Topic on Lecture 1 THE PERSONAL INCOME TAX*

Overview of the Chapter

Structure Exemptions and Deductions

Objectives of the Chapter

To understand the structure of income and to compute individual income tax liability. To compute the amount of extraction from taxable income.

Contents of Chapter
BASIC STRUCTURE Three major steps in the calculation of income tax liability: 1. Compute adjusted gross income (AGI) - total income from all taxable sourcess less certain expenses incurred in earning that income. 2. Convert AGI to taxable income the amount of income subject to tax by subtracting exemptions and deductions from AGI. 3. Calculate the amount of tax due. THE HAIG-SIMON (HS) INCOME Income is the money value of the net increase to an individuals power to consume during a period. The H-S criterion requires the inclusion of all sources of potential income in consumption, regardless of whether the actual consumption take place, and regardless of the form in which the consumption occurs. Items included in H-S income:

Wages and salaries Business profit Rents royalties Dividends

Interest Employer contributions to pensions and other retirement plans

Based on Harvey S. Rosen, Public Finance Chapter 15, 6 th Edition, 2002. L1 - 1

Employer for insurance

contributions employees

Transfer payment Capital gains Income in kind

Difficulties in attempts to use H-S criterion as a basis for constructing a tax system 1) 2) 3) Income must be measured net of the expenses of earning Unrealized capital gains and the imputed income from durables measurement are not easily. In kind services are hard to value.

Figure 1.1 Computation of federal personal income tax liability

Step 1
ADD Income from all taxable source: Wages Interest Rents dividends Business profits Realized capital gains Unemployed compensation

Step 2
SUBTRACT Certain business expenses

Step 3
APPLY Certain business expenses

SUBTRACT Eligible itemized deductions: Charitable contributions Certain medical expenses State income taxes Property taxes Certain net interest payments .. or SUBTRACT

SUBTRACT Tax credits

SUBTRACT Certain business expenses

TAX LIABILITY

ADJUSTED GROSS INCOME (AGI)

TAXABLE INCOME

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EXCLUDABLE FORMS OF MONEY INCOME Several forms of income that would be administratively relative easy to tax are partially or altogether excluded from adjusted gross income: Interest on State and Local Bonds Capital gains Employer contributions to benefit plans Gift and inheritances

EXEMPTIONS AND DEDUCTIONS Exemptions Exemptions are fixed amount per family member. Suppose: In 2001, the exemption = $2,900 is adjusted annually for inflation. So, for a husband and wife with 3 children, could subtract $14,500 from AGI. Exemptions are phased out for people with AGIs above certain levels. For joint returns, personal exemptions are reduced by 2 percentage points for each $2,500 (or fraction thereof) by which AGI > $199,450. Suppose: AGI = $250,000 ($250,000-$199,450)/$2,500 = 21 Hence, the family loses = 21*2% = 42% of its exemptions. 42%*14,500 = $6,090. Thus, the family can subtract $8,410 in determining its taxable income. More generally, the greater the exemption level, the greater is the progressivity with respect to average tax rates. This effect is reinforced when exemptions are phased out for high-income families. Deductions There are two kinds of deductions: (a) Itemized deductions

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Subtractions for specific expenditures cited in the law. The taxpayer must list each item separately on the tax return and be able to prove (at least in principle) that the expenditures have been made. (b) Standard deductions Reduces taxable income by a fixed amount. Deductibility and relative prices. Suppose:

The price of Z is = PZ Individuals marginal tax rate = t Hence, Zs effective price lower from PZ to (1-t)PZ

Important facts:

Because deductibility changes the relative price of the commodity involved, in general, we expect the quantity demanded to change. The higher the individuals value of t, the greater the value to the individual of a given dollar amount of deductions and the lower the effective price of the good.

