The Personal Income Tax in the United States

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The Personal Income Tax in the United States
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Figure 15.1
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Defining Income

• Which forms of income are taxed?
• Wages and salaries
• Rents
• Dividends
• Business profits
• Capital Gains
• Interest Income
• Transfers, gifts, etc.

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Excludable Forms of Income

• Interest earned on bond issued by a state or a
  local municipality is untaxed (while interest
  earned on the bond of a private company is
  taxed).
• In 2003, legislation was passed which lowered the
  maximal tax rate on dividends to 15.

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Capital Gains

• The maximum capital gains tax rate (in 2004) is
  15, while the maximum federal tax rate on
  ordinary income is 35.0.
• Capital gains held for less than 12 months are
  taxed as ordinary income.
• Capital losses offset capital gains, and can be
  subtracted from ordinary income (up to a cap of
  3,000).

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Realized versus Unrealized Gains

• One interesting aspect of the treatment of
  capital gains is that only realized capital gains
  are taxed.
• As the illustration below dramatically shows, the
  timing of realizations can matter greatly for
  total portfolio wealth, even holding the
  composition of assets fixed.

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Capital Gains An Example

• Example
• Asset with principal of 100,000
• r12
• Time horizon is 20 years
• Tax rate 15

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Capital Gains

• Capital gains not realized until end of 20 years
• Value of investment is 100,000x(1.12)20
  964,629.
• Capital gain is 964,629-100,000 864,629
• Tax owed is 15x864,629 129,694
• Wealth 964,629-129,694 834,935

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Capital Gains

• Capital gains realized each year
• After tax rate of return is not 12, but rather
  (1-.15)x12 10.2 since taxes are paid along
  the way rather than at the end
• Value of investment is 100,000x(1.102)20
  697,641.
• Wealth 697,641

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Capital Gains and Lock-in Effect

• Wealth is more than 137,000 lower by realizing
  capital gains along the way rather than deferring
  tax payments until the end.
• Deferral allows the money to grow geometrically
  at the before-tax rate of return.
• Taxes deferred are taxes saved
• Investors may be less likely to change their
  portfolios, known as the lock-in effect.

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Employer Health Care Contributions

• If an employer pays premiums for a health
  insurance plan, those contributions are not
  taxed.
• If the employer instead paid the employee in the
  form of higher wages, the wages would be taxed.

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Retirement Saving

• There are numerous tax-deferred or tax-free
  savings vehicles.
• Although they have different names, they usually
  share a number of characteristics.
• In all of these plans, the investment accrues at
  the before tax rate of return, and do not suffer
  from the lock-in effect.

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Retirement Accounts
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Exemptions and Deductions

• Once AGI is determined, subtract certain
  exemptions and deductions to arrive at taxable
  income.

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Exemptions

• Family allowed an exemption for each member
• Exemption in 2003 was 3,050 per family member,
  so a husband and wife with three dependent
  children could claim five exemptions and subtract
  15,250 from AGI.
• Exemptions phased out for households with high
  AGIs.

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Deductions

• The other subtraction from AGI is a deduction.
  There are two types
• Standard deduction a fixed amount that requires
  no documentation
• Itemized deduction subtractions for specific
  items cited in the law, must list each item
  separately, and be able to prove the expenditures
  were made
• Taxpayers would choose whichever one minimized
  their tax liabilities.

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Standard Deductions

• Standard deduction in 2003 was 4,750 for single
  individuals, and 7,950 for joint filers.
• Around 67 of tax returns take the standard
  deduction.

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Unreimbursed Medical Expenses

• Must exceed 7.5 of AGI
• Only medical expenses above the threshold are
  deductible
• Creates incentives to stack medical procedures
  in one calendar year.
• Time medical procedures for years when AGI is low

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State and Local Income and Property Taxes

• In 2000, these deductions amounted to 290
  billion.
• Sales taxes are not deductible.
• For those who itemize, lowers the effective costs
  of paying these taxes.
• State and local taxes vary substantially within
  the U.S.

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Some Types of Interest Payment

• Interest on home equity loans
• Interest on conventional mortgages
• Interest on some student loans
• Not interest paid on consumer debt like credit
  cards

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Charitable Contributions

• Charitable deductions cannot exceed 50 of AGI
• In 2000, 134 billion in deductions for
  charitable contributions
• Tax deductibility lowers the effective price of
  giving. Elasticity estimates around 0.5, which
  mean that lowering the effective price from 1 to
  0.7 increases giving by 15.

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Tax Credits

• A tax credit is a subtraction from tax liability
  (not taxable income).
• Unlike deductions, the value of the credit is
  independent of the tax rate.
• Number of credits in the tax system, including
  the kiddie tax credit which is 1000 per child,
  and credits for college expenses.

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The Cost of Tax Loop Holes

• Tax expenditures are the revenues forgone due to
  preferential tax treatment.
• The revenue loss for 2004 will exceed 600
  billion.
• Deductions and Exemptions lead to higher marginal
  tax rates.

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Rate Structure

• The taxable income scale is divided into
  segments, and the law specifies the marginal tax
  rate that applies to income from each segment.
• Four different schedules
• Single
• Married, filing jointly
• Married, filing separately
• Heads of household

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Historical Overview

• In 1913, bracket rates ranged between 1-7
• In 1945, rates ranges between 23-94
• In mid-1980s, rates ranges between 11-50, with
  14 brackets
• 1986 Two brackets, 15 and 28
• Rates crept up in 1990s
• Trend was reversed in 2001/03

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Married Filling Joint 2006

• 0 -15,100 mtr10
• 15,100-61,300 mtr15
• 61,300-123,700 mtr25
• 123,700-188,450 mtr28
• 188,450-336,550 mtr33
• gt336,550 mtr35

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Single Tax Payer 2006

• 0-7,550 mtr10
• 7,550 30,650 mtr15
• 30,650-74,200 mtr25
• 74,200-154,800 mtr28
• 154,800-336,550 mtr33
• gt336,550 mtr35

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Statutory versus Effective Tax Rates

• Official statutory marginal tax rates may not
  correspond well to actual marginal tax rates
  because of various deductions and credits.
• Figure 15.2 illustrates actual marginal tax rates
  for a family of 4 that takes advantage of various
  education credits based on the 2001 tax law.

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Figure 15.2
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Alternative Minimum Tax

• Compute taxable income without most deductions
  and exemptions
• AMT exemption for joint filers 58,000
• Taxable income lt175,000 mtr26
• Taxable income gt175,000 mtr28
• AMT is not indexed by inflation.
• By 2010 92 of all households with incomes over
  100,000 will pay AMT, 52 of all households with
  income below 100,00 will pay AMT.