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THE THEORY OF INCOME TAXATION
C h a p t e r 13
Income Tax
Taxes on personal income represent the dominant source of revenue for federal government in the U.S.
Accounted for 44% of federal income in 2006
Also used by state governments
Before 1913, major source of revenue for federal government was customs duty, or tariffs.
A 1913 constitutional amendment empowered Congress to levy taxes on personal and business incomes.
Chapter discussion assumes that all income, regardless of its source or use, is taxed at the same rate.
Comprehensive Income
Comprehensive income is the sum of a person’s annual consumption expenditures and the increment in that person’s net worth in a given year:
I = C + ΔNW
Concept also called the Haig-Simons definition of income
Net worth is the value of a person’s assets held at any point in time less the value of a person’s liabilities, or debts.
Capital gains are increases in the value of assets over the accounting period.
Sources of Personal Income
Sources and Uses of Income
Net capital gains are capital gains minus capital losses
Sources are always equal to uses
Income-in-Kind
Income in the form of goods and services rather than cash payments
Home production of goods and services
Occupations allowing workers flexible hours and freedom from pressures
Serious problem involved in administering income tax is treatment of nonmonetary transactions
Taxation of all types of income-in-kind infeasible
Some easy to tax, such as fringe benefits provided by employers (medical and life insurance, vehicles, etc.)
Flat-Rate Income Tax
Reformers suggest that U.S. tax system would be more efficient with a flat-rate income tax.
No loss in efficiency will occur in how people spend money or earn it
The tax, however, is likely to distort choices made concerning allocation between work and leisure and between consumption and saving or productive investment.
Flat-Rate Income Tax
Income and Substitution Effects
Impact of tax on work effort depends on income and substitution effects of tax-induced reduction in wages.
Tax lowers implicit price of leisure by reducing the return from work effort.
Income tax results in a substitution effect that is unfavorable to work effort; therefore tends to increase consumption of leisure.
Income effect, however, provides an incentive to increase work effort when leisure is a normal good; individual tends to work harder to maintain previous (before tax) income.
Income and Substitution Effects
Perfectly Inelastic Labor Supply
Tax-induced distortion in work-leisure choice used to measure excess burden of tax must be based only on change in work hours due to substitution effect caused by tax
Labor supply response must be adjusted to remove income effect of tax-induced wage change
Curve showing how hours worked per day vary with wages when income effect of wage changes is removed is a compensated labor supply curve
Perfectly Inelastic Labor Supply
Income tax on labor reduces wages by full amount of tax per hour when supply of labor is perfectly inelastic:
Perfectly Inelastic Labor Supply
Excess burden of the income tax is not zero because substitution effect of tax reduces labor hours supplied per year; lump sum used, workers work more hours:
Elasticity of Supply of Labor Exceeding Zero
Empirical Evidence on Labor Supply
For males between ages of 25 and 55, income effect of wage changes roughly equal to substitution effect.
May be that substitution effect of wage reductions caused by income tax is large, but offset by equally large income effect
Studies conclude that income taxes have little effect on labor supply decisions of workers who provide main source of income to household but have much greater effect on labor supply of other household members.
The Payroll Tax
Taxation of Interest Income
Taxation of interest income lowers return to saving but can either increase or decrease actual amount of saving observed.
Indifference curve analysis can be used to analyze one’s choice between consumption and saving.
Marginal rate of time preference (MRTP) is the slope of an indifference curve for present and future consumption multiplied by –1.
Taxation of Interest Income
Savings and Taxation of Interest Income
Incidence of Taxes on Interest Income
If annual amount of saving is responsive to tax-induced declines in net interest payments, tax can be shifted from savers to borrowers through increase in market rate of interest
Higher interest offsets some tax burden on savers, but increases production costs, resulting in tax being shifted to consumers in form of higher prices
Decreased investment results in slower growth of nation’s capital stock
Lower ratio of capital to labor decreases labor productivity, implying that, in competitive labor markets, wages would be lower than if there were no tax on interest income

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