Major Tax Structures:Income Taxes

Troy University

PA6650- Governmental Budgeting

Chapter 8

Three Predominant Tax Bases

• INCOME

• Spending on GOODS & SERVICES

• PROPERTY

Overview

• Governments apply taxes to the income of individuals and corporations

– Unincorporated business (proprietorship, partnership) is taxed through the individual income tax system

– Wage and salary income (payrolls) and income of the self-employed are taxed through the individual income tax and by separate taxes to finance the social insurance system (Social Security, unemployment compensation)

– Corporate income taxation is through a separate system

Some Background• USA relied on excise taxes (customs,

duties, liquor taxes) and tariffs before the Civil War

• Income Tax levied from 1862-1872

• In 1894 another income tax.• Struck down by the Supreme Court as a direct tax

• 16th Amendment passed in 1913• 3-5% income tax in excess of $10,000• 1% of the population eligible to pay it

Some Background

• In 2004,– individual income taxes yielded $1,025.8 billion– Corporate income taxes yielded $258.9 billion– Social Security receipts yielded $822.2 billion– Total receipts of $3.2 trillion (all governments)

• Page 335 of text– Income tax is 40% of all government receipts– Income tax is 11% of total GDP

The Argument About Taxing Income

• FOR– Income is a reliable indicator of relative

affluence and capacity to bear burden– Income tax can be made to account for

individual taxpayer conditions (adjustable)– The size of the income base permits

significant revenue at socially acceptable rates (good yield)

– The resource distortion is low

The Argument About Taxing Income

• AGAINST• Transparency and compliance (complicated,

loopholes)• Administration and compliance (expensive and

complex to administer)• Economic effects (some negative effects)• Economic distortion (some unique groups

punished or favored)• Equity (distributes the cost of government unfairly)• Overuse (has become a large burden at several

governmental levels)

Individual Income Taxation

• How it works– Figure 8-1, page 341

Individual Income Taxation

• Defining Income• Wages• Salaries• Interest• Stock dividends• Rents• Royalties• Etc.

Individual Income Taxation

• Haig-Simons says:– “personal income is defined as the algebraic

sum of 1) the market value of rights exercised in consumption and 2)the change in the value of the store of property rights between the beginning and the end of the period in question”

(text lists examples of some problems with Haig Simons)

Adjusted Gross Income

• Applies to net income, not gross receipts

• Adjusted for expenses

• Other adjustments (alimony, pensions)

• Many exclusions (food stamps, Social Security, tax-exempt bonds, life insurance receipts, gifts)

• Tax-exempt municipal bonds are a federal subsidy to states/localities

Personal Deductions

• May improve horizontal and vertical equity

• Three types of itemized personal deductions

• Medical, dental, casualty, theft, state & local taxes (these are not under your control)

• Encouraged spending (charitable contributions, home mortgage interest)

• Net income adjustments (job expenses, education expenses, tax prep fees)

• Standard deduction still available (about $5K)

Personal Exemptions

• Flat amount

• About $3k per person

• Table 8-3 page 348

Taxable Income

• Take AGI and subtract personal deductions and exemptions

• TAX YIELD = TAX BASE x TAX RATE

• Trend is toward broader base, lower rates

Tax Rates

• Federal tax rates increase as income increases

• AVERAGE RATE = tax liability/taxable income

• MARGINAL RATE = increase in tax liability from an additional $1 in income

• Average rate is always below the marginal rate.

• It means that you will always pay less than a dollar in tax for an additional dollar earned

Credits

• Direct forgiveness of tax owed…comes right off of what you owe in tax

• Powerful device to stimulate desired activity

• Examples include political contributions, energy saving purchases, home purchase, child care, low-income EITC)

Effective Tax Rates

• Nominal rates are the published rates• Marginal rates are each additional dollar

earned• Average rate is tax liability/taxable income

• AVERAGE EFFECTIVE RATE is taxes paid/AGI (includes all the credits and loopholes)

Practice• Page 358

• Total income = $142,500• Municipal Bond income = $7,500 (excluded from total

income)• Adjustments of $12,000• AGI = $130, 500• Itemized deductions = $12,500• 3 EXEMPTIONS @ $3,200 = $9,600• Taxable income = $130,500 – ($12,500+$9,600) =

$108,400• Tax table shows a tax owed of $20,480

• WHAT ARE AVERAGE, AVERAGE EFECTIVE, MARGINAL RATES?

Practice– AVERAGE RATE

• Tax/Taxable Income• $20,480 / $108,400 = 18.8%

– AVERAGE EFFECTIVE RATE• tax / (taxable income+adjustments+exclusions)• $20,480 / ($108,400 = $12,000 + $7,500) = 16%

– MARGINAL RATE • change in tax/change in taxable income• 25% (from the table)

Indexation

• Removes the effect of bracket creep– Bracket creep – higher income due to inflation without

any real increase in purchasing power.

Corporate Income Tax

• Corporate net income tax based on net earnings of the company

• Allows deductions for operating costs and charity

• Federal rate of 35% @$18.3 million or more

• Complex problem calculating depreciation, international transactions (transfer pricing)

• Different formulas for multiple states based on property, payroll, or sales

Integration with theIndividual Tax

• Double tax should be eliminated

• Currently there is no full integration between the individual income tax and the corporate income tax

Payroll Taxation

• Social Security, Medicare, Unemployment Compensation, Earned Income Taxes

• Peculiarities of payroll taxes– Vertical and horizontal equity problems– Unusual rate patterns– Earmarks for particular funds

Conclusion

• Income tax is the heart of the federal revenue system

• Problems with income tax include:– Inefficiency– Horizontal inequity– Expensive collection– Failure of transparency

• Corporate and payroll taxes yield considerable revenue