Chs.17 and 18Personal Income Tax and

Behavior

Impact of Exemptions and Deductions on the Tax Base

Impact of Subtractions from AGI on the Tax Base, 2004

32%

68%

Subtractions from AGI Taxable Income

Tax Expenditures

• What are tax expenditures?

• Annual tax expenditure budget

• Technical problems with measuring tax expenditures– Incentive effects– Defining income– Philosophical objections

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

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

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

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

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

Tax Liabilities Under a Hypothetical System

Individual Income

Individual Tax

Family Tax with Individual

Filing

Joint Income

Joint Tax

Lucy $1,000 $ 100

$12,200 $30,000 $12,600Ricky 29,000 12,100

Ethel 15,000 5,100

10,200 30,000 12,600Fred 15,000 5,100

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”

Analyzing the Marriage Tax• Advantages to using the family as taxable unit

– Fairer treatment of nonlabor income (bedchamber transfers of property)

– Family a bedrock institution of society

• Disadvantages of using the family as taxable unit– 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

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

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

Politics and Tax Reform

• Disagreements among experts

• Any change will hurt someone

• Tax system with low rates and broad base is not stable politically

• -political patronage

• Ch. 21 discusses fundamental changes to tax system

Personal tax and behavior

1260

Effects of Taxation

Hours of leisure per week

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Hours of work before tax

Hours of work after tax

Labor Supply Response:Empirical Evidence

• Small inelastic response for men- .05

• Married women are more responsive- .4

Impact of taxes on savings

Empirical Evidence: Tax on Savings

• Expected real rate of return difficult to measure

• Bernheim(2002)—very little effect of after-tax ROR– Income and substitution effect tend to cancel

each other

• Tax expenditures for savings: 1975: $20b 2006: $105b