Tax Issues

Taxes play a big role in the economy and different tax issues have different affects on taxpayers. This page will address basic tax knowledge as well as various tax related issues that affect the United States economy. There is some analysis of taxation in the section on Negative Externalities and the Environment, since taxation is one method of correcting a negative externality. For the most part, though, the purpose of taxation is to raise revenue rather than to influence behavior. Economists tend to focus on two aspects: the efficiency of a given tax, which has to do with how much deadweight loss the tax generates, and tax equity. For non-economists, the two concerns are the administrative costs of taxation (an efficient tax is one with low collection and compliance costs) and tax fairness (most believe that taxes should treat equals equally and unequals unequally). There are many different types of taxation in the U.S. Government, such as taxes on: income, capital gains, interest, dividends, property, estates, and corporate profit. A public economic class does not attempt to study every aspect of taxation, but does focus on topics like how taxes affect incentives to work, save, and invest.

Types of Taxes


Taxes on Earnings
Payroll tax- A Payroll Tax is levied on earnings of workers. Payroll taxes are the primary means for financing social insurance programs.

Taxes on Individual Income
Individual income tax- the individual income tax is paid on income accrued by an individual throughout the year. An example would be taxation of capital gains earned on investments properties.

Taxes on Corporate Income
Corporate income tax- the corporate income tax is levied on the earnings of corporations as a means of taxing the "owners of capital that might otherwise escape taxation by the individual-based income tax system."

Taxes on Wealth
Wealth taxes- wealth taxes are paid on the value of assets held. Examples include state and local property taxes and estate taxes.
Property taxes- property taxes are taxes based on the value of land and any structures built on the land.
Estate taxes- estate taxes are taxes based on bequests (money, property, and so on) left behind when one dies.

Taxes on Consumption
Consumption tax - consumption tax is a tax paid on by individual or household consumption of goods and sometimes services.
Consumption taxes are often levied in the form of sales tax.
Sales taxes- sales taxes are paid by customers to vendors at the time of sale.
Excise taxes- excise taxes are sales taxes applied to only specific goods such as cigarettes or gasoline.

Payroll, income, and wealth taxes are considered direct taxes because they are assessed directly on individuals. Consumption taxes are considered indirect taxes because they are assessed on transactions.
(Public Finance & Public Policy, Second Edition. Jonathan Gruber. Chapter 18. Pages 513-514.)


Reasons for taxation

  • Revenue- the government collects taxes in order to provide public goods
  • Redistribution- redistribute some of the wealth to poorer members of society
  • Controlling externalities- taxes can be implemented to discourage an activity. For example, the tobacco tax discourages people from smoking

Computation of Taxes

To understand the economics of taxation in the United States, it is helpful to have a better understanding of how the U.S. tax system works. This section shows how income and wealth transfer taxes are calculated.


Income Tax example


Tax on Individual Income

Gross Income
Less: Deductions for Adjusted Gross Income
Equals: Adjusted Gross Income
Less: Itemized Deductions or Standard Deduction
Less: Personal and Dependency Exemption
Equals: Taxable Income
Times: Applicable Tax Rates
Equals: Gross Tax liability
Less: Tax Credits
Plus: Additional Tax
Less: Tax Prepayments
Equals: Tax Due

Gross income is the total of an individual’s various sources of income.
Adjusted gross income (AGI) is an individual’s gross income minus certain deductions including:

  1. Contributions to certain pension or retirement plans (including IRAs
  2. Health savings account contributions
  3. Moving expenses
  4. One-half of self-employment taxes
  5. Self-employed health insurance premiums
  6. Penalty on early withdrawal of savings
  7. Alimony paid
  8. Qualified student loan interest

Exemption is a fixed amount a taxpayer can subtract from AGI for each dependent member of the household, as well as for the taxpayer and the taxpayer’s spouse.
Standard deductions are fixed amount that a taxpayer can deduct from taxable income.
Itemized deductions are 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.


Gross income is generally income from all sources unless the Internal Revenue Code allows an exception, such as income from municiple bonds. Adjusted Gross Income (AGI) is a special subtotal because it is used to limit the amount of itemized deductions that an individual is allowed later in the tax calculation.
Personal exemptions and the standard deduction depend on family size and the amounts are adjusted for inflation each year

(Public Economics. Susan Dadres. class notes handout.)

Once AGI has been calculated, an individual can choose to take itemized deductions or the standard deduction, whichever is larger. Itemized deductions are based on actual expenses during the year while the standard deduction is a single amount that depends on filing status. Itemized deductions are “phased out” as income increases, which means that as a taxpayer’s income increases, the amount eligible to be claimed is reduced. The most common examples of itemized deductions include:
  1. Medical and dental expenses in excess of 7.5% of AGI
  2. Taxes (state, local, and foreign income and property taxes)
  3. Interest ( mortgage interest and investment interest expense)
  4. Charitable contributions (up to 50% of AGI)
  5. Casualty and theft losses (in excess of 10% of AGI
  6. Unreimbursed employee business expenses, investment expenses, and tax preparation fees ( in excess of 2 % AGI)
  7. Gambling losses ( to extent of gambling winnings

Taxpayers are allowed a personal exemption for themselves and dependency exemptions for others in their household. After those deductions, the taxpayer is left with taxable income, which is multiplied by the tax rates necessary to calculate the gross tax liability.

Tax credits are amounts that are taken directly against gross tax liability. Some examples include the Child Tax Credit, various Education Credits, and the Earned Income Tax Credit discussed below.

Taxpayers who make prepayments for taxes throughout a year may offset those payments against the amount of tax owed on their federal income tax return.


( Taxation for Decision Makers, 2000 Edition. Shirley Dennes-Escoffier, Karen A. Fortin. Pages 437-471)

projected-2009-income-tax-brackets.gif
(Bargaineering; Engineering for a better life - Jim Wang)

Tax on Corporate Income

Gross Income
Less: Deductions
Equals: Taxable Income Before Special Deductions
Less: U.S. Production Activities Deduction
Less: Dividends Received Deduction
Less: Net Operating Loss
Equals: Taxable Income
Times: Applicable corporate tax rates
Equals: Tax Before Credits
Less: Credits
Net Corporate Tax

The corporate income tax does not distinguish gross income and Adjusted Gross Income. Instead, gross income is reduced by a general category of deductions for ordinary and necessary business expenses. Corporations are eligible for three special deductions. The U.S. Production Activities deduction is a special deduction for companies that have operations in the United States. The Dividends Received Deduction allows corporations to partially or fully eliminate the effect of triple taxation on dividends received from stock held by the company depending on the amount of ownership in the stock of the company held. Corporations that have less than 20% ownership interest in the paying dividend corporation get a 70% deduction on the dividend paid. Corporations having a 20-80% interest in the paying dividend corporation receive an 80% dividend received deduction. Corporations that have 100% ownership interest in the paying divided corporation receive a 100% dividend receive deduction. Finally, corporations are also allowed to deduct losses sustained in other years.
taxs-2009.JPG

(Federal Taxation, 2008 Edition. Kenneth E. Anderson, Thomas R. Pope, and John L. Kramer. Chapter 5, page 3)

Tax on Wealth Transfer

The United States imposes a wealth transfer tax on estates and gifts. Taxes are paid by the estate or the person making the gift. Recipients do not include the value of money or property received in their income. The reason for both an estate and gift tax is that if there was no gift tax, taxpayers would deplete their estate with gifts before their death, which would render the estate tax ineffective. The calculations for the gift tax and the estate tax are similar. Both are shown below.

Gift tax
Includible gifts made during the current period
Less: Annual exclusions
Less: Charitable deduction
Less: Marital deduction
Equals: Taxable gifts for the current period
Plus: Taxable gifts in previous periods
Equals Cumulative Taxable Gifts

Gift tax payable:
Gift tax on cumulative taxable gifts
Less: Gross gift tax on previous taxable gifts
Less: Available unified credit
Equals: Gift taxes payable on current period gifts

Individuals are allowed to gift $1 million before they must pay gift tax. The unified credit in the calculation is equivalent to the tax due on $1 million in gifts, so it effectively eliminates the gift tax on any amount below $1 million. Furthermore, individuals are also allowed to gift $12,000 ($13,000 for 2009) per year per person without filing a gift tax return. This amount is referred to as the annual exclusion amount, and it does not count against the $1 million lifetime limit.

Estate Tax
Gross Estate
Less: Deductible expenses, debts, taxes, and losses
Less: Charitable Deduction
Less: Marital Deduction
Equals: Taxable Estate
Plus: Adjusted taxable gifts from previous periods
Equals: Tax base

Gross estate tax
Less: Gift tax on prior gifts
Less: Unified Credit
Less Other allowable credits
Equals: Net estate tax liability

Individuals are allowed to leave $2 million ($3.5 million in 2009) before their estate is subject to estate tax. The $2 million lifetime exemption amount is reduced for any gifts made, so the lifetime amount individuals are allowed to transfer is $2 million in both the estate and gifts. Like the gift tax, the Unified Credit is equal to the tax due on a $2 million estate. The top rate for calculating estate tax is the highest of any tax rate in the United States at 45% (compared with 35% for both individuals and corporations).

(Taxation for Decision Makers, 2008 Edition. Shirley Dennis-Escoffier, Karen A. Fortin. Pages 509-510)

Arguments for the Estate Tax

1. Why tax the stock of wealth at death? First it’s a progressive means to raise revenue, in 2006 only 6,343 estates were taxed or about 27% of estates from that year. In 2004 the estate taxed raised $21.5 billion dollars in revenue. 2. To avoid the excessive concentrations of wealth and power in society in the hands of a few wealthy dynasties.

3. Those in favor of the estate tax claim that allowing children of wealthy families to inherit all their parents’ wealth saps them of all motivation to work hard and achieve their own success.


Arguments against the Estate Tax

1. A “death tax” is cruel; it argues that it is morally inappropriate to tax individuals upon their death. But death is not the only means to incur a transfer tax, and 98% of deaths result in no estate taxes.
2. The estate tax amounts to double taxation, you are taxed on income when you earn it, and then your children are taxed on it again when you die. The counter to this is we are double taxed quite often the most notable is the sales tax.


3. Administrative difficulties when taxed on actual of assets you may have to sell the assets to pay the estate tax. The main issue raised is if a child inherits the farm and wishes to continue to farm they may have to sell the farm to pay all the estate taxes. The counter is the American Farm Bureau Federation has zero documented cases of this.

4. Compliance and fairness, there are several ways to “get around” the estate tax (legally). One is to create a trust fund. In this the assets are transferred to a third party with instructions for them to only be distributed to the retainer(s) at this time and with these conditions. Another popular method is to leave the heirs shares of stock in a new family business. Estate and gift taxes are levied on one type of transfer, cash and property, but not on another type of transfer, services. So many consider the estate tax a “voluntary tax” only those too naive to avoid the tax end up paying it.


(Public Finance & Public Policy, Second Edition, Jonathan Gruber. Chapter 23. Pages 676-681)
IRS page
Current presidential canidates
Estate Tax Calculator

Taxes and Incentive to Work
(From Encyclopedia Britannica online)

It is difficult to determine the extent to which an income tax reduces the incentive to work. To the extent that the tax reduces total income after taxes, it may lead some persons to work longer in an effort to maintain an established standard of living (the income effect). To the extent that the tax reduces the reward for an extra hour’s work, it may make the taxpayer decide to work less and to indulge in more leisure (the substitution effect); presumably, the larger the income and the more steeply progressive the tax, the greater this substitution effect will be.
.external image n23915533_36541118_3932.jpg
The notion that individual labor supply functions are backward-bending is based on the belief that as the wage rate rises, the income effect will eventually dominate the substitution effect.
As a general rule, if the labor supply is downward-sloping, then the income effect is dominant. If the labor supply is upward-sloping, then the substitution effect is dominant.

(Public Economics. Susan Dadres. Graph from class notes.)



Retirement Savings
There are several tax subsidies for retirement savings. They include: employer-provided pension plans, 401(k)s, individual retirement accounts (IRAs), and Keogh accounts. These retirement plans are preferred to others because taxes are not paid on the initial contribution or any interest earned. Taxes are paid once the individual retires and begins to withdraw funds from the retirement plan.

Even though taxes are eventually paid, these subsidies are preferred because they earn a higher return. The time value of money, tells us that a dollar received today is worth more than a dollar received in the future. A dollar is worth more today because you can invest it and begin to earn interest. In a tax preferred retirement plan, taxes that would have been paid on the initial contribution can instead be invested and earn interest. If taxes are paid initially, there is less to invest and less interest earned. This tax incentive has encouraged individuals to save more.
(Public Finance & Public Policy, Second Edition. Jonathan Gruber. Chapter 22. Pages 647-649.)

Types of Retirement Plans

**IRA-Based Plans**
Payroll Deduction IRAs, SARSEPs, SEPs, and SIMPLE IRA Plans are "No Fuss" plans that range from those with little employer involvement to those that the employer establishes and funds.

**IRC 401(k) Plans**
IRC 401(k) plans are the most popular type of retirement plan used today. 401(k) plans are available to all employers of any size...making a basic understanding of their pros and cons vitally important.

**IRC 403(b) Tax-Sheltered Annuity Plans**
General questions, resources, guidance and other useful information on IRC 403(b) Tax-Sheltered Annuity Plans.

**IRC 457(b) Deferred Compensation Plans**
General questions, resources, guidance and other useful information on IRC 457(b) Deferred Compensation Plans.

**Designated Roth Accounts in 401(k) and 403(b) Plans**
Although designated Roth accounts are not a type of plan, they are a feature now available in 401(k) and 403(b) plans. Learn more about designated Roth accounts.

**Retirement Plans Check-Up**
Three-step approach designed to help business owners properly operate their retirement plans.

**Retirement Plans for Small Businesses**
Information for starting and maintaining a small business retirement savings plan.
(IRS- United States Department of Treasurey. July 07,2008)



Individual Retirement Account (IRAs)
An IRA is a personal savings plan which provides income tax advantages for retirement. IRAs were created because Congress knew that not all employers provided 401(k) plans for all employees. IRAs are created for low and middle-income households and also higher income households with less tax advantages. IRAs allow any person who earned taxable compensation and who is not 70 1/2 years of age by the end of the year to contribute some of their pre-taxed earned income into this plan. Individuals can currently contribute up $5,000 per year and accumulate interest tax free, however, after 2008 the limit may be adjusted for inflation. Since IRAs are retirement accounts, there is a 10% tax penalty for withdrawing the funds before the predetermined age of 59 1/2. The income will remain tax free until the individual makes a withdrawal. Only a portion of earned income can be contributed to this plan unless you are 50 years or older in which you could contribute more.

(Public Finance & Public Policy, Second Edition. Jonathan Gruber. Chapter 22. Pages 647-648.)
(IRA.com, Research Center)

There are different types of IRAs such as the Traditional IRA, Simple IRA, Roth IRA, Education IRA, and Simplified Employee Pension (SEP) IRA. Below are the main differences between the most common IRAs, Traditional and Roth: (excluding certain rules)
Traditional IRA
Roth IRA
Contributions pre-tax and potentially tax deductible
Contributions post-tax and non-deductible
No income caps
Income caps
Only contribute until age 75
No age limit
Required minimum distributions
No required minimum distributions
Taxed withdrawals
Tax-free withdrawals

For more information on IRAs visit www.ira.com
To find out which type of IRA is better for you, check out this IRA comparison calculator.

401K Plan
A 401k plan is one of the best ways to save for a retirement. With the future of social security unsure, many people are realizing a 401k plan could be vital to their lifestyle once they retire. In a 401k plan, an employee is allowed to select a portion of their paycheck to be deposited in their 401k account. The employer will then match that contribution, up to a certain percentage of the employee's salary. Common numbers that an employer will usually match range from 3%-6%. Often employees are allowed to contribute up to 10% of their salary. Some companies also require employees to work for a period of time before they can retain all of their matching funds. For example, a corporation is matching John's contributions into his 401k account up to 6%, but if he quits before he has been employed with them for two years, he will lose much of what they have matched. Once he has been employed with them for two years, he will be 100% vested in his 401k plan with this company. Below is a link for an interesting 401k calculator to help people plan their savings:

http://www.pensiononline.com/401khelpcenter/roth401ktool.asp

Vesting: The percentage of 401k match you earn for each year you work for an employer. Employers often use a cliff vesting schedule (where you have to meet a certain number of years of service to earn any match at all) or accelerated vesting (where a portion of the match is vested depending on how many years you are employed, typically over a 3 or 5 year period).

*In the real world, employers can tailor their retirement savings plans to match their employee population. Employers are required to have their 401k plan pass annual IRS/ERISA "fairness" testing, and based on this can change the maximum employees can contribute to 401k plans, matching/profit sharing amounts, and other features to encourage employees to join the retirement plan.

Keogh Accounts & SEPs

A Keogh Plan is a tax-deferred trust savings account, similar to an IRA, that allows self-employed individuals or those who own their own incorporated businesses to save for their retirement. Savers place a portion of their income each year in their Keogh account until they reach at least age 59 1/2. Federal income tax on the deposited funds and the interest they earn is deferred until withdrawals begin. This is presumably when the saver has retired and is, therefore, in a lower tax bracket. Employers who establish a Keogh plan for themselves must also make the benefit available to qualified employees.

A big difference between Keogh account withdrawals and SEP withdrawals is that with a Keogh account, you can withdraw a large sum of your savings immediately (after age 59 1/2) and then spread the tax burden out over the next 5 years (or 10 years if you were 50 years old before January 1986). With a SEP you have to pay the tax on that sum all at once, possibly putting you in a higher marginal tax bracket. Also to be eligible to set up a SEP, you must either be self-employed or the owner of a company with less than 25 employees.

Keoghs and SEPs typically work out better than IRAs for many people. After the Tax Reform Act of 1986, most Americans lost their eligibility for tax-deferred individual retirement accounts. Even if you still qualify for a tax-deferred IRA (which means you are covered by no other pension plan, even through a spouse, and that you earn less than $25,000 as a single taxpayer or $40,000 as a couple), you can shelter more retirement savings in a Keogh or SEP, also called a SEP-IRA.

Follow this link to an in-depth article describing all types of Keogh Accounts/SEPs.



