Gruber4e ch18

Public Finance and Public Policy Jonathan Copyright Gruber 2010Fourth WorthEdition Publishers Copyright 2012 Worth Publishers
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Taxation in the United States and Around the World
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18.1 Types of Taxation 18.2 Structure of the Individual Income Tax in the United States 18.3 Measuring the Fairness of Tax Systems 18.4 Defining the Income Tax Base 18.5 Externality/Public Goods Rationales for Deviating from Haig-Simons 18.6 The Appropriate Unit of Taxation 18.7 Conclusion PREPARED BY
Dan Sacks
Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright 2012 Worth Publishers
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CHAPTER 18 TAXATION IN THE UNITED STATES AND AROUND THE WORLD
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18.1
Types of Taxation
Taxes on Earnings
o Payroll tax: A tax levied on income earned on ones job.

Taxes on Individual Income
o Individual income tax: A tax paid on individual income accrued during the year.
o Capital gains: Earnings from selling capital assets, such as stocks, paintings, and houses.
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18.1
Types of Taxation
Taxes on Corporate Income
o Corporate income tax: Tax levied on the earnings of corporations.

Taxes on Wealth
o Wealth taxes: Taxes paid on the value of the assets held by a person or family.
o Property taxes: A form of wealth tax based on the value of real estate. o Estate taxes: A form of wealth tax based on the value of the estate left behind when one dies.
Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright 2012 Worth Publishers 5 of 46
18.1
Taxes on Consumption
Consumption tax: A tax paid on individual or household consumption of goods (and sometimes services). Sales taxes: Taxes paid by consumers to vendors at the point of sale. Excise tax: A tax paid on the sales of particular goods, for example, cigarettes or gasoline.
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18.1
Tax Revenue by Type of Tax in the United States (2010, % of Total Tax Revenue) Federal Individual income taxes Social insurance contributions (payroll tax) Corporate taxes Consumption tax Property tax Other 42% 35 13 3 0 7 State and Total Local 20% 34% 0 4 34 33 9 24 10 14 11 7
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18.1
Taxation Around the World
Individual income taxes Social insurance contributions (payroll tax) Corporate taxes Consumption tax Property tax Other
OECD Norway Denmark Average 24% 55% 25% 23 22 26 3 2 2 5 30 4 4 27 8 31 5 4
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18.2
Computing the Tax Base
Income tax is assessed on adjusted gross income minus deductions and exemptions. Gross income: The total of an individuals various sources of income.
Adjusted gross income (AGI): An individuals gross income minus certain adjustments.
Taxable income: The amount of income left after
subtracting exemptions and deductions from adjusted gross income.
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18.2
Adjustments vary over time, but as of 2009 they include:

Some contributions to retirement savings
Alimony paid to a former spouse Health insurance premiums paid by the self-employed One-half the payroll taxes paid by the self-employed Educator expenses and interest paid on student loans Contributions to Health Savings Accounts Expenses for job-related moves
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18.2
To form AGI from gross income, subtract exemptions and deductions. Exemption: An amount tax payers subtract from AGI for dependent household members, self, and spouse.
Taxpayers can take one of two kinds of deductions:

o Standard deduction: A fixed deduction that a taxpayer can take. o Itemized deduction: Taxpayer deducts all qualifying expenses.
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18.2
Deductible expenses include:

