1. Chapter 18 Taxation in the United States and Around the World Jonathan Gruber Public Finance and Public Policy Aaron S. Yelowitz - Copyright 2005 © Worth Publishers

2. Introduction Taxes play an important role in both the political arena and government policy making. For example, George H. W. Bush’s 1988 pledge “Read my lips, no new taxes” ultimately isolated many conservatives when he raised taxes in 1990, and was one of the reasons for his 1992 election loss.

3. Introduction This lesson begins the study of taxation by setting the institutional and theoretical stage for understanding tax policy. Overview of the types of taxation that exist in the U.S. at different governmental levels. Federal income tax. Structure of the income tax and “fairness.” How to measure the tax base.

4. TYPES OF TAXATION The five most common types of taxes are those on: Earnings Individual income Corporate income Wealth Consumption

5. Types of taxation Taxes on earnings The first kind of tax is on earnings. A payroll tax is a tax levied on income earned from one’s job. Examples include taxes for Social Security, Medicare, and Unemployment Insurance.

6. Types of taxation Taxes on individual income The second type of taxes is on individual income, which includes broader sources than earnings. Individual income tax is a tax paid on individual income accrued during the year. Examples include interest earnings and dividend income. In many cases, the tax applies to family, not individual, income. Capital gains are earnings from selling capital assets. Stocks, paintings and houses are all examples.

7. Types of taxation Taxes on corporate income A third kind of tax is on corporations. The corporate income tax are taxes levied on the earnings of corporations. If corporations were not taxed, the earnings of the owners of capital might otherwise escape taxation.

8. Types of taxation Taxes on wealth A fourth type of tax is on accumulated wealth. Wealth taxes are taxes paid on the value of the assets held by a person or family. Examples of wealth might include real estate or stocks. Property taxes are a form of wealth tax based on the value of a house and the land on which it is built. Estate taxes are a form of wealth tax based on the value of the estate left behind when one dies.

9. Types of taxation Taxes on consumption The fifth, and most common source of taxation around the world, is a consumption tax. Consumption tax is a tax paid on individual or household consumption of goods (and sometimes services). Sales taxes are taxes paid by consumers to vendors at the point of sale. An excise tax is a tax paid on the consumption of a particular good. Cigarettes and gasoline are examples.

10. Types of taxation Payroll, income, and wealth taxes are called direct taxes, because they directly tax individual resources. Consumption taxes are called indirect taxes, because they tax the use of the resources rather than the resources themselves.

11. Types of taxation Taxation around the world Figure 1 Figure 1 shows the distribution of tax revenue in the U.S. for different levels of government. Federal government relies primarily on the individual income tax and the payroll tax (87.3%). State and localities rely much more on consumption taxes and wealth taxes.

12. Figure 1 The federal government relies heavily on the individual income tax and the payroll tax. State and local governments rely more heavily on sales taxes and property taxes.

13. Types of taxation Taxation around the world Figure 2 Figure 2 shows similar breakdowns for other nations. Other countries tend to rely less on the individual income tax, and much more on consumption taxes.

14. Figure 2 Other countries are more dependent on consumption taxes than the United States.

15. Basic structure of the income tax in the United States Computing the tax base The federal income tax is the most important source of revenue in the U.S. for the federal government. Table 1 The structure of the tax code is laid out for a hypothetical earner, named Jack, in Table 1.

16. Table 1 Computing Jack’s income tax Gross income $60,000 minus Deductions- $2,000 equals Adjusted gross income (AGI)= $58,000 minus Exemptions- $15,500 minus Itemized (or standard) deduction- $13,000 (or $9,700) equals Taxable income= $29,500 Use income tax schedule (Figure 3) equals Taxes owed= $3,710 minus Credits - $3,000 equals Total tax payment= $710 minus Withholding - $2,000 equals Final payment (refund) due= ($1,290) The income tax system includes deductions (for actions like contributing to a 401k). The income tax system includes exemptions (for family size) and deductions (standard or itemized). The tax liability is computed from taxable income using the income tax schedule. There are also credits such as the EITC, child credit, saver’s credit, and child care credit. Finally, the difference between a person’s withholding and tax liability determines the payment/refund.

