Lecture Issues in economics today - Chapter 36

After studying this chapter you will be able to understand: What is land? Economic rent, are prices high because rents are high, or are rents high because prices are high? What is capital? How is the interest rate determined? The net productivity of capital, the capitalization of assets, the present value of future income, how are profits determined? Theories of profit.

Chapter 36

Personal Income Taxes

Chapter Outline

• HOW INCOME TAXES WORK

• ISSUES IN INCOME TAXATION

• INCENTIVES AND THE TAX CODE

• THE TAX DEBATE OF THE 1990s

AND BEYOND

Where Personal Income

Taxes Fit

• In 2000 the federal government

collected $1,956 billion in taxes.

• $952 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.

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 Income Tax Return filed

by April 15th of the following year.

The Vocabulary of Income Taxes

• Adjusted Gross Income (AGI)

– total net income from all sources

• 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 Income

– AGI-Exemptions-Deductions

More Vocabulary

• Filing Status

– the type of household for tax purposes (Single, Married Filing Jointly, Married Filing Separately and Single Head of Household)

• Marginal Tax Rate

– the percentage of each dollar in that bracket that must be paid in tax

• Tax Credits

– The reductions off of the amount of tax owed

How the Pieces Fit Together: 2000 Tax Year

AGI

Adjusted Gross Income =

Wages+Salaries+Tips+Inter

est+ Dividends+Business

Profit+ Rents

(received)+Capital

Gains+other income.

­

Exemptions

Exemptions=$2800*(the number of people in the household + the number of people over 65 + the number of people who are blind)

­

Deductions

The Bigger of

Itemized Deductions=medical expenses in excess of 7.5% of AGI + interest paid on a home mortgage + unreimbursed business expenses in excess of 2% of AGI + charitable donations state and local income and property taxes.

standard deduction = ($4400 for a single person and

$7350 for a married couple) 

= Taxable

Income => =>

Tax Table

Taxes Owed

­ Credits

Credits=Earned Income Tax Credit +College Tuition Credit+ Child Care Credit+Dependent Child Credit

= What You Owe

• Horizontal Equity

– equal people should be treated equally

• Vertical Equity

– people across the income scale are treated fairly with regard to ability to pay

– with higher income you pay a higher rate of tax

The marginal tax rate rises from 15% to 28% to 31% and higher as taxable income rises

Issues in Income Taxation:

Fairness

Issues in Income Taxation:

The Equity-Simplicity Tradeoff

• Economists want a tax code to be neutral (a characteristic of a tax code that implies that it does not favor particular forms of income or expenditure).

• For neutrality to happen taxes must often be complicated Consider capital gains (any

profit you have from asset sales) as an example It order to tax capital gains in a neutral way to other income you have to make capital gains tax rules very

complicated.

Capital Gains

• To be neutral you should

– not tax the gains that exist only because of inflation, – tax each year based on the paper increases or decreases in value (called on accrual) rather than when the asset is sold (called on realization)

– tax the capital gains on assets of those who have died before they sold their assets.

• To be simple you should

– tax all gains, – tax only on realization, – Forgive capital gains taxes on death (because locating the paperwork is difficult.

• What we do

– Tax all gains on realization while forgiving gains for those who have died

Incentives in the Tax System

• Whether the income tax discourages or

encourages work or savings boils down to the

that tax policy.

– Income effect

• The effect on work or saving just accounting for the tax money taken away.

– Substitution effect

• The effect on work or saving just accounting for the change in the relative value of working or saving.

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% increase in the marginal tax rate 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%

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.

Who Pays the Federal Income

Taxes

• the bottom half of taxpayers pays only

5% of the income tax while the top half pays the remaining 95%

• the top 10% of taxpayers accounts for

63% of federal income taxes paid

• The top 5% of taxpayers accounts for

more than half of federal income taxes paid

Who Pays Income Taxes: A

Graphical Portrayal

0

0.2

0.4

0.6

0.8

1

0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90 1.00

% of tax returns Returns AGI TAX

Income and Tax Distributions

Higher income earners pay a higher percentage of the income

than they receive in income The red line indicates perfect

Tax Debates

• The tax debates between Republicans and

Democrats tend to boil down to whether tax cuts should go to

– The people who pay federal income taxes

– The people who “need” the money

• An across-the-board tax cut

– will go almost entirely to people in the top 50% of income earners and more than half will go the top 5%

– will change the after-tax income distribution in