1
Chapter 15 – The Personal
Income Tax
Public Economics
2
Basic Structure
? Figure 15.1 shows the series of steps used to
compute a person’s tax liability.
? Step 1,Compute Adjusted Gross Income
(AGI)
? Step 2,Convert AGI into taxable income by
subtracting exemptions and deductions
? Step 3,Compute tax due by applying a rate
schedule,and subtracting tax credits.
Figure 15.1
4
Basic Structure
? Later in this lesson,will discuss
extensively the,real-life” aspects of the
U.S,tax code.
? Before doing that,useful to think about
what the tax code,should” look like.
5
Defining Income
? Which forms of income could be taxed?
– Wages and salaries,rents,dividends,and so
on …
? Haig-Simons definition of income,
Income is the money value of the net
increase in an individual’s power to
consumer during a period.
6
Defining Income
? H-S criterion:
– Includes net additions to wealth
– All sources of potential increases in
consumption (regardless of whether
consumption took place)
– Subtracts losses
7
Defining Income:
Items included in H-S Income
? H-S definition encompasses:
– Items ordinarily thought of as income include wages,
salaries,business profits,rents,royalties,dividends,
and interest
– Employer pension contributions and insurance
premiums
– Transfer payments like Social Security,
Unemployment Insurances,and Welfare
– Capital Gains (whether they are realized or
unrealized)
– Imputed rental income from durable goods
8
Defining Income:
Problems
? Business expenses are often difficult to parse
out into,consumption” and,costs of obtaining
income”
? Unrealized capital gains and losses difficult to
measure
? Imputed rental income from durables difficult to
impute
? In-kind services (such as housework) difficult to
value
9
Defining Income:
Evaluating the H-S Criterion
? Clearly,arbitrary decisions need to be
made on how to define income from a
practical point of view.
? H-S criterion appeal to:
– Horizontal equity – people with equal
incomes should pay equal taxes
– Neutrality – it treats all forms of income the
same,and does not distort economic activity.
10
Excludable Forms of Income:
Interest on State and Local Bonds
? Interest earned on bond issued by state
or locality is untaxed (while interest
earned on the bond of a private company
is taxed).
? Investors are therefore willing to accept a
lower before-tax rate of return on these
bonds.
11
Excludable Forms of Income:
Interest on State and Local Bonds
? For example,if the return in the private
market is r,then investors will purchase
state bonds as long as the return is
higher than (1-t)r,where t is the marginal
tax rate on investment income.
12
Excludable Forms of Income:
Interest on State and Local Bonds
? The state save money (by paying less
interest) while the federal government
loses (by collecting less tax revenue).
? It is not usually the case that the state’s
gains exactly offset the federal
government’s losses – it will usually be
the case that the federal government’s
loss is greater.
13
Excludable Forms of Income:
Interest on State and Local Bonds
? Illustration
– Suppose the private market return is r=20%
– Progressive tax system
? Low income – t=0%
? Moderate income – t=15%
? High income – t=28%
14
Excludable Forms of Income:
Interest on State and Local Bonds
? Illustration
– With this information,the return necessary to induce
a person to invest in the state bond is:
? (1-tLOW)r = 20% for low income group
? (1-tMOD)r = 17% for moderate income group
? (1-tHIGH)r = 14.4% for high income group
? Thus,people in higher tax brackets are more
likely to benefit from buying state bonds.
15
Excludable Forms of Income:
Interest on State and Local Bonds
? Illustration
– Assume each group has some amount of
capital that can be invested in either a private
bond or state bond (each with equal
riskiness).
? Low income,$100,000 to invest
? Moderate income,$75,000 to invest
? High income,$250,000 to invest
16
Excludable Forms of Income:
Interest on State and Local Bonds
? Illustration,Equal gains and losses
– If the state government needs to raise $100,000,
what rate of return should it offer?
? It should offer a return r=14.4%,because it can induce the high income people to supply enough capital.
