The US Personal Income Tax & how taxes affect behavior Today: Calculating the federal personal income tax liability The marriage penalty How are labor decisions affected by taxes?

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?

Federal personal income tax liability

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

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

Other features of the US tax system Exemptions  $3,650 per family member is 2009 Deductions  Standard deduction $5,700 per single filer in 2009 $11,340 per joint filer in 2009 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

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 automatically adjusted for inflation  More Americans are subject to the AMT each year when Congress does not adjust for inflation  What used to be a policy on the rich, is now a policy that affects many upper-middle income Americans

The marriage penalty We examine the marriage issue further There are many reasons that people in the United States decide NOT to marry  Costly to divorce if the marriage does not work out well  Many low-income people may lose benefits People receiving public assistance may lose qualification for these programs if they marry someone who is working  Tax burden may increase as a married couple than as if they lived together unmarried

Example of the marriage penalty: Taxes Suppose a simple case  Only taxable income determines taxes that have to be paid See what happens to tax burden when some couples get married

Recall marginal tax rates, 2007 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:

Example 1, single Cameron has $80,000 in taxable income  Tax burden: $16, total 10% of $7,825 15% of $24,025 25% of $45,250 28% of $2,900 Erin has $80,000 in taxable income  Tax burden: $16, total 10% of $7,825 15% of $24,025 25% of $45,250 28% of $2,900 Official Statutory Tax Rate Schedule (2007) Single ReturnsJoint Returns Taxable Income Marginal Tax Rate Taxable Income Marginal Tax Rate $0-$7,82510%$0-$15,65010% $7,825- $31,850 15$15,650- $63, $31,850- $77,100 25$63,700- $128, $77,100- $160,850 28$128,500- $195, $160,850- $349,700 33$195,850- $349, $349,700 and over 35$349,700 and over 35 As single people, Cameron and Erin pay a total of $33, in taxes

Example 1, married Cameron and Erin get married Total taxable income is $160,000  Tax burden: $33, total 10% of $15,650 15% of $48,050 25% of $64,800 28% of $31,500 $771 more than the total paid if they are single Official Statutory Tax Rate Schedule (2007) Single ReturnsJoint Returns Taxable Income Marginal Tax Rate Taxable Income Marginal Tax Rate $0-$7,82510%$0-$15,65010% $7,825- $31,850 15$15,650- $63, $31,850- $77,100 25$63,700- $128, $77,100- $160,850 28$128,500- $195, $160,850- $349,700 33$195,850- $349, $349,700 and over 35$349,700 and over 35

Example 2, single Pat has $30,000 in taxable income  Tax burden: $4, total 10% of $7,825 15% of $22,175 Shannon has $200,000 in taxable income  Tax burden: $52, total 10% of $7,825 15% of $24,025 25% of $45,250 28% of $83,750 33% of $39,150 Official Statutory Tax Rate Schedule (2007) Single ReturnsJoint Returns Taxable Income Marginal Tax Rate Taxable Income Marginal Tax Rate $0-$7,82510%$0-$15,65010% $7,825- $31,850 15$15,650- $63, $31,850- $77,100 25$63,700- $128, $77,100- $160,850 28$128,500- $195, $160,850- $349,700 33$195,850- $349, $349,700 and over 35$349,700 and over 35 As single people, Pat and Shannon pay a total of $56,177 in taxes

Example 2, married Pat and Shannon get married Total taxable income is $230,000  Tax burden: $55,100 total 10% of $15,650 15% of $48,050 25% of $64,800 28% of $67,350 33% of $34,150 $1,077 less than the total paid if they are single Official Statutory Tax Rate Schedule (2007) Single ReturnsJoint Returns Taxable Income Marginal Tax Rate Taxable Income Marginal Tax Rate $0-$7,82510%$0-$15,65010% $7,825- $31,850 15$15,650- $63, $31,850- $77,100 25$63,700- $128, $77,100- $160,850 28$128,500- $195, $160,850- $349,700 33$195,850- $349, $349,700 and over 35$349,700 and over 35

