Taxation of Personal Income in the United States

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Chapter 14

• Taxation of Personal Income in the United States

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Sources of Income Subject to Tax

• Gross Income is the sum of
• Wages and Salaries,
• Interest Income Received,
• Dividends,
• Rental Income,
• Profits from Noncorporate Business Activities,
• Taxable Pension Benefits,
• Realized Capital Gains (Special Tax Rates Apply
  in Many Cases),
• Unemployment Compensation and a Portion of Other
  Government Payments to Individuals,
• Alimony Received, and
• Miscellaneous Income (e.g., Awards and Prizes).

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Adjustments to Gross Income

• The sum of
• Moving Expenses Relating to Start of Work,
• Contributions to Special Retirement Plans and
  Medical Savings Accounts,
• Penalties for Early Withdrawal of Savings,
• Alimony Paid,
• A Portion of Self-Employment Tax and Heath
  Insurance,
• Miscellaneous Costs for Employees and Businesses,
  and
• Miscellaneous Education expenses.

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Personal Exemptions

• Personal Exemptions are pre-set sums of money
  that taxpayers are allowed to subtract from AGI
  in the process of calculating taxable income.
• In 2003, the personal exemption was 3050 for
  each person per household.

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The Standard Deduction

• The Standard Deduction is a fixed dollar amount
  that may be used to reduce AGI to compute taxable
  income.
• It is adjusted for inflation each year and varies
  with the filing status of the taxpayer.
• For those filing as singles, the standard
  deduction in 2003 was 4,750, while for married
  couples filing jointly it was 9,500.

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Itemized Deductions

• Itemized Deductions are legally deductible
  expenses from AGI to compute taxable income. The
  most significant of these are the deductions for
• home mortgage interest,
• major medical expenses,
• charitable contributions, and
• state and local income and property taxes.

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Figure 14.1 Statutory Marginal Tax Rates for the
U.S. Personal Income Tax, 2003
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Tax Preferences

• Tax Preferences are exclusions, exemptions, and
  deductions from the tax base.
• They are intentional or unintentional means by
  which income can be earned but not be subject to
  the income tax.

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The Administrative Difficulty Justification

• When a tax provision is difficult to administer
  or comply with properly, a provision that
  partially or fully exempts certain income may be
  better (in terms of net tax efficiency) than a
  complicated provision with which it is difficult
  to comply.

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The Equity Justification

• Tax preferences are often justified with the
  argument that they make society fairer.

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The External Benefits Justification

• Offering a subsidy to a good with an external
  benefit increases societal welfare.
• Tax provisions can be used to implement that
  subsidy.

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Figure 14.2 Tax Preference and Efficiency

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Figure 14.3 Decrease in Excess Burden of Tax
Preferences
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Tax Preferences in the US Income Tax
SystemExclusions from Income

• In-Kind Income
• Fringe Benefits
• Transfers
• Capital Gains
• Interest on State and Local Bonds
• Miscellaneous Exclusions and Adjustments

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The Tax Preference for In-Kind Income

• Taxpayers who own their own homes and pay no
  mortgage or rent get what economists call imputed
  rent.
• It is not treated as income, in part because
  doing so would be nearly impossible to implement.

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The Tax Preference for Fringe Benefits

• Employer paid health insurance, pension funds,
  and other perks of employment are not taxed.
• This tax preference costs the federal government
  180 billion annually in lost tax revenue.

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The Tax Preference for Transfers

• Most government welfare payments are tax-exempt.
• A portion of Social Security income is taxable if
  other income is sufficiently high.

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The Tax Preference for Capital Gains

• Capital Gains income is not taxed until it is
  realized.
• This tax deferral amounts to a tax preference.
• Those capital gains that are realized are taxed
  at a reduced rate (5 for those in the 15 tax
  bracket and at 15 for those in the higher tax
  brackets).
• Capital gains taxes are typically forgiven at
  death.
• These amount to substantial preferences and are
  justified by the fact that many capital gains is
  not income at all, but simply inflationary gains.

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The Tax Preferences for Interest on State and
Local Bonds

• State and Local bonds are more attractive to
  investors and this allows these entities to pay
  lower interest rates.