17. Basic structure of the income tax in the United States Computing the tax base The first step is computing the tax base for Jack. Gross income is the total of an individual’s various sources of income. Table 1 This is $60,000 in Table 1. It includes wages, interest, dividends, rental income, etc. Adjusted gross income (AGI) is an individual’s gross income minus certain deductions. Table 1 This is $58,000 in Table 1 for Jack because of an IRA contribution. These include retirement account contributions, alimony, and other items.

18. Basic structure of the income tax in the United States Computing the tax base The next step it to subtract exemptions and deductions from AGI. An exemption is a fixed amount a taxpayer can subtract from her AGI for each dependent member of her household, as well as herself and her spouse. The standard deduction is a fixed amount that a taxpayer can deduct from his taxable income. Itemized deductions are an alternative to the standard deduction, whereby a taxpayer deducts the total amount of money spent on various expenses. These include charitable contributions, mortgage interest on a home, and state and local income taxes.

19. Basic structure of the income tax in the United States Computing the tax base Table 1 In Table 1, Jack receives exemptions totaling $15,500 for himself, his wife, and three children. Jack’s itemized deductions (mainly mortgage interest, state income taxes, and charitable contributions) exceed his standard deduction. Thus, he subtracts $13,000 rather than $9,700. Nationwide, 65% of tax units choose the standard deduction, while 35% itemize.

20. Basic structure of the income tax in the United States Computing the tax base After subtracting these exemptions and deductions, Jack is left with $29,500 of taxable income. Taxable income is the amount of income left after subtracting exemptions and deductions from AGI. The tax base is the net income on which taxes are paid. It is analogous to taxable income.

21. Basic structure of the income tax in the United States Tax rates and taxes paid Figure 3 Figure 3 shows the schedule of tax rates that Jack would use to convert taxable income into taxes owed. The marginal tax rates currently vary between 10% (for taxable income under $14,300) and 35% (for taxable income over $319,100).

22. Figure 3 Marginal tax rates rise with taxable income, with a current maximum rate of 35%.

23. Basic structure of the income tax in the United States Tax rates and taxes paid To illustrate how dramatically a tax-savy worker could change his tax base, imagine a married, one- earner couple that: Earned $90,000 Contributed $13,000 to a 401k and $3,000 to an IRA Took the standard deduction Their taxable income of $58,100 puts them at the very end of the 15% bracket.

24. Basic structure of the income tax in the United States Tax rates and taxes paid Table 1 In Jack’s case in Table 1, his taxable income is $29,500. He owes 10% of the first $14,300 plus 15% of the remaining $15,200. This comes to $3,710 in taxes.

25. Basic structure of the income tax in the United States Tax rates and taxes paid Some taxpayers can reduce their tax liabilities further. Tax credits are amounts by which taxpayers are allowed to reduce the taxes they owe to the government through spending, for example, on child care. Child Tax Credit Credit for Child and Dependent Care Expenses Credit for the Elderly or Disabled Hope and Lifetime Learning Credit Work Opportunity Credit

26. Basic structure of the income tax in the United States Tax rates and taxes paid With three children, Jack’s credit is $3,000, reducing the taxes he owes from $3,710 to $710. During the course of the year, Jack’s employer took money out of his paycheck. Withholding is the subtraction of estimated taxes owed directly from a worker’s earnings. A refund is the difference between the amount withheld from a worker’s earnings and his taxes owed if the former is higher. Jack’s refund is $1,290, because his employer withheld too much during the year.

