More on taxation

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

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

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)

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?

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

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

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

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

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

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

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 > 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

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

people’s minds Tax evasion and tax avoidance are used to

lower the amount of taxes a person pays Note that tax evasion is illegal

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

Digesting federal income tax liability 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

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.

Phase-out with income

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

Six ordinary rates (10%, 15%, 25%, 28%, 33%, 35%);

differs by filing status; special

rates for dividends and capital gains

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

homebuyer’s credit, etc.; Phase-out with income

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

How should income be defined? Haig-Simons definition of income

“Money value of the net increase in an individual’s 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

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

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

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

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

Marginal tax rates

Official Statutory Tax Rate Schedule (2006)

Single Returns Joint ReturnsTaxable Income Marginal

Tax RateTaxable 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,,id=150856,00.html

Marginal tax rates

Official Statutory Tax Rate Schedule (2007)

Single Returns Joint ReturnsTaxable Income Marginal

Tax RateTaxable 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,,id=164272,00.html

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

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