More on taxation Today: More on efficiency and equitability; An introduction to the US personal income tax

Today More on taxation  What should be taxed in order to gain efficiency?  Tax evasion versus tax avoidance Underground economies  An introduction to the US personal income tax Defining income  Money value  Income used for tax purposes Computation of tax liability  Exemptions, deductions, credits, marginal tax rates, inflation, the alternative minimum tax

Recall from last lecture Taxes will sometimes change behavior so much that total taxes collected may actually go down  Example: Yacht tax in the early 1990s Tax on yachts over $100,000 purchased in the US People bought yachts in other countries Net economic impact  $16.6 million in taxes collected (less than the $31 million predicted)  Less income tax paid by workers (7,600 jobs lost in the US)

Efficient taxation/tax dodging Although the yacht tax was likely implemented to be “equitable,” efficiency suffered on all margins  Excess burden due to the tax  Decreased overall tax revenue collected due to jobs lost in the US What kinds of taxes lead to less excess burden?

Efficient taxation Assume that the amount of tax revenue collected is set at a constant level Should everything be taxed at the same rate in order to make the most efficient outcome?  Taxing each good at the same rate is known as neutral taxation See Figure 16.1, p. 355  Marginal excess burden

The Ramsey rule How do we tax to reduce excess burden?  Ramsey rule Percentage reduction in quantity demanded for every good is the same Back to our old question: Should everything be taxed at the same rate in order to make the most efficient outcome? NO  One other concept to keep in mind Marginal excess burden generally increases as the tax increases

Equity concerns From the Ramsey rule, inelastic goods should be taxed at higher rates in order to gain efficiency  Coffee  Theater/opera  Salt  Many prescription drugs Example: Insulin needed to live

Should we look at fairness, too? Many people believe that fairness is just as important as efficiency  This type of person would… Probably not want to tax insulin Impose a higher tax on goods that high-income consume more Not want to impose a lump sum tax

Tax evasion/tax avoidance Tax evasion  Not paying taxes that are legally owed to a government Tax avoidance  Altering behavior to legally pay less in taxes

Examples of tax avoidance Recall yacht tax in the early 1990s  Tax on yachts over $100,000 purchased in the US  Tax avoidance: People bought yachts in other countries  Net economic impact in the US was negative 18 th century tax in Brazil  Tax on finished churches  Tax avoidance: Build churches that were complete except for some trivial part that was not built  See bottom picture on p. 371 This church is not “finished” since it is missing one of its towers

Tax evasion theory Marginal benefit of cheating on taxes is constant  $1 for each dollar in taxes avoided Marginal cost is increasing  Probability of getting caught cheating increases as the number of “red flags” increases If MB > MC for some people (for the first dollar in tax evasion), an underground economy develops See Figures 16.5 and 16.6, p. 373 and 374, respectively  Figure 16.5: Tax evasion is positive  Figure 16.6: Tax evasion is zero

Summary: Efficient taxation/tax dodging Efficient taxation comes from the Ramsey rule  Percentage reduction in quantity demanded for every good is the same Equity concerns are important in many people’s minds Tax evasion and tax avoidance are used to lower the amount of taxes a person pays  Note that tax evasion is illegal

The US Personal Income Tax About 45% of federal revenues are generated through personal income taxes Federal taxes are easy and simple to understand, right?  See Figure 17.1, p. 381 for the answer

Digesting federal income tax liability 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 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. Phase-out with income 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 Six ordinary rates (10%, 15%, 25%, 28%, 33%, 35%); differs by filing status; special rates for dividends and capital gains 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 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

How should income be defined? Haig-Simons definition of income  “Money value of the net increase in an individual’s power to consume during a period” (R/G p. 382)  Besides traditional income, what should be counted according to this definition? Pension contributions, insurance purchases, and in-kind benefits given by an employer Any monetary or in-kind transfer from the government Capital gains

Is all Haig-Simons income taxed? No  Interest on state and local bonds Legal issues? Makes these bonds more attractive  Unrealized capital gains Leads to “lock-in” effect  People tend to hold on to assets longer than optimal to avoid paying taxes on the gains  Pension and some retirement contributions (until benefits are received)  Education Savings Accounts

Other features of the US tax system Exemptions  $3,300 per family member is 2006 Deductions  Standard deduction $5,150 per single filer in 2006 $10,300 per joint filer in 2006 Fixed amount, no documentation needed  Itemized deductions Unreimbursed medical expenses above 7.5% of AGI State and local income and property Taxes Certain interest expenses Charitable contributions

More on simplicity The Tax Reform Act of 1986 (TRA86) tried to simplify the tax system  Increased standard deduction Fewer people needed to itemize deductions Personal exemption increased substantially  Fewer people needed to file tax returns Since 1986  Tax laws became more complicated  About 15,000 changes to the tax code

More on simplicity Is the tax code too complex?  Some support a flat income tax Same tax rate to everyone and each component of income No deductions Little room for personal exemptions and business expenses  Criticism of flat income tax Move tax burden from rich to middle class

Marginal tax rates Official Statutory Tax Rate Schedule (2006) Single ReturnsJoint Returns Taxable IncomeMarginal Tax Rate Taxable IncomeMarginal Tax Rate $0-$7,55010%$0-$15,10010% $7,550-$30,65015$15,100-$61,30015 $30,650-$74,20025$61,300-$123,70025 $74,200-$154,80028$123,700-$188,45028 $154,800-$336,55033$188,450-$336,55033 $336,550 and over35$336,550 and over35 Source:

Marginal tax rates Official Statutory Tax Rate Schedule (2007) Single ReturnsJoint Returns Taxable IncomeMarginal Tax Rate Taxable IncomeMarginal Tax Rate $0-$7,82510%$0-$15,65010% $7,825-$31,85015$15,650-$63,70015 $31,850-$77,10025$63,700-$128,50025 $77,100-$160,85028$128,500-$195,85028 $160,850-$349,70033$195,850-$349,70033 $349,700 and over35$349,700 and over35 Source:

Inflation issues Notice that the ranges on the marginal tax rate tables increase from year to year  About 3.5-4% from tax years  Increases account for inflation Taxes are on real income, so to speak Alternative minimum tax (AMT)  Not adjusted for inflation  More Americans are subject to the AMT each year  Under current law, 28.5 million taxpayers expected to be subject to AMT in 2015

Summary: The US Personal Income Tax The US Personal Income Tax system is notoriously complex  Most of Haig-Simons income is counted, but not all Exemptions and deductions lower the tax burden on Americans Marginal tax rates increase as income increases