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Miscellaneous Exclusions and Adjustments

• Certain scholarships and fellowships for academic
  purposes are not taxable as income.
• Earnings contributed to certain savings plans
  allow for income to be saved pre-tax that is,
  not subject to taxation when it is earned (e.g.,
  401k plans).

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Deducting Medical Expenses

• Medical expenses and health insurance payments
  that exceed 7.5 of AGI are deductible.
• For practical purposes, one must be quite ill or
  in a nursing home to benefit from this provision.

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Deducting State and Local Income and Property
Taxes

• All income and property taxes paid to state and
  local governments are deductible.
• This makes it somewhat easier for state and local
  governments to raise their taxes.

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Deducting Interest Payments on Home Mortgages

• The interest paid on the mortgages of first and
  second homes is deductible.
• Interest on credit cards or loans for automobiles
  and college loans are not deductible.
• This provision has lead to the phenomenon whereby
  people take out second mortgages to purchase
  automobiles rather than getting a car loan
  directly.

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Deducting Charitable Contributions

• Money given to charitable organizations is
  deductible.

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Miscellaneous Deductions

• If unreimbursed business expenses exceed 2 of
  AGI, then the excess is deductible.

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Deductions versus Credits

• A tax credit directly reduces taxes owed, while a
  tax deduction reduces the amount of income
  subject to tax.
• Generally, for an equal cost to government
  revenues, a credit favors low-income earners
  while a deduction favors high-income earners.

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Tax Expenditures
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The Alternative Minimum Tax

• The Alternative Minimum Tax (AMT) prevents
  high-income earners from having so many
  deductions and credits that they owe little tax.

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Issues in Income Tax Policy

• The Flat Tax
• Capital Gains Taxes
• Bracket Creep
• The Marriage Penalty
• A National Sales Tax

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The Economic Impact of a Flat Tax

• Depending on the proposal, a flat tax would
  generally reduce excess burden associated with
  tax preferences.
• Depending on the size of the personal exemption,
  it would dramatically lower taxes paid by the
  upper end of the tax scale.
• If the flat tax eliminated the EITC, it would
  dramatically raise the net income tax paid by
  those at the lower end of tax scale.

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Capital Gains Taxes

• Inflation and Capital Gains Inflation raises the
  price of assets. Economists see this as taxing a
  gain that does not exist. All else equal, this
  provision overtaxes long-term capital gains
  income. 
• Taxation of Capital Gains on Realization This
  provision allows people to decide when or whether
  they will pay taxes on capital gains. They can
  defer the tax by deferring the gain.
• The Stepped-up Basis on Death This provision
  means that the taxes that would be owed on
  capital gains are forgiven at death.
• The latter two provisions lead to a lock-in
  effect where people are encouraged to hold
  assets rather than sell them.

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Bracket Creep

• Prior to 1986, tax brackets were not subject to
  inflation indexation, which meant that inflation
  caused people to owe more taxes each year on the
  same real income. This is called bracket creep.
• The AMT has not been indexed for inflation.
• Tax brackets are indexed by the CPI. Economists
  generally agree the CPI over-estimates inflation
  by around 1 percentage point. This has the effect
  of lowering real taxes owed each year.

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The Marriage Tax

• People who are married pay more in taxes than
  they would if they were not married and simply
  living together, based on the same income levels.
  This is called the marriage tax.
• Married couples earning 50,000 where each party
  earns 25,000 a year pay more than 1000 more in
  tax because they are married than if they filed
  separately.

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A National Consumption or Sales Tax

• Another policy option that has been suggested is
  to allow taxpayers to deduct savings from taxable
  income. This would be a tax on consumption.
• Evidence suggests that this would substantially
  increase savings rates and improve economic
  growth

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Effective Rates for Federal Individual Income
Taxes and Total Federal Taxes by Income Quintile,
1998
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Marginal Tax Rates for a Couple With Two Children
in College, One Eligible for a Hope Credit and
the Other Eligible for a Lifetime Learning Credit
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Marginal Tax Rates for a Single Head of Household
With Two Children Under Age 17
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State Income Taxes

• All but seven states have income taxes (AK, FL,
  NV, SD, TX, WA, and WY).
• Most have progressive rate structures though some
  (CA, MA, MI, and PA) have proportional
  structures.
• Income taxes account for 40 of state revenues
• Most states start with the Federal Adjusted Gross
  Income and then use their own system of
  deductions and exemptions.