Taxation and Savings

In the traditional theory of savings, the role of savings is to smooth consumption across periods of time. Individuals have more income in some periods (such as their working lives) and less in others (such as retirement). With no savings, individuals would be forced to consume much less in periods when income is lower. Yet, due to diminishing marginal utility, such a consumption pattern is unlikely to be utility maximizing: individuals would prefer to smooth their consumption over time, consuming a constant amount rather than feasting in some periods and starving in others. By reducing spending in periods when it is high, and raising spending in periods when income is low, savings play that consumption-smoothing role.
Under the intertemporal choice model, the choice about how much to save is really the choice about how to allocate one's consumption over time. As with modeling labor supply, we do not model savings directly, but rather model consumption over time. Intertemporal choice was introduced by John Rae in 1834 in the "Sociological Theory of Capital". Later, Eugen von Böhm-Bawerk in 1889 and Irving Fisher in 1930 elaborated on the model.

Tax Subsidies & External Benefits
Deviations from a comprehensive income definition is the possibility that reducing taxes on certain activities will yield external benefits to society.
  • Charitable giving: donations to charitable organizations can be deducted from taxable income. Since there is a free rider problem, it is unlikely that the private market will provide enough charitable support for many public goods.
    • Government provision may crowd-out private contributions to the public good, leading charitable contributions to fall. When government subsidizes charitable giving, it may "crowd in" or increase charitable contributions.
(Public Finance & Public Policy, Second Edition. Jonathan Gruber. Chapter 18. Pages 528-529.)

The Problem of the "Marriage Tax"
Marriage tax is a rise in the total tax burdens of two individuals simply from marrying.
Suppose that government would like to design a tax system that has three goals:
  1. Progressivity: marginal tax rates rise as family incomes rise
  2. Across-Family Horizontal Equity: Families with equal incomes would pay equal taxes
  3. Across-Marriage Horizontal Equity: Tax burdens would be marriage neutral, independent of whether two individuals decide to wed

Suppose the tax rate on the first $10,000 of taxable income is 10%, but the marginal tax rate for taxable income above $10,000 is 15%. Then, tax liabilities for the four individuals listed below can be calculated.

-----------------------------------------Taxable Income------------------------- Tax Liability--------------------------- Average Tax Rate

Bob------------------------------------------$0-------------------------------------------$0----------------------------------------------0%
Sue----------------------------------------- $20,000------------------------------------$2,500----------------------------------------12.5%
Jack-----------------------------------------$10,000------------------------------------$1,000----------------------------------------10%
Jill----------------------------------------- --$10,000------------------------------------$1,000----------------------------------------10%

If Bob and Sue get married, their combined taxable income is $20,000 and they continue to pay the same amount of taxes.
If Jack and Jill get married, their combined taxable income is $20,000 and their combined tax liability increases from $2,000 to $2,500, so there is a marriage penalty of $500.

The U.S. income tax attempts to eliminate the marriage penalty by altering bracket widths. Suppose the bracket width for single filers is the same as above, but the bracket width for married taxpayers changes so that the 10% tax rate applies to taxable income up to $20,000, and the 15% tax rate applies to income above $20,000.

As a result, Jack and Jill pay no marriage penalty since there combined tax liability remains $2,000 after they are married. However, with the new bracket width for married couples, Bob and Sue now pay les after they get married($2,000 instead of $2,500), so there is a marriage subsidy of $500.


Note that this simplified tax system is progressive since the average tax rate rises with income.

(Public Economics. Susan Dadres. Class notes handout 2009)

  • If individuals are taxed based on Progressivity, then raising the marginal rates will mean that individuals with higher income will pay a higher share of their income in taxes. Families with a more equal distribution of income will pay lower taxes, violating the second condition.
  • Rising marginal rates will mean that when individuals combine their income into families, a larger share of the total family income is subject to higher marginal tax rate.
  • Therefore, individuals will pay more taxes if married than single.
(Public Finance & Public Policy, Second Edition. Jonathan Gruber. Chapter 18. Pages 538-540.)

A tax is marriage-neutral only if it eliminates both marriage penalties and marriage subsidies, at all levels of taxable income. As Gruber argues, there is no way to make the tax code completely marriage-neutral as long as it is progressive and provideds for across-family horizontal equity by making the family the taxing unit. We can achieve two of the goals, but not all three.
(Public Economics. Susan Dadres. Class notes from August 5, 2008.)

Read more about the Marriage tax in the article by Fraser.
The Marriage Tax
Jane M. Fraser
Management Science, Vol. 32, No. 7 (Jul., 1986), pp. 831-840
Publisher: INFORMS
Stable URL: http://www.jstor.org/stable/2631764



Earned Income Tax Credit (EITC)
The Earned Income Tax Credit (EITC) is an income tax policy aimed specifically at low-income wage earners.
The EITC subsidizes the wages of low-income earners to accomplish two goals:
1.) To redistribute resources to lower-income groups
2.) To increase the amount of labor supplied to these groups

The EITC is the nation's single largest cash antipoverty program. The federal government spends $34.6 billion a year on the program.

To be eligible for the EITC:

· A family must have annual earnings greater than zero and below about $34,000, if supporting one child, or $36,000 if supporting more than one child
· A family that supports no children must have earnings greater than zero and below about $12,000, but their EITC is significantly smaller.
Note: For all types of families the EITC is refundable, so even if the family owes no other taxes, it can still qualify for this credit, and the government will send the family a check for the amount as a tax rebate.

(Public Finance & Public Policy, Second Edition. Jonathan Gruber. Chapter 21. Pages 619-620.)


Ø Wikipedia provides more detail on this topic Wikipedia's EITC.
Ø This link to the IRS website will help you determine if you qualify for the EITC.

"Overall, the United States' experience with the EITC seems fairly successful. It is a powerful redistributive device that now delivers more cash to low-income families than any other welfare program in the United States. And it has done so without reducing overall labor supply, the problem with standard cash welfare; rather, this redistribution has been associated with increased labor supply among single mothers (increased labor force participation with no offsetting reduction in hours worked), no effect on fathers, and a modest reduction in labor supply among married mothers."


(Public Finance & Public Policy, Second Edition. Jonathan Gruber. Chapter 21. Page 625.)

