14 CHAPTER Personal Income Taxation in the United States PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe

14CHAPTER

Personal Income Taxation in the United

StatesPUBLIC SECTOR ECONOMICS: The Role of Government in the American

EconomyRandall Holcombe

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PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe

Brief History of U.S. Brief History of U.S. Income Tax SystemIncome Tax System

First income tax - 1861-1871First income tax - 1861-1871 Financed Civil WarFinanced Civil War Relatively low tax rateRelatively low tax rate

Federal Income Tax - 1913Federal Income Tax - 1913

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WithholdingWithholding

Employer withholding established Employer withholding established during WWIIduring WWII

Portion of employee’s pay sent Portion of employee’s pay sent directly to federal governmentdirectly to federal government

Government able to collect more in Government able to collect more in income taxesincome taxes

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Tax Reform in Tax Reform in 1964, 1986, and 20021964, 1986, and 2002

1964 1964 Tax cut to stimulate aggregate demandTax cut to stimulate aggregate demand Keynesian principlesKeynesian principles

1986 1986 Tax Reform ActTax Reform Act Concerned excess burden of taxationConcerned excess burden of taxation

2002 2002 No clear motivationNo clear motivation

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Calculating Taxable Calculating Taxable IncomeIncome

Computation of IncomeComputation of Income Taxable income includes: Taxable income includes:

WagesWages SalariesSalaries TipsTips InterestInterest DividendsDividends

Capital gains taxed at lower rateCapital gains taxed at lower rate

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ExemptionsExemptions

Personal exemptionPersonal exemption Individual retirement accountsIndividual retirement accounts AlimonyAlimony Adjusted gross income = total Adjusted gross income = total

income minus exemptionsincome minus exemptions

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DeductionsDeductions

Standard deductionStandard deduction – fixed amount – fixed amount Itemized deductionItemized deduction – addition of – addition of

allowable deductionsallowable deductions Medical and dental expensesMedical and dental expenses State, local, and property taxesState, local, and property taxes Home mortgage interestHome mortgage interest Charitable contributionsCharitable contributions

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Tax ComputationTax Computation

Taxable Income = Total income Taxable Income = Total income minus exemptions and deductionsminus exemptions and deductions

Compute tax due on taxable incomeCompute tax due on taxable income

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Marginal Rates in 2003 Marginal Rates in 2003 for a Single Individualfor a Single Individual

Taxable I ncome Marginal Tax RateUp to $7,000 10%$7,001 to $28,400 15%$28,401 to $68,800 25%$68,801 to $143,500 33%$143,501 to $311,950 33%Above $311,950 35%

Table 14.3 Marginal Tax Rates in 2003 for a Single I ndividual

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Tax CreditsTax Credits

Can subtract certain items from tax Can subtract certain items from tax liabilityliability

Credits more beneficial than Credits more beneficial than exemptions/deductionsexemptions/deductions

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Broadening the Tax BaseBroadening the Tax Base

Exemptions, deductions, and credits Exemptions, deductions, and credits narrow tax basenarrow tax base

Broader base Broader base Allows lower marginal ratesAllows lower marginal rates Reduces excess burdenReduces excess burden

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Comparison of Broadly Comparison of Broadly Based and Narrowly Based and Narrowly

Based TaxesBased Taxes

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Alternative Minimum TaxAlternative Minimum Tax

Created in 1969Created in 1969 Targets upper-income taxpayers Targets upper-income taxpayers

using tax preferences to avoid using tax preferences to avoid federal income taxfederal income tax

Must calculate taxes without most Must calculate taxes without most tax preferences and pay AMT if tax preferences and pay AMT if higher than calculating tax burdens higher than calculating tax burdens by regular methodby regular method

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Tax ExpendituresTax Expenditures

Reductions in taxationReductions in taxation Designed to further some goal of Designed to further some goal of

social policysocial policy Create loopholes making tax Create loopholes making tax

structure less efficientstructure less efficient

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Inflation, Indexation, and Inflation, Indexation, and Bracket CreepBracket Creep

Indexation Indexation Tax rates adjusted for inflationTax rates adjusted for inflation

Bracket creep Bracket creep When nominal tax structure remains the When nominal tax structure remains the

same but taxpayers pay more in real same but taxpayers pay more in real taxes because of inflationtaxes because of inflation

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Individual Retirement Individual Retirement Accounts (IRA)Accounts (IRA)

Money contributed to IRA does not Money contributed to IRA does not count as taxable incomecount as taxable income

Tax paid on withdrawals from IRATax paid on withdrawals from IRA Eliminates double tax on savingEliminates double tax on saving Can only contribute limited amountCan only contribute limited amount

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Roth IRARoth IRA

Allows no deduction for depositsAllows no deduction for deposits Principle and earnings can be Principle and earnings can be

withdrawn tax-freewithdrawn tax-free

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Other Tax-Deferred Other Tax-Deferred Savings MethodsSavings Methods

Keogh plansKeogh plans 401(k)401(k) 403(b)403(b) Company pension plansCompany pension plans

Documents

14 CHAPTER Personal Income Taxation in the United States PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe