Income Tax Base and Rates Anderson: Income and Payroll Taxes

2 Introduction In this chapter we examine more specifics of how the U.S. personal income tax system works. We also examine how a payroll tax, such as the one used to fund Social Security, works.

Principles of Sound Tax Policy Adequacy Neutrality Fair or equitable Horizontal Vertical Ease of Administration and Compliance Accountability Administration and enforcement should be efficient and fair Government must enforce the laws Open, transparent tax policy

Tax Base and Rate Review Tax rates Statutory Effective Computation Average Marginal Tax classifications based on average tax rates relative to gross income Regressive Proportional or flat Progressive

Defining the Income Tax Base An ideal definition of taxable income (Haig-Simons) The U.S. definition of taxable income Adjusted gross income (AGI) Excluded forms of money income Taxable income (TI) Exemptions and deductions Taxable income thresholds

Adjusted Gross Income (AGI) AGI = wages + salaries + tips + interest income + dividend income + capital gains + net business/farm income – adjustments.

Excluded Forms of Money Income Interest earnings on municipal bonds. Employer contributions to benefit plans, e.g. medical/dental/vision insurance. Contributions to retirement savings plans, e.g. pension contributions, IRA contributions, KEOGH contributions.

Taxable Income (TI) TI = AGI – personal exemptions – deductions. Deductions may be either the standard deduction or itemized deductions.

Deductions are permitted for: Medical and dental care--expenditures in excess of 7.5% of AGI may be deducted Taxes paid, including state and local income taxes, real estate taxes, and personal property taxes (sales tax ?) Interest paid, including home mortgage interest and investment interest Gifts to charity, including cash gifts and other than cash gifts Casualty or theft loss Job expenses, including un-reimbursed employee expenses, job travel, union dues, and job educational expenses Other miscellaneous expenses (including tax preparation fees

Hard to determine appropriate business deductions: A rabbi claimed as a business expense the $4,031 he spent on 700 guests who attended his son’s bar mitzvah. o Tax court found the Rabbi “was not required to invite the entire…congregation…as a condition of his employment.” The entertainer Dinah Shore claimed several dresses as business expenses, prompting an investigation by the IRS. o “Dinah Shore ruling”: A dress may be deducted as a business expense only if it is too tight to sit in. APPLICATION: What Are Appropriate Business Deductions?

A man tried to deduct $30,000 in expenses on illegal drugs. o Allowed to claim deductions, he was sentenced for criminal charges. Many OECD countries have traditionally allowed/ treated foreign bribes as business expenses. APPLICATION: What Are Appropriate Business Deductions?

Tax Facts: Personal Exemptions and Standard Deductions Personal Exemption: $3,950 Standard Deductions: Single: $6,200 Head of Household: $9,100 Married: $12,400 Married filing separately: $6,200 Standard Deduction for Dependents: $1,000 Source: Urban Institute and Brooking Institute

Taxable Income Thresholds If your gross income exceeds the following amounts, then a citizen must file an income tax return: Single: $10,150 Head of Household: $13,050 Married filing jointly: $20,300 Source: Urban Institute and Brookings Institute

Income Tax Rate Structures The U.S. income tax has a progressive rate structure. Current tax rates range from 10% to 39.6%. Table of personal income tax brackets Source: Urban Institute and Brookings Institute

Figure 13.1: Tax Rates for a Single Filers, 2001

Copyright © by Houghton Mifflin Company. All rights reserved. 16 Figure 13.2: Tax Rates for Married Couples Filing Jointly, 2001

18.2 U.S. Federal Income Tax Rate Schedule, 2012

Deductibility and Its Effects Deductibility at the federal level. What is deductible? What is the effect of deductibility on the effective tax rate? State deductibility and reciprocal deductibility.

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Effects of Deductibility on Efficiency Changes the price of purchases Effect of elasticity of demand Medical care Tithing Missionary service Real Estate Positive externalities Research and development Oil and gas exploration Medical care

Effects of Deductibility on Equity Itemizers tend to have higher incomes Percentage of deductions relative to total income declines Phase out of deductions for very high income individuals Lessens the progressivity of the personal income tax