27. The coming AMT time bomb Figure 3 Figure 3 is actually a simplified schedule, because it does not include the Earned Income Tax Credit or the Alternative Minimum Tax. The Alternative Minimum Tax (AMT) is a tax schedule applied to taxpayers with a high ratio of deductions and exemptions to total income. Application

28. The coming AMT time bomb The AMT was motivated, back in 1969, by the fact that 155 high-income households in 1966 paid no income taxes whatsoever, by legally taking advantage of the existing tax law. The complicated AMT calculation excludes many exemptions and deductions. The AMT figures are not indexed for inflation, meaning that many middle-income households will eventually be subject to it if there are not changes in the law. Application

29. MEASURING THE FAIRNESS OF TAX SYSTEMS Tax fairness is an important concern to citizens worldwide. For example, Margaret Thatcher’s proposed “poll tax” in 1990, which levied a flat charge equally on all individuals regardless of income, caused riots. Yet, notions of what is fair vary across people. There are several common concepts used to measure fairness.

30. Measuring the fairness of tax systems Average and marginal tax rates First, there are two key concepts to describe the set of tax rates on income. A marginal tax rate is the percentage that is paid in taxes on the next dollar earned. In the example with the worker who earned $90,000, the marginal tax rate was 15%. An average tax rate is the percentage of total income is that is paid in taxes. This workers average tax rate was 8.9%.

31. Measuring the fairness of tax systems Effective versus statutory rates Another important distinction is between statutory and effective tax rates. Statutory tax rates are tax rates laid out in the legal tax schedule. Effective tax rates are tax rates an individual actually pays. The two diverge because of the host of exemptions and deductions from taxable income, which reduces the tax base.

32. Measuring the fairness of tax systems Vertical and horizontal equity Two distributional goals are frequently cited in measuring tax fairness. Vertical equity is the principle that groups with more resources should pay higher taxes than groups with fewer resources. Could be motivated by utilitarian SWF, that calls for redistribution. Horizontal equity is the principle that similar individuals who make different economic choices should be treated similarly by the tax system. In reality, horizontal inequities are hard to define, because the person endogenously made a choice to earn more or less.

33. Measuring the fairness of tax systems Measuring vertical equity There are fairly standard ways of measuring vertical equity. A progressive tax system is one in which effective average tax rates rise with income. A proportional tax system is one in which effective average rates do not change with income, so that everyone pays the same proportion of their income in taxes. A regressive tax system is one in which effective average tax rates fall with income.

34. The political process of measuring tax fairness Most analysts would agree that to be vertically equitable, the tax system should be progressive. Yet, politicians often choose a notion of fairness that fits their agenda. In the debate over tax cuts in 2003, Democrats argued that 44% of the tax reductions went to the top 1% of taxpayers, while Republicans pointed out that these taxpayers already paid 38% of all income taxes – roughly proportional to the tax cut. Application

35. DEFINING THE INCOME TAX BASE In the U.S., and elsewhere, there are a variety of deductions, exemptions, and credits that cause the tax base to be smaller than total income. What is the theoretically appropriate income tax base, and why is it deviated from?

36. Defining the income tax base The Haig-Simons comprehensive income definition The Haig-Simons comprehensive income definition defines taxable resources as the change in an individual’s power to consume during the year. It is best viewed as a measure of ability to pay – regardless of the actual choices in terms of consumption and savings. In reality, the U.S. tax system deviates from this definition in many ways, for example, the exclusion of employer-provided health insurance.

37. Defining the income tax base The Haig-Simons comprehensive income definition The Haig-Simons definition improves both vertical and horizontal equity. In terms of vertical equity, those who have more resources (even through untaxed channels) have higher income. In terms of horizontal equity, people who are the same in terms of underlying resources pay the same amount regardless of the form in which they spend their resources.

