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ALL RIGHTS RESERVED. Instructors of classes adopting PUBLIC FINANCE: A CONTEMPORARY APPLICATION OF THEORY TO POLICY, Seventh Edition by David N. Hyman as an assigned textbook may reproduce material from this publication for classroom
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The Tax Base: Basic Rules for Calculating Taxable Income and Why Much of Income Is Untaxed Taxable Income is the portion of income
received by households that is subject to the personal income tax.
Gross Income is all income received during the year from taxable sources.
Adjusted Gross Income (AGI) is Gross Income – allowable adjustments (reimbursed employee business expenses, contributions to special retirement plans, penalties for early withdrawal, and alimony.
Itemized Deductions are expenses that are legally deductible from AGI to compute taxable income. The most significant of these are the deductions for home mortgage interest, major medical expenses, charitable contributions, and state and local income and property taxes.
Only 45% of total personal income in the United States is subject to the federal income tax. This can be seen with a simple example. Take a family of four with an income of
$35,000. If it takes the personal exemption for each person in the household and the standard deduction for a married couple filing jointly they only have to pay taxes on $16,450. ($35,000 – 4 × $2,800 – $7,350).
Low-income households in the U.S. typically pay no federal income tax and many actually face a negative income tax.
This works because the Earned Income Tax Credit targets money to families with low-income and this credit can easily exceed their federal income tax obligations.
They still face FICA (Social Security) taxes and other state and local taxes.
The Effect of Various Credits on the Tax Rate Structure
Some credits, such as the Hope Credit and the Lifetime Learning credit have income phase-in and phase-out periods in which households with higher incomes are decreasingly eligible or ineligible for certain tax credits.
This can mean that an individual family has eleven potential tax brackets.
Tax preferences are usually justified because having the preference: Reduces Administrative Difficulty Improves Tax Equity Encourages Private Expenditures on
When a tax provision is difficult to administer or comply with properly, it is argued that a provision that partially or fully exempts certain income may be better than a complicated, difficult to comply with provision in terms of net tax efficiency.
This argument is used to justify the provision that allows capital gains taxes to be deferred until the gains are realized.
Tax preferences are often justified with the argument that they make society fairer.
A college education tax break can be justified as making it easier for lower-income households to send their children to college so that these children may have the same chance in life as children from higher-income households.
Capital Gains income is not taxed until it is realized. This tax deferral amounts to a tax preference. Those capital gains that are realized are taxed at a reduced
rate (10% for those in the 15% tax bracket and at 20% for those in the higher tax brackets).
Capital gains taxes are typically forgiven at death. These amount to substantial preferences and are justified
by the fact that much of capital gains is not income at all but simply inflationary gains that should not be taxed under the Haig-Simons definition.
At various times, politicians have responded to the anger citizens have concerning the complicated nature of the federal income tax by recommending a flat tax.
Such a tax would allow few, if any, tax preferences and would tax the entire tax base at the same rate.
Capital Gains Taxes Inflation and Capital Gains: Inflation raises the price of
assets. Economists see this as taxing a gain that does not exist. All else equal, this provision overtaxes long-term capital gains income.
Taxation of Capital Gains on Realization: This provision allows people to decide when or if they will pay taxes on capital gains. You can defer the tax by deferring the gain.
The Stepped-up Basis on Death: This provision means that the taxes that would be owed on capital gains are forgiven at death.
The latter two provisions lead to a “lock-in effect” where people are encouraged to hold assets rather than sell them.
Prior to 1986 tax brackets were not subject to inflation indexation, which meant that inflation caused people to owe more taxes each year on the same real income. This is called bracket creep.
The AMT has not been indexed for inflation. Tax brackets are indexed by the CPI.
Economists generally agree the CPI over-estimates inflation by around 1 percentage point. This has the effect of lowering real taxes owed each year.
People who are married and earn about the same level of income pay more in taxes than they would if they were not married and simply living together. This is called the marriage penalty.
Married couples earning $50,000 where each party earns $25,000 a year pay more than $1000 more in tax because they are married.
Conversely, people who are married with only one spouse earning all or most of the income pay less than they would if they were not married and living together. This is called the marriage bonus.
Another policy option that has been suggested is to convert the system to a national sales tax or a national consumption tax. A sales tax would operate just like most sales tax
in the states that have them. A consumption tax would operate just like the
current income tax except reinvested capital gains would not be considered income and contributions to savings plans would be deductible.