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CHAPTER 18:

Taxation: How It Works and What It Means

CHAPTER 18: Taxation: How It Works and What It Means

Taxation: How It Works and What It Means

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

CHAPTER 18: Taxation: How It Works and What It Means

Introduction 5

• In December 2017, President Trump signed into law the biggest tax cuts since the 2001 Bush cuts.

• These tax cuts were seen by Democrats as giving money away to the richest Americans and the biggest corporations.

• Republicans saw them as a welcome reduction of the tax burden to boost economic activity.

CHAPTER 18: Taxation: How It Works and What It Means

Types of Taxation: Taxes on Earnings and Individual Income

• Taxes on Earnings o Payroll tax: A tax levied on income earned on one’s 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.

FICA

CHAPTER 18: Taxation: How It Works and What It Means

Types of Taxation: Taxes on Corporate Income and Wealth

• 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, such as

real estate or stocks, held by a person or family. o Property taxes: A form of wealth tax based on the value of real

estate, including the value of the land and any structures built on the land.

o Estate taxes: A form of wealth tax based on the value of the estate left behind when one dies.

CHAPTER 18: Taxation: How It Works and What It Means

Taxes on Consumption

• Taxes on Consumption: o Sales taxes: Taxes paid by consumers to vendors at the point

of sale.

o Excise tax: A tax paid on the sales of particular goods, such as cigarettes or gasoline.

CHAPTER 18: Taxation: How It Works and What It Means

Tax Revenues by Type of Tax in the United States

Figure 18-1

0000

CHAPTER 18: Taxation: How It Works and What It Means

International Tax Revenues by Type of Tax

Figure 18-2

CHAPTER 18: Taxation: How It Works and What It Means

Example: Computing Jack’s Taxes

The government withheld $2,000 from his earnings. Jack is due a refund of $1,301, the difference between what was withheld and the amount he owes.

Gross income −Deductions

$85,000 −2,000

=Adjusted gross income (AGI) −Standard (or itemized) deduction

=83,000 −24,000

=Taxable income Use income tax schedule (Figure 18-3) =Taxes owed −Credits

Use income tax schedule (Figure 18-3)

=59,000 =6,699 −6,000

=Total tax payment −Withholding

=699 −2,000

=Final payment (refund) due

=(1,301)

Table 18-1

CHAPTER 18: Taxation: How It Works and What It Means

Structure of the Individual Income Tax in the United States: Computing the Tax Base

Income tax is assessed on adjusted gross income minus deductions and exemptions.

• Gross income: The total of an individual’s various sources of income.

• Adjusted gross income (AGI): An individual’s gross income minus certain deductions, such as contributions to IRAs.

• Taxable income: The amount of income left after subtracting exemptions and deductions from adjusted gross income.

CHAPTER 18: Taxation: How It Works and What It Means

Individual Income Tax: Computing the Tax Base 1

Adjustments vary over time but currently 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.)

• (Interest paid on student loans.)

CHAPTER 18: Taxation: How It Works and What It Means

Individual Income Tax: Computing the Tax Base 2

To form AGI from gross income, subtract exemptions and deductions.

• Exemption: A fixed amount a taxpayer can subtract from AGI for dependent member of a household as well as for the taxpayer and the taxpayers spouse.

• Taxpayers can take one of two kinds of deductions: o Standard deduction: A fixed amount that a taxpayer can

deduct from taxable income.

o Itemized deductions: Alternative to the standard deduction whereby a taxpayer deducts the total amount of money spent on various expenses.

CHAPTER 18: Taxation: How It Works and What It Means

Individual Income Tax: Computing the Tax Base 3

Allowable deductions for claiming itemized deductions include:

• Medical and dental expenses exceeding 10% 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.

CHAPTER 18: Taxation: How It Works and What It Means

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.

CHAPTER 18: Taxation: How It Works and What It Means

U.S. Federal Income Tax Rate Schedule, 2018 Figure 18-3

I l

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I I i i i lI

CHAPTER 18: Taxation: How It Works and What It Means

Measuring the Fairness of Tax Systems

Fairness is an important concern and elusive goal.

• 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 gross income that is paid in taxes.

• In the United States, the marginal tax rate rises with income, from 10% to 37%.

Taxes paid Grossincome

x x

CHAPTER 18: Taxation: How It Works and What It Means

Vertical and Horizontal Equity

Two distributional goals are considered 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.

CHAPTER 18: Taxation: How It Works and What It Means

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.

CHAPTER 18: Taxation: How It Works and What It Means

Defining the Income Tax Base: The Haig-Simons Comprehensive Income Definition

What kind of income should be taxed?

• Haig-Simons comprehensive income definition: Defines taxable resources as the change in an individual’s power to consume during the year.

• Potential annual consumption: Total consumption during the year, plus any increases in wealth… … minus expense related to earning a living, or non-desired consumption.

CHAPTER 18: Taxation: How It Works and What It Means

Externality/Public Goods Rationales for Deviating from Haig-Simons: Charitable Giving • One reason to deviate from Haig-Simons is to correct

externalities.

Ex: Charitable giving, home ownership.

CHAPTER 18: Taxation: How It Works and What It Means

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?

CHAPTER 18: Taxation: How It Works and What It Means

Efficiency Considerations

• 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 (A credit achieved the exact amount)

• On vertical equity grounds, tax credits are more equitable than deductions. o The value of a deduction rises with one’s tax rate, making

deductions regressive. o Credits, on the other hand, are available equally to all

incomes so that they are progressive.

CHAPTER 18: Taxation: How It Works and What It Means

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, and in 2018 the government was projected to lose $1.56 trillion through tax expenditures.

largest is exclusion of employee provided health insurance premium from taxable income cost 235 8 b

Videos tax system

https://www.youtube.com/watch?v=5qW-TWOAdFo (2 min)

https://www.youtube.com/watch?v=gBTq1Mvrbjs (6 min)