Public Finance by John E. Anderson Power Point Slides to Accompany:

Chapter 13 Income and Payroll Taxes

Copyright © by Houghton Mifflin Company. All rights reserved.3 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.

Copyright © by Houghton Mifflin Company. All rights reserved.4 Defining the Income Tax Base An ideal definition of taxable income. 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.

Copyright © by Houghton Mifflin Company. All rights reserved.5 Adjusted Gross Income (AGI) AGI = wages + salaries + tips + interest income + dividend income + capital gains + net business/farm income – adjustments.

Copyright © by Houghton Mifflin Company. All rights reserved.6 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.

Copyright © by Houghton Mifflin Company. All rights reserved.7 Taxable Income (TI) TI = AGI – personal exemptions – deductions. Deductions may be either the standard deduction or itemized deductions.

Copyright © by Houghton Mifflin Company. All rights reserved.8 Deductions Deductions are permitted for: –medical expenses, –taxes paid to state and local governments (income taxes and property taxes, but not sales taxes), –interest paid on home mortgages,

Copyright © by Houghton Mifflin Company. All rights reserved.9 Deductions [continued] charitable contributions, casualty or theft loss, un-reimbursed employee expenses, and other miscellaneous expenses (including tax preparation fees!).

Copyright © by Houghton Mifflin Company. All rights reserved.10

Copyright © by Houghton Mifflin Company. All rights reserved.11 Taxable Income Thresholds The last row of Table 1 provides the taxable income threshold for each type of taxpayer in A single filer reaches the taxable income threshold with an income of $7,450. A married couple filing jointly reaches the taxable income threshold with an income of $13,400. A family of four reaches the threshold with an income of $19,200.

Copyright © by Houghton Mifflin Company. All rights reserved.12 Income Tax Rate Structures The U.S. income tax has a progressive rate structure. Current tax rates range from 15% to 39.1%. Table 2 lists the current rate structure.

Copyright © by Houghton Mifflin Company. All rights reserved.13

Copyright © by Houghton Mifflin Company. All rights reserved.14 Figure 13.1: Tax Rates for a Single Filers, 2001

Copyright © by Houghton Mifflin Company. All rights reserved.15 Figure 13.2: Tax Rates for Married Couples Filing Jointly, 2001

Copyright © by Houghton Mifflin Company. All rights reserved.16 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.

Copyright © by Houghton Mifflin Company. All rights reserved.17 Effects of Deductibility Economic effects of deductibility. –Efficiency effects. –Equity effects.

Copyright © by Houghton Mifflin Company. All rights reserved.18 Deductibility 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. Interest paid, including home mortgage interest and investment interest.

Copyright © by Houghton Mifflin Company. All rights reserved.19 Deductibility, [continued] Gifts to Charity, including cash gifts and other than cash gifts Casualty and Theft Losses Job Expenses, including un-reimbursed employee expenses, job travel, union dues, and job educational expenses Tax preparation fees

Copyright © by Houghton Mifflin Company. All rights reserved.20

Copyright © by Houghton Mifflin Company. All rights reserved.21 U.S. Income Tax Design and Policy Issues Taxable unit. Marriage bonuses and penalties. Earned income tax credit.

Copyright © by Houghton Mifflin Company. All rights reserved.22 Taxable Unit The taxable unit in the U.S. is the family, not the individual. Income splitting permitted since Creates marriage bonus for some, marriage penalty for others.

Copyright © by Houghton Mifflin Company. All rights reserved.23

Copyright © by Houghton Mifflin Company. All rights reserved.24

Copyright © by Houghton Mifflin Company. All rights reserved.25

Copyright © by Houghton Mifflin Company. All rights reserved.26

Copyright © by Houghton Mifflin Company. All rights reserved.27

Copyright © by Houghton Mifflin Company. All rights reserved.28 Earned Income Tax Credit (EITC) EITC is a mechanism designed to provide assistance to low-income working households. It is a refundable credit.

Copyright © by Houghton Mifflin Company. All rights reserved.29 Figure 13.3: Earned Income Tax Credit Design

Copyright © by Houghton Mifflin Company. All rights reserved.30

Copyright © by Houghton Mifflin Company. All rights reserved.31

Copyright © by Houghton Mifflin Company. All rights reserved.32 Figure 13.4: Earned Income Tax Credit and the Tax Structure

Copyright © by Houghton Mifflin Company. All rights reserved.33 Payroll Taxes Payroll taxes are a related form of taxation, with a narrow base including only wage and salary income. This is the major source of revenue for the social security system in the U.S. The FICA tax applies to employees (Federal Insurance Contributions Act). The SECA tax applies to self-employed persons (Self Employed Contributions Act).

Copyright © by Houghton Mifflin Company. All rights reserved.34

Copyright © by Houghton Mifflin Company. All rights reserved.35 Proposals National sales tax Value-added tax Armey-Shelby flat tax USA tax Income tax reform

Copyright © by Houghton Mifflin Company. All rights reserved.36 Flat Tax The tax is best though of as a consumption type value-added tax that would be applied in two pieces. A consumption type VAT taxes gross receipts, less the cost of raw materials and intermediate goods, less investment. The deduction of investment expenses for new machinery, equipment, and facilities is what makes this version of a VAT a consumption-type VAT.

Copyright © by Houghton Mifflin Company. All rights reserved.37 Flat Tax [continued] In terms of simple national income accounting, national income or product Y is comprised of the components C, consumption expenditures and I, investment expenditures: Y=C+I. If investment expenditure is deducted, we are left with consumption expenditures. This consumption-type VAT is then applied in two parts.

Copyright © by Houghton Mifflin Company. All rights reserved.38 Flat Tax [continued] First, a tax is applied at the household level on wages, salaries, and pension benefits. Second, a tax is applied to all businesses on their gross receipts less wages, pension contributions, raw materials costs, and investment. Table 11 provides details on the major aspects of the plan.

Copyright © by Houghton Mifflin Company. All rights reserved.39 USA Tax The USA tax plan is actually a hybrid of two distinct forms of taxation. First, households are subject to a personal consumption tax applied to income less deductions and exemptions and an unlimited savings allowance (hence the name of the tax--USA). Households are also given a refundable credit for the employee’s portion of the payroll tax.

Copyright © by Houghton Mifflin Company. All rights reserved.40 USA Tax [continued] Second, businesses would be subject to a VAT, less a credit for the employer’s portion of the payroll tax. As a result, the USA tax is a progressive consumption tax. It differs from our current income tax system in that it taxes consumption rather than income.

Copyright © by Houghton Mifflin Company. All rights reserved.41 Figure 13.5: Distributional Properties of Major Tax Plans