CHAPTER 17
THE PERSONAL
INCOME TAX
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
Computation of Federal Personal Income
Tax Liability
Wages and compensation, Trade or business expenses,
interest, dividends, capital gain moving expenses, educator
(or loss), business income (or
expenses, self-employed
loss), pensions, farm income (or health insurance premium
loss), rents, royalties, Social
payments, student loan
Security benefits, etc.
payments, tuition and fees,
alimony paid, etc.
Tax Base
- “Above-the-line” Phase-out
deductions
Child tax,
with additional
income child tax, EITC,
Adjusted Gross
Income
Six HOPE
ordinary
rates
and
Lifetime Learning,
(10%,
15%,
25%,
electric vehicles, health coverage
- Exemptions 28%,
35%);mortgage interest,
tax, 33%,
adoption,
differs
by filing
retirement
savings contribution,
- Larger of standard
deduction
or itemized deductions
status;
special
child and
dependent care credit,
rates
creditfor
fordividends
the elderly or the disabled,
Start over to determine AMT
Taxable Income
and
capital
gainshomebuyer’s credit,
D.C. First-Time
tax liability using AMT base.
etc.; Phase-out with income
• tax rate
Pay tentative AMT liability in
excess of regular tax liability
Tax liability before credits
- Tax credits
Charitable contributions, home
mortgage interest, state and
local taxes, medical expenses
in excess of 7.5% of AGI,
casualty and theft losses, nonreimbursed employee
expenses; Phase out with
income; Differs by filing status
Regular tax liability
Pay tax or claim refund
17-2
Haig-Simons Income (Comprehensive Income)

Income = Consumption + DNet Worth

Maximum consumption taxpayers can enjoy
without spending down their wealth

Anything received that can be used, either
now or later, to purchase goods and services

Subtract costs of earning income
17-3
Items Included in H-S Income



Employer pension contributions and insurance
purchase
Transfer payments, including Social Security
benefits, unemployment compensation, and
welfare
Capital gains


Realized versus unrealized
Income in kind

Imputed rent
17-4
Some Practical and Conceptual Problems

Computing income net of business expenses

Computing capital gains and losses

Computing imputed income from durables

Valuing in-kind services
17-5
Evaluating the H-S Criterion

Equity – treats likes alike

Efficiency – treats all forms of income the
same; decisions made on the basis of
economic value not tax consequences
17-6
Excludable Forms of Money Income

Interest on State & Local Bonds

Some dividends

Capital gains

Employer contributions to benefit plans

Some types of saving


Individual retirement account (IRA)

Roth IRA

401(k) plan

Keogh plan

Education savings account
Gifts and Inheritances
17-7
Personal Exemptions

Allowable Exemptions





Taxpayer and spouse
Children under 19 (or 24 if in school)
Children and other relatives who pass certain tests
(depend on taxpayer for support)
Phase out
Why are there exemptions?


Adjust ability to pay for presence of children
Provide tax relief for low-income families
17-8
Deductions

Standard versus Itemized

Deductibility and Relative Prices

PZ  (1-t)PZ
17-9
Important Itemized Deductions

Unreimbursed medical expenses > 7.5% AGI

State and Local Income and Property Taxes

Certain Interest Expenses

Interest on consumer debt

Interest on qualified education loans

Interest on debt incurred to purchase financial assets

Interest on home mortgages

Interest rules in terms of H-S criterion

Tax Arbitrage

Charitable Contributions
17-10
More Deduction Issues

Deductions and complexity

Deductions versus credits

Itemized deduction phaseout

Standard deduction
17-11
Impact on the Tax Base
Impact of Subtractions from AGI on the
Tax Base, 2004
32%
68%
Subtractions from AGI
Taxable Income
17-12
Tax Expenditures

What are tax expenditures?

Annual tax expenditure budget

Technical problems with measuring tax
expenditures

Incentive effects

Defining income

Philosophical objections
17-13
The Simplicity Issue

Tax Reform Act of 1986 (TRA86)

Economic Growth and Tax Relief
Reconciliation Act of 2001 (EGTRRA)
17-14
Rate Structure
Official Statutory Tax Rate Schedule (2006)
Single Returns
Joint Returns
Taxable Income
Taxable Income
$0-$7,550
Marginal
Tax Rate
10%
$0-$15,100
Marginal
Tax Rate
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
17-15
Effective versus Statutory Rates

Statutory rates differ from effective rates

Tax system treats some forms of income
preferentially

Tax shifting

Excess burden and administrative costs
17-16
Flat Income Tax

Features of Flat income tax



Arguments in favor





Reduces excess burden
Reduces incentive to cheat
Greater simplicity
Equity
Arguments against



Applies same tax rate to everyone and each component of income
Limited deductions
Shifts burden from rich to middle class
Simplicity an illusion
Altig et. Al. [2001]
17-17
Taxes and Inflation

Tax Indexing

How inflation can affect taxes

Bracket creep

Deductions and exemptions set in nominal terms

Taxation of nominal capital gains

Taxation of nominal interest
17-18
Coping with the Tax/Inflation Problem

Ad hoc reductions in tax rates

Indexing of parts of tax code [1981]

Should indexing be maintained?

