1. THE PERSONAL INCOME TAX
Chapter 17

2. Computation of Federal Personal Income Tax Liability
Start with Tax Base
Wages and compensation, interest, dividends, capital gain (or loss), business income (or loss), pensions, farm income (or loss), rents, royalties, Social Security benefits, etc.
Subtract by “Above-the-line” deductions
Trade or business expenses, moving expenses, educator expenses, self-employed health insurance premium payments, student loan payments, tuition and fees, alimony paid, etc.
Equals Adjusted Gross Income
Subtract Exemptions
Phaseout with income
Compare Larger of: Standard Deduction or Itemized Deductions
Charitable contributions, home mortgage interest, state and local taxes, medical expenses in excess of 10% of AGI, casualty and theft losses, non-reimbursed employee expenses; Differs by filing status
Equals Taxable Income
Apply Tax Rate
Seven ordinary rates (10%, 15%, 25%, 28%, 33%, 35%, 39.6); differs by filing status; special rates for dividends and capital gains
Equals Tax Liability Before Credits
Subtract Tax Credits
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.
Equals Regular Tax Liability
Start over to determine AMT tax liability using AMT base. Pay tentative AMT liability in excess of regular tax liability
Then Pay Tax or Claim Refund
Incur additional compliance, administration, and efficiency costs

3. Haig-Simons Income (Comprehensive Income)
Income = Consumption + DNet Worth
Maximum consumption taxpayers can enjoy without spending down their wealth
Anything received that can be used, either now or later, to purchase goods and services
Subtract costs of earning income

4. Items Included in H-S Income
Employer pension contributions and insurance purchases
Transfer payments, including Social Security benefits, unemployment compensation, and welfare
Capital gains
Realized versus unrealized
Income in-kind

5. Some Practical and Conceptual Problems
Computing income net of business expenses
Computing capital gains and losses
Valuing in-kind services

6. Evaluating the H-S Criterion
Equity – treats likes alike
Efficiency – treats all forms of income the same so that decisions are made on the basis of economic value, not tax consequences

7. Excluded Forms of Money Income
Interest on State & Local Bonds
Some dividends
Capital gains
Employer contributions to benefit plans
Some types of saving
Individual retirement account (IRA)
Roth IRA
401(k) plan
Keogh plan
Education savings account
Gifts and Inheritances

8. Interest on State and Local Bonds
Tax break reduces interest rate S&L governments have to pay
Market ROR on Taxable Bonds = ip = 15%
Individuals MTR = t = 30%
Government Tax-Exempt Bond ROR = ig = (1-t)ip = 10.5%
Cost of break to Treasury exceeds gain to S&L government
ip = 15% t1 = 30% ig = 10.5%
t2 = 20% ig = 12%
If person 2 lends $1,000 Treasury loses $1,000*.15*.20 = $30 and State saves $1,000*.03 = $30
If person 1 lends $1,000 Treasury loses $1,000*.15*.30 = $45 and State saves $1,000*.03 = $30
1st box - shows that tax break reduces the interest rate S&L governments have to pay
2nd box – shows that cost of break to Treasury exceeds gain to S&L government

9. Capital Gains
Example 1: Tax is levied only when capital gains are realized
P = $100, ROR=g = 10% # Years held= MTR=.2
$100,000*(1+.1)^20 = $672,750
Capital Gain = $672,750 - $100,000 = $572,750
Tax = $572,750 * .2 = 114,550
Net Gain = $458,200
Example 2: Tax is levied as capital gains accrue regardless of whether realized
P = $100, g = 10% net g = 10%(1-.2) = 8%
$100,000*(1+.08)^20 = $466,096
Capital Gain = $466,096 - $100,000 = $366,096
Taxes deferred are taxes saved
Lock-in Effect
Gains Not Realized at Death

10. Evaluation of Capital Gains Rules
No justification under optimal tax literature for preferential treatment of capital gains under H-S criterion
Other justifications
Capital gains are unexpected windfalls
Require sacrifice of abstaining from consumption
Needed to stimulate capital accumulation and risk taking
Counterbalance to effect of inflation

11. Personal Exemptions Allowable Exemptions Taxpayer and spouse
Children under 19 (or 24 if in school)
Children and other relatives who pass certain tests (depend on taxpayer for support)
Phase out
Why are there exemptions?
Adjust ability to pay for presence of children
Provide tax relief for low-income families

12. Deductions Standard versus Itemized Deductibility and Relative Prices
PZ  (1-t)PZ

13. Deductions Important Itemized Deductions
Charitable Contributions
Unreimbursed medical expenses > 10% AGI
State and Local Income and Property Taxes
Certain Interest Expenses
Interest on consumer debt
Interest on qualified education loans
Interest on debt incurred to purchase financial assets
Interest on home mortgages
Interest rules in terms of H-S criterion
Tax Arbitrage

14. More Deduction Issues Deductions and complexity
Deductions versus credits
Itemized deduction phase out
Standard deduction

15. Exemptions and Deductions Impact on the Tax Base
17-15

16. Tax Expenditures What are tax expenditures?
Annual tax expenditure budget
Technical problems with measuring tax expenditures
Incentive effects
Defining income
The decision not to tax is not equivalent to a government expenditure
Why are tax expenditures to popular?