Medical and dental expenses exceeding 7.5% of AGI
Other taxes paid, such as state or local income tax Interest paid on investments and home mortgages Gifts to charity Casualty and theft loss Unreimbursed employee expenses
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18.2
U.S. Federal Income Tax Rate Schedule, 2012
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18.2
Tax Rates and Taxes Paid
Tax credits: Amounts by which taxpayers are allowed to reduce the taxes they owe to the government through spending, for example, on child care. Withholding: The subtraction of estimated taxes owed directly from a worker s earnings. Refund: The difference between the amount withheld from a worker s earnings and the taxes owed if the former is higher.
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18.2
Computing Jacks Taxes
Gross income
Deductions
= Adjusted gross income (AGI)
= Taxable income Find taxes owed from tax schedule = Total tax payment = Final payment (refund) due
18.2
APPLICATION: The Coming AMT Timebomb
In 1969, Treasury Secretary Joseph W. Barr found that 155 high-income households had earned over $200,000 in 1966 but paid zero income taxes. The alternative minimum tax was meant to correct make sure high-earners still paid taxes. o Alternative Minimum Tax: A tax schedule applied to taxpayers with a high ratio of deductions and exemptions to total income. Requires that income (before subtracting exemptions and deductions) be taxed at 26% or more.
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18.2
APPLICATION: The Coming AMT Timebomb
The AMT allows a single deduction of $33,750 for individuals and $45,000 for joint filers
but these numbers are not indexed for inflation, so many households end up facing the AMT.
The AMT add dramatic complexity to the tax code, so repealing it has broad support
but it is an important source of revenue; repeal would cost at least $1.3 trillion between 2011 and 2012.
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18.3
Measuring the Fairness of Tax Systems
Two key features of any tax system:
o Marginal tax rate: The percentage that is paid in taxes of the next dollar earned.
o Average tax rate: The percentage of total income that is paid in taxes. In the United States, the marginal tax rate rises with income, from 10% to 35%.
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18.3
Vertical and Horizontal Equity
Two goals are in measuring tax fairness:
Vertical equity: The principle that groups with more resources should pay higher taxes than groups with fewer resources. Horizontal equity: The principle that similar individuals who make different economic choices should be treated similarly by the tax system.
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18.3
Measuring Vertical Equity
Vertical equity likely requires progressive taxation.
Progressive: Tax systems in which effective average tax rates rise with income.
Proportional: Tax systems in which effective average tax rates do not change with income so that all taxpayers pay the same proportion of their income in taxes. Regressive: Tax systems in which effective average tax rates fall with income.
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18.3
APPLICATION: The Political Process of Measuring Tax Fairness Fairness is ambiguous, and politicians pick the meaning that bests suit them. Consider the income tax cuts proposed by President Bush and signed into law by Congress in 2003:
o 44% of the tax cuts went to the top 1% of payers o but top taxpayers pay 38% of income taxes. o but they pay only 30% of all taxes. o but 34 million families with children would
receive an average tax cut of $1,549 each.
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18.4
The Haig-Simons Comprehensive Income Definition
What kind of income should be taxed?
Haig-Simons comprehensive income definition: Taxable resources are an individuals ability to pay (i.e. potential annual consumption). Potential annual consumption: Total consumption during the year, plus any increases in wealth.
Difficulties: o Defining power to consumption/ability to pay o Non-consumption expenditures
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18.4
Deviations Due to Ability-to-Pay Considerations
Haig-Simons promotes horizontal equity by treating all income equally.
One reason for deviation is to account for not associated with desired consumption.
o Deductions for property and casualty losses
o Deduction for medical expenditures

o Deduction for state and local tax payments
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18.4
APPLICATION: What Are Appropriate Business Deductions? Hard to determine appropriate business deductions:
A rabbi claimed as a business expense the $4,031 he
spent on 700 guests who attended his sons bar mitzvah.

o Tax court found the Rabbi was not required to
invite the entirecongregationas a condition of his employment.

An exotic dancer claimed breasted implants as a
business expense.
o Tax court agreed since the implants were far too
large for the dancer to derive pleasure from.
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18.4
APPLICATION: What Are Appropriate Business Deductions?

The entertainer Dinah Shore claimed several dresses
as business expenses, prompting an investigation by the IRS.

o Dinah Shore ruling: A dress may be deducted as
a business expense only if it is too tight to sit in.

A man tried to deduct $30,000 in expenses on illegal
drugs.
o Allowed to claim deductions, he was sentenced
for criminal charges.

Many OECD countries have traditionally allowed/
treated foreign bribes as business expenses.
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18.5
Externality/Public Goods and Charitable Giving
One reason to deviate from Haig-Simons is to correct externalities.
Charitable giving likely underprovided.

o People may give to homeless shelters because of the tax break, but these would be underfunded otherwise.
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18.5
Spending Crowd-Out versus Tax Subsidy Crowd-In
Alternatively, the government could it could provide homeless shelters itself. Why not do so?
If the government subsidizes homeless shelters, the amount of private charitable giving to those shelters would most likely fall.
When the government tax subsidizes charitable giving, it may crowd in, or increase, private contributions.
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18.5
Marginal versus Inframarginal Effects of Tax Subsidies Tax breaks have the marginal and inframarginal effects. Marginal impacts: Changes in behavior the government hopes to encourage through a given tax incentive. Inframarginal impacts: Tax breaks the government gives to those whose behavior is not changed by new tax policy.
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18.5
Effects of Tax Subsidies versus Direct Spending
Mathematically, the government should use a tax break instead of direct spending if: The increase in charity per $ of tax break > 1 Reduction in charity per $ of government spending
If this holds, then giving more of a tax break (and reducing government spending) increases charitable giving.
Several studies have concluded that for each 1% fall in the price of charitable giving, the amount of giving rises by 1%.
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18.5
Consumer Sovereignty versus Imperfect Information
Direct government provision imposes preferences about how funds are spent.
Tax subsidies to private individuals respects the preferences of citizens.