38. Defining the income tax base Deviations from Haig-Simons Implementing this idealized definition is challenging, however, for two reasons. Defining a person’s power to consume Dealing with work-related expenditures

39. Defining the income tax base Deviations due to ability-to-pay considerations First, it is challenging to define an individual’s ability to pay taxes. Various shocks affect ability to pay, and are used to justify deductions in the actual tax system: Property and casualty losses Medical expenditures State and local income taxes

40. Defining the income tax base Deviations due to ability-to-pay considerations Although these affect ability to pay, they may be choices to some extent. Individuals have some control over medical expenditures, and some of this deduction may represent consumption. Higher state and local tax payments could reflect greater amenities and local public goods. Thus, full deductions for both are hard to justify with the Haig-Simons definition.

41. Defining the income tax base Deviations due to the costs of earning income The other key problem is that some expenditures are not for consumption but reflect the cost of earning a living. Yet, defining legitimate business expenses is difficult – for example, part of a business lunch represents consumption, but how much? Currently, the tax code allows for 50% of the expenses of such a meal to be deducted.

42. What are appropriate business deductions? More generally, there are a many difficulties in defining appropriate or inappropriate business deductions. A high school geography teacher claimed a $5,047, six-month, 18-country world tour as a business expense. He claimed visiting these exotic places aided him in his teaching. The tax court disallowed the deduction, concluding that “any educational benefit gained from these experiences was de minimis.” Application

43. What are appropriate business deductions? In another case, a man claimed $30,000 worth of business expenses for selling amphetamines, cocaine, and marijuana in 1981. Although the IRS disallowed the deductions, a tax court overturned the decision. After he was allowed to claim the deductions for business expenses, he was sentenced to four years in prison for possessing cocaine with intent to distribute it. Application

44. What are appropriate business deductions? Finally, before 1996, U.S. companies were at a disadvantage in international business because other countries allowed their companies to write off as a business expense the cost of bribing foreign officials. After 1996, this was no longer deductible. Application

45. EXTERNALITY/PUBLIC GOODS RATIONALES FOR DEVIATING FROM HAIG-SIMONS Some activities yield external benefits to society, which gives a rationale for deviating from the Haig-Simons income definition. Two major deviations that are justified on such grounds are charitable giving and home ownership.

46. Externality/Public goods rationales for deviating from Haig-Simons: Charitable giving The private market is likely to underprovide charitable support for many public goods because of the free-rider problem. Because charitable contributions are tax-deductible, the relative price of giving $1 to charity is $(1- J ). The tax treatment yields a benefit (providing a public good) at the cost of deviating from the H-S definition.

47. Externality/Public goods rationales for deviating: Spending crowd-out versus tax subsidy crowd-in An alternative to this tax subsidy would be direct provision of the public good by the government. Why, then, does the government choose to deviate from the Haig-Simons definition of income rather than increase government spending?

48. Externality/Public goods rationales for deviating: Spending crowd-out versus tax subsidy crowd-in The first reason relates to crowd-out. If the government provides the good directly, it may crowd-out private charitable giving. By providing a tax subsidy, both the income and substitution effects lead to greater private giving. This “crowds- in” private giving.

49. Externality/Public goods rationales for deviating: Spending crowd-out versus tax subsidy crowd-in At the same time, the tax subsidy gives a tax break to those who would have already supported the public good without the break. Marginal impacts are changes in behavior the government hopes to encourage through a given tax incentive. Inframarginal impacts are tax breaks the government gives to those whose behavior is not changed by new tax policy.

50. Externality/Public goods rationales for deviating: Spending crowd-out versus tax subsidy crowd-in For example, imagine that $1 million would be given to the homeless without any tax breaks. If the government allowed deductibility for charitable giving, and J =50%, suppose that giving went up to $1.5 million. Giving has gone up. Yet, for those who were giving before, the tax break simply rewards them for what they were already doing.

51. Externality/Public goods rationales for deviating: Spending crowd-out versus tax subsidy crowd-in The marginal impact is the $500 thousand increase in giving. The inframarginal impact is the $500 thousand in new tax deductions for those already giving. The most cost-efficient tax breaks have large marginal impacts from those who change their behavior; in those cases small government expenditure can deliver large externalities.