EITC Reform
The EITC has, for the most part, been a major success story. However, there are significant flaws in its design to be addressed:
  • There is only a very small EITC for childless workers, with a maximum of $412 per year.
  • Families receive no additional EITC transfer as family size grows beyond 2 children.
  • A major objection to the current form of the EITC is that it penalizes many single parents who subsequently marry because the credit is based on the income of the tax filing unit. (Note: not all marriages are penalized, such as if a single mother with two children marries a man with an annual income of $12,000, they will both qualify for the maximum credit of $4,536, even though she would not receive any credit on her own.)
  • The EITC is complex. The IRS documentation explaining the program is 56 pages long. As a likely result, only about one-seventh of those eligible to the EITC do not participate, and a majority of recipients spend some of their income to hire professionals to prepare their taxes.

(Public Finance & Public Policy, Second Edition. Jonathan Gruber. Chapter 21. Page 625-626.)



Tax Equity and Tax Efficiency


Tax Equity
Tax equity normally refers to horizontal equity or the notion that people with the same ability to pay should have the same tax burden.

Vertical Equity
Vertical equity is the principal that groups with more resources (higher income, higher wealth, higher profits) should pay higher taxes than lower-resource groups. Vertical equity or progressive tax move the tax rate up as income increases. There are pros and cons to this type of system, which can be viewed at the following link:Debate on progressive tax rates
  • Measuring Vertical Equity
    • Most analysts conclude that to be vertically equitable tax systems must be progressive: effective average tax rates must rise with income, so that the rich pay a higher share of income in taxes than the poor.
    • Other systems use a proportional tax in which all individuals pay the same proportion of their incomes in taxes.
    • A regressive tax system is one in which average tax rates fall with income.
(Public Finance & Public Policy, Second Edition. Jonathan Gruber. Chapter 18. Page 522-523.)

Horizontal Equity
Horizontal equity is the principal that individuals who are similar but who make different economic or lifestyle choices should be treated in the same way by the tax system.

Tax Efficiency
Tax efficiency refers to the costs of collecting taxes, including compliance costs. In the public discussion of taxation, an efficient tax is typically defined as a tax with relatively low administrative and compliance costs.
  • Having less of a tax consequence than other similar investments. <www.investorwords.com>
  • Administrative Ease
  • Minimal distortion of various decisions on work savings, and investment

Statutory Incidence or burden vs. Economic Incidence or burden
Statutory incidence or burden refers to which party is legally responsible for sending the tax dollars to the government and typically falls on sellers. While economic incidence or burden is often partially shifted to consumers in the form of higher product prices.

In economics, equity relates to tax incidence and whether tax burdens are shifted, and efficiency relates to the deadweight loss or excess burden created by taxes. Chapter 19 provides these rules:
  • The statutory burden of a tax does not describe who really bears the tax.
  • The side of the market on which the tax is imposed is irrelevant to the distribution of the tax burden.
  • Parties with inelastic supply or demand bear taxes; parties with elastic supply or demand avoid them.

Egalitarianism
The tax system should try to achieve more equal distribution of after tax-incomes. Greg Mankiw's Blog


Optimal Commodity Taxation

Optimal Commodity Taxation refers to choosing the tax rates across goods to minimize deadweight loss for a given government revenue requirement. Early 20th century economist, Frank Ramsey, formulated the problem of optimal taxation by asking the question: How can we raise a given amount of revenue with the least amount of distortion? Ramsey therefore came up with the following rule:

Ramsey Rule

"To minimize the deadweight loss of a tax system while raising a fixed amount of revenue, taxes should be set across commodities so that the ratio of the marginal deadweight loss to marginal revenue raised is equal across commodities."

That is, the formula for Ramsey Rule is:
Set commodity taxes such that [MDWL i / MR i] equal to the [Value of additional government revenue]
where MDWL i is Marginal deadweight loss of commodity i
where MR i is Marginal revenue raised from the increase in tax on commodity

The Ramsey Rule recommends that if the government wants to minimize the total excess burden of commodity taxation, it should set tax rates so that the percentage reduction in the quantity demanded of each commodity is the same.


Inverse Elasticity Rule

The Inverse-elasticity formula:
tax_Image2.JPG
It is convenient to express the Ramsey result in a simplified form that relates us to elasticities of demand. If we assume that the supply side of commodity markets is perfectly competitive (elasticity of supply is infinite), then Ramsey result implies that:
[The optimal tax rate for commodity i] is equal to the [(Inverse of elasticity of demand for commodity i) which is multiplied by (The value of additional government revenues)]

Applying the inverse elasticity version of the Ramsey Rule shows that an efficient tax structure imposes high tax rates on products for which the demand is relatively inelastic and low taxes rates on products for which the demand is relatively elastic. While this strategy may result in an efficient outcome, the results are not likely to be equitable because products with relatively inelastic demand may be necessities without good substitutes.
(Public Economics. Susan Dadres. Class notes from November 12, 2008.)

This formulation of Ramsey's rule shows that two factors must be balanced when setting optimal commodity taxes:

The elasticity rule
When elasticity of demand for a good is high, it should be taxed at a low rate; when the elasticity is low, the tax rate
should be high. The deadweight loss from any tax rises with the elasticity of demand, so efficiency is enhanced by taxing inelastically demanded goods more than elastically demanded goods.
Elasticity Formulas:
Elasticity of Demand = Absolute Value of ( Change in Quantity Demanded/Change in Price) * (Price/Quantity)
Elasticity of Supply = (Change in Quantity Supplied/Change in Price) * (Price/Quantity)

The broad base rule
It is better to tax a wide variety of goods at a moderate rate than to tax very few goods at a high rate. Because the deadweight loss from a tax rises with the square of the tax rate, the government should spread taxes across a large number of commodities and not tax any one commodity at a very high rate.

(Public Finance & Public Policy, Second Edition. Jonathan Gruber, Chapter 20. Pages 586-8.)


Definition of Deadweight Loss:

The costs to society created by an inefficiency in the market. The term "deadweight loss" can be applied to any deficiency due to an inefficient allocation of resources.
Tax Incidence
Assessing which party (consumers or producers) bears the true economic tax burden of a tax.
  • Tax Incidence could be the burden of the seller, buyer, or both
  • Tax Incidence is not based on "fairness."