– How much does the state government save?
? Instead of paying r=20% on $100,000,it instead pays r=14.4%,saving 5.6%x$100,000 or $5,600.
– How much does the federal government lose?
? The federal government would have collected taxes on interest of $20,000 (20%x$100,000),It therefore loses
28%x$20,000=$5,600.
17
Excludable Forms of Income:
Interest on State and Local Bonds
? Illustration,Unequal gains and losses
– If the state government needs to raise
$325,000,what rate of return should it offer?
? It should raise the return to r=17%,because it
must also induce the moderate income group
to provide capital.
? The high income group (which provides
$250,000 of capital) receives some economic
rents because it would have provided the
capital for r=14.4%.
18
Excludable Forms of Income:
Interest on State and Local Bonds
? Illustration,Unequal gains and losses
– How much does the state government save?
? Instead of paying r=20% on $100,000,it instead pays r=17%,saving 3%x$325,000 or $9,750.
– How much does the federal government lose?
? From the high income group,the federal government would have collected taxes on interest of $50,000
(20%x$250,000),It therefore loses 28%x$50,000=$14,000.
? From the moderate income group,the federal government would have collected taxes on interest of
$15,000 (20%x$75,000),It therefore loses 15%x$15,000=$2,250.
19
Excludable Forms of Income:
Interest on State and Local Bonds
? Illustration,Unequal gains and losses
– The state government saves $9,750 in interest
payments
– The federal government loses $16,250 in tax
collections
? The net effect of tax exempt bonds is zero only
for those investors who are just on the margin
of choosing tax-exempt versus taxable
securities.
20
Excludable Forms of Income:
Some Dividends
? In 2003,legislation was passed which
lowered the maximal tax rate on
dividends to 15%.
? Previously,it was taxed as ordinary
income.
21
Excludable Forms of Income:
Capital Gains
? The maximum capital gains tax rate (in
2004) is 15%,while the maximum federal
tax rate on ordinary income is 38.6%.
? Capital gains held for less than 12
months are taxed as ordinary income.
? Capital losses offset capital gains,and
can be subtracted from ordinary income
(up to a cap of $3,000).
22
Excludable Forms of Income:
Capital Gains
? One interesting aspect of the treatment of
capital gains is that only realized capital
gains are taxed.
? As the illustration below dramatically
shows,the timing of realizations can
matter greatly for total portfolio wealth,
even holding the composition of assets
fixed.
23
Excludable Forms of Income:
Capital Gains
? Example:
– Asset with principal of $100,000
– r=12%
– Time horizon is 20 years
– Tax rate = 15%
24
Excludable Forms of Income:
Capital Gains
? Capital gains not realized until end of 20
years:
– Value of investment is $100,000x(1+.12)20 =
$964,629.
– Capital gain is $964,629-$100,000 =
$864,629
– Tax owed is 15%x$864,629 = $129,694
– Wealth = $964,629-$129,694 = $834,935
25
Excludable Forms of Income:
Capital Gains
? Capital gains realized each year
– After tax rate of return is not 12%,but rather
(1-.15)x12% = 10.2% since taxes are paid
along the way rather than at the end
– Value of investment is $100,000x(1+.102)20
=$697,641,
– Wealth = $697,641
26
Excludable Forms of Income:
Capital Gains
? Wealth is more than $137,000 lower by
realizing capital gains along the way
rather than deferring tax payments until
the end.
? Deferral allows the money to grow
geometrically at the before-tax rate of
return.
?,Taxes deferred are taxes saved”
27
Excludable Forms of Income:
Capital Gains
? Investors who are considering switching
or selling assets must therefore take into
account the fact that a tax liability will be
created.
? Investors may be less likely to change
their portfolios,known as the lock-in
effect.
? May lead to misallocation of capital.
28
Excludable Forms of Income:
Capital Gains
? Capital gains are not taxed at death
– Basis is raised to current level
– If person sold $1200 portfolio (with $200 of
capital gains) immediately before death,the
gain is subject to taxes.
