Wrapping up taxation Today: Studying taxation graphically The US Personal Income Tax The marriage penalty

Problem 1a OHOH OMOM.8.6 $ 16,000 18,000 DMDM DHDH Note that shares are on the vertical axis, and that the upward-sloping line has a vertical intercept of 0.6 relative to O H. Full credit required that the intercepts were properly labeled. Megan’s share is 0.8 – Q/20,000 and Haley’s share is 0.6 – Q/30,000.

Problem 5b Bjorn has just broken his hip and will require a trip to the hospital The total cost of being in the hospital is 20,000Q; his total benefit of being in the hospital is 100,000Q – 5,000Q 2  How long will Bjorn want to stay in the hospital if he must pay a $60,000 co-payment for his hospital stay? Note that MB of 1st day is higher than his co-payment  Bjorn will decide to enter the hospital After the co-payment is made, Bjorn’s MC is zero Set Bjorn’s MC equal to his MB  0 = 100,000 – 10,000Q  Q = 10

Problem 6b Assume that you work 40 hours per week, and that your hourly wage is $8 per hour U(H,E) = HE 4 Each unemployed person receives $100 per week in public health care; for the first $400 earned, $0.25 in public health care is lost for each dollar earned  Thus, for anybody earning more than $400, no public health care funds are received.

Problem 6b For someone unemployed, only $100 in public health care is consumed; for the first 40 hours worked, the person earns $8 but loses $2 in public health care  Net gain per hour worked is $6  Thus, working 40 hours leads to total consumption of $100 + $6 * 40 = $340. Then, solve the same way as in part (a), except use $340 instead of $320: E = $272, H = $68

Changes in consumption due to taxes Recall that people typically consume less of a good or service once it is taxed  Example: Yacht tax in the early 1990s Tax on yachts over $100,000 purchased in the US People bought yachts in other countries Net economic impact  $16.6 million in taxes collected (less than the $31 million predicted)  Less income tax paid by workers (7,600 jobs lost in the US)

Study of taxation graphically Individual behavior Excess burden in a market with horizontal supply Taxes on labor Subsidies Pigouvian taxes

How do taxes affect individual behavior? Pounds of corn per year Pounds of barley per year E1E1 B1B1 C1C1 D F A CbCb CaCa B0B0 E2E2 i ii G

Market excess burden, horizontal supply Pounds of barley per year Price per pound of barley a DbDb SbSb q1q1 q2q2 i h S’ b PbPb (1 + t b )P b gf d Tax revenues Excess burden of tax Remember: Excess burden and deadweight loss mean the same thing

Taxing labor Hours per year Wage rate per hour SLSL L1L1 L2L2 a g (1 – t)w w f i h Excess burden d

Subsidies lead to excess burden, too Housing services per year Price per unit of housing services m DhDh Sh’Sh’ h2h2 h1h1 u q ShSh (1 – s)P h PhPh no r Excess burden v

Recall: Pigouvian taxes reduce excess burden Q per year $ MB 0 MD MPC MSC = MPC + MD Q1Q1 Q* c d (MPC + cd) Pigouvian tax revenues i j

Recall double dividend hypothesis Industry with negative externality  Pigouvian tax  Reduces excess burden If tax proceeds are used to reduce other taxes, excess burden from these taxes are lowered Criticism: An environmental tax could lead to an increase in the excess burden in the labor market

An economist’s analysis Given an amount of revenue that is generated, taxes should be imposed such that one of the following goals is achieved  Excess burden is minimized  Social welfare is maximized

The real world Taxes are often imposed that have the lowest amount of political resistance Excess burden seems less important than revenue generation  Sometimes efficiency is completely ignored

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

Other features of the US tax system Exemptions  $3,300 per family member is 2006 Deductions  Standard deduction $5,150 per single filer in 2006 $10,300 per joint filer in 2006 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

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

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 adjusted for inflation  More Americans are subject to the AMT each year  What used to be a policy on the rich, is now a policy on 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