Perfectly Inelastic Demand (bear taxes)
When demand is perfectly inelastic, producers bear none of the tax and consumers bear all of the tax. This is called the full shifting of the tax onto consumers.

Perfectly Elastic Demand (avoid taxes)
In this case producers bear all the of the tax and consumers bear none of the tax.
(Public Finance & Public Policy, Second Edition. Jonathan Gruber. Chapter 19. Pages 545-553.)

Tax Incidence Formulas
Formulas.jpg

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Substitution & income effects Wikipedia explains Substitution and Income effects in relation to budget constraints the link includes graphs to help one further understand the effects better.

Attached is a link with scenarios of maximizing utility and how this affects substitution and income effects The Substitution and Income Effects with Indifference Curve Analysis.


Tax on Interest Income

1. Find the two extremes: Everything now.
if C2 =0, C1 = Y1 + Y2 / (1 + r)
Everything later.
if C1 =0, C2 = Y1 (1 + r) + Y2
2. Plot the two extremes and mark the endowment point, set up C1 = Y1, C2 = Y2
3. Use the given information about optimal saving and plot the optimal point.
4. Plot both C1 = Y1 - S(optimal to save) and C2 = (1+ r) S + Y2. (Using given value for S)
5. Show how a tax on interest affects budget line, given a percent tax is provided.
(Assuming substitution and income effect cancel each other out.)
6. Calculate new values....
One way in doing this is: use (1 - t) r, t = percent tax, r = percent rate
C2= [1+ (1-t)r] S(new ) + Y2

Example:

Jesse earns $82,000 in the current period, but his income will drop to $19,170 in period 2. The graph below shows his inter-temporal budget line assuming a 6.5 percent rate of interest and draw an indifference curve to illustrate optimal consumption in both periods assuming he optimally chooses to save $40,000 in the current period. It also shows the effect of a 50% tax on interest income assuming the substitution and income effects cancel each other out.
tax_Image1.JPG
When r=6.5%,
If C2=0 C1=Y1+Y2/(1+r)=100,000
If C1=0 S=Y1=82000
C2=(1+r)S+Y2=106,500
If S=40,000
C2=(1.065)40,000+19,170=61,770

When r=3.25%, repeat the calculation above,
If C1=0, C2=(1+3.25%)82,000+19,170=103,835
If S=40,000
C2=(1.0325)40,000+19,170=60,470


(Public Economics. Susan Dadres. Class notes April 29, 2009)


The Substitution Effect and Income Effect

on a change in the after-tax wage rate or after-tax interest rate

interest_rate_and_savings.jpg
An increase in (1- t) r alters the relative price of current consumption, making it more expensive to consume now because a larger amount of future consumption must be sacrificed. Individuals react by substituting more future consumption in favor of current consumption, which leads to greater savings, ceteris paribus. This substitution effect implies a positive or direct relationship between savings and (1- t) r.

An increase in (1- t) r also acts as an increase in income, since the individual can enjoy the same amount of future consumption with less effort today, or the same amount of future consumption with a boost to current consumption. Because the individual is in a sense wealthier as a result of a higher rate of return on savings, the income effect leads the individual to enjoy more current consumption and save less for the future, ceteris paribus. The income effect, therefore implies a negative or inverse relationship between savings and (1- t) r.

(Public Economics. Susan Dadres. Class notes December 1, 2008)



Topics on Taxes

When do those tax cuts expire? USA Today article

Alternative Minimum Tax (AMT)
The Alternative Minimum Tax was introduced by the Tax Reform Act of 1969 in response to 155 high-income households that were eligible for so many tax benefits that they owed little or no tax under the tax code of that time. The AMT is a separately filed tax that eliminates many tax credits and deductions, which increase tax liability for people that would otherwise pay less in taxes. If taxes owed through AMT are higher than regular income taxes than the higher tax is paid or vice versa. Though the AMT was intended to only affect taxpayers who avoid paying taxes through exemptions, the tax has began to pervade the pockets of many taxpayers. Since the AMT is not indexed to inflation and recent tax cuts, many more people are finding themselves subject to this tax. By 2010, almost 1/3 of Americans will be subject to the AMT. (Public Finance & Public Policy, Second Edition. Jonathan Gruber. Chapter 18. Page 520). If the 2001-06 tax cuts expire in 2010, 43 million taxpayers will be affected by the AMT in 2018 and if the tax cuts are extended the number jumps to 57 million.This link shows areas that will cause AMT liability.www.fairmark.com

The purpose of the AMT was an attempt to ensure that those who bebefit from various tax shelters pay at least some tax. The AMT is projected to produce more revenue than the ordinary federal income tax. AMT would be costly torepeal, $670 billion between 2006 and 2015.


The Tax Preference Items or Deductions


Taxpayers to which many of these deductions apply to are subject to AMT, but will still compute taxes under both the regular schedule and the AMT.
Tax preference items- items specified by the tax law that give taxpayer special benefits and exemptions on taxable income that must be included in calculating the Alternative Minimum Tax (AMT). If an individual has many of these preference items then they will most likely pay the AMT. Preference items include:


1. Addition of personal exemptions.
2. Addition of the standard deduction or a fixed amount taxpayers can deduct from their taxable income.

The most recent numbers for basic standard deduction from 2007 and 2008:


Filing status
Amount
Single
$5,450
Married Filing Jointly
$10,900
Married Filing Separately
$5,450
Head of household
$8,000
Qualifying widow(er)
$10,700
Standard Deduction. 1 August 2008 <http://en.wikipedia.org/wiki/Standard_deduction>.
IRS. 28 July 2008 <
//http://www.irs.gov/newsroom/article/0,,id=174876,00.html//>.


3. If taxpayers forgo standard deduction then they choose itemized deduction, in which the taxpayer deducts from his/her income the sum from a few categories denoted by *
*Medical and Dental expenses exceeding 7.5% of adjusted gross income (AGI), individuals adjusted income minus certain deductions, which include:
- Contributions to individual retirement plans through Individual Retirement Accounts
- Alimony paid to former spouse
- Health insurance premiums paid by self-employed
- ½ of payroll taxes paid by self-employed
*State and local taxes (sales tax if no state income tax), real estate tax, and personal property tax

*Interest taxpayers pay on funds borrowed to make investments and home mortgages
*Gifts to charity
(Public Finance & Public Policy, Second Edition. Jonathan Gruber. Chapter 18. Page 517.)
4. Changes to accelerated depreciation of certain property.
5. Difference between gain and loss on the sale of property reported for regular tax purposes and AMT purposes.
6. Incentive stock options and long-term capital gains.
7. Changes to passive activity, activity from which one does not physically participate, (example, income from rental properties) loss deductions.
8. Certain depletion that is more than the adjusted basis of the property.
9. Intangible drilling costs, intangible completion costs, depreciation of equipment, and depletion of well
10. Addition of tax-exempt interest on certain private activity bonds.