– If the person bequeathed the $1200 portfolio
to his heirs,who then sold it immediately,
there is no,gain” and thus no taxes.
29
Excludable Forms of Income:
Employer Contributions
? If an employer pays premiums for a
health insurance plan,those contributions
are not taxed.
? If the employer instead paid the
employee in the form of higher wages,
the wages would be taxed,
30
Excludable Forms of Income:
Some types of Saving
? There are numerous tax-deferred or tax-
free savings vehicles.
? Although they have different names,they
usually share a number of characteristics.
? In all of these plans,the investment
accrues at the before tax rate of return,
and do not suffer from the lock-in effect.
31
Excludable Forms of Income:
Some types of Saving
? IRAs (Individual Retirement Accounts)
? Roth IRAs
? 401(k) (also 403(b) for not-profit,457(b)
for government)
? Self-employment Retirement Plans
? Education Savings Account
32
Excludable Forms of Income:
Some types of Saving
Plan Immediate
Deduction?
Limit Tax free
withdrawal
IRA Yes $3,000 No
Roth IRA No $3,000 Yes
401(k) Yes $13,000 No
SEP Yes $41,000 No
Education No $2,000 Yes
33
Excludable Forms of Income:
Some types of Saving
? Do the existence of various tax-favored
saving options stimulate saving?
? Not clear whether aggregate saving is
affected,or whether people merely
shuffle around their portfolios.
? Very contentious issue,but most
research favors the view that at least
some of the saving is new saving.
34
Exemptions and Deductions
? One AGI is determined,subtract certain
exemptions and deductions to arrive at
taxable income.
35
Exemptions
? Exemptions
– Family allowed an exemption for each
member
– Exemption in 2003 was $3,050 per family
member,so a husband and wife with three
dependent children could claim five
exemptions and subtract $15,250 from AGI.
– Exemptions phased out for households with
high AGI’s.
36
Exemptions
? Exemptions
– Why have exemptions?
– Adjust ability to pay in the presence of
children
? Relative to deductions,not much room for
affecting the exemptions claimed.
37
Deductions
? The other subtraction from AGI is a deduction,
There are two types:
– Standard deduction – a fixed amount that requires
no documentation
– Itemized deduction – subtractions for specific items
cited in the law,must list each item separately,and
be able to prove the expenditures were made
? Taxpayers would choose whichever one
minimized their tax liabilities.
38
Deductions
? Standard deduction in 2003 was $4,750
for single individuals,and $7,950 for joint
filers.
? Around 67% of tax returns take the
standard deduction.
39
Deductions
? As long as a household is itemizing,
deductibility changes relative prices.
? If the price of Z is PZ and the household’s
marginal tax rate is t,then the,effective price” is
lowered from PZ to (1-t)PZ.
– This would likely affect the quantity demanded
– The higher the tax rate,the lower the effective price
40
Deductions:
Some Specific Items
? Unreimbursed medical expenses that
exceed 7.5% of AGI
– Only medical expenses above the threshold
are deductible
– Creates incentives to,stack” medical
procedures in one calendar year,and
potentially time these procedures for years
when AGI is low
41
Deductions:
Some Specific Items
? State and local income and property
taxes
– In 2000,these deductions amounted to $290
billion.
– Sales taxes are not deductible.
– For those who itemize,lowers the effective
costs of paying these taxes.
42
Deductions:
Some Specific Items
? Certain interest expenses
– Interest on home mortgages
? Conventional mortgages
? Home equity loans
? Lowers the effective price of home ownership
– Student loans
– Not interest paid on consumer debt like credit
cards
43
Deductions:
Some Specific Items
? Charitable contributions
– Charitable deductions cannot exceed 50% of
AGI
– In 2000,$134 billion in deductions for
charitable contributions
– Tax deductibility lowers the effective,price”
of giving,Elasticity estimates around 0.5,
which mean that lowering the effective price
from $1 to $0.7 increases giving by 15%.
