More on taxation

1
More on taxation

• Today More on efficiency and equitability An
  introduction to the US personal income tax

2
Today

• More on taxation
• What should be taxed in order to gain efficiency?
• Tax evasion versus tax avoidance
• Underground economies
• An introduction to the US personal income tax
• Defining income
• Money value
• Income used for tax purposes
• Computation of tax liability
• Exemptions, deductions, credits, marginal tax
  rates, inflation, the alternative minimum tax

3
Recall from last lecture

• Taxes will sometimes change behavior so much that
  total taxes collected may actually go down
• Example Yacht tax in the early 1990s
• Tax on yachts over 100,000 purchased in the US
• People bought yachts in other countries
• Net economic impact
• 16.6 million in taxes collected (less than the
  31 million predicted)
• Less income tax paid by workers (7,600 jobs lost
  in the US)

4
Efficient taxation/tax dodging

• Although the yacht tax was likely implemented to
  be equitable, efficiency suffered on all
  margins
• Excess burden due to the tax
• Decreased overall tax revenue collected due to
  jobs lost in the US
• What kinds of taxes lead to less excess burden?

5
Efficient taxation

• Assume that the amount of tax revenue collected
  is set at a constant level
• Should everything be taxed at the same rate in
  order to make the most efficient outcome?
• Taxing each good at the same rate is known as
  neutral taxation
• See Figure 16.1, p. 355
• Marginal excess burden

6
The Ramsey rule

• How do we tax to reduce excess burden?
• Ramsey rule
• Percentage reduction in quantity demanded for
  every good is the same
• Back to our old question Should everything be
  taxed at the same rate in order to make the most
  efficient outcome? NO
• One other concept to keep in mind
• Marginal excess burden generally increases as the
  tax increases

7
Equity concerns

• From the Ramsey rule, inelastic goods should be
  taxed at higher rates in order to gain efficiency
• Coffee
• Theater/opera
• Salt
• Many prescription drugs
• Example Insulin needed to live

8
Should we look at fairness, too?

• Many people believe that fairness is just as
  important as efficiency
• This type of person would
• Probably not want to tax insulin
• Impose a higher tax on goods that high-income
  consume more
• Not want to impose a lump sum tax

9
Tax evasion/tax avoidance

• Tax evasion
• Not paying taxes that are legally owed to a
  government
• Tax avoidance
• Altering behavior to legally pay less in taxes

10
Examples of tax avoidance

• Recall yacht tax in the early 1990s
• Tax on yachts over 100,000 purchased in the US
• Tax avoidance People bought yachts in other
  countries
• Net economic impact in the US was negative
• 18th century tax in Brazil
• Tax on finished churches
• Tax avoidance Build churches that were complete
  except for some trivial part that was not built
• See bottom picture on p. 371
• This church is not finished since it is missing
  one of its towers

11
Tax evasion theory

• Marginal benefit of cheating on taxes is constant
• 1 for each dollar in taxes avoided
• Marginal cost is increasing
• Probability of getting caught cheating increases
  as the number of red flags increases
• If MB gt MC for some people (for the first dollar
  in tax evasion), an underground economy develops
• See Figures 16.5 and 16.6, p. 373 and 374,
  respectively
• Figure 16.5 Tax evasion is positive
• Figure 16.6 Tax evasion is zero

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Summary Efficient taxation/tax dodging

• Efficient taxation comes from the Ramsey rule
• Percentage reduction in quantity demanded for
  every good is the same
• Equity concerns are important in many peoples
  minds
• Tax evasion and tax avoidance are used to lower
  the amount of taxes a person pays
• Note that tax evasion is illegal

13
The US Personal Income Tax

• About 45 of federal revenues are generated
  through personal income taxes
• Federal taxes are easy and simple to understand,
  right?
• See Figure 17.1, p. 381 for the answer

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Digesting federal income tax liability
Wages and compensation, interest, dividends,
capital gain (or loss), business income (or
loss), pensions, farm income (or loss), rents,
royalties, Social Security benefits, etc.
Trade or business expenses, moving expenses,
educator expenses, self-employed health insurance
premium payments, student loan payments, tuition
and fees, alimony paid, etc.
Charitable contributions, home mortgage interest,
state and local taxes, medical expenses in excess
of 7.5 of AGI, casualty and theft losses,
non-reimbursed employee expenses Phase out with
income Differs by filing status

• Tax Base
• Above-the-line deductions
• Adjusted Gross Income
• - Exemptions
• Larger of standard deduction or itemized
  deductions
• Taxable Income
• tax rate
• Tax liability before credits
• Tax credits
• Regular tax liability

