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18
18.1 Types of Taxation
18.2 Structure of the Individual Income Tax in the United States
18.3 Measuring the Fairness of Tax Systems
18.4 Defining the Income Tax Base
18.5 Externality/Public Goods Rationales for Deviating from Haig-Simons
18.6 The Appropriate Family Unit of Taxation
18.7 Conclusion
Taxation: How it Works and What it Means
18.1
In January, 2001, President George W. Bush was faced with a rare opportunity: a projected federal budget surplus.
Bush quickly decided that the government should use this surplus to lower the federal tax burden.
Tax rates lowered across the board, with rates falling from 15%–39.6% to 10%–35%.
Estate tax was phased out.
These cuts were further extended by the Jobs and Growth Tax Relief Reconciliation Act of 2003 which lowered the maximum tax rate on stock dividend and capital gains income, and increased deductions from the corporate tax.
Introduction
18.1
Unfortunately, by the time President Bush left office this surplus had become a very large deficit.
An ongoing debate throughout the Obama presidency was whether and how to end the Bush tax cuts.
Obama stated tax cuts for the wealthiest Americans are the tax cuts that are least likely to promote growth.
Republicans argued that higher taxes in the midst of a recession would hurt the economy further by punishing job-creating small businesses that pay taxes under the individual income tax code.
Introduction
18.1
Ultimately, both sides compromised:
The tax cuts were extended for another two years.
When they expired (again) in 2012, a compromise was reached through the American Taxpayer Relief Act of 2012.
Introduction
18.1
The American Taxpayer Relief Act:
Made permanent all tax cuts for households making under $450,000;
Above $450,000, tax cuts expired and top tax rate increased from 35% to 39.6%.
Tax deductions and tax credits began to be phased out for those making over $250,000 or $300,000, for individuals and couples, respectively.
The estate tax increased from 35% to 40%.
These debates highlight the important role that taxes play in both the political arena and government policy making in the United States.
Introduction
18.1
Taxes on Earnings
Payroll tax: A tax levied on income earned on one’s job.
Taxes on Individual Income
Individual income tax: A tax paid on individual income accrued during the year.
Capital gains: Earnings from selling capital assets, such as stocks, paintings, and houses.
Types of Taxation
18.1
Taxes on Corporate Income
Corporate income tax: Tax levied on the earnings of corporations.
Taxes on Wealth
Wealth taxes: Taxes paid on the value of the assets, such as real estate or stocks, held by a person or family.
Property taxes: A form of wealth tax based on the value of real estate, including the value of the land and any structures built on the land.
Estate taxes: A form of wealth tax based on the value of the estate left behind when one dies.
Types of Taxation
18.1
Taxes on Consumption:
Sales taxes: Taxes paid by consumers to vendors at the point of sale.
Excise tax: A tax paid on the sales of particular goods, such as cigarettes or gasoline.
Taxes on Consumption
18.1
Tax Revenues by Type of Tax in the United States
(2010, of Total Tax Revenue)
Federal State and Local Total
Individual income taxes 41.6% 13.9% 35.2%
Social Security contributions 34.8 0 26.7
Corporate income tax 15.1 4.4 12.6
Consumption tax 2.9 21.6 7.2
Property tax 0 18.5 4.3
Other 5.6 41.6 14
The federal government receives a large portion of its tax revenue from individual income tax and payroll taxes. The two major sources of revenues for state and local governments are sales taxes and local property taxes.
18.1
International Tax Revenues by Type of Tax
(2010, % of Total Tax Revenue)
Norway Denmark OECD
Average
Individual income taxes 24% 55% 25%
Social Security contributions 23 2 27
Corporate income tax 22 5 8
Consumption tax 26 30 31
Property tax 3 4 5
Other 2 4 4
Consumption taxes provide a greater portion of national government revenue in all OECD countries than in the United States.
18.2
Income tax is assessed on adjusted gross income minus deductions and exemptions.
Gross income: The total of an individual’s various sources of income.
Adjusted gross income (AGI): An individual’s gross income minus certain deductions, such as contributions to IRAs.
Taxable income: The amount of income left after subtracting exemptions and deductions from adjusted gross income.
Structure of the Individual Income Tax in the United States: Computing the Tax Base
18.2
Adjustments vary over time, but currently include:
Some contributions to retirement savings
Alimony paid to a former spouse
Health insurance premiums paid by the self-employed
One-half the payroll taxes paid by the self-employed
Educator expenses and interest paid on student loans
Contributions to Health Savings Accounts
Expenses for job-related moves
Interest paid on student loans
Individual Income Tax: Computing the Tax Base
18.2
To form AGI from gross income, subtract exemptions and deductions.
