1. Major Tax Structures: Income Taxes Troy University PA6650- Governmental Budgeting Chapter 8

2. Three Predominant Tax Bases INCOME Spending on GOODS & SERVICES PROPERTY

3. Overview Governments apply taxes to the income of individuals and corporations –Unincorporated business (proprietorship, partnership) is taxed through the individual income tax system –Wage and salary income (payrolls) and income of the self- employed are taxed through the individual income tax and by separate taxes to finance the social insurance system (Social Security, unemployment compensation) –Corporate income taxation is through a separate system

4. Some Background USA relied on excise taxes (customs, duties, liquor taxes) and tariffs before the Civil War Income Tax levied from 1862-1872 In 1894 another income tax. Struck down by the Supreme Court as a direct tax 16 th Amendment passed in 1913 3-5% income tax in excess of $10,000 1% of the population eligible to pay it

5. Some Background In 2004, – individual income taxes yielded $1,025.8 billion –Corporate income taxes yielded $258.9 billion –Social Security receipts yielded $822.2 billion –Total receipts of $3.2 trillion (all governments) Page 335 of text –Income tax is 40% of all government receipts –Income tax is 11% of total GDP

6. The Argument About Taxing Income FOR –Income is a reliable indicator of relative affluence and capacity to bear burden –Income tax can be made to account for individual taxpayer conditions (adjustable) –The size of the income base permits significant revenue at socially acceptable rates (good yield) –The resource distortion is low

7. The Argument About Taxing Income AGAINST Transparency and compliance (complicated, loopholes) Administration and compliance (expensive and complex to administer) Economic effects (some negative effects) Economic distortion (some unique groups punished or favored) Equity (distributes the cost of government unfairly) Overuse (has become a large burden at several governmental levels)

8. Individual Income Taxation How it works –Figure 8-1, page 341

9. Individual Income Taxation Defining Income Wages Salaries Interest Stock dividends Rents Royalties Etc.

10. Individual Income Taxation Haig-Simons says: –“personal income is defined as the algebraic sum of 1) the market value of rights exercised in consumption and 2)the change in the value of the store of property rights between the beginning and the end of the period in question” (text lists examples of some problems with Haig Simons)

11. Adjusted Gross Income Applies to net income, not gross receipts Adjusted for expenses Other adjustments (alimony, pensions) Many exclusions (food stamps, Social Security, tax-exempt bonds, life insurance receipts, gifts) Tax-exempt municipal bonds are a federal subsidy to states/localities

12. Personal Deductions May improve horizontal and vertical equity Three types of itemized personal deductions Medical, dental, casualty, theft, state & local taxes (these are not under your control) Encouraged spending (charitable contributions, home mortgage interest) Net income adjustments (job expenses, education expenses, tax prep fees) Standard deduction still available (about $5K)

13. Personal Exemptions Flat amount About $3k per person Table 8-3 page 348

14. Taxable Income Take AGI and subtract personal deductions and exemptions TAX YIELD = TAX BASE x TAX RATE Trend is toward broader base, lower rates

15. Tax Rates Federal tax rates increase as income increases AVERAGE RATE = tax liability/taxable income MARGINAL RATE = increase in tax liability from an additional $1 in income Average rate is always below the marginal rate. It means that you will always pay less than a dollar in tax for an additional dollar earned

16. Credits Direct forgiveness of tax owed…comes right off of what you owe in tax Powerful device to stimulate desired activity Examples include political contributions, energy saving purchases, home purchase, child care, low-income EITC)

17. Effective Tax Rates Nominal rates are the published rates Marginal rates are each additional dollar earned Average rate is tax liability/taxable income AVERAGE EFFECTIVE RATE is taxes paid/AGI (includes all the credits and loopholes)

18. Practice Page 358 Total income = $142,500 Municipal Bond income = $7,500 (excluded from total income) Adjustments of $12,000 AGI = $130, 500 Itemized deductions = $12,500 3 EXEMPTIONS @ $3,200 = $9,600 Taxable income = $130,500 – ($12,500+$9,600) = $108,400 Tax table shows a tax owed of $20,480 WHAT ARE AVERAGE, AVERAGE EFECTIVE, MARGINAL RATES?

19. Practice –AVERAGE RATE Tax/Taxable Income $20,480 / $108,400 = 18.8% –AVERAGE EFFECTIVE RATE tax / (taxable income+adjustments+exclusions) $20,480 / ($108,400 = $12,000 + $7,500) = 16% –MARGINAL RATE change in tax/change in taxable income 25% (from the table)

20. Indexation Removes the effect of bracket creep –Bracket creep – higher income due to inflation without any real increase in purchasing power.

21. Corporate Income Tax Corporate net income tax based on net earnings of the company Allows deductions for operating costs and charity Federal rate of 35% @$18.3 million or more Complex problem calculating depreciation, international transactions (transfer pricing) Different formulas for multiple states based on property, payroll, or sales

22. Integration with the Individual Tax Double tax should be eliminated Currently there is no full integration between the individual income tax and the corporate income tax

23. Payroll Taxation Social Security, Medicare, Unemployment Compensation, Earned Income Taxes Peculiarities of payroll taxes –Vertical and horizontal equity problems –Unusual rate patterns –Earmarks for particular funds

24. Conclusion Income tax is the heart of the federal revenue system Problems with income tax include: –Inefficiency –Horizontal inequity –Expensive collection –Failure of transparency Corporate and payroll taxes yield considerable revenue