17. The Simplicity Issue
The U.S. personal income tax has always been complicated
Additional Confusion: Sunset Provisions that require given changes in laws to expire at specific dates in the future
Make long-term planning difficult
Example: Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA)

18. Rate Structure Official Statutory Tax Rate Schedule (2013) Marginal
Taxable Income
Tax Rate %
$0-$8,925
10.0
$0-$17,850
$8,926-$36,250
15.0
$17,851-$72,500
$36,251-$87,850
25.0
$72,501-$146,400
$87,851-$183,250
28.0
$146,401-$223,050
$183,251-$398,350
33.0
$223,051-$398,350
$398,351-$400,000
35.0
$398,351-$450,000
$400,001 and over
39.6
$450,001 and over
Single Returns
Joint Returns
Source:
17-18

19. Effective versus Statutory Rates
Statutory rates differ from effective rates
Tax system treats some forms of income preferentially
Tax shifting
Excess burden and administrative costs

20. Flat Income Tax Features of Flat income tax Arguments in favor
Applies same tax rate to everyone and each component of income
Limited deductions
Arguments in favor
Reduces excess burden
Reduces incentive to cheat
Greater simplicity
Equity
Arguments against
Shifts burden from rich to middle class
Simplicity an illusion
Altig et. Al. [2001]

21. Taxes and Inflation Tax Indexing How inflation affects taxes
Bracket creep
Deductions and exemptions set in nominal terms
Taxation of nominal capital gains
Taxation of nominal interest

22. Taxation of Nominal Interest
Real after-tax rate of return: r = (1 – t)i – π
Let t = 25%, i = 16%, π = expected inflation rate = 10%
r = ( )(.16) = .02 = 2%
Now assume expected rate of inflation and nominal interest rate both increase by 4 percentage points
r = ( )(.20) = .01 = 1%

23. Tax Indexing Ad hoc reductions in tax rates
Indexing of parts of tax code [1981]
Should indexing be maintained?
No – ad hoc adjustments force legislature to reexamine the entire tax code
Yes – desirable to have a stable and predictable tax code and fewer opportunities for legislative mischief

24. The Alternative Minimum Tax
Brief history of the AMT
Computing the tax base under AMT
Add AMT tax preferences to regular taxable income
Subtract AMT exemption
Alternative minimum tax income (AMTI)
Computing Tentative AMT
Apply AMT tax rate schedule to AMTI
Taxpayer pays higher of tentative AMT or regular income tax liability

25. Why does the AMT affect so many taxpayers?
Why has AMT become more important?
Cuts in regular tax liability relative to the AMT
Problems with AMT
Fairness
Efficiency
Simplicity

26. Choice of Unit and the Marriage Tax
Three principles
The income tax should embody increasing marginal tax rates
Families with equal income should, other things being the same, pay equal taxes
Two individuals’ tax burdens should not change when they marry; the tax system should be marriage neutral
No tax system can adhere to all three simultaneously

27. Tax Liabilities Under a Hypothetical System
Individual Income
Individual Tax
Family Tax with Individual Filing
Joint Income
Joint Tax
Lucy
$1,000
$ 100
$12,200
$30,000
$12,600
Ricky
29,000
12,100
Ethel
15,000
5,100
10,200
30,000
12,600
Fred
17-27

28. Brief History of Marriage Tax in the United States
Pre-1948 taxable unit was individual
1948 family became taxable unit
Income splitting
1969 New tax rate schedule for unmarried people created
1981 New deduction for two-earner married couples added
1986 Two-earner deduction eliminated
2001 law reduced (but did not eliminate) marriage penalty

29. Analyzing the Marriage Tax
Advantages to using the family as taxable unit
Fairer treatment of non-labor income (bedchamber transfers of property)
Family a bedrock institution of society
Disadvantages of using the family as taxable unit
Given high divorce rates, bedchamber transfers of property may not be significant
Defining the family
Efficiency issues
Does tax system affect marriage and divorce rates?
Labor supply

30. Treatment of International Income
Global versus territorial systems
Equity
Efficiency
Production decisions
Residential decisions

31. State Income Taxes State income taxes similar to federal tax
Lower marginal tax rates
Including state tax rates when assessing overall marginal tax rates

32. Tax Arbitrage
Assume Caesar pays taxes at a 35% rate and can borrow all he wants at a 15% interest rate
Let Cesar borrow $1,000
Each year he pays $150 in interest (= .15*1,000)
Interest payment reduces taxable income $150 and saves $52.50 in taxes (= .35*150)
His net payment of interest is $150 - $52.50 = $97.50 for an effective interest rate of $97.50/$1,000 = 9.75%
If he can invest in state & local bonds at 11%, the tax system has created a “money machine”
Each line enters separately with a mouse click.

33. Chapter 17 Summary
The Haig-Simons criterion of income is the next change in the individual’s power to consume. The U.S. federal tax system is far removed from the Haig-Simons criterion
Computing federal income tax liability involves determining the total income base, taxable income – the tax base minus deductions and exemptions - and tax liability – taxable income times a tax rate
Tax expenditures are forgone revenues due to preferential tax treatment
The alternative minimum tax was designed to ensure that high-income earners who use tax shelters pay some federal income tax, although it affects millions of middle-class earners
Currently, joint tax liabilities can increase or decrease upon marriage
Taxes due are roughly independent of whether the income is earned at home or abroad