But the private sector may not have the appropriate mechanisms in place to ensure efficient distribution of charitable spending.
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18.5
Housing
Home ownership is subsidized through the home mortgage interest deduction. o Mortgage: Agreement to use a certain property, usually a home, as security for a loan.
Rent is not tax deductible.

Home ownership may provide externalities through responsible citizenship.
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18.5
EVIDENCE: The Social Benefits of Homeownership
The American Dream Demonstration subsidized home ownership for a random treatment group.
Subsidy increased home ownership by 713%.

But no external benefits: o Treatment and control groups equally involved in civic activities. o Treatment group spent more on home improvements, but only on the inside, providing no external benefit.
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18.5
Effect of Tax Subsidies for Housing
Despite wide variation in this tax subsidy, the home ownership rate has remained essentially constant since the 1950s, at about 65%. The tax subsidy is inducing individuals to spend more on houses, but not moving people from renting to buying.
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18.5
Tax Deductions versus Tax Credits
Tax subsidies can be offered as deductions or credits.
Tax deductions: Amounts by which taxpayers are allowed to reduce their taxable income through spending on items such as charitable donations or home mortgage interest.
Tax credits allow taxpayers to reduce the amount of tax they owe to the government by a certain amount (e.g., the amount they spend on child care).
How should the government decide which to use?
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18.5
Efficiency Considerations
Consider replacing charitable giving deduction with a tax credit for up to $1,000. For people giving less than $1,000, the credit provides a much stronger incentive to increase giving up Once a person gives more than $1,000, there is no more benefit from the tax credit. Policy preference depends on: o The nature of the demand for the subsidized good. o How important it is to achieve some minimal level of the behavior.
18.5
Equity Considerations
On vertical equity grounds, tax credits are more equitable than deductions. The value of a deduction rises with ones tax rate, making deductions regressive.
Credits, on the other hand, are available equally to all incomes so that they are progressive.
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18.5
APPLICATION: The Refundability Debate
Should tax credits be refundable?
Refundable: Describes tax credits that are available to individuals even if they pay few or no taxes.
Many conservatives object to the notion that those who owe little or no income taxes get a refund. Supporters note that, while low-income families pay little income tax, they do pay a large share of their income on other taxes.
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18.5
APPLICATION: The Refundability Debate
Tax refunds and the child credit:
The child credit was a non-refundable tax credit for low- and middle-income families.
In 2001 tax cuts, families received a refund for at most 10% of their income above $10,500. 2003 tax cuts expanded the credit, and the President said families would get a $400 check in the mail. But only high-income families received the refund because the refund increases with income.
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18.5
Bottom Line: Tax Expenditures
Deviations from Haig-Simons are tax expenditures.
o Tax expenditures: Government revenue losses attributable to tax law provisions that allow special exclusions, exemptions, or deductions from gross income, or that provide a special credit, preferential tax rate, or deferral of liability.
Tax expenditures are enormous, predicted to be $1.3 trillion in 2013.
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18.5
Select Tax Expenditures in 2013
Tax Expenditure Employer-provided health insurance Home mortgage interest deduction Exclusion of pension/401(k) contributions
Amount (Millions) $180,580 100,910 72,740
Exclusion of net imputed rental income Deductibility of charitable contributions Total income tax expenditures
51,080 39,770 1,135,967
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18.6
The Problem of the Marriage Tax
How should couples be taxed?
We might like a tax system to satisfy three principles:

o Progressivity o Across-Family Horizontal Equity o Across-Marriage Horizontal Equity It is impossible to achieve all three goals at once.
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18.6
Any tax system that tries to achieve horizontal equity and progressivity have a marriage tax for some people. o Marriage tax: A rise in the joint tax burden on two individuals from becoming married.
Progressivity, with taxes applied to individual income, means that two couples with different earnings distributions have different tax burdens.
Taxing family incomes leads to a marriage tax.
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18.6
Michelle Barack
Individual Income $140,000 10,000
Individual Tax $32,000 1,000
Family Tax with Individual Filing 35,000
Bill Hilary
75,000 75,000
13,000 13,000
26,000
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18.6
Marriage Taxes in Practice
Very large deductions for married couples relative to single tax filers would eliminate marriage tax. But no set of deductions can make the system of family-based taxation marriage neutral. Marriage Taxes in the United States o Some families face marriage subsidies and some face marriage taxes. o Some families pay marriage taxes.
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18.6
Marriage Taxes around the World
The United States is almost alone in having a tax system based on family income. Of the industrialized nations in the OECD, o 19 tax husbands and wives individually
o five (France, Germany, Luxembourg, Portugal, and Switzerland) offer marriage subsidies to virtually all couples through family taxation with income splitting.
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18.7
Conclusion
In this chapter, we set the stage for our study of taxation by discussing: The different types of taxation used by the United States and the rest of the world.
How to measure tax fairness.