Exemption: A fixed amount a taxpayer can subtract from AGI for dependent member of a household, as well as for the taxpayer and the taxpayers spouse.
Taxpayers can take one of two kinds of deductions:
Standard deduction: A fixed amount that a taxpayer can deduct from taxable income.
Itemized deductions: Alternative to the standard deduction, whereby a taxpayer deducts the total amount of money spent on various expenses, such as gifts to charity and interest on home mortgages.
Individual Income Tax: Computing the Tax Base
18.2
Allowable deductions for claiming itemized deductions include:
Medical and dental expenses exceeding 10% of AGI
Other taxes paid, such as state or local income tax
Interest paid on investments and home mortgages
Gifts to charity
Casualty and theft loss
Unreimbursed employee expenses
Individual Income Tax: Computing the Tax Base
18.2
U.S. Federal Income Tax Rate Schedule, 2015
Consumption taxes provide a greater portion of national government revenue in all OECD countries than in the United States.
18.2
Tax credits: Amounts by which taxpayers are allowed to reduce the taxes they owe to the government through spending, for example on child care.
Withholding: The subtraction of estimated taxes owed directly from a worker’s earnings.
Refund: The difference between the amount withheld from a worker’s earnings and the taxes owed if the former is higher.
Tax Rates and Taxes Paid
18.2
Example: Computing Jack’s Taxes
The government withheld $2,000 from his earnings. Jack is due a refund of $545, the difference between what was withheld and the amount he owes.
18.2
In 1969, Treasury Secretary Joseph W. Barr found that 155 high-income households had earned over $200,000 in 1966 but paid zero income taxes.
The alternative minimum tax was meant to make sure high-earners still paid taxes.
Alternative Minimum Tax: A tax schedule applied to taxpayers with a high ratio of deductions and exemptions to total income.
Requires that income (before subtracting exemptions and deductions) be taxed at 26% or more.
APPLICATION: Fixing the AMT
18.2
The AMT allows a single deduction of $53,600 for individuals and $83,400 for joint filers…
…but these numbers are not indexed for inflation, so many households end up facing the AMT.
The AMT adds dramatic complexity to the tax code, so repealing it has broad support…
…but it is an important source of revenue; repeal would cost at least $1.3 trillion between 2011 and 2022.
APPLICATION: Fixing the AMT
18.2
In 2012, a major “fix” was proposed to the AMT which raised the threshold and indexed them for inflation.
The fix was more affordable due to partially ended tax cuts from prior years, costing $350 billion over next decade.
Under the revision, 3.9% of taxpayers versus 41.8% would be hit by the AMT.
APPLICATION: Fixing the AMT
18.3
Fairness is an important concern and elusive goal.
Two key features of any tax system:
Marginal tax rate: The percentage that is paid in taxes of the next dollar earned.
Average tax rate: The percentage of gross income that is paid in taxes.
In the United States, the marginal tax rate rises with income, from 10% to 35%.
Measuring the Fairness of Tax Systems
18.3
Two distributional goals are considered in measuring tax fairness:
Vertical equity: The principle that groups with more resources should pay higher taxes than groups with fewer resources.
Horizontal equity: The principle that similar individuals who make different economic choices should be treated similarly by the tax system.
Vertical and Horizontal Equity
18.3
Vertical equity likely requires progressive taxation.
Progressive: Tax systems in which effective average tax rates rise with income.
Proportional: Tax systems in which effective average tax rates do not change with income, so that all taxpayers pay the same proportion of their income in taxes.
Regressive: Tax systems in which effective average tax rates fall with income.
Measuring Vertical Equity
18.3
“Fairness” is ambiguous, and politicians pick the meaning that bests suit them.
Consider the income tax cuts proposed by President Bush and signed into law by Congress in 2003:
44% of the tax cuts went to the top 1% of payers…
…but top taxpayers pay 38% of income taxes, and
…they pay only 30% of all taxes, due to the other tax revenues being collected from proportional taxes, and
…34 million families with children would receive an average tax cut of $1,549 each.
APPLICATION: The Political Process of Measuring Tax Fairness
What kind of income should be taxed
Haig-Simons comprehensive income definition: Defines taxable resources as the change in an individual’s power to consume during the year.
Potential annual consumption: Total consumption during the year, plus any increases in wealth.
