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PERSONAL INCOME TAXES CHAPTER 35

WHERE PERSONAL INCOME TAXES FIT In 2008 the federal government collected $2,524 billion in taxes. $1,146 billion of that was collected from the personal income tax. The remainder was collected in payroll taxes (for Social Security and Medicare), corporate income taxes, tariffs and other taxes. 2

Composition of Federal Taxes 3

HOW INCOME TAXES WORK When people get a new job they fill out a W-4 which is used to calculate withholding (an estimate as to how much tax you are going to owe on the earned income). This money is taken out of a paycheck and sent, by the employer to the federal government. The estimate is reconciled with actual income taxes owed with the Tax Return filed by April 15 th of the following year. 4

THE VOCABULARY OF INCOME TAXES Adjusted Gross (AGI) total net income from all sources, basically earnings from working and income from investments Exemptions an amount by which AGI is reduced that is determined by the size of the family Deductions amounts by which AGI is reduced; the greater of either the standard deduction (the minimum level of deduction)or itemized deductions (deductions for particular expenses on which the government does not want taxes paid) Taxable 5

Adjusted Gross 6

Adjusted Gross - Exemptions 6

Adjusted Gross - Exemptions - Deductions= minimum of Standard Deduction and Itemized Deduction 6

Adjusted Gross - Exemptions - Deductions= minimum of Standard Deduction and Itemized Deduction = 6

Adjusted Gross - Exemptions - Deductions= minimum of Standard Deduction and Itemized Deduction = Taxable 6

Adjusted Gross - Exemptions - Deductions= minimum of Standard Deduction and Itemized Deduction = Taxable Tax Table 6

Adjusted Gross - Exemptions - Deductions= minimum of Standard Deduction and Itemized Deduction = Taxable Tax Table Alternative Minimum Tax 6

Adjusted Gross - Exemptions - Deductions= minimum of Standard Deduction and Itemized Deduction = Taxable Tax Table Alternative Minimum Tax Taxes Owed 6

Adjusted Gross - Exemptions - Deductions= minimum of Standard Deduction and Itemized Deduction = Taxable Tax Table Alternative Minimum Tax Taxes Owed - Credits 6

Adjusted Gross - Exemptions - Deductions= minimum of Standard Deduction and Itemized Deduction = Taxable Tax Table Alternative Minimum Tax Taxes Owed - Credits = 6

Adjusted Gross - Exemptions - Deductions= minimum of Standard Deduction and Itemized Deduction = Taxable Tax Table Alternative Minimum Tax Taxes Owed - Credits = What You Owe 6

MORE VOCABULARY Filing Status the type of household for tax purposes (Single, Married Filing Jointly, Married Filing Separately and Single Head of Household) Average Tax Rate the fraction of your taxable income that you pay in taxes Marginal Tax Rate the percentage of each dollar in that bracket that must be paid in tax-the amount you pay on the last dollar you earn (this is what is economically relevant) Tax Credits 7 The reductions off of the amount of tax owed.

THE ALTERNATIVE MINIMUM TAX Began in the 1960s Intended to insure that high income earners could not use deductions to avoid taxes. The point at which it begins is not indexed for inflation Affected 40% of taxpayers in 2010 Adds a high level of complication 8

THE IMPACT OF THE AMT 9

ISSUES IN INCOME TAXATION: FAIRNESS Horizontal Equity equal people should be treated equally Vertical Equity people across the income scale are treated fairly with regard to ability to pay Progressive Tax with higher income you pay a higher rate of tax. 10

CURRENT TAX RATES FOR SINGLE FILERS Range Marginal Tax Rate 0-$8500 10% $8501-$34,500 15% $34,501-$83,600 25% $83,601-$174,400 28% $174,401-$379,150 33% More than $379,150 35% 11

60000 Taxes Paid by Taxable 45000 30000 15000 0 0 50000 100000 150000 200000 12

60000 Taxes Paid by Taxable 45000 30000 Double your income and you pay more than double the taxes 15000 0 0 50000 100000 150000 200000 12

INCENTIVES IN THE TAX SYSTEM 13

INCENTIVES IN THE TAX SYSTEM Whether the income tax discourages or encourages work or savings boils down to the income effect and the substitution effect of that tax policy. 13

INCENTIVES IN THE TAX SYSTEM Whether the income tax discourages or encourages work or savings boils down to the income effect and the substitution effect of that tax policy. effect 13

INCENTIVES IN THE TAX SYSTEM Whether the income tax discourages or encourages work or savings boils down to the income effect and the substitution effect of that tax policy. effect The effect on work or saving just accounting for the tax money taken away. Substitution effect 13