Itemized deductions Itemized deductions are permitted for expenditures on particular goods and services. They are phased out at a high-income level. Itemized deductions change after tax relative prices, which often affects economic behavior. Major itemized deductions in the US tax code: Unreimbursed medical expenses that exceed 7.5 percent of AGI. State and local and property taxes. Certain interest expenses. Charitable contributions

Deductions versus credits The higher individuals marginal tax rate, the greater the value of a deduction of a given dollar amount. A tax credit is a subtraction from tax liability (not taxable income) Its value is independent of the individuals marginal tax rate.

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The choices between deduction and credit should depend at least in the part on the purpose of the exclusion:

If the motivation is to correct for the fact that a given expenditure reduces ability to pay deductions.

If the purpose is mainly to encourage certain behavior it is not clear whether credits or deductions are superior. A credit reduces the effective price of the favored good by the same percentage for all individuals. A deduction decreases the price by different percentage for different people.

Itemized deduction phaseout. Example:

Deductions 3% if AGI> $118,000 AGI = $130,000 Mortgage interest $15,000 Local property taxes $5,000 In the absence of the phase out : deductions = $20,000 Itemized deduction : ($130,000-$111,800)*3% = $546

Hence, Deduction are allowed = $19,454. The standard deduction

Introduced to simplify tax returns. (Itemized deduction are listed separately on individuals tax return, and in principle each one requires documentation to prove that the expenditure has indeed been made).

Adjusted annually for inflation.

RATE STRUCTURE Actually, there are four different rate schedules, one each for married people who file together (joint returns), married people who file separately, unmarried people, and single people who are heads of households.

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Table 1.1 Official statutory tax rate schedule, 2001 Single Returns Taxable Income Marginal Tax Rate $0 - $27,050 15% $27,050 - $65,550 $65,550 - $136,750 $136,750 - $297,350 $297,350 and over 28 31 36 39.6 Joint Returns Marginal Tax Rate 15% 28 31 36 39.6

Taxable Income $0 - $45,200

$45,200 - $109,250 $109,250 - $166,500 $166,500- $297,350 $297,350 and over

Rates under the AMT Certain types of income such as interest on state and local bonds are treated prefentially by the tax system. It is therefore possible for some households to have rather high incomes, yet pay little or no tax. The alternative minimum tax (AMT) is an attempt to ensure that people who benefit from some of these preferences pay at least some tax. AMT is essentially a shadow tax system with its own rules for computing the tax base and its own rate schedule. The calculation of the alternative tax base requires taking AGI and adding to it some of the income not taxed at ordinary rates. Clearly, AMT is an ad hoc method for adjusting the tax burdens of upper-income individuals. Effective versus Statutory Rates In general, there is a tendency for the rate of return on tax-preferenced items to fall by an amount that reflects the tax advantage. Because of this tendency, high-income individuals face higher tax rates on their capital income than their tax bills would suggest. They are taxed implicitly in the form of lower rates of return. A statute with lower marginal tax rates but a broader base would lead to a system with incidence as progressive as that of the current system, and perhaps more so. At the same time, a system with lower marginal tax rates would reduce excess burden and perhaps lower tax evasion. To restructure the income tax Flat tax. A flat tax has two attributes: It applies the same rate of tax to everyone and to each component of the tax base.

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It allows computation of the tax base with no deductions from total income except personal exemptions and strictly defined business expenses.

Proponent of the flat tax: Lowering marginal tax rats would reduce both excess burden of the tax system and the incentive to cheat. The simplicity gained would cut down on administrative costs and improve taxpayer morale. Opponents of the flat tax: It would probably redistributive more of the tax burden from the rich to the middle classes. There will be never be a simple income tax code.

Summary of Chapter
Computation of federal individual income tax liability has three major step: measuring total income (adjusted gross income), converting total income to taxable income, and calculating taxes due. A traditional benchmark measure of income is the Haig-Simons definition: Income during a given period is the net change in the individuals power to consume. The two principal subtractions from income are exemptions and deductions. Exemptions are fixed amount per family member. It phased out at high-income levels. Deductions are either standard or itemized. A standard deductions reduces taxable income by a fixed amount. Itemized deductions are permitted for expenditures on particular goods and services. They are phased out at highincome levels. Itemized deductions change after-tax relative prices, which often affects economic behavior.

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