52. Externality/Public goods rationales for deviating: Spending crowd-out versus tax subsidy crowd-in In determining whether to give tax subsidies or use direct spending, the government implicitly must weigh the following tradeoff: If the first term is larger, the government gets more bang-per-buck from the tax subsidy.

53. Externality/Public goods rationales for deviating: Spending crowd-out versus tax subsidy crowd-in Empirical evidence suggests that the elasticity of charitable giving with respect to the tax subsidy is around -1. With this elasticity, the marginal effect of the tax subsidy is equal to the inframarginal effect, or $1 in reduced government revenue leads to $1 in increased charitable spending. Evidence also suggests $1 direct government spending raises overall spending by 30-90¢. On this basis, subsidizing private giving is a more efficient way of providing charitable resources.

54. Externality/Public goods rationales for deviating: Consumer sovereignty vs. imperfect information Tax subsidization may also be preferred because it preserves consumer sovereignty. The preferences of the legislators may not be the same as those of the citizens. A disadvantage is that the private sector may not be able to ensure efficient distribution of charitable spending.

55. Externality/Public goods rationales for deviating from Haig-Simons: Housing Another deviation from the H-S definition, justified on externality grounds is the tax subsidy to homeownership. A mortgage is an agreement to use a certain property, usually a home, as security for a loan. The interest payments from such a mortgage are tax deductible, while rental payments for an apartment are not. The mortgage interest deduction leads to forgone revenue of $70 billion per year for the federal government.

56. Externality/Public goods rationales for deviating from Haig-Simons: Housing Does homeownership have positive externalities? Although there are certainly positive correlations between homeownership and good neighborhood outcomes (e.g., more political activism, etc.), these findings may be the result of “selection bias.” By selection bias, we mean that homeowners are better neighbors in ways that are unobservable to researchers. For example, those who own homes may be more inclined to social connection and better maintenance regardless of their ownership status.

57. Externality/Public goods rationales for deviating from Haig-Simons: Housing A large body of evidence suggest the tax subsidy does increase housing consumption, but along the intensive margin (how much housing to consume) rather than the extensive margin (whether to own or rent). Most arguments about positive externalities rely on the extensive margin; thus the current structure of the subsidy does little to address this issue. Thus, there is no clear rationale for deviating from the Haig-Simons income definition for housing.

58. Externality/Public goods rationales for deviating from Haig-Simons: Tax deductions vs. tax credits Another consideration that arises when deviating from the Haig-Simons income definition is whether a tax deduction or tax credit is more appropriate. Tax deductions are amounts by which taxpayers are allowed to reduce their taxable income through spending on charitable donations or home mortgage interest. The effective price of the activity is lowered from $1 to $(1- J ).

59. Externality/Public goods rationales for deviating from Haig-Simons: Tax deductions vs. tax credits Tax credits allow taxpayers to reduce the amount of tax they owe to the government by a certain amount. If the individual’s expenditure is below the amount of the credit, the effective price of the activity is lowered from $1 to $0. If the expenditure is above, the effective price is $1.

60. Externality/Public goods rationales for deviating from Haig-Simons: Tax deductions vs. tax credits In deciding whether a deduction or credit is more appropriate, the trade-off the government faces is between a system that subsidizes all giving partially (the deduction) or some giving fully and some not at all (the credit). On efficiency grounds, the appropriate instrument will depend on: The nature of the demand for the subsidized good. And whether it is important to achieve some minimal level of behavior (e.g., health coverage or housing consumption).

61. Externality/Public goods rationales for deviating from Haig-Simons: Tax deductions vs. tax credits On equity grounds, however, tax credits are more equitable than deductions. The value of deductions rises with a person’s marginal tax rate, making them regressive. Credits are equally available for all incomes, so they are progressive.

62. Externality/Public goods rationales for deviating from Haig-Simons: Tax deductions vs. tax credits In reality, a tax credit may not be very progressive if those with low tax liabilities cannot have the excess of the credit refunded. A tax credit is refundable if it is available to individuals even if they pay few or no taxes. The recent raising of the child credit from $600 to $1,000 raised this refundability issue.

