14 CHAPTER Personal Income Taxation in the United States PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 14-2 Brief History of U.S. Income Tax System  First income tax  Financed Civil War  Relatively low tax rate  Federal Income Tax

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 14-3 Withholding  Employer withholding established during WWII  Portion of employee’s pay sent directly to federal government  Government able to collect more in income taxes

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 14-4 Tax Reform in 1964, 1986, and 2002  1964  Tax cut to stimulate aggregate demand  Keynesian principles  1986  Tax Reform Act  Concerned excess burden of taxation  2002  No clear motivation

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 14-5 Calculating Taxable Income  Computation of Income  Taxable income includes:  Wages  Salaries  Tips  Interest  Dividends  Capital gains taxed at lower rate

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 14-6 Exemptions  Personal exemption  Individual retirement accounts  Alimony  Adjusted gross income = total income minus exemptions

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 14-7 Deductions  Standard deduction – fixed amount  Itemized deduction – addition of allowable deductions  Medical and dental expenses  State, local, and property taxes  Home mortgage interest  Charitable contributions

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 14-8 Tax Computation  Taxable Income = Total income minus exemptions and deductions  Compute tax due on taxable income

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 14-9 Marginal Rates in 2003 for a Single Individual

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe Tax Credits  Can subtract certain items from tax liability  Credits more beneficial than exemptions/deductions

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe Broadening the Tax Base  Exemptions, deductions, and credits narrow tax base  Broader base  Allows lower marginal rates  Reduces excess burden

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe Comparison of Broadly Based and Narrowly Based Taxes

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe Alternative Minimum Tax  Created in 1969  Targets upper-income taxpayers using tax preferences to avoid federal income tax  Must calculate taxes without most tax preferences and pay AMT if higher than calculating tax burdens by regular method

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe Tax Expenditures  Reductions in taxation  Designed to further some goal of social policy  Create loopholes making tax structure less efficient

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe Inflation, Indexation, and Bracket Creep  Indexation  Tax rates adjusted for inflation  Bracket creep  When nominal tax structure remains the same but taxpayers pay more in real taxes because of inflation

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe Individual Retirement Accounts (IRA)  Money contributed to IRA does not count as taxable income  Tax paid on withdrawals from IRA  Eliminates double tax on saving  Can only contribute limited amount

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe Roth IRA  Allows no deduction for deposits  Principle and earnings can be withdrawn tax-free

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe Other Tax-Deferred Savings Methods  Keogh plans  401(k)  403(b)  Company pension plans