Tax Preference Item. 30 July 2008 <__//http://www.answers.com/topic/tax-preference-item//__>.
-Thus, if one has a high ratio of these deductions to total income then they would compute their tax under AMT system without these exemptions. People that make up to a certain income woul be exempted. These numbers are shown below.



AMT Exemption Amounts

1986-1992
1993-2000
2001-2002
2003-2005
2006 only
2007 only
2008 only
Married Filing Jointly
$40000
$45000
$49000
$58000
$62550
$66250
$45000
Single or Head of Household
$30000
$33750
$35750
$40250
$42500
$44350
$33750

- The income above the current exemption amount up to $175,000 is taxed at 26%, while income above this is taxed at 28%. Furthermore, the AMT is not completely phased out until income surpasses $415,000 for joint returns.
AMT. 15 July 2008 <
//http://en.wikipedia.org/wiki/Alternative_Minimum_Tax#AMT_Exemption_Phaseout_and_Effective_Marginal_Rates//>.


- In 1970, only 20,000 taxpayers were subject to the AMT, now (2008) 26.8 million people are affected and the AMT is encroaching on the middle class.

Major AMT Issues

1. AMT is impinging on the middle class. The distribution of AMT liability is shifting toward tax unit with lower incomes.
-78% of households with income between $100,000 and $200,000 46% with incomes between $75,000 and $100,000 will pay AMT by 2010 (compared with 3.6% and 0.6% in 2007).
2. AMT is not indexed for inflation, therefore; the tax affects taxpayers with lower real income over time.
3. In 2007, 72% of AMT taxpayers faced higher effective tax rates because of AMT. In 2010, 89% will face higher rates.
4. Disallows dependent exemptions and state and local tax deductions. Thus, families with children are more likely to be subject to AMT and families in high-tax states were nearly three times more likely to face AMT than families in low-income states.
5. Repeal would be expensive and regressive. Repealing AMT in 2008 would reduce revenues by $960 billion through the end of 2018 if 2001-06 tax cuts expire and this rises to $1.8 trillion if tax cuts are extended. If repealed, more that 90% of benefits would go to households with $100,000 plus income.

Tax Policy Center. 28 July 2008 <//http://www.taxpolicycenter.org/UploadedPDF/411707_12AMTFacts.pdf//>.



Difference between Deductions and Tax Credits


As noted earlier, that there are two types of deductions a taxpayer may choose to use in order to reduce his/her taxable income. Recall that the two options of deductions are: standard deductions or itemized deductions. Unlike deductions, tax credits differ in the sense that they are used to subtract the taxes owed under an individual income tax structure. That is, deductions and exemptions are subtracted from Adjusted Gross Income (AGI) to arrive at Taxable Income (TI). But, tax credits are subtracted from the income tax liability (amount of taxes owed), which is below the taxable income amount.
The amount of tax credits can make a significant difference for a taxpayer in terms of having either additional taxes owed at the end of the tax year (taxes for each year must be paid by April 15 of the following year) or receiving a tax refund. If the amount of tax credits are larger than the amount of taxes withheld, then the taxpayer may receive a refund, otherwise the taxpayer may owe additional taxes to the government.
Note that an amount withheld is an estimate of the taxes the worker will owe based on his or her earnings, but this estimate is rarely ever perfect. This also means that individuals with low incomes that believe they may not need to file a return, should investigate further as they may be eligible for tax credits and/ or a large refund.

For more information on how to determine which deduction method to use, special case tax breaks, and different types of tax credits, please check out this link to bankrate.com. Bankrate.com

(Public Finance & Public Policy, Second Edition. Jonathan Gruber. Chapter 18. Pages 518-9.)


Haig-Simons Comprehensive Income Definition


Haig-Simons defines taxable resources as an individual's ability to pay taxes or the change in an individual's power to consume during the year. This differs from the U.S. tax system. The U.S. tax systems allows for certain items of "income" to be disregarded in taxable income. For example, employer-provided health insurance is not currently included in taxable income under the U.S. tax system, however, the amount is included under the Haig-Simons definition. The individual does not have to pay for the insurance him/herself, therefore the individual has that much more income to spend or save. Another example of how the Haig-Simons definition works is if a person borrows to consume, there is no increase in income because the change in net worth is negative or if a person sells an asset for the purpose to consume, there is no increase in income. This definition measures the consumer's change in net worth and in both of these examples the net worth balanced out.

The Haig-Simons approach improves horizontal equity by ensuring that people who are the same in terms of their underlying resources pay the same amount of tax regardless of the form in which they choose to receive or spend their resources. Additionally, using the Haig-Simons approach also improves vertical equity because those who have more resources pay more tax, even though they get those resources through a nontaxed channel (such as with employer-provided health insurance). Although adhering to a Haig-Simons definition could greatly improve the horizontal equity and vertical equity of a tax system, there are two major difficulties with implementing this in the U.S. tax system: (a) the difficulty of how to define a person's power to consume/ability to pay, and (b) how to deal with expenditures that are associated with earning a living and not personal consumption.

(Public Finance & Public Policy, Second Edition. Jonathan Gruber. Chapter 18. Pages 525-6.)



Tax Rates and Taxes Paid

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.