63. Externality/Public goods rationales for deviating from Haig-Simons: Tax expenditures Tax expenditures are government revenue losses attributable to tax law provisions that allow special exclusions, exemptions, or deductions from gross income, or that provide a special credit, preferential tax rate or deferral of liability. The government measures how much tax revenue is lost by excluding health insurance from taxable compensation, or allowing deductibility of charitable contributions.

64. Externality/Public goods rationales for deviating from Haig-Simons: Tax expenditures Table 2 Table 2 shows the major tax expenditures. Overall, in 2005, the government is projected to lose $740 billion through all tax expenditures, the largest of which is the exclusion of employer-provided health insurance.

65. Table 2 Top 10 Federal Government Tax Expenditures by Estimated 2005 Revenue Impact (billions of $) Tax Expenditure Revenue Impact Exclusion of employer contributions for medical insurance $113.0 Deductibility of home mortgage interest 69.7 Exclusion of pension contributions and earnings: employer plans 61.7 Exclusion of pension contributions and earnings: 401(k) plans 58.9 Deductibility of state and local taxes 46.2 Preferential treatment of capital gains income 30.2 Child credit 29.9 Deductibility of charitable contributions29.7 Exclusion of interest on state and local bonds26.4 Exclusion of interest on life insurance savings22.1 Total of all tax expenditures$740.0 Overall, “tax expenditures” amount to $740 billion in lost tax revenue. Employer health insurance, mortgage interest, and retirement plans are key.

66. THE APPROPRIATE UNIT OF TAXATION The problem of the “marriage tax” Choosing the appropriate unit of taxation is a difficult task as well. Should the government impose taxes on family income or individual income? It is not possible to design a tax system that achieves the following three goals: Progressivity. Across-Family Horizontal Equity. Across-Marriage Horizontal Equity (e.g., marriage neutrality).

67. The appropriate unit of taxation The problem of the “marriage tax” Table 3 The example in Table 3 illustrates this problem.

68. Table 3 Tax liabilities under hypothetical system Individual Income Individual Tax Family Tax with Individual Filing Joint IncomeJoint Tax Hillary$140,000 $32,000 $33,000$150,000$35,000 Bill10,0001,000 George75,00013,000 26,000 150,00035,000 Laura75,00013,000 Both households have the same total income. If they file individually, then Hillary and Bill pay substantially more in this case.

69. The appropriate unit of taxation The problem of the “marriage tax” Taxing on an individual basis violates the concept of horizontal equity across families, because Hillary and Bill pay more than George and Laura. Taxing on a family basis violates the marriage neutrality criterion, because both families pay more in taxes married than they did when they were single. The marriage tax is the rise in the joint burden on two individuals from becoming married.

70. The appropriate unit of taxation Marriage taxes in practice Note that it is possible to remove the marriage tax if the standard deduction for married couples is large enough. But this is still not marriage neutral. In reality, some couples face marriage taxes and other marriage bonuses. There is no evidence that the “marriage penalty” does discourage marriage.

71. The appropriate unit of taxation Marriage taxes in practice Why the concern about marriage taxes? Horizontal equity. The tax might discourage marriage. The high marginal tax rate on the secondary earner. This last problem could be solved with a secondary earner deduction.

72. The appropriate unit of taxation Marriage taxes in practice The U.S. is fairly unique in have a tax system based on family income. 19 OECD countries tax husbands and wives individually. 5 OECD countries offer marriage subsidies through family taxation with income splitting – which lowers the tax burden with a progressive tax schedule. Only 2 other OECD nations have pure family taxation system similar to the U.S.

73. Recap of Taxation in the United States and Around the World Types of Taxation Basic Structure of the Income Tax in the United States Measuring the Fairness of Tax Systems Defining the Income Tax Base Externality/Public Goods Rationales for Deviating from Haig-Simons The Appropriate Unit of Taxation