Why the difference? Look at marginal tax rates and the cut-offs

Example 1: Cameron/Erin, $80K each 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 More income is taxed in the 28% bracket after they get married

Example 2: Pat $30K/Shannon $200K 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 As a married couple, less income is taxed in the 28% and 33% brackets; more in the 25% bracket

Two reasons that this happens When there is one person that earns almost all of the income, more money is usually subject to the lower marginal rates  Notice that the two lowest brackets vary by a factor of two At the higher brackets, the income ranges converge  Notice that the 35% bracket is the same whether or not you are married Official Statutory Tax Rate Schedule (2007) Single ReturnsJoint Returns Taxable Income Marginal Tax Rate Taxable Income Marginal Tax Rate $0-$7,82510%$0-$15,65010% $7,825- $31,850 15$15,650- $63, $31,850- $77,100 25$63,700- $128, $77,100- $160,850 28$128,500- $195, $160,850- $349,700 33$195,850- $349, $349,700 and over 35$349,700 and over 35

Current tax rate schedule Official Statutory Tax Rate Schedule (2010) Single ReturnsJoint Returns Taxable IncomeMarginal Tax Rate Taxable IncomeMarginal Tax Rate $0-$8,37510%$0-$16,75010% $8,375-$34,00015$16,750-$68,00015 $34,000-$82,40025$68,000-$137,30025 $82,400-$171,85028$137,300-$209,25028 $171,850-$373,65033$209,250-$373,65033 $373,650 and over35$373,650 and over35 Source:

Changes in behavior due to taxation Although taxation typically is on income, it is indirectly based on other types of decisions  Labor decisions  Saving decisions

Labor decisions Taxes reduce the marginal wage that a person receives How do taxes alter people’s behavior?

Labor supply without taxes Hours of leisure per week Income per week 0T time endowment D |Slope| = w F G Leisure Work i ii iii E1E1 Income

Fewer hours worked after labor tax for this person Hours of leisure per week Income per week 0T D |Slope| = w F G ii iii E1E1 i I E2E2 |Slope| = (1-t)w H G’ Hours of work before tax Hours of work after tax

More hours worked after labor tax for this person Hours of leisure per week Income per week 0T D F G ii iii E1E1 i J E3E3 H K Hours of work before tax Hours of work after tax This may happen to people that are poor and have no social safety net. Example: Suppose that you need an income of at least K to survive.

Effects of Taxation Hours of leisure per week Income per week 0T D F N E1E1 P E4E4 Hours of work before tax |Slope| = w |Slope| = (1-t 1 )w |Slope| = (1-t 2 )w |Slope| = (1-t 3 )w (1-t 1 )$5,000 (1-t 1 )$5,000 + (1-t 2 )$5,000 Kink points are in red

Empirical literature Who responds to changes in tax rates?  Women Example: Tax Reform Act of 1986 (TRA86)  Marginal tax rates for high incomes were decreased significantly  Women with husbands earning a lot increased their work by a lot (on average)  Women with husbands earning moderate amounts increased their work by a smaller amount (on average)  For more, see Eissa (2001)

Summary: Changes in behavior Theory is unclear as to how people change their labor decisions when taxes change  Empirical evidence shows that women with high- earning husbands increase their labor supply significantly when marginal tax rates decrease

Wrapping up the quarter No class on Monday  Memorial Day, enjoy the day off Next Wednesday is review day  Bring your questions  I will answer questions until 1:45 or you are done asking questions, whichever comes first Tuesday, June 8, Noon-2:30 pm  Scheduled time for final exam  Office hours will remain as scheduled through June 7

End of lecture material Thank you for your attention this quarter. I will answer your questions for the final on Wednesday, for those of you that want to come. Good luck on the final and have a great summer!