EMPIRICAL EVIDENCE ON INCENTIVES Work Most economists have found that there is nearly no impact of tax rates on number of hours worked. Some estimate that it takes an 8% decrease in after tax wages to reduce work by 1%. Saving There are differing estimates of the impact but most economists agree that an increase in taxes reduces savings slightly. One estimate has a 2.5% decrease in the after-tax interest rate decreasing savings by 1%. 14

TAXES FOR SOCIAL ENGINEERING Tax Incentives exist to induce people to Save for college. Send their children to college. It is uncertain whether these tax provisions cause people to go to college. Other incentives: Buy Houses (as opposed to rent) Give to Charities Save for Retirement 15

WHO PAYS FEDERAL INCOME TAXES? Looking at 2009 (source Taxfoundation.org) Table 1 Summary of Federal Tax Data, 2009 Number of Returns with Positive AGI AGI ($ millions) Taxes Paid ($ millions) Group's Share of Total AGI Group's Share of Taxes Split Point Average Tax Rate All Taxpayers 137,982,203 $7,825,389 $865,863 100.0% 100.0% - 11.06% Top 1% 1,379,822 $1,324,572 $318,043 16.9% 36.7% $343,927.00 24.01% 1-5% 5,519,288 $1,157,918 $189,864 14.8% 22.0% 16.40% Top 5% 6,899,110 $2,482,490 $507,907 31.7% 58.7% $154,643.00 20.46% 5-10% 6,899,110 $897,241 $102,249 11.5% 11.8% 11.40% Top 10% 13,798,220 $3,379,731 $610,156 43.2% 70.5% $112,124.00 18.05% 10-25% 20,697,331 $1,770,140 $145,747 22.6% 17.0% 8.23% Top 25% 34,495,551 $5,149,871 $755,903 65.8% 87.3% $ 66,193.00 14.68% 25-50% 34,495,551 $1,620,303 $90,449 20.7% 11.0% 5.58% Top 50% 68,991,102 $6,770,174 $846,352 86.5% 97.7% > $32,396 12.50% Bottom 50% 68,991,102 $1,055,215 $19,511 13.5% 2.3% < $32,396 1.85% Source: Internal Revenue Service 16

TAX DEBATES There are many different types of arguments about taxes lets go through a few of them 17

LEVEL OF TAXES An ongoing major debate is about the level of taxes: Republicans generally want lower taxes Democrats generally want higher taxes Arguments for higher taxes: We want the money to fix the deficit We want to expand things that the government does Arguments for lower taxes: I like having more money to myself Disincentives of tax system Government is inefficient and market should solve problems 18

ALTERNATIVE MINIMUM TAX Its a mess Originally designed for rich people but is hitting more and more people However, its not so easy to get rid of when we have a big deficit 19

PROGRESSIVITY OF TAX SYSTEM Currently richer people (at least higher AGI people) pay higher average taxes and higher marginal taxes Some people (mostly democrats) want to make the tax system more progressive Others (more likely republican) would like to make it less progressive Equity: Rich pay more than poor now, but they are also richer. Is more progressivity or less progressivity more equitable? Efficiency Marginal tax rates among the rich are getting pretty high If too high might have major problems Depends upon the elasticities 20

TAX BASE Currently we have an Tax which taxes both Earnings from a job received from an investment Its not at all obvious we want to tax both-and at the same rate Once I earn money I can do one of two things with it: Spend it on consumption now Invest it If you spend it federal government collects nothing more If you invest it, federal government taxes earnings from that Thus the federal tax code discourages investing in the economy 21

Many economists regard this as a serious problem We could achieve this either by taxing wage income only taxing consumption rather than income Among other things, Cain s 999 plan does this with a national savings plan Problems with taxing consumption Not so good for retired people, they paid the income tax when they were young and now pay the sales tax when old If you care about progressivity, not easy to do with aconsumption tax 22

MARRIAGE PENALTIES People worry about the tax code discouraging Marriage It can not be Neutral with respect to Marriage Consider the following example: Couple A: Jane makes $150,000 and Paul makes $50,000 Couple B: Lois makes $100,000 and Carl makes $100,000 If they get married (and file jointly) they will pay exactly the same amount in taxes However, if they are not married and the tax is progressive, Couple A must pay more (because the average tax rate is higher when you make more money) Thus it must be the case that either couple A pays less in taxes after getting married or couple B pays more 23

SIMPLICITY OF TAX CODE Another concern is how complicated the tax code is This really leads to two problems: Dead weight loss in terms of the amount of time it takes to do taxes Inefficient collection of taxes because of all of the loopholes Easy to talk about, harder to actually implement because of all of the groups you affect This is one argument for flat taxes-though this seems to confuse the progressivity and the simplicity issue which to me are separate(figure) 24