Phase-out with income
Child tax, additional child tax, EITC, HOPE and
Lifetime Learning, electric vehicles, health
coverage tax, adoption, mortgage interest,
retirement savings contribution, child and
dependent care credit, credit for the elderly or
the disabled, D.C. First-Time homebuyers credit,
etc. Phase-out with income
Six ordinary rates (10, 15, 25, 28, 33,
35) differs by filing status special rates for
dividends and capital gains
Start over to determine AMT tax liability using
AMT base. Pay tentative AMT liability in excess
of regular tax liability
Pay tax or claim refund
15
How should income be defined?

• Haig-Simons definition of income
• Money value of the net increase in an
  individuals power to consume during a period
  (R/G p. 382)
• Besides traditional income, what should be
  counted according to this definition?
• Pension contributions, insurance purchases, and
  in-kind benefits given by an employer
• Any monetary or in-kind transfer from the
  government
• Capital gains

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Is all Haig-Simons income taxed?

• No
• Interest on state and local bonds
• Legal issues?
• Makes these bonds more attractive
• Unrealized capital gains
• Leads to lock-in effect
• People tend to hold on to assets longer than
  optimal to avoid paying taxes on the gains
• Pension and some retirement contributions (until
  benefits are received)
• Education Savings Accounts

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Other features of the US tax system

• Exemptions
• 3,300 per family member is 2006
• Deductions
• Standard deduction
• 5,150 per single filer in 2006
• 10,300 per joint filer in 2006
• Fixed amount, no documentation needed
• Itemized deductions
• Unreimbursed medical expenses above 7.5 of AGI
• State and local income and property Taxes
• Certain interest expenses
• Charitable contributions

18
More on simplicity

• The Tax Reform Act of 1986 (TRA86) tried to
  simplify the tax system
• Increased standard deduction
• Fewer people needed to itemize deductions
• Personal exemption increased substantially ?
  Fewer people needed to file tax returns
• Since 1986
• Tax laws became more complicated
• About 15,000 changes to the tax code

19
More on simplicity

• Is the tax code too complex?
• Some support a flat income tax
• Same tax rate to everyone and each component of
  income
• No deductions
• Little room for personal exemptions and business
  expenses
• Criticism of flat income tax
• Move tax burden from rich to middle class

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Marginal tax rates
Official Statutory Tax Rate Schedule (2006) Official Statutory Tax Rate Schedule (2006) Official Statutory Tax Rate Schedule (2006) Official Statutory Tax Rate Schedule (2006)
Single Returns Single Returns Joint Returns Joint Returns
Taxable Income Marginal Tax Rate Taxable Income Marginal Tax Rate
0-7,550 10 0-15,100 10
7,550-30,650 15 15,100-61,300 15
30,650-74,200 25 61,300-123,700 25
74,200-154,800 28 123,700-188,450 28
154,800-336,550 33 188,450-336,550 33
336,550 and over 35 336,550 and over 35
Source http//www.irs.gov/formspubs/article/0,,i
d150856,00.html
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Marginal tax rates
Official Statutory Tax Rate Schedule (2007) Official Statutory Tax Rate Schedule (2007) Official Statutory Tax Rate Schedule (2007) Official Statutory Tax Rate Schedule (2007)
Single Returns Single Returns Joint Returns Joint Returns
Taxable Income Marginal Tax Rate Taxable Income Marginal Tax Rate
0-7,825 10 0-15,650 10
7,825-31,850 15 15,650-63,700 15
31,850-77,100 25 63,700-128,500 25
77,100-160,850 28 128,500-195,850 28
160,850-349,700 33 195,850-349,700 33
349,700 and over 35 349,700 and over 35
Source http//www.irs.gov/formspubs/article/0,,i
d164272,00.html
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Inflation issues

• Notice that the ranges on the marginal tax rate
  tables increase from year to year
• About 3.5-4 from 2006-2007 tax years
• Increases account for inflation
• Taxes are on real income, so to speak
• Alternative minimum tax (AMT)
• Not adjusted for inflation ? More Americans are
  subject to the AMT each year
• Under current law, 28.5 million taxpayers
  expected to be subject to AMT in 2015

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Summary The US Personal Income Tax

• The US Personal Income Tax system is notoriously
  complex
• Most of Haig-Simons income is counted, but not
  all
• Exemptions and deductions lower the tax burden on
  Americans
• Marginal tax rates increase as income increases