Chapter 13

The Theory of
Income Taxation

1
Income Taxes
 Income Taxes were introduced as an emergency
measure during the U.S.
Civil War.

 An 1894 attempt to introduce a regular income tax

was declared unconstitutional.

 In 1913, the 16th Amendment to the U.S.

Constitution allowed for personal and business
income taxes.

2
The First Regular US Income Tax
 The initial income tax exempted the
first $3,000 for singles and the first
$4,000 for married couples.

 It imposed a 1% rate on income up to

$20,000 and higher rates at higher
levels of income.

3
 Comprehensive Income: The Haig-
Simons Definition
It is “the exercise of control over the use of society’s
scarce resources.”
Algebraically it is defined as

I = C + ∆ NW
Where
I = Income
C = Consumption
∆ NW = The Change in Net Worth
4
Implications of the Haig-Simons Definition

 If a person borrows to consume, there is

no increase in income because the
change in net worth is negative.

 If a person sells an asset so as to

consume, there is no increase in income.

5
Capital Gains
 Capital gains are the increased value of assets
that a person holds.

 If people own stocks that go up in value, net worth

increases and therefore they have an increase in
income by this definition.

 This is true whether or not they actually sell the

assets and see the money in their bank accounts.

6
Realized and Unrealized Capital Gains
 Realized Capital Gains are those gains
that a person has received by selling an
asset.

 Unrealized Capital Gains are those gains

that a person has not yet received by
selling an asset, but which exist only on
paper as the market price of the asset
they hold has increased.

7
 An Income Statement
Sources of Funds:
 Earnings from Sale of Productive Services
 Transfer Payments Received
 Capital Gains (or Losses)
Uses of Funds:
 Consumption
 Taxes
 Donations
 Gifts
 Saving (Increases in Net Worth)
Sources = Uses, So
Earnings + Transfer Payments + Net Capital Gains =
Consumption + Taxes + Donations + Gifts + Saving

8
 Modifications to the Income Definition
 The cost of acquiring income needs to be
accounted for in the definition.

 Earnings + Transfer Payments + Net Capital

Gains – Cost of Acquiring Income
=
Consumption + Taxes + Donations + Gifts +
Saving – Cost of Acquiring Income

9
 Problems with Measuring Income using the
Haig-Simons Definition
 How do you measure unrealized capital gains on assets
that are not regularly traded?

 Is the cost of an automobile used to drive to and from

work a “cost of acquiring income?” Are child care
expenses? Union Dues? Education expenses?

 How do you distinguish what part of an expense is a cost

of acquiring income and what part is merely
consumption?

10
In-Kind Income in Haig-Simons Definition

 Under the comprehensive income

definition, all income should be treated
equally, whether it is paid in cash or in-
kind.

 Many jobs offer free parking,

subsidized medical insurance.

11
Home Production
 Home production is any activity that is
performed by people in the home.

 Most of the things we do for ourselves can be

purchased.

 If you earn the money to have things done for

you, then you are taxed on that income. If you
do it yourself, you are not.

12
 The Home Itself

 Under a Haig-Simons definition of income,

whether or not you own your home, you are
consuming housing services and it is therefore
income.

 Economists call the money that homeowners

do not have to pay for the housing services
they consume imputed rent.

13
 The Impracticality of Taxing In-Kind
Income, Home Production, and Imputed Rent
 It would be impractical to tax any of these kinds of
income, because the value that is being received
by the consumer depends upon the tastes of the
consumer.

 Suppose the market value of a parking space for a

year is $1000. Suppose it is given to a person as a
part of their job. Taxing a person as though they
earned that $1000 would be inappropriate if they did
not value the parking space at $1000 and could not
sell the rights to that spot for $1000.

14
 A General Tax on Comprehensive
Income

 Suppose there is a flat-rate income tax

on all income. What are the effects on
the labor-leisure trade-off and the
savings decision?

15
Figure 13.1 The Impact of a Flat-Rate Income
Tax on the Work-Leisure Choice
J
Income per Day

J'
I1 E
IG
B U2
T {I E'
N
U1

H
0 L1 L2
Leisure Hours per Day 16
 The Algebraic View
 Individuals maximize welfare where
w = MRSLI.

 The after-tax wage is wN = wG(1 – t).

 Income is then I = wG(1 – t)(24 – L).

 This means that individuals maximize their welfare

in response to the tax by choosing labor such that
wG(1 – t) = MRSLI…

17
 Income and Substitution Effects of a
Tax on Labor Income
 It is possible for a tax to increase or decrease
the amount of work effort, depending on whether
leisure is a normal good.
 If people target the amount of money they must take
home to meet a standard of living, then a tax may
increase work effort.
 If leisure is a normal good, then the income effect
and substitution effect of a tax on labor income are in
the same direction and a tax decreases work effort.

