Lecture Issues in economics today - Chapter 36

Chapter 36
Personal Income Taxes

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Chapter Outline
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HOW INCOME TAXES WORK
ISSUES IN INCOME TAXATION
INCENTIVES AND THE TAX CODE
THE TAX DEBATE OF THE 1990s
AND BEYOND

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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.
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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.
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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
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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.
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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
standard
deduction =
($4400 for a
single person and
$7350 for a

married couple) 

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.

Tax Table

= Taxable
Income

=>

=>Taxes Owed
­
Credits

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

=
What You Owe
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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 Income Tax
– 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.
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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.
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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.
– The tax rate is lower for capital gains than for ordinary
income.

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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.
– 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.

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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%.

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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.

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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
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% o f p e r s o n a l in c o m e ta

Who Pays Income Taxes: A
Graphical Portrayal

Income and Tax D

1

0.8
0.6
0.4

0.2
0

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

Higher income earners pay a higher percentage of the income
than they receive in income. The red line indicates perfect
equality and the income line is closer to equality than the tax line.
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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
favor of high-income taxpayers.
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