44
Credits
? A tax credit is a subtraction from tax
liability (not taxable income).
? Unlike deductions,the value of the credit
is independent of the tax rate.
? Number of credits in the tax system,
including the,kiddie tax credit” which is
$1000 per child,and credits for college
expenses.
45
Tax expenditures
? Tax expenditures are the revenues
forgone due to preferential tax treatment.
? The revenue loss for 2004 will exceed
$600 billion.
46
Rate Structure
? The taxable income scale is divided into
segments,and the law specifies the marginal
tax rate that applies to income from each
segment.
? Four different schedules
– Single
– Married,filing jointly
– Married,filing separately
– Heads of household
47
Rate Structure
? In 1913,bracket rates ranged between 1-7%
? In 1945,rates ranges between 23-94%
? In mid-1980s,rates ranges between 11-50%,
with 14 brackets
? 1986,Two brackets,15% and 28%
? Rates crept up in 1990s
? Trend was reversed in 2001
48
Rate Structure
? Table 15.1 shows the official statutory tax
rate schedule for 2003.
? Rates vary between 10% and 38.6%.
Table 15.1
50
Rate Structure
? Official statutory marginal tax rates may
not correspond well to actual marginal tax
rates because of various deductions and
credits.
? Figure 15.2 illustrates actual marginal tax
rates for a family of 4 that takes
advantage of various education credits.
Figure 15.2
52
Alternative Minimum Tax
? Because of various deductions and tax
treatment of certain forms of income,it is
possible that some high-income
households have little or no tax liability.
? In 1969,Secretary of Treasury
announced that 155 individuals with
incomes above $200,000 had no federal
income tax liability
53
Alternative Minimum Tax
? The alternative minimum tax (AMT)
was then enacted,and is an attempt to
ensure that rich people who benefited
from various tax shelters paid at least
some tax.
? AMT is essentially a shadow tax system,
with its own rules for computing the tax
base and rate schedule.
54
Alternative Minimum Tax
? Step 1,Add taxable income and AMT
preferences
– Personal exemptions,standard deduction,
and itemized deductions for state income
taxes
? Step 2,Subtract AMT exemption
– Currently $49,000 for married couples,and
$35,750 for single individuals
55
Alternative Minimum Tax
? Step 3,Compute Alternative Minimum Tax
Income (AMTI)
– Tax rate is 26% on first $175,000
– Tax rate is 28% on remainder
– Neither exemption nor brackets indexed for inflation
? Tax liability is the tentative AMT,If this is
greater than the regular income tax liability,
difference between them is the AMT,which
must be added on top of the regular income tax.
56
Alternative Minimum Tax
? Initially targeted to catch high-income people.
? Under current law,however,by 2010 about 35
million taxpayers will be on the AMT.
– Anything that tends to reduce the tax liability under
the regular tax relative to the AMT tends to increase
the number of AMT taxpayers.
? 2001 tax reform reduced tax rates in regular
income tax code but not AMT.
57
Alternative Minimum Tax
? AMT of policy concern because:
– Will target those with moderate incomes
– Higher tax rates lead to efficiency losses
– Complicated
? U.S,tax code,along its current path,is
headed for some serious problems.
58
Choice of Unit and the Marriage
Tax
? Suppose that the following 3 characteristics of a
tax system are considered desirable:
– Progressivity
– Families with equal incomes should pay equal taxes
– Marriage neutrality
? No tax system can adhere to all three of these
simultaneously.
? Consider Table 15.2
Table 15.2
60
Choice of Unit and the Marriage
Tax
? In this example,the tax rate is 10% for
income up to $6,000 and 50% thereafter.
? Families with equal total incomes pay
unequal taxes.
61
Recap of the Personal Income
Tax
? Basic Structure
? Defining Income
? Excludable Forms of Income
? Exemptions,Deductions,and Credits
? AMT
? Marriage Tax
Chapter 15 – The Personal
Income Tax
Public Economics
2
Basic Structure
? Figure 15.1 shows the series of steps used to
compute a person’s tax liability.
? Step 1,Compute Adjusted Gross Income
(AGI)
? Step 2,Convert AGI into taxable income by
subtracting exemptions and deductions
? Step 3,Compute tax due by applying a rate
schedule,and subtracting tax credits.
Figure 15.1
4
Basic Structure
? Later in this lesson,will discuss
extensively the,real-life” aspects of the
U.S,tax code.
? Before doing that,useful to think about
what the tax code,should” look like.
5
Defining Income
? Which forms of income could be taxed?
– Wages and salaries,rents,dividends,and so
on …
? Haig-Simons definition of income,
Income is the money value of the net
increase in an individual’s power to
consumer during a period.
6
Defining Income
? H-S criterion:
– Includes net additions to wealth
– All sources of potential increases in
consumption (regardless of whether
consumption took place)
– Subtracts losses
7
Defining Income:
Items included in H-S Income
? H-S definition encompasses:
– Items ordinarily thought of as income include wages,
salaries,business profits,rents,royalties,dividends,
and interest
– Employer pension contributions and insurance
premiums
– Transfer payments like Social Security,
Unemployment Insurances,and Welfare
– Capital Gains (whether they are realized or
unrealized)
– Imputed rental income from durable goods
8
Defining Income:
Problems
? Business expenses are often difficult to parse
out into,consumption” and,costs of obtaining
income”
? Unrealized capital gains and losses difficult to
measure
? Imputed rental income from durables difficult to
impute
? In-kind services (such as housework) difficult to
value
9
Defining Income:
Evaluating the H-S Criterion
? Clearly,arbitrary decisions need to be
made on how to define income from a
practical point of view.
? H-S criterion appeal to:
– Horizontal equity – people with equal
incomes should pay equal taxes
– Neutrality – it treats all forms of income the
same,and does not distort economic activity.
10
Excludable Forms of Income:
Interest on State and Local Bonds
? Interest earned on bond issued by state
or locality is untaxed (while interest
earned on the bond of a private company
is taxed).
? Investors are therefore willing to accept a
lower before-tax rate of return on these
bonds.
11
Excludable Forms of Income:
Interest on State and Local Bonds
? For example,if the return in the private
market is r,then investors will purchase
state bonds as long as the return is
higher than (1-t)r,where t is the marginal
tax rate on investment income.
12
Excludable Forms of Income:
Interest on State and Local Bonds
? The state save money (by paying less
interest) while the federal government
loses (by collecting less tax revenue).
? It is not usually the case that the state’s
gains exactly offset the federal
government’s losses – it will usually be
the case that the federal government’s
loss is greater.
13
Excludable Forms of Income:
Interest on State and Local Bonds
? Illustration
– Suppose the private market return is r=20%
– Progressive tax system
? Low income – t=0%
? Moderate income – t=15%
? High income – t=28%
14
Excludable Forms of Income:
Interest on State and Local Bonds
? Illustration
– With this information,the return necessary to induce
a person to invest in the state bond is:
? (1-tLOW)r = 20% for low income group
? (1-tMOD)r = 17% for moderate income group
? (1-tHIGH)r = 14.4% for high income group
? Thus,people in higher tax brackets are more
likely to benefit from buying state bonds.
15
Excludable Forms of Income:
Interest on State and Local Bonds
? Illustration
– Assume each group has some amount of
capital that can be invested in either a private
bond or state bond (each with equal
riskiness).
? Low income,$100,000 to invest
? Moderate income,$75,000 to invest
? High income,$250,000 to invest
16
Excludable Forms of Income:
Interest on State and Local Bonds
? Illustration,Equal gains and losses
– If the state government needs to raise $100,000,
what rate of return should it offer?
? It should offer a return r=14.4%,because it can induce the high income people to supply enough capital.
– How much does the state government save?
