Chs.17 and 18 Personal Income Tax and Behavior

1. Chs.17 and 18Personal Income Tax and Behavior

3. Impact of Exemptions and Deductions on the Tax Base

4. Tax Expenditures • What are tax expenditures? • Annual tax expenditure budget • Technical problems with measuring tax expenditures • Incentive effects • Defining income • Philosophical objections

6. Taxes and Inflation • Tax Indexing • How inflation can affect taxes • Bracket creep • Deductions and exemptions set in nominal terms • Taxation of nominal capital gains • Taxation of nominal interest

7. Coping with the Tax/Inflation Problem • Ad hoc reductions in tax rates • Indexing of parts of tax code [1981] • Should indexing be maintained? • No – ad hoc adjustments force legislature to reexamine the entire tax code • Yes – desirable to have a stable and predictable tax code and fewer opportunities for legislative mischief; repeal would have a larger impact on low-income families

8. The Alternative Minimum Tax • Brief history of the AMT • Computing the tax base under AMT • Add AMT tax preferences to regular taxable income • Subtract AMT exemption • Alternative minimum tax income (AMTI) • Computing Tentative AMT • Apply AMT tax rate schedule to AMTI • Taxpayer pays higher of tentative AMT or regular income tax liability

9. AMT as a Mass Tax • Why has AMT become more important? • AMT not adjusted for inflation • Cuts in regular tax • Problems with AMT • Fairness • Efficiency • Simplicity

10. Choice of Unit and the Marriage Tax • Three principles • The income tax should embody increasing marginal tax rates • Families with equal income should, other things being the same, pay equal taxes • Two individuals’ tax burdens should not change when they marry; the tax system should be marriage neutral • No tax system can adhere to all three simultaneously

11. Tax Liabilities Under a Hypothetical System

12. Brief History of Marriage Tax in the United States • Pre-1948 taxable unit was individual • 1948 family became taxable unit • Income splitting • 1969 New tax rate schedule for unmarried people created • 1981 New deduction for two-earner married couples added • 1986 Two-earner deduction eliminated • 2001 law reduces (but does not eliminate) marriage penalty”

13. Analyzing the Marriage Tax • Advantages to using the family as taxable unit • Fairer treatment of nonlabor income (bedchamber transfers of property) • Family a bedrock institution of society • Disadvantages of using the family as taxable unit • Given high divorce rates, bedchamber transfers of property may not be significant • Defining the family • Efficiency issues • Does tax system affect marriage and divorce rates? • Labor supply

14. Capital Gains P = $100,000 g = 10% $100,000*(1+.1)^20 = $672,750 Capital Gain = $672,750 - $100,000 = $572,750 Tax $572,750 * .2 = 114,550 Net Gain = $458,200 P = $100,000 g = 10% net g = 10%(1-.2) = 8% $100,000*(1+.08)^20 = $466,096 Capital Gain = $466,096 - $100,000 = $366,096 Taxes deferred are taxes saved Lock-in Effect Gains Not Realized at Death

15. Evaluation of Capital Gains Rules • No justification under optimal tax literature for preferential treatment of capital gains under H-S criterion • Other justifications • Capital gains are unexpected windfalls • Require sacrifice of abstaining from consumption • Needed to stimulate capital accumulation and risk taking • Counterbalance to effect of inflation

16. Politics and Tax Reform • Disagreements among experts • Any change will hurt someone • Tax system with low rates and broad base is not stable politically • -political patronage • Ch. 21 discusses fundamental changes to tax system

17. Personal tax and behavior

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20. Effects of Taxation D Income per week H E1 G iii E3 ii K i J 0 T F Hours of leisure per week Hours of work after tax Hours of work before tax

21. Labor Supply Response:Empirical Evidence • Small inelastic response for men- .05 • Married women are more responsive- .4

22. Impact of taxes on savings

39. Empirical Evidence: Tax on Savings • Expected real rate of return difficult to measure • Bernheim(2002)—very little effect of after-tax ROR • Income and substitution effect tend to cancel each other • Tax expenditures for savings: 1975: $20b 2006: $105b