1. Copyright © 2002 by Thomson Learning, Inc. Chapter 13 The Theory of Income Taxation Copyright © 2002 Thomson Learning, Inc. Thomson Learning™ is a trademark used herein under license. ALL RIGHTS RESERVED. Instructors of classes adopting PUBLIC FINANCE: A CONTEMPORARY APPLICATION OF THEORY TO POLICY, Seventh Edition by David N. Hyman as an assigned textbook may reproduce material from this publication for classroom use or in a secure electronic network environment that prevents downloading or reproducing the copyrighted material. Otherwise, no part of this work covered by the copyright hereon may be reproduced or used in any form or by any means—graphic, electronic, or mechanical, including, but not limited to, photocopying, recording, taping, Web distribution, information networks, or information storage and retrieval systems—without the written permission of the publisher. Printed in the United States of America ISBN 0-03-033652-X

2. Copyright © 2002 by Thomson Learning, Inc. Income Taxes  Income Taxes were introduced as an emergency measure during the U.S. Civil War.  An attempt in 1894 to introduce a regular income tax was declared unconstitutional.  In 1913 the 16 th Amendment to the U.S. Constitution allowed for personal and business income taxes.

3. Copyright © 2002 by Thomson Learning, Inc. The First Regular US Income Tax  The initial income tax exempted the first $3,000 for singles and the first $4,000 for married couples.  It imposed a 1% rate on income up to $20,000 and higher rates at higher levels of income.

4. Copyright © 2002 by Thomson Learning, Inc. Comprehensive Income: The Haig-Simons Definition It is “the exercise of control over the use of society’s scarce resources.” Algebraically it is defined as I = C +  NW Where I = Income C = Consumption  NW = The Change in Net Worth

5. Copyright © 2002 by Thomson Learning, Inc. Implications of the Haig- Simons Definition  If a person borrows to consume, there is no increase in income because the change in net worth is negative.  If a person sells an asset so as to consume, there is no increase in income.

6. Copyright © 2002 by Thomson Learning, Inc. Capital Gains  Capital gains are the increased value of assets that a person holds.  If a person owns a stock that has gone up in value, their net worth increases and therefore they have an increase in income by this definition.  This is true whether or not they actually sell the asset and see the money in their bank accounts.

7. Copyright © 2002 by Thomson Learning, Inc. Realized and Unrealized Capital Gains  Realized Capital Gains are those gains that a person has received by selling an asset.  Unrealized Capital Gains are those gains that a person has not yet received by selling an asset but exist only on paper as the market price of the asset they hold has increased.

8. Copyright © 2002 by Thomson Learning, Inc. An Income Statement  Sources of Funds:  Earnings from Sale of Productive Services  Transfer Payments Received  Capital Gains (or Losses)  Uses of Funds:  Consumption  Taxes  Donations  Gifts  Saving (Increases in Net Worth) Sources = Uses So  Earnings + Transfer Payments + Net Capital Gains = Consumption + Taxes + Donations + Gifts + Saving

9. Copyright © 2002 by Thomson Learning, Inc. Modifications to the Income Definition  The cost of acquiring income needs to be accounted for in the definition.  Earnings + Transfer Payments + Net Capital Gains – Cost of Acquiring Income = Consumption + Taxes + Donations + Gifts + Saving – Cost of Acquiring Income

10. Copyright © 2002 by Thomson Learning, Inc. Problems with Measuring Income using the Haig-Simons Definition  How do you measure unrealized capital gains on an asset that is not regularly traded?  Is the cost of an automobile used to drive to and from work a “cost of acquiring income?” Are child care expenses? Union Dues? Education expenses?  How do you distinguish what part of an expense is a cost of acquiring income and what part is merely consumption?

11. Copyright © 2002 by Thomson Learning, Inc. In-Kind Income in the Haig- Simons Definition  Under the comprehensive income definition, all income should be treated equally whether it is paid in cash or in- kind.  Many jobs offer free parking, subsidized medical insurance.

12. Copyright © 2002 by Thomson Learning, Inc. Home Production  Home production is any activity that is performed by people in the home.  Most of the things we do for ourselves can be purchased.  If you earn the money to have things done for you, then you are taxed on that income. If you do it yourself, you are not.

13. Copyright © 2002 by Thomson Learning, Inc. The Home Itself  Under a Haig-Simons definition of income, whether or not you own your home you are consuming housing services and it is therefore income.  Economists call the money that homeowners do not have to pay for the housing services they consume imputed rent.

14. Copyright © 2002 by Thomson Learning, Inc. The Impracticality of Taxing In-Kind Income, Home Production, and Imputed Rent  It would be impractical to tax any of these kinds of income because the value that is being received by the consumer depends upon the tastes of the consumer.  Suppose the market value of a parking space for a year is $1000. Suppose it is given to a person as a part of their job. Taxing a person as though they earned that $1000 would be inappropriate if they did not value the parking space at $1000 and could not sell the rights to that spot for $1000.

15. Copyright © 2002 by Thomson Learning, Inc. A General Tax on Comprehensive Income  Suppose there is a flat-rate income tax on all income. What are the effects on the labor-leisure trade-off and the savings decision?