The key issues policy makers face in designing the base of income taxation.
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Public Finance and Public Policy Jonathan Copyright Gruber 2010Fourth WorthEdition Publishers Copyright 2012 Worth Publishers

Taxation in the United States and Around the World

CHAPTER 18 TAXATION IN THE UNITED STATES AND AROUND THE WORLD

CHAPTER 18 TAXATION IN THE UNITED STATES AND AROUND THE WORLD

o Payroll tax: A tax levied on income earned on ones job.

CHAPTER 18 TAXATION IN THE UNITED STATES AND AROUND THE WORLD

Taxes on Corporate Income

o Corporate income tax: Tax levied on the earnings of corporations.

CHAPTER 18 TAXATION IN THE UNITED STATES AND AROUND THE WORLD

CHAPTER 18 TAXATION IN THE UNITED STATES AND AROUND THE WORLD

CHAPTER 18 TAXATION IN THE UNITED STATES AND AROUND THE WORLD

Taxation Around the World

OECD Norway Denmark Average 24% 55% 25% 23 22 26 3 2 2 5 30 4 4 27 8 31 5 4

CHAPTER 18 TAXATION IN THE UNITED STATES AND AROUND THE WORLD

Computing the Tax Base

subtracting exemptions and deductions from adjusted gross income.

CHAPTER 18 TAXATION IN THE UNITED STATES AND AROUND THE WORLD

Computing the Tax Base

Adjustments vary over time, but as of 2009 they include:

CHAPTER 18 TAXATION IN THE UNITED STATES AND AROUND THE WORLD

Computing the Tax Base

Taxpayers can take one of two kinds of deductions:

CHAPTER 18 TAXATION IN THE UNITED STATES AND AROUND THE WORLD

Computing the Tax Base

Deductible expenses include:

CHAPTER 18 TAXATION IN THE UNITED STATES AND AROUND THE WORLD

U.S. Federal Income Tax Rate Schedule, 2012

CHAPTER 18 TAXATION IN THE UNITED STATES AND AROUND THE WORLD

Tax Rates and Taxes Paid

CHAPTER 18 TAXATION IN THE UNITED STATES AND AROUND THE WORLD

Computing Jacks Taxes

CHAPTER 18 TAXATION IN THE UNITED STATES AND AROUND THE WORLD

APPLICATION: The Coming AMT Timebomb

CHAPTER 18 TAXATION IN THE UNITED STATES AND AROUND THE WORLD

APPLICATION: The Coming AMT Timebomb

CHAPTER 18 TAXATION IN THE UNITED STATES AND AROUND THE WORLD

Measuring the Fairness of Tax Systems

Two key features of any tax system:

CHAPTER 18 TAXATION IN THE UNITED STATES AND AROUND THE WORLD

Vertical and Horizontal Equity

Two goals are in measuring tax fairness:

CHAPTER 18 TAXATION IN THE UNITED STATES AND AROUND THE WORLD

Measuring Vertical Equity

Vertical equity likely requires progressive taxation.

CHAPTER 18 TAXATION IN THE UNITED STATES AND AROUND THE WORLD

receive an average tax cut of $1,549 each.

CHAPTER 18 TAXATION IN THE UNITED STATES AND AROUND THE WORLD

The Haig-Simons Comprehensive Income Definition

What kind of income should be taxed?

CHAPTER 18 TAXATION IN THE UNITED STATES AND AROUND THE WORLD

Deviations Due to Ability-to-Pay Considerations

Haig-Simons promotes horizontal equity by treating all income equally.

o Deduction for medical expenditures

CHAPTER 18 TAXATION IN THE UNITED STATES AND AROUND THE WORLD

spent on 700 guests who attended his sons bar mitzvah.

invite the entirecongregationas a condition of his employment.

large for the dancer to derive pleasure from.

CHAPTER 18 TAXATION IN THE UNITED STATES AND AROUND THE WORLD

APPLICATION: What Are Appropriate Business Deductions?

as business expenses, prompting an investigation by the IRS.

a business expense only if it is too tight to sit in.

for criminal charges.

treated foreign bribes as business expenses.