc.

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 and is not subject to the income tax.

Page 16: Chapter 14- TAXATION OF PERSONAL INCOME IN THE UNITED STATES

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Justification for Tax Preferences

Tax preferences are usually justified because having the preference: Reduces Administrative Difficulty Improves Tax Equity Encourages Private Expenditures on

Goods With External Benefits

Page 17: Chapter 14- TAXATION OF PERSONAL INCOME IN THE UNITED STATES

Copyright © 2002 by Thomson Learning, Inc.

The Administrative Difficulty Justification

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

This argument is used to justify the provision that allows capital gains taxes to be deferred until the gains are realized.

Page 18: Chapter 14- TAXATION OF PERSONAL INCOME IN THE UNITED STATES

Copyright © 2002 by Thomson Learning, Inc.

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.

Page 19: Chapter 14- TAXATION OF PERSONAL INCOME IN THE UNITED STATES

Copyright © 2002 by Thomson Learning, Inc.

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.

Page 20: Chapter 14- TAXATION OF PERSONAL INCOME IN THE UNITED STATES

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Excess Burden of Tax Preferences

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

Page 21: Chapter 14- TAXATION OF PERSONAL INCOME IN THE UNITED STATES

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Figure 14.2 Tax Preference and Efficiency

Price

Output of Tax-Preferred Activity per Year

0 Q1 Q*

PG A B

C

D = MSB

Net Price

S = MSC

PG (1 – t) = PN

Page 22: Chapter 14- TAXATION OF PERSONAL INCOME IN THE UNITED STATES

Copyright © 2002 by Thomson Learning, Inc.

Figure 14.3 Decrease in Excess Burden of Tax Preferences

Pri

ce

(D

olla

rs)

New NetPrice

Tax-Preferred Activity per Year 0 Q1 Q*

PG S = MSC

D = MSB

A

Q2

B

Initial NetPrice

0.72 PG

0.50 PG

B’

C’

C

Page 23: Chapter 14- TAXATION OF PERSONAL INCOME IN THE UNITED STATES

Copyright © 2002 by Thomson Learning, Inc.

Tax Preferences in the US Income Tax System

In-Kind Income Home Production Fringe Benefits Transfers Capital Gains Interest on State and Local Bonds Miscellaneous Exclusions and Adjustments

Page 24: Chapter 14- TAXATION OF PERSONAL INCOME IN THE UNITED STATES

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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 in part because doing so would be nearly impossible to implement.

Page 25: Chapter 14- TAXATION OF PERSONAL INCOME IN THE UNITED STATES

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The Tax Preference for Home Production

Improvements that taxpayers perform on their house increases their net worth.

This increase in value is not taxed. Again, it would be impossible to

implement a system by which home production was taxed.

Page 26: Chapter 14- TAXATION OF PERSONAL INCOME IN THE UNITED STATES

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The Tax Preference for Fringe Benefits

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

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

Page 27: Chapter 14- TAXATION OF PERSONAL INCOME IN THE UNITED STATES

Copyright © 2002 by Thomson Learning, Inc.

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.

Page 28: Chapter 14- TAXATION OF PERSONAL INCOME IN THE UNITED STATES

Copyright © 2002 by Thomson Learning, Inc.

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 (10% for those in the 15% tax bracket and at 20% 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 much of capital gains is not income at all but simply inflationary gains that should not be taxed under the Haig-Simons definition.

Page 29: Chapter 14- TAXATION OF PERSONAL INCOME IN THE UNITED STATES

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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.

Page 30: Chapter 14- TAXATION OF PERSONAL INCOME IN THE UNITED STATES

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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.

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

Page 31: Chapter 14- TAXATION OF PERSONAL INCOME IN THE UNITED STATES

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Itemized Deductions

Medical Expenses State and Local Income and Property

Taxes Interest Payments for First and Second

Homes Charitable Contributions Miscellaneous Deductions

Page 32: Chapter 14- TAXATION OF PERSONAL INCOME IN THE UNITED STATES

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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.

Page 33: Chapter 14- TAXATION OF PERSONAL INCOME IN THE UNITED STATES

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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.

Page 34: Chapter 14- TAXATION OF PERSONAL INCOME IN THE UNITED STATES

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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.

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

Page 35: Chapter 14- TAXATION OF PERSONAL INCOME IN THE UNITED STATES

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Deducting Charitable Contributions

Money given to charitable organizations is deductible.

Page 36: Chapter 14- TAXATION OF PERSONAL INCOME IN THE UNITED STATES

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Miscellaneous Deductions

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

Page 37: Chapter 14- TAXATION OF PERSONAL INCOME IN THE UNITED STATES

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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.

Page 38: Chapter 14- TAXATION OF PERSONAL INCOME IN THE UNITED STATES

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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.

Page 39: Chapter 14- TAXATION OF PERSONAL INCOME IN THE UNITED STATES

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Tax Expenditures Item Projected

Revenue Loss (in billions)

Exclusion of Employer Pension Contributions 88.83

Employer Contributions for Medical Insurance 75.01

Deduction of Mortgage Interest 58.81

Deduction of State and Local Taxes (not home property) 40.24

Accelerated Depreciation of Machinery and Equipment 27.74

Step-Up Basis of Capital Gains at Death 27.09

Exclusion of Social Security Pension Benefits for Retirees 24.50

Deduction of Charitable Contributions 24.46

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

22.95

Deduction of State and Local Property Taxes on Homes 22.18

Page 40: Chapter 14- TAXATION OF PERSONAL INCOME IN THE UNITED STATES

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Issues in Income Tax Policy

The Flat Tax Capital Gains Taxes Bracket Creep The Marriage Penalty A National Sales Tax

Page 41: Chapter 14- TAXATION OF PERSONAL INCOME IN THE UNITED STATES

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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.

Page 42: Chapter 14- TAXATION OF PERSONAL INCOME IN THE UNITED STATES

Copyright © 2002 by Thomson Learning, Inc.

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.

Page 43: Chapter 14- TAXATION OF PERSONAL INCOME IN THE UNITED STATES

Copyright © 2002 by Thomson Learning, Inc.

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 if they will pay taxes on capital gains. You 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.

Page 44: Chapter 14- TAXATION OF PERSONAL INCOME IN THE UNITED STATES

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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.

Page 45: Chapter 14- TAXATION OF PERSONAL INCOME IN THE UNITED STATES

Copyright © 2002 by Thomson Learning, Inc.

The Marriage Penalty and Bonus

People who are married and earn about the same level of income pay more in taxes than they would if they were not married and simply living together. This is called the marriage penalty.

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

Conversely, people who are married with only one spouse earning all or most of the income pay less than they would if they were not married and living together. This is called the marriage bonus.

Page 46: Chapter 14- TAXATION OF PERSONAL INCOME IN THE UNITED STATES

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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 tax

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

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

Page 47: Chapter 14- TAXATION OF PERSONAL INCOME IN THE UNITED STATES

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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.