Difficulties:
Defining power to consume/ability to pay
Nonconsumption expenditures
18.4
Defining the Income Tax Base: The Haig-Simons Comprehensive Income Definition
18.4
Haig-Simons promotes horizontal equity by treating all income equally.
One reason for deviation is to account for expenses not associated with desired consumption.
Deductions for property and casualty losses
Deduction for medical expenditures
Deduction for state and local tax payments
Defining the Income Tax Base: Deviations due to Ability-to-Pay Considerations
18.4
Another reason for deviation is some expenditures are not for consumption but rather reflect the cost of earning a living.
Legitimate costs of doing business should be deducted from income.
Difficulties arise in defining “legitimate.”
Defining the Income Tax Base: Deviations due to Costs of Earning Income
18.4
Hard to determine appropriate business deductions:
A rabbi claimed as a business expense the $4,031 he spent on 700 guests who attended his son’s bar mitzvah.
Tax court found the Rabbi “was not required to invite the entire…congregation…as a condition of his employment.”
An exotic dancer claimed breast implants as a business expense.
Tax court agreed since the implants were far too large for the dancer to derive pleasure from.
APPLICATION: What Are Appropriate Business Deductions
18.4
The entertainer Dinah Shore claimed several dresses as business expenses, prompting an investigation by the IRS.
“Dinah Shore ruling”: A dress may be deducted as a business expense only if it is too tight to sit in.
A man tried to deduct $30,000 in expenses on illegal drugs.
Allowed to claim deductions, he was sentenced for criminal charges.
Many OECD countries have traditionally allowed/ treated foreign bribes as business expenses.
APPLICATION: What Are Appropriate Business Deductions
18.5
One reason to deviate from Haig-Simons is to correct externalities.
Charitable giving likely underprovided.
People may give to homeless shelters because of the tax break, but these would be underfunded otherwise.
Externality/Public Goods Rationales for Deviating from Haig-Simons: Charitable Giving
18.5
Alternatively, the government could provide homeless shelters. Why not do so
If the government subsidizes homeless shelters, the amount of private charitable giving to those shelters would most likely fall.
When the government tax subsidizes charitable giving, it may “crowd in,” or increase, private contributions.
Spending Crowd-Out Versus Tax Subsidy Crowd-In
18.5
Tax breaks have marginal and inframarginal effects.
Marginal impacts: Changes in behavior the government hopes to encourage through a given tax incentive.
Inframarginal impacts: Tax breaks the government gives to those whose behavior is not changed by new tax policy.
Marginal Versus Inframarginal Effects of Tax Subsidies
18.5
Mathematically, the government should use a tax break instead of direct spending if:
the increase in charity per $ of tax break >
1 — reduction in charity per $ of government spending.
If this holds, then giving more of a tax break (and reducing government spending) increases charitable giving.
Several studies have concluded that for each 1% fall in the price of charitable giving, the amount of giving rises by 1%.
Effects of Tax Subsidies Versus Direct Spending
18.5
Direct government provision imposes preferences about how funds are spent.
Tax subsidies to private individuals respects the preferences of citizens.
But the private sector may not have the appropriate mechanisms in place to ensure efficient distribution of charitable spending.
Most individuals do little research before donating.
This approach has the potential to lead to gifts that don’t provide much benefit to the intended target.
Consumer Sovereignty Versus Imperfect Information
18.5
Home ownership is subsidized through the home mortgage interest deduction.
Mortgage: Agreement to use a certain property, usually a home, as security for a loan.
Rent is not tax deductible.
Home ownership may provide externalities through responsible citizenship.
Housing
18.5
The “American Dream Demonstration” subsidized home ownership for a random treatment group.
Subsidy increased home ownership by 7 11%.
But no external benefits:
Treatment and control groups equally involved in civic activities.
Treatment group spent more on home improvements, but only on the inside, providing no external benefit.
EVIDENCE: The Social Benefits of Homeownership
18.5
Despite wide variation in this tax subsidy, the home ownership rate has remained essentially constant since the 1950s, at about 65%.
The tax subsidy is inducing individuals to spend more on houses, but not moving people from renting to buying.
Effect of Tax Subsidies for Housing
18.5
Tax subsidies can be offered as deductions or credits.
Tax deductions: Amounts by which taxpayers are allowed to reduce their taxable income through spending on items such as charitable donations or home mortgage interest.
Tax credits allow taxpayers to reduce the amount of tax they owe to the government by a certain amount (e.g., the amount they spend on child care).