18
Treatment of Capital Gains
 In the U.S. capital gains on assets held one year pay
a maximum rate of 15% (compared to 35% for
ordinary income).

 No capital gains taxes are owed:

 on residences (as long as the gain is less than $500,000),
 on inherited capital gains, or on
 unrealized capital gains.

 Little evidence exists to support the conclusion that a

lower rate encourages entrepreneurship.

19
Figure 13.2 Income and Substitution Effects of A
Tax Induced Wage Decline
I

C
Income per Day

I’
E1
E2 E’
U2
U1
B
∆ L1
H
0 L2 L1 L’

∆L
Leisure Hours per Day 20
 Labor Market Analysis of Income
Taxation: Perfectly Inelastic Supply
 Even if the labor supply curve is perfectly
inelastic, this does not imply that no excess
burden arises from a tax on labor income.

 The labor supply curve that is appropriate for

making such statements is the compensated
labor supply curve (which is almost certain to
be upward sloping, even if the regular labor
supply curve is not).
21
 Figure 13.3 Impact of an Income Tax on Labor
Markets and Efficiency When the Market Supply of
Labor is Perfectly Inelastic
A B

Compensated Labor
S Supply Curve S'
Regular Labor
Supply Curve
Wages

WG *
tWG*
WN = WG* (1– t)

D=W
WN = WG (1 – t)

0 Q* 0 –∆ QSL

Labor Hours per Year

22
Labor Market Analysis of Income Taxation:
Wage responsive Labor Supply

 When the regular labor supply curve is

not perfectly inelastic, the excess
burden of a tax on labor income is
understated, unless the analysis is
performed with a compensated labor
supply curve.

23
 Figure 13.4 The Effect of Income Taxes on Labor
Markets When the Supply of Labor is Responsive
SR
SC

W* C
W A
Wages

∆W tW*
G
W* B

D = WG
∆Q WN

0 Q3 Q2Q1 Hours Worked

∆ QSL per Year
24
 Empirical Analysis
 Regular labor supply is perfectly inelastic for
men 25 to 55.

 Estimates suggest a large substitution effect

that is almost perfectly offset by an equally
large income effect.

 The efficiency-loss ratio for these men

suggests that for every dollar raised in income
taxes, 13.5 cents of excess burden is created.

25
 Lower Tax Rates, More Work, Less
Excess Burden

 Tax changes in 1983 and 1986 lowered the

marginal tax rates facing most Americans.

 Recent estimates suggest that this lower rate

induced a 3% increase in work by men and a
16% drop in excess burden.

26
Incidence of Payroll Taxes
 In the U.S., the FICA tax that funds
Social Security has a legal incidence of
7.65% tax on both employers and
employees.

 If the regular labor supply curve is

perfectly inelastic, this implies that all of
this tax is being borne by workers.

27
 The Payroll Tax
SL

A
Wages

WG
TB + TE WE B
DL = MRPL
WN C

DN DL' = MRPL – TB

0 QL
Labor Hours per Year 28
Taxation of Interest Income and the
Effect on Saving

 Just as a tax on earned income can

lead to an increase or a decrease in
work, a tax interest can lead to an
increase or a decrease in saving.

29
Figure 13.5 Income Taxation and Intertemporal Choice

E
Future Consumption

C2 E1

E2 U2
C 2'

U1

0 C1 C’2 D
Current Consumption 30
 Excess Burden of a Tax on Interest
Income

 A tax on interest income will also have

an excess burden that will depend on
the magnitude of the tax and the
elasticity of supply and demand for
loanable funds.

31
 Figure 13.6 Impact of an Income Tax on
Investment Markets and Savings
Supply of Savings

rG* B
Interest

r1 A
rN*
C
D = rG

rN
S2 S1
Annual Savings and Investments 32
 Empirical Estimates
 The elasticity of the supply of savings
has been estimated to be in the
neighborhood of .4.

 This indicates that the efficiency-loss

ratio for such a tax is .30 (meaning that
for every dollar raised with the tax on
interest income,excess burden increases
by 30%).

33
Supply-Side Tax Cuts of the 1980s
 Supply-Siders argued that cuts in tax
rates would increase overall revenues
because the cuts would motivate harder
work and greater investment.

 The cuts in tax rates did not increase

revenues, but the decrease was much
less than expected (by tax cut
opponents).

34