? Instead of paying r=20% on $100,000,it instead pays r=14.4%,saving 5.6%x$100,000 or $5,600.
– How much does the federal government lose?
? The federal government would have collected taxes on interest of $20,000 (20%x$100,000),It therefore loses
28%x$20,000=$5,600.
17
Excludable Forms of Income:
Interest on State and Local Bonds
? Illustration,Unequal gains and losses
– If the state government needs to raise
$325,000,what rate of return should it offer?
? It should raise the return to r=17%,because it
must also induce the moderate income group
to provide capital.
? The high income group (which provides
$250,000 of capital) receives some economic
rents because it would have provided the
capital for r=14.4%.
18
Excludable Forms of Income:
Interest on State and Local Bonds
? Illustration,Unequal gains and losses
– How much does the state government save?
? Instead of paying r=20% on $100,000,it instead pays r=17%,saving 3%x$325,000 or $9,750.
– How much does the federal government lose?
? From the high income group,the federal government would have collected taxes on interest of $50,000
(20%x$250,000),It therefore loses 28%x$50,000=$14,000.
? From the moderate income group,the federal government would have collected taxes on interest of
$15,000 (20%x$75,000),It therefore loses 15%x$15,000=$2,250.
19
Excludable Forms of Income:
Interest on State and Local Bonds
? Illustration,Unequal gains and losses
– The state government saves $9,750 in interest
payments
– The federal government loses $16,250 in tax
collections
? The net effect of tax exempt bonds is zero only
for those investors who are just on the margin
of choosing tax-exempt versus taxable
securities.
20
Excludable Forms of Income:
Some Dividends
? In 2003,legislation was passed which
lowered the maximal tax rate on
dividends to 15%.
? Previously,it was taxed as ordinary
income.
21
Excludable Forms of Income:
Capital Gains
? The maximum capital gains tax rate (in
2004) is 15%,while the maximum federal
tax rate on ordinary income is 38.6%.
? Capital gains held for less than 12
months are taxed as ordinary income.
? Capital losses offset capital gains,and
can be subtracted from ordinary income
(up to a cap of $3,000).
22
Excludable Forms of Income:
Capital Gains
? One interesting aspect of the treatment of
capital gains is that only realized capital
gains are taxed.
? As the illustration below dramatically
shows,the timing of realizations can
matter greatly for total portfolio wealth,
even holding the composition of assets
fixed.
23
Excludable Forms of Income:
Capital Gains
? Example:
– Asset with principal of $100,000
– r=12%
– Time horizon is 20 years
– Tax rate = 15%
24
Excludable Forms of Income:
Capital Gains
? Capital gains not realized until end of 20
years:
– Value of investment is $100,000x(1+.12)20 =
$964,629.
– Capital gain is $964,629-$100,000 =
$864,629
– Tax owed is 15%x$864,629 = $129,694
– Wealth = $964,629-$129,694 = $834,935
25
Excludable Forms of Income:
Capital Gains
? Capital gains realized each year
– After tax rate of return is not 12%,but rather
(1-.15)x12% = 10.2% since taxes are paid
along the way rather than at the end
– Value of investment is $100,000x(1+.102)20
=$697,641,
– Wealth = $697,641
26
Excludable Forms of Income:
Capital Gains
? Wealth is more than $137,000 lower by
realizing capital gains along the way
rather than deferring tax payments until
the end.
? Deferral allows the money to grow
geometrically at the before-tax rate of
return.
?,Taxes deferred are taxes saved”
27
Excludable Forms of Income:
Capital Gains
? Investors who are considering switching
or selling assets must therefore take into
account the fact that a tax liability will be
created.
? Investors may be less likely to change
their portfolios,known as the lock-in
effect.
? May lead to misallocation of capital.
28
Excludable Forms of Income:
Capital Gains
? Capital gains are not taxed at death
– Basis is raised to current level
– If person sold $1200 portfolio (with $200 of
capital gains) immediately before death,the
gain is subject to taxes.
