1. Categories of taxation Taxes on income – Income tax – FICA (social security) tax – Disability tax Taxes on spending – Sales tax – Excise tax Taxes on wealth – Property tax – Estate and inheritance taxes

2. Taxes create incentives that distort economic activity People do less of the activities that are taxed People do more of the activities that are tax- exempt or subsidized Examples – mortgage interest deduction encourages home ownership and borrowing, punishes renters – child credit encourages breeding – marriage penalty encourages fathers to abandon their families

3. Tax compliance is a huge additional burden Tax code is about 4 million words Estimated national compliance cost: $168 billion plus 6 billion hours of effort 59% of individuals pay tax preparers, 30% use tax software Public choice theory explains tax complexity – Politicians have incentive to insert tax provisions that benefit their particular constituency – No one is looking after the overall cost and complexity of the tax code as a whole

4. Do corporations pay taxes? Corporations are subject to income taxes Corporations are not people. Tax burdens imposed on corporations are borne by  Stockholders: lower dividends & capital gains  Employees: lower salaries  Customers: higher prices

5. How taxes distort corporate finance Dividends are taxed twice – paid out of corporate earnings after tax – taxable to shareholder recipients – partly offset by Bush tax reforms Interest paid by corporations – deductible from corporate taxable income – taxable to bondholder recipients Tax incentivizes debt finance over equity

6. Taxes incentivize evasion and avoidance Evasion is illegal; avoidance is legal Examples of evasion – Income tax: unreported cash payments – Sales tax: cash payments, under-reporting – Property taxes: under-state tax basis – Death taxes: gifts of cash or gold

7. Progressive income tax Most income tax systems are progressive: higher percentage levied on higher incomes Federal income tax rates, married filing jointly  10% of first $18,150  15% to $73,800  25% to $148,850  28% to $226,850  33% to $405,100  35% to $457,000  39.6% above $457,000

8. Tax on $100,000 taxable income 10% of $18,500$1,850 15% of (73,800-18,500)$8,295 25% of (100,000-73,800)$6,550 Total$16,695 Average rate 16,695/100,000 = 16.69% Marginal rate 25% – This rate is relevant to incentives to work and save

9. Tax on $500,000 taxable income 10% of $18,500 $1,850 15% of (73,800-18,500)$8,295 25% of (226,850-73,800)$38,262 28% of (405,100-226,850)$49,910 33% of (457,000-405,100)$17,120 39.6% of (500,000-457,000)$17,028 Total$132,465 Average rate = 132,465/500,000 = 26.49% Marginal rate = 39.6% 5x increase in income → 8x increase in tax

10. Progressive taxation, pro and con “Ability to pay” principle: – Wealthy person suffers less from extraction of an additional $1 in taxes than does a poor person – Therefore progressive income taxes impose roughly the same burden on all Counter-argument – Interpersonal utility comparison is not possible – Many high-income people direct large amounts of their income to saving and investing or to charity (T. J. Rodgers)

11. Tax deductions Subtract deductions from gross income to get taxable income Common deductions  Mortgage interest  Medical expense, but only the portion in excess of 7.5% of gross income  Donations to charity  Real estate taxes  State income tax (deductible from federal)

12. Tax credits Subtracted from tax payable – Much more valuable than tax deductions, which reduce your tax due by your marginal tax rate times amount of deduction Examples – Foreign tax paid – Earned income credit – Education credit (?)

13. Taxes paid by investors Interest and non-qualified dividends  Taxed like wage income Qualified dividends  Taxed at 0%, 15% or 20%  Offsets double taxation since corporations pay dividends out of their after-tax income Capital gains  Held less than one year: ordinary income  More than one year: 15% or 20%

14. Tax deferral Wage earners are given incentive to save for retirement using tax-deferred accounts Example: $10,000 saved for 30 years at 5% interest, 25% marginal tax bracket  Tax deferred: 10000x1.05 30 = $43,219, then subtract 25% income tax, leaving $32,415  Not deferred: 7500 after tax income compounded at after- tax rate of 5% x (1-0.25) = 3.75% 7500x1.0375 30 = $22,631

15. Pensions Offered by governments and a decreasing number of private companies Contributions  From employee’s pre-tax income  From employer Employee gets an annuity at retirement Many pension funds have made unrealistic assumptions

16. Social security Almost all wages are subject to FICA (social security) tax – 6.2% nominally paid by employer – 6.2% nominally paid by employee – tax is regressive, no tax on income above $100,000 – self-employed people must pay 12.4% Medicare tax is an additional 2.3% on all income

17. Social security Normal retirement age is 66 (rising to 67) Payments are based on employment history – Fosters the illusion that your payments are set aside for you to draw on during retirement – Congress can change payments any time – Formerly tax free, then 50% subject to income tax, now 85% Automatic yearly inflation adjustment

18. Social security Massive increase in social security tax rates in 1983 led to annual surpluses, which were invested in Treasury securities Taxes no longer cover payouts – some interest income being used. After that, some rollovers will stop. After that, some bonds will have to be sold prior to maturity. Social security trust fund is an accounting fiction – Trust fund money has been spent by the Treasury

19. 401k and IRA 401k offered by most large companies  Pre-tax earnings contributed to account  Matched by employers in many cases  Penalty for withdrawal prior to age 59.5 except in special circumstances  Withdrawals must begin by age 70.5 IRA available to workers without an employer program, similar to 401k

20. Investments allowed in IRA Shares of stock Bonds Mutual funds, ETFs Sale of covered calls Real estate, gold bullion (?) Not allowed: short sales, option trading other than sales of covered calls, futures contracts

21. IRA and 401k pro and con Pro – Tax deferral is a significant benefit – Automatic saving – Employer matching of 401k contributions is like free money Con – Vulnerable to confiscation or taxation by politicians