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TAXATION OF PERSONAL INCOME IN THE UNITED STATES
C h a p t e r 14
Tax Reform
Income tax in the U.S. is continually being reformed in hopes of simplifying it.
In 2001, Congress enacted the Economic Growth and Tax Relief Reconciliation Act (EGTRRA):
Reduction in MTRs for all brackets
Reduction in the “marriage penalty”
Increase in child credits, tuition credits, contribution to tax-deferred retirement accounts
Jobs and Growth Tax Relief Reconciliation Act of 2003 accelerated many EGTRRA provisions.
EGTRRA changes will expire at the end of 2010 unless it is renewed by Congress.
Obama Plan
Cut income tax for households with less than $250,000 annual income
Increases in marginal tax rates on the upper 2 percent of income earners
Tax cuts for senior citizens, those without health insurance, first-time homebuyers, and families with college age children
Calculating Taxable Income
Taxable income – portion of income received by individuals that is subject to personal income tax
Gross income – all income received during the year from taxable sources
Adjusted gross income (AGI) – gross income minus any allowable adjustments
Personal exemption – certain sum of money a taxpayer is allowed to deduct from AGI that varies with number of dependents claimed
Standard deduction – fixed dollar amount that is adjusted for inflation each year and varies with filing status of the taxpayer
Itemized deductions – expenses deducted as alternative to the standard deduction from AGI in figuring taxable income
Calculating Taxable Income
Tax Rate Structure
Different tax rate schedules apply to different taxpayers, depending on filing status:
Single, married filing jointly, married filing separately, head of household
Tax bracket is a range of income subject to a given marginal tax rate (MTR).
As of 2009, the tax schedule contained six tax brackets.
Tax Rate Structure
Tax Preferences
Exclusions, exemptions, and deductions from the tax base
Justified on various grounds:
Administrative difficulty in taxing certain activities
Improving equity
Encouraging private expenditures that generate external benefits
Excess Burden of Tax Preferences
Tax preferences can distort relative prices of items and activities in ways that lead to efficiency losses in markets.
Marginal tax benefit of an activity is extra tax reduction resulting when an individual engages in it.
Unless marginal tax benefits are balanced by marginal external benefits, tax preferences decrease efficiency by encouraging more than the efficient amount of an activity to be undertaken.
Excess Burden of Tax Preferences
Excess Burden of Tax Preferences
Exclusions from Income
Income-in-kind and imputed housing rental income: Much income-in-kind is difficult to measure and therefore typically excluded from taxable income
Fringe benefits: Though employer contributions to programs such as pension plans constitute compensation of workers, they are excluded from current gross income
Transfers: Most government transfers, as in the form of government income support or social insurance payments, are excluded from gross income
Exclusions from Income
Capital gains and dividends: Only realized capital gains, or those sold for cash or exchanged for another asset, are included in taxable income
Interest on state and local bonds: Exclusion of interest earned on state and local government bonds from taxable income represents a subsidy to these governments
Miscellaneous exclusions and adjustments:
Scholarships and fellowships for degree candidates
Saving for retirement in special accounts
Itemized Deductions from AGI
Medical expenses: Unreimbursed medical expenses in excess of 7.5% of AGI are tax deductible
State and local income and property taxes: These deductions constitute indirect subsidies to those governments, encouraging them to adjust tax rate structures to include more types of taxes that are deductible from AGI under federal income tax
Itemized Deductions from AGI
Interest payments: Those such as interest on mortgages of first and second homes and interest incurred to make investments are deductible
Charitable contributions: Constitute a subsidy to private transfers to charitable and other nonprofit organizations, including educational institutions
Miscellaneous deductions: Business travel expenses, for example, can be deducted under some circumstances
Deductions Versus Credits
Credits are based on a certain percentage of expense incurred; this percentage is fixed for all taxpayers regardless of income and MTRs.