– If the person bequeathed the $1200 portfolio
to his heirs,who then sold it immediately,
there is no,gain” and thus no taxes.
29
Excludable Forms of Income:
Employer Contributions
? If an employer pays premiums for a
health insurance plan,those contributions
are not taxed.
? If the employer instead paid the
employee in the form of higher wages,
the wages would be taxed,
30
Excludable Forms of Income:
Some types of Saving
? There are numerous tax-deferred or tax-
free savings vehicles.
? Although they have different names,they
usually share a number of characteristics.
? In all of these plans,the investment
accrues at the before tax rate of return,
and do not suffer from the lock-in effect.
31
Excludable Forms of Income:
Some types of Saving
? IRAs (Individual Retirement Accounts)
? Roth IRAs
? 401(k) (also 403(b) for not-profit,457(b)
for government)
? Self-employment Retirement Plans
? Education Savings Account
32
Excludable Forms of Income:
Some types of Saving
Plan Immediate
Deduction?
Limit Tax free
withdrawal
IRA Yes $3,000 No
Roth IRA No $3,000 Yes
401(k) Yes $13,000 No
SEP Yes $41,000 No
Education No $2,000 Yes
33
Excludable Forms of Income:
Some types of Saving
? Do the existence of various tax-favored
saving options stimulate saving?
? Not clear whether aggregate saving is
affected,or whether people merely
shuffle around their portfolios.
? Very contentious issue,but most
research favors the view that at least
some of the saving is new saving.
34
Exemptions and Deductions
? One AGI is determined,subtract certain
exemptions and deductions to arrive at
taxable income.
35
Exemptions
? Exemptions
– Family allowed an exemption for each
member
– Exemption in 2003 was $3,050 per family
member,so a husband and wife with three
dependent children could claim five
exemptions and subtract $15,250 from AGI.
– Exemptions phased out for households with
high AGI’s.
36
Exemptions
? Exemptions
– Why have exemptions?
– Adjust ability to pay in the presence of
children
? Relative to deductions,not much room for
affecting the exemptions claimed.
37
Deductions
? The other subtraction from AGI is a deduction,
There are two types:
– Standard deduction – a fixed amount that requires
no documentation
– Itemized deduction – subtractions for specific items
cited in the law,must list each item separately,and
be able to prove the expenditures were made
? Taxpayers would choose whichever one
minimized their tax liabilities.
38
Deductions
? Standard deduction in 2003 was $4,750
for single individuals,and $7,950 for joint
filers.
? Around 67% of tax returns take the
standard deduction.
39
Deductions
? As long as a household is itemizing,
deductibility changes relative prices.
? If the price of Z is PZ and the household’s
marginal tax rate is t,then the,effective price” is
lowered from PZ to (1-t)PZ.
– This would likely affect the quantity demanded
– The higher the tax rate,the lower the effective price
40
Deductions:
Some Specific Items
? Unreimbursed medical expenses that
exceed 7.5% of AGI
– Only medical expenses above the threshold
are deductible
– Creates incentives to,stack” medical
procedures in one calendar year,and
potentially time these procedures for years
when AGI is low
41
Deductions:
Some Specific Items
? State and local income and property
taxes
– In 2000,these deductions amounted to $290
billion.
– Sales taxes are not deductible.
– For those who itemize,lowers the effective
costs of paying these taxes.
42
Deductions:
Some Specific Items
? Certain interest expenses
– Interest on home mortgages
? Conventional mortgages
? Home equity loans
? Lowers the effective price of home ownership
– Student loans
– Not interest paid on consumer debt like credit
cards
43
Deductions:
Some Specific Items
? Charitable contributions
– Charitable deductions cannot exceed 50% of
AGI
– In 2000,$134 billion in deductions for
charitable contributions
– Tax deductibility lowers the effective,price”
of giving,Elasticity estimates around 0.5,
which mean that lowering the effective price
from $1 to $0.7 increases giving by 15%.