16. Copyright © 2002 by Thomson Learning, Inc. Figure 13.1 The Impact of a Flat-Rate Income Tax on the Work-Leisure Choice Income per Day Leisure Hours per Day 0 IGIG J' L1L1 L2L2 ININ J H I1I1 T U2U2 U1U1 E' E B

17. Copyright © 2002 by Thomson Learning, Inc. The Algebraic View  Individuals maximize welfare where w = MRS LI  The after-tax wage is w N = w G (1 – t)  Income is then I = w G (1 – t)(24 – L)  Which means that individuals maximize their welfare in response to the tax by choosing labor such that w G (1 – t) = MRS LI

18. Copyright © 2002 by Thomson Learning, Inc. Capital Gains in the Rest of the World  U.S. reduced rate for assets held more than 18 months.  Most nations only tax gains on realization.  Little evidence exists to support the conclusion that a lower rate encourages entrepreneurship.

19. Copyright © 2002 by Thomson Learning, Inc. Income and Substitution Effects of a Tax on Labor Income  It is possible for a tax to increase or decrease the amount of work effort depending on whether leisure is a normal good.  If people target the amount of money they must take home to meet a standard of living, then a tax may increase work effort.  If leisure is a normal good, then the income effect and substitution effect of a tax on labor income are in the same direction and a tax decreases work effort.

20. Copyright © 2002 by Thomson Learning, Inc. Figure 13.2 Income and Substitution Effects of A Tax Induced Wage Decline Leisure Hours per Day 0 B L1L1 L2L2 H I ' I C L ' Income per Day LL L1L1 U2U2 U1U1 E1E1 E ' E2E2

21. Copyright © 2002 by Thomson Learning, Inc. Labor Market Analysis of Income Taxation: Perfectly Inelastic Supply  Even if the labor supply curve is perfectly inelastic, this does not imply there is no excess burden of a tax on labor income.  The labor supply curve that is appropriate for making such statements is the compensated labor supply curve (which is almost certain to be upward sloping even if the regular labor supply curve is not).

22. Copyright © 2002 by Thomson Learning, Inc. Figure 13.3 Impact of an Income Tax on Labor Markets and Efficiency When the Market Supply of Labor is Perfectly Inelastic Wages Labor Hours per Year 00Q* A S S' Regular Labor Supply Curve W N = W G (1 – t) D = W Compensated Labor Supply Curve B tW* G W* G –– Q SL W N = W* (1– t) G

23. Copyright © 2002 by Thomson Learning, Inc. Labor Market Analysis of Income Taxation: Wage responsive Labor Supply  When the regular labor supply curve is not perfectly inelastic, the excess burden of a tax on labor income is understated unless the analysis is performed with a compensated labor supply curve.

24. Copyright © 2002 by Thomson Learning, Inc. Figure 13.4 The Effect of Income Taxes on Labor Markets When the Supply of Labor is Responsive Wages Hours Worked per Year 0 Q2Q2 W W* A C Q3Q3 Q1Q1 SCSC QQ SRSR D = W G WW  Q SL tW* G B WNWN

25. Copyright © 2002 by Thomson Learning, Inc. Empirical Analysis  Regular labor supply is perfectly inelastic for men 25 to 55.  Estimates suggest that there is a large substitution effect that is almost perfectly offset by an equally large income effect.  The efficiency-loss ratio for these men suggests that for every dollar raised in income taxes, 13.5 cents of excess burden is created.

26. Copyright © 2002 by Thomson Learning, Inc. Lower Tax Rates, More Work, Less Excess Burden  Tax changes in 1983 and 1986 lowered the marginal tax rates facing most Americans.  Recent estimates suggest that this lower rate induced a 3% increase in work by men and a 16% drop in excess burden.

27. Copyright © 2002 by Thomson Learning, Inc. Incidence of Payroll Taxes  In the U.S., the FICA tax that funds Social Security has a legal incidence that is a 7.65% tax on both employers and employees.  If the regular labor supply curve is perfectly inelastic, this implies that all of this tax is being borne by workers.

28. Copyright © 2002 by Thomson Learning, Inc. The Payroll Tax Wages 0 QLQL WGWG A WEWE WNWN B C DNDN Labor Hours per Year SLSL T B + T E D L = MRP L D' = MRP L – T B L

29. Copyright © 2002 by Thomson Learning, Inc. Taxation of Interest Income and the Effect on Saving  Just as a tax on earned income can lead to an increase or a decrease in work, a tax interest can lead to an increase or a decrease in saving.

30. Copyright © 2002 by Thomson Learning, Inc. Figure 13.5 Income Taxation and Intertemporal Choice Future Consumption Current Consumption 0 C1C1 C2C2 E F DC’ 2 C' 2 U2U2 U1U1 E1E1 E2E2

31. Copyright © 2002 by Thomson Learning, Inc. Excess Burden of a Tax on Interest Income  A tax on interest income will also have an excess burden that will depend on the magnitude of the tax and the elasticity of supply and demand for loanable funds.

32. Copyright © 2002 by Thomson Learning, Inc. Figure 13.6 Impact of an Income Tax on Investment Markets and Savings Annual Savings and Investments Interest S1S1 D = r G r* G Supply of Savings rNrN A B C r1r1 r* N S2S2

33. Copyright © 2002 by Thomson Learning, Inc. Empirical Estimates  The elasticity of the supply of savings has been estimated to be in the neighborhood of.4.  This indicates that the efficiency-loss ratio for such a tax is.30 (meaning that for every dollar raised with the tax on interest income there is a 30 cent increase in excess burden).

34. Copyright © 2002 by Thomson Learning, Inc. Supply-Side Tax Cuts of the 1980s  Supply-Siders argued that cuts in tax rates would increase overall revenues because of the cuts would motivate harder work and greater investment.  The cuts in tax rates did not increase revenues but the decrease was much less than expected (by the tax cut opponents).