Stimulus Package

The Stimulus Package, a form of refund, was signed and introduced by President George W. Bush in 2008. President Bush signed a $168 billion economic stimulus package that will extend rebates to U.S. taxpayers, give tax breaks to businesses, and make more-expensive mortgages available through the government and government-sponsored mortgage-finance companies.
Click here for more information on Stimulus Package
(By Robert Schroeder, MarketWatch)

In the first quarter of 2009 Congress passed another stimulus package in the amount of $787 billion. This package included among other things: an $8000 tax credit for first time buyers that does not need to be paid back, a $400 tax credit for most americans or $800 for most married couples, $7 billion for broadband internet deployment in rural markets across the USA, and incentives to weatherize your home.
2009 Stimulus Package Information
(By Sue Kirchhoff, USA TODAY)
Tax Reform

In 1986 the U.S. moved toward a broad-based, low-tax-rate system that economists have long advocated but by 1993 Congress and the Presidential administration increased taxes for high income earners and created more tax brackets. In 1997, the Taxpayer Relief Act modified the code to give more tax credits to families with children, for business expenses, and for educational expenses. The code was muddled even more in 2001 and 2003. So why was the tax code moved from simple to complex again? One of the main reasons was identified by Dr. Dadres in class; one of congress' greatest power is in granting tax incentives to gain popular support and keep politicians in office. One of their favorite means is through the creations of tax shelters. Which are activities whose sole reason for existence is tax minimization. These are used as incentives to gain financial backing as well as popular support from the people. The tax code is littered with these and complicates the whole system.
There are two very popular tax reforms that are often mentioned; one is the consumption tax. The basic idea is to tax on what people take out of the economy not to tax what they contribute to the economy. The most common type of consumption tax is the sales tax.

Pros of the consumption tax
  1. Improved efficiency. A single rate sales tax could reduce many of the inefficiencies associated with the current tax system. The major inefficiency it can combat is the lack of a “level playing field” in the realm of investments. The current tax system penalizes many types of savings and promotes other types of savings. The consumption tax would eliminate this.
  2. Fairer treatment of savers and less distortion of savings decisions. The current tax system favors consumption now and tends to penalize savings in many forms.
  3. Simplicity. The consumption tax would be much easier than the current system to implement and to maintain and control. Many criticize the system and say it will give rise to a larger black market, but this can be combated by taking a value added approach (more information on VAT here).

Cons of the consumption tax
  1. Vertical equity problems. One idea behind taxation is to redistribute wealth form the relatively rich to the relatively poor. A consumption tax some say would be a regressive tax because the lower income brackets spend greater percentages of their income on consumption goods than do the rich. So in essence a consumption tax will take more money for the poor than it will the rich because the rich will just chose to save more to get around the tax (this issue is looked at closer in the articles below).
  2. Asymmetrical information. Government has limited information on how to tax, thus with the income tax it can tax the rich more than the poor because it has a traceable means to allocate taxes for wealth distribution. Also if only a consumption tax is used then there is no way for the government to initiate transfer taxes.
  3. Transition issues. If we switched today to a consumption based system then college age students and young children would benefit from the change over but the middle aged and retired aged people would face significant losses and hardships. Due to the fact that they have already paid large sums into social security and retirement type funds. So if we switched today they would essentially be taxed twice and the second taxation would be higher and more compact than the first.
  4. Compliance. How will we enforce the tax and it creates major incentives to cheat to get around the system I.e. black market transactions and so forth.
  5. Cascading. Basic idea is that many business type inputs could be double or triply taxed. Which will cause the price of final goods and services to rise greatly.

(Public Finance & Public Policy, Second Edition, Jonathan Gruber. Chapter 23. Pages 735-747)

Flat Tax
Main points of a flat tax system.
  1. Cooperation’s pay a flat-rate value added tax (VAT) on their sales, but also get to deduct wage payments to workers from their VAT tax base. There is no corporate income tax.
  2. Individuals pay a tax on labor income only, not capital income, at the same flat rate.
  3. All tax expenditures would be eliminated (health insurance would be treated like wage payments, charitable contributions and home mortgage interest would no longer be deductable.) and would be replaced by a single family level exemption.

Advantages- The major advantage is the efficiency gains from a single flat tax on broad income definitions. Also saving are excluded from the flat tax so this could cause savings to rise and increase the capital stock of the nation. Lastly the flat tax system would be very simple. This would make it hard to evade taxes and greatly reduce individual and corporate tax expenditures.

Disadvantages- Many of the same issues that are present with consumption based taxes. The flat tax would be fairly progressive for middle and low income families but will not be as progressive as the current tax system on high income families. Vertical equity issues may concern voters greatly. There are many transition issues that must be overcome as well. Two prominent ones are possibility of greatly reducing the value of houses due to the removal of mortgage deductions. Second is the possible devaluation and large disruptions in the health care market.

(Public Finance & Public Policy, Second Edition, Jonathan Gruber. Chapter 23. Pages 750-752)


Consumption Tax- Good source for information on the ideas behind consumption tax. A short article of current issues surrounding consumption tax.
Numerous ideas on what might cause the current income tax system to collapse and create a new tax system.
The Fair Tax- this article is a little flowery and puts this idea in a great light, but on the whole the plan seems quite sound and seems to solve many of the problems people have with the income tax. This plan as it’s laid out also seems to not diminish the overall revenue the government receives, and an added bonus is it eliminates the IRS: thus freeing up a large block of tax expenditure for other government projects.

Tax Simplicity:
In the year 2000, studies estimated that taxpayers spent 3.2 billion hours and $18.8 billion filling out tax forms. In 2004, presidential candidate Steve Forbes proposed a flat tax that would "simplify the tax process, eliminating dozens of pages of forms and boiling hundreds of pages of the tax code down to one easy-to-use form. With this new system, you can figure out whether or not you need to pay taxes just by filling out three lines. The first is your income; the second is your marital status; the third line is the number of children you have...[In fact,] under my plan, more than half of America's taxpayers won't need to file any tax forms at all." As you can see, the flat tax is much easier however, taxpayers must realize the implications of implementing a different system.

2 Tax Systems Compared:
Current Tax System:
Flat Tax System:

Gross income (wages, interest, etc.)-Deductions Wage Income-Exemptions

Adjusted gross Income-Exemptions-Itemized Deduction

Taxable Income=Taxable Income X 20%
=Taxes Owed-Credits
=Total tax payment- withholding

Final Refund Due

Total tax payment(Source: Public Finance & Public Police, First Edition, Jonathan Gruber. Chapter 25. Pages 695-696)

This is something that is interesting to think about, and wonder if it will ever happen. If this does eventually become a reality there will be a lot of people out of a job.