No – ad hoc adjustments force legislature to
reexamine the entire tax code

Yes – desirable to have a stable and predictable
tax code and fewer opportunities for legislative
mischief; repeal would have a larger impact on
low-income families
17-19
The Alternative Minimum Tax

Brief history of the AMT

Computing the tax base under AMT


Add AMT tax preferences to regular taxable income

Subtract AMT exemption

Alternative minimum tax income (AMTI)
Computing Tentative AMT


Apply AMT tax rate schedule to AMTI
Taxpayer pays higher of tentative AMT or regular income tax
liability
17-20
AMT as a Mass Tax


Why has AMT become more important?

AMT not adjusted for inflation

Cuts in regular tax
Problems with AMT

Fairness

Efficiency

Simplicity
17-21
Choice of Unit and the Marriage Tax

Three principles




The income tax should embody increasing
marginal tax rates
Families with equal income should, other things
being the same, pay equal taxes
Two individuals’ tax burdens should not change
when they marry; the tax system should be
marriage neutral
No tax system can adhere to all three
simultaneously
17-22
Tax Liabilities Under a Hypothetical System
Lucy
Individual
Income
Individual
Tax
$1,000
$ 100
Ricky
29,000
12,100
Ethel
15,000
5,100
Fred
15,000
5,100
Family Tax
with
Individual
Filing
Joint
Income
Joint Tax
$12,200 $30,000 $12,600
10,200
30,000
12,600
17-23
Brief History of Marriage Tax in the United
States

Pre-1948 taxable unit was individual

1948 family became taxable unit

Income splitting

1969 New tax rate schedule for unmarried people created

1981 New deduction for two-earner married couples added

1986 Two-earner deduction eliminated

2001 law reduces (but does not eliminate) marriage penalty
and adds “tax dowry”
17-24
Analyzing the Marriage Tax

Advantages to using the family as taxable unit



Disadvantages of using the family as taxable unit



Fairer treatment of nonlabor income (bedchamber
transfers of property)
Family a bedrock institution of society
Given high divorce rates, bedchamber transfers of
property may not be significant
Defining the family
Efficiency issues


Does tax system affect marriage and divorce rates?
Labor supply
17-25
Treatment of International Income

Global versus territorial systems

Equity

Efficiency

Production decisions

Residential decisions
17-26
State Income Taxes

State income taxes similar to federal tax

Lower marginal tax rates

Including state tax rates when assessing
overall marginal tax rates
17-27
Politics and Tax Reform

Disagreements among experts

Any change will hurt someone

Tax system with low rates and broad base is
not stable politically
17-28
Interest on State and Local Bonds
ip = 15%
t = 30%
ig = 10.5%
ig = (1-t)ip
ip = 15%
t1 = 30%
t2 = 20%
ig = 10.5%
ig = 12%
If person 2 lends $1,000 Treasury loses
$1,000*.15*.20 = $30 and State saves $1,000*.03 =
$30
If person 1 lends $1,000 Treasury loses
$1,000*.15*.30 = $45 and State saves $1,000*.03 =
$30
17-29
Capital Gains
P = $100,000
g = 10%
$100,000*(1+.1)^20 = $672,750
Capital Gain = $672,750 - $100,000 = $572,750
Tax $572,750 * .2 = 114,550
Net Gain = $458,200
P = $100,000
g = 10% net g = 10%(1-.2) = 8%
$100,000*(1+.08)^20 = $466,096
Capital Gain = $466,096 - $100,000 = $366,096
Taxes deferred are taxes saved
Lock-in Effect
Gains Not Realized at Death
17-30
Evaluation of Capital Gains Rules


No justification under optimal tax literature
for preferential treatment of capital gains
under H-S criterion
Other justifications




Capital gains are unexpected windfalls
Require sacrifice of abstaining from consumption
Needed to stimulate capital accumulation and risk
taking
Counterbalance to effect of inflation
17-31
Tax Arbitrage
Assume Caesar pays taxes at a 35% rate and can borrow all he
wants at a 15% interest rate
Let Cesar borrow $1,000.
Each year he pays $150 in interest (= .15*1,000)
Interest payment reduces taxable income $150 and saves $52.50 in
taxes (= .35*150)
His net payment of interest is $150 - $52.50 = $97.50 for an
effective interest rate of $97.50/$1,000 = 9.75%.
If he can invest in state & local bonds at 11%, the tax system has
created a “money machine.”
17-32
Taxation of Nominal Interest
Real after-tax rate of return: r = (1 – t)i – π
Let t = 25%, i = 16%, π = 10%
r = (1 - .25)(.16) - .10 = .02 = 2%
Now assume expected rate of inflation and nominal interest
rate both increase by 4 percentage points
r = (1 - .25)(.20) - .14 = .01 = 1%
17-33