How should the government decide which to use
Tax Deductions Versus Tax Credits
18.5
Consider replacing charitable giving deduction with a tax credit for up to $1,000.
For people giving less than $1,000, the credit provides a much stronger incentive to increase giving.
Once a person gives more than $1,000, there is no more benefit from the tax credit.
Policy preference depends on:
The nature of the demand for the subsidized good.
How important it is to achieve some minimal level of the behavior.
Efficiency Considerations
18.5
On vertical equity grounds, tax credits are more equitable than deductions.
The value of a deduction rises with one’s tax rate, making deductions regressive.
Credits, on the other hand, are available equally to all incomes so that they are progressive.
Equity Considerations
18.5
Should tax credits be refundable
Refundable: Describes tax credits that are available to individuals even if they pay few or no taxes.
Many conservatives object to the notion that those who owe little or no income taxes get a refund.
Supporters note that, while low-income families pay little income tax, they do pay a large share of their income on other taxes.
APPLICATION: The Refundability Debate
18.5
Tax refunds and the child credit:
The child credit was a nonrefundable tax credit for low- and middle-income families.
In 2001 tax cuts, families received a refund for at most 10% of their income above $10,500.
2003 tax cuts expanded the credit, and the President said families would get a $400 check in the mail, but last-minute changes prevented low-income families from receiving the benefit of the increase.
In 2009, the earnings threshold was lowered so an additional 3 million children qualified for the credit, thus increasing the benefit to 10 million children.
APPLICATION: The Refundability Debate
18.5
Deviations from Haig-Simons are tax expenditures.
Tax expenditures: Government revenue losses attributable to tax law provisions that allow special exclusions, exemptions, or deductions from gross income, or that provide a special credit, preferential tax rate, or deferral of liability.
Tax expenditures are enormous, predicted to be $1.3 trillion in 2016.
Bottom Line: Tax Expenditures
18.5
Selected Major Tax Expenditures in 2014
The government was projected to lose $1,205.9 billion. The largest single tax expenditure is the exclusion of employer-provided health insurance premiums from taxable income, which cost the federal government $212.8 billion in forgone income tax revenues.
18.6
How should couples be taxed
We might like a tax system to satisfy three principles:
Progressivity
Across-Family Horizontal Equity
Across-Marriage Horizontal Equity
It is impossible to achieve all three goals at once.
The Problem of the “Marriage Tax”
18.6
Any tax system that tries to achieve horizontal equity and progressivity has a marriage tax for some people.
Marriage tax: A rise in the joint tax burden on two individuals from becoming married.
Progressivity, with taxes applied to individual income, means that two couples with different earnings distributions have different tax burdens.
Taxing family incomes leads to a marriage tax.
The Problem of the “Marriage Tax”
18.6
The Problem of the “Marriage Tax”
Individual Income Individual Tax Family Tax with Individual Filing Family Tax with Total Family Income
Michelle $140,000 $32,000 33,000 35,000
Barack 10,000 1,000
Bill 75,000 13,000 26,000 35,000
Hilary 75,000 13,000 A progressive tax system based on total family income imposes a “marriage tax” on both couples, as they both pay more in tax as married couples than they would as singles. Consider a tax system with a 10% tax rate on income up to $20,000, a 20% marginal rate up to $80,000, and a 30% marginal rate on any income above $80,000.
18.6
Very large deductions for married couples relative to single tax filers would eliminate marriage tax.
But no set of deductions can make the system of family-based taxation marriage neutral.
Marriage Taxes in the United States
Some families face marriage subsidies, and some face marriage taxes.
Some families pay marriage taxes.
Marriage Taxes in Practice
18.6
Families with equal incomes are not paying equal taxes. There is no set of deductions that would make the system of family-based taxation marriage neutral, rather than providing subsidies to some marriages and taxing others.
Society might actually want to encourage marriage, not discourage it through marriage taxes.
High marginal tax rate on secondary earners could reduce the labor supply of secondary earners.
Marriage Taxes in Practice—Why We Care
18.6
The United States is almost alone in having a tax system based on family income.
Of the industrialized nations in the OECD,
19 tax husbands and wives individually…
…five (France, Germany, Luxembourg, Portugal, and Switzerland) offer marriage subsidies to virtually all couples through family taxation with income splitting.
Marriage Taxes Around the World
18.7
In this chapter, we set the stage for our study of taxation by discussing:
The different types of taxation used by the United States and the rest of the world.
How to measure tax “fairness.”
The key issues policy makers face in designing the base of income taxation.
Conclusion

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