PA 546 Constantine Hadjilambrinos
Income Taxes
Lecture 6
October 3, 2005
PA 546 Constantine Hadjilambrinos
History of the Income Tax
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First applied in 1862 to finance civil war—
expired in 1872.
Constitutional requirement for apportionment
of direct taxes prevented income tax from
being applied until 1913. Then, ratification of
16th amendment made income tax possible.
Until end of WW II, very few people earned
enough income to be eligible to pay tax.
PA 546 Constantine Hadjilambrinos
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Advantages
Equity: Measures ability
to pay
Equity: Adjustable for
individual circumstances
Broad base—possibly
less resource distortions,
(if low rate) efficiency
and equity advantages
Yield: Significant
revenue at socially
acceptable rates; rate
base self-adjusting with
economic growth
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Disadvantages
Transparency and
compliance: Too complex
Administration and
compliance: Too expensive
to collect
Adverse economic effects
Economic distortions
Equity: Too progressive, too
many loopholes
Overuse: Too burdensome
when rates too high
PA 546 Constantine Hadjilambrinos
Defining Income
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Economic Income (Haig-Simmons):
Consumption + increase in net wealth
(would include increase in stock values,
imputed income, gifts)
Adjusted Gross Income (AGI): IRS-defined
income—Excludes many types of income:
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Imputed income (too difficult to calculate)
Income from activities government wants to
promote
Income from state and municipal bonds
PA 546 Constantine Hadjilambrinos
Personal Deductions:
What is the rationale?
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Expenses outside control of household
Medical expenses, “casualty” losses, etc.
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Areas where Fed. Gov. wants to encourage
spending
Charitable contributions, home mortgage interest, etc.
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Adjusting gross income to net income
Moving expenses, business expenses, etc.
PA 546 Constantine Hadjilambrinos
Narrow definition of taxable income:
Many deductions, exclusions, & exemptions
Higher rates to generate needed revenue
Very high marginal rates (always higher than
average rates) contribute little revenue but
can have serious adverse effects on tax
system
PA 546 Constantine Hadjilambrinos
Preferential rates for some activities—
it all represents a violation of normal
principles
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Complicates tax system
Distorts tax system
Increases uncertainty
Decreases transparency
PA 546 Constantine Hadjilambrinos
Graduated tax structures
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Income separated into brackets ($0 - $10,000
and $1001-$10,000).
Each bracket subject to different tax rate ($0 $10,000 at 3% and $1001-$10,000 at 5%).
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Tax rate of highest bracket is the marginal tax
rate.
Not all income is taxed at the same rate
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Introduces distortions and inefficiencies.
PA 546 Constantine Hadjilambrinos
Average Tax Rate
ATR = Tax / Taxable Income
Taxable Income = Adjusted Gross Income – Exemptions
Tax = (SBracket Income x Bracket Tax Rate) – Tax Credits
PA 546 Constantine Hadjilambrinos
Effective Tax Rate
ETR = Tax / Adjusted Gross Income
Taxable Income = Adjusted Gross Income – Exemptions
Tax = (SBracket Income x Bracket Tax Rate) – Tax Credits
PA 546 Constantine Hadjilambrinos
Bracket creep: Movement into higher tax
bracket during high inflation.
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Accelerates collection and provides
macroeconomic tax brake.
Slows collection during recession—
macroeconomic stimulus.
Indexation: Adjusts tax brackets,
exemptions, standard deductions, etc. to
account for inflation.
PA 546 Constantine Hadjilambrinos
Corporate Income Tax
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Tax on profits (Earnings – expenses)
Multinational firms can avoid it:
Non–US branches can charge US branches high
prices for goods and services, artificially lowering US
profits
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State taxes—Issue of apportionment.
Dual taxation: Taxing both corporate profits
and individual dividend income taxes same
income twice.
PA 546 Constantine Hadjilambrinos
Payroll Tax
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Narrow tax, only applied to certain kinds of
income (wages and salaries).
Collected from employers, so easier to enforce.
Exclusion of income from interest, dividends,
capital gains, etc., creates both vertical and
horizontal equity issues.