44
Credits
? A tax credit is a subtraction from tax
liability (not taxable income).
? Unlike deductions,the value of the credit
is independent of the tax rate.
? Number of credits in the tax system,
including the,kiddie tax credit” which is
$1000 per child,and credits for college
expenses.
45
Tax expenditures
? Tax expenditures are the revenues
forgone due to preferential tax treatment.
? The revenue loss for 2004 will exceed
$600 billion.
46
Rate Structure
? The taxable income scale is divided into
segments,and the law specifies the marginal
tax rate that applies to income from each
segment.
? Four different schedules
– Single
– Married,filing jointly
– Married,filing separately
– Heads of household
47
Rate Structure
? In 1913,bracket rates ranged between 1-7%
? In 1945,rates ranges between 23-94%
? In mid-1980s,rates ranges between 11-50%,
with 14 brackets
? 1986,Two brackets,15% and 28%
? Rates crept up in 1990s
? Trend was reversed in 2001
48
Rate Structure
? Table 15.1 shows the official statutory tax
rate schedule for 2003.
? Rates vary between 10% and 38.6%.
Table 15.1
50
Rate Structure
? Official statutory marginal tax rates may
not correspond well to actual marginal tax
rates because of various deductions and
credits.
? Figure 15.2 illustrates actual marginal tax
rates for a family of 4 that takes
advantage of various education credits.
Figure 15.2
52
Alternative Minimum Tax
? Because of various deductions and tax
treatment of certain forms of income,it is
possible that some high-income
households have little or no tax liability.
? In 1969,Secretary of Treasury
announced that 155 individuals with
incomes above $200,000 had no federal
income tax liability
53
Alternative Minimum Tax
? The alternative minimum tax (AMT)
was then enacted,and is an attempt to
ensure that rich people who benefited
from various tax shelters paid at least
some tax.
? AMT is essentially a shadow tax system,
with its own rules for computing the tax
base and rate schedule.
54
Alternative Minimum Tax
? Step 1,Add taxable income and AMT
preferences
– Personal exemptions,standard deduction,
and itemized deductions for state income
taxes
? Step 2,Subtract AMT exemption
– Currently $49,000 for married couples,and
$35,750 for single individuals
55
Alternative Minimum Tax
? Step 3,Compute Alternative Minimum Tax
Income (AMTI)
– Tax rate is 26% on first $175,000
– Tax rate is 28% on remainder
– Neither exemption nor brackets indexed for inflation
? Tax liability is the tentative AMT,If this is
greater than the regular income tax liability,
difference between them is the AMT,which
must be added on top of the regular income tax.
56
Alternative Minimum Tax
? Initially targeted to catch high-income people.
? Under current law,however,by 2010 about 35
million taxpayers will be on the AMT.
– Anything that tends to reduce the tax liability under
the regular tax relative to the AMT tends to increase
the number of AMT taxpayers.
? 2001 tax reform reduced tax rates in regular
income tax code but not AMT.
57
Alternative Minimum Tax
? AMT of policy concern because:
– Will target those with moderate incomes
– Higher tax rates lead to efficiency losses
– Complicated
? U.S,tax code,along its current path,is
headed for some serious problems.
58
Choice of Unit and the Marriage
Tax
? Suppose that the following 3 characteristics of a
tax system are considered desirable:
– Progressivity
– Families with equal incomes should pay equal taxes
– Marriage neutrality
? No tax system can adhere to all three of these
simultaneously.
? Consider Table 15.2
Table 15.2
60
Choice of Unit and the Marriage
Tax
? In this example,the tax rate is 10% for
income up to $6,000 and 50% thereafter.
? Families with equal total incomes pay
unequal taxes.
61
Recap of the Personal Income
Tax
? Basic Structure
? Defining Income
? Excludable Forms of Income
? Exemptions,Deductions,and Credits
? AMT
? Marriage Tax
