1 Chapter 14 Taxation of Personal Income in the United States

2 Sources of Income Subject to Tax Gross Income is the sum of: Wages and Salaries, Interest Income Received, Dividends, Rental Income, Profits from Noncorporate Business Activities, Taxable Pension Benefits, Realized Capital Gains (Special Tax Rates Apply in Many Cases), Unemployment Compensation and a Portion of Other Government Payments to Individuals, Alimony Received, and Miscellaneous Income (e.g., Awards and Prizes).

3 Adjustments to Gross Income The sum of: Moving Expenses Relating to Start of Work, Contributions to Special Retirement Plans and Medical Savings Accounts, Penalties for Early Withdrawal of Savings, Alimony Paid, A Portion of Self-Employment Tax and Heath Insurance, Miscellaneous Costs for Employees and Businesses, and Miscellaneous Education expenses.

4 Personal Exemptions Personal Exemptions are pre-set sums of money that taxpayers are allowed to subtract from AGI in the process of calculating taxable income. In 2003, the personal exemption was $3050 for each person per household.

5 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 2003 was $4,750, while for married couples filing jointly it was $9,500.

6 Itemized Deductions Itemized Deductions are legally deductible expenses 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.

7 Figure 14.1 Statutory Marginal Tax Rates for the U.S. Personal Income Tax, 2003

8 Tax Preferences Tax Preferences are exclusions, exemptions, and deductions from the tax base. They are intentional or unintentional means by which income can be earned but not be subject to the income tax.

9 The Administrative Difficulty Justification When a tax provision is difficult to administer or comply with properly, a provision that partially or fully exempts certain income may be better (in terms of net tax efficiency) than a complicated provision with which it is difficult to comply.

10 The Equity Justification Tax preferences are often justified with the argument that they make society fairer.

11 The External Benefits Justification Offering a subsidy to a good with an external benefit increases societal welfare. Tax provisions can be used to implement that subsidy.

12 Figure 14.2 Tax Preference and Efficiency Price Output of Tax-Preferred Activity per Year 0 Q* PGPG A D = MSB S = MSC Net Price Q1Q1 B C P G (1 – t) = P N

13 Figure 14.3 Decrease in Excess Burden of Tax Preferences New Net Price 0.72 P G Q2Q2 B’ C’ Price (Dollars) Tax-Preferred Activity per Year 0Q1Q1 Q* PGPG S = MSC D = MSB AB Initial Net Price 0.50 P G C

14 Tax Preferences in the US Income Tax System Exclusions from Income In-Kind Income Fringe Benefits Transfers Capital Gains Interest on State and Local Bonds Miscellaneous Exclusions and Adjustments

15 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. It is not treated as income, in part because doing so would be nearly impossible to implement.

16 The Tax Preference for Fringe Benefits Employer paid health insurance, pension funds, and other perks of employment are not taxed. This tax preference costs the federal government $180 billion annually in lost tax revenue.

17 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.

18 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 (5% for those in the 15% tax bracket and at 15% 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 many capital gains is not income at all, but simply inflationary gains.

19 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.

20 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; that is, not subject to taxation when it is earned (e.g., 401k plans).

21 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.

22 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.

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

24 Deducting Charitable Contributions Money given to charitable organizations is deductible.

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

26 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.

27 Tax Expenditures Item Projected Revenue Loss (in billions) Exclusion of Employer Pension Contributions 123 Employer Contributions for Medical Insurance120 Deduction of Mortgage Interest68 Deduction of State and Local Taxes (not home property)51 Capital Gains54 Step-Up Basis of Capital Gains at Death29 Exclusion of Social Security Pension Benefits for Retirees19 Deduction of Charitable Contributions34 Exclusion of Interest on Public-Purpose State and Local Government Debt 27 Deduction of State and Local Property Taxes on Homes22

28 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.

29 Issues in Income Tax Policy The Flat Tax Capital Gains Taxes Bracket Creep The Marriage Penalty A National Sales Tax

30 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.

31 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 whether they will pay taxes on capital gains. They 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.

32 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.

33 The Marriage Tax People who are married pay more in taxes than they would if they were not married and simply living together, based on the same income levels. This is called the marriage tax. Married couples earning $50,000 where each party earns $25,000 a year pay more than $1000 more in tax because they are married than if they filed separately.

34 A National Consumption or Sales Tax Another policy option that has been suggested is to allow taxpayers to deduct savings from taxable income. This would be a tax on consumption. Evidence suggests that this would substantially increase savings rates and improve economic growth

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

36 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

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

38 State Income Taxes All but seven states have income taxes (AK, FL, NV, SD, TX, WA, and WY). Most have progressive rate structures though some (CA, MA, MI, and PA) have proportional structures. Income taxes account for 40% of state revenues Most states start with the Federal Adjusted Gross Income and then use their own system of deductions and exemptions.