Value of deductions varies with taxpayer’s marginal tax bracket in terms of reduction in taxes that they entail
Taxpayer Relief Act of 1997 expanded scope of tax credits available to families with children
Credits also available to taxpayers with higher education expenses
Tax Expenditures
Losses in tax revenues attributable to tax preferences
Provide useful starting point for evaluating tax preferences in terms of loss in tax revenues
Elimination of tax preferences broadens tax base, allows lower rates of taxation without reducing revenues collected
Elimination of certain tax preferences would cause people to decrease tax-preferred activities and increase activities that still receive preferential treatment for tax purposes
Therefore, gains in revenue to the Treasury due to elimination of tax preferences are overestimated
Tax Expenditures
Alternative Minimum Tax (AMT)
Conceived as a way to ensure that a few wealthy taxpayers paid a reasonable amount of tax on their gross income
Has increased tax liability of many middle- and upper-middle-income taxpayers in recent years
Brackets under AMT not indexed for inflation
Set up as a shadow tax rate structure applied to taxpayers with significant amounts of certain tax preferences
Unless current rules change, number of taxpayers subject to AMT expected to climb from 3.5 million in 2005 to 36 million by 2010
Alternative Minimum Tax (AMT)
After allowable exemption deducted, the sum calculated is subject to the following tax rate schedule:
The first $175,000 of net income calculated for purposes of AMT is subject to 26% tax rate
Amounts over $175,000 subject to 28% tax rate
AMT exemption phased out for upper-income taxpayers, which essentially increases effective AMT tax rate above 28% for these tax filers
The Flat Tax
Has been proposed to simplify taxes and solve many of the nation’s problems, including low growth
Would be a general tax on a comprehensive income tax base with no exemptions or deductions
Would reduce excess burden of tax by eliminating distortions that arise from tax preferences
Most proposals exempt low-income households from taxation
Shift from Progressive to Flat-Rate Tax
Flat-rate tax would tax all income at the same rate; progressive taxation implies increase in taxation rates as income increases.
Change from progressive to flat-rate tax would change the distribution of tax burden:
Low-income groups harmed by having both average and marginal rates of taxation increased
Middle-income groups see average rate of taxation increase but marginal tax rates decrease
Upper-income groups have both average and marginal rates of taxation reduced
Inflation
Inflation implies that nominal income increases faster than real income.
Bracket creep is an increase in effective rates of taxation of real taxable income when tax rate schedules are based on nominal values of income rather than real values.
Indexation of tax brackets can prevent bracket creep, but inflation can still cause serious distortions in taxation of capital income.
Creates problems in accurately measuring interest income and capital gains
Debtors benefit during inflation because outstanding balances on loans decrease in real terms
The Tax System and Marriage
Income-splitting effect divides the income of both married taxpayers equally between them in computing taxes and pulls the income of the spouse who earns higher income into a lower tax bracket.
Under the so-called “marriage tax”, the rate for equal-income married taxpayers rose above the corresponding rate for two single taxpayers with the same income.
Tax rate schedule for a married person filing separately has tax brackets that result in higher tax rates compared to single taxpayers
Marriage penalty somewhat reduced for lower-income taxpayers
EGTRRA addressed several concerns about the marriage penalty.
The Consumption Tax
To encourage saving, reformers have suggested allowing taxpayers to deduct saving for any purpose from taxable income:
Withdrawal of saving, negative saving (loans) would be added to income
Tax base, therefore, becomes consumption.
If savings increase, would increase supply of loanable funds in credit markets and lower interest rates
Would shift burden of taxation from owners of capital toward workers
Over long run, however, if economic growth, all benefit in form of high wages, job opportunities
Effective Tax Rates
Congressional Budget Office (CBO) uses broad measure of family income
Sum of wages, salaries, business income, rents, interest, dividends, realized capital gains, cash transfer payments, payroll taxes (employers), other business payments such as contributions to retirement plans
Then divides families into five groups, ranked according to income
Estimates taxes paid by each group, divides by gross income of each group
Results show average effective tax rate, or actual taxes as a percent of a measure of gross income for each group
Effective Tax Rates
Distribution of Federal Tax Burden
Effective Tax Rates, Single Filer
Effective Tax Rates, Single Filer
Effective Tax Rates, Married Couple
Effective Tax Rates, Married Couple
Income Tax Progressivity Index
Relative Index 1980-2003
State Income Taxes
As of 2008, all but seven states used personal income taxation as major source of revenue.
Excludes Alaska, Florida, Nevada, South Dakota, Texas, Washington, Wyoming
Most states have progressive rate structures.
California, Massachusetts, Michigan, Pennsylvania use flat-rate proportional rate structure
On average, income tax generates nearly 30% of yearly revenue for state governments.
Most states link personal income tax to federal income tax in some way.
State Income Taxes
EGTRRA introduced many changes that adversely affected tax collections for state government:
Expansion in tax-deferred retirement plan contribution amounts reduced AGI, which is the starting point for many state income taxes
More generous depreciation allowances for business reduced size of tax base for states that link income tax base to federal tax base
Allowing deduction of education expenses even if taxpayers do not itemize deductions contributed to state revenue losses
State Income Taxes
State Income Taxes
State Income Taxes
State Income Taxes

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