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Federal Income Tax
Rutgers University, Newark School of Law
Blank, Joshua D.

GOALS OF A TAX SYSTEM
 
1.       Attributes of an Ideal Tax System
 
A.      Revenue Generation (Primary Goal of Taxation)
Income tax is the largest source of revenue for the federal government.
Income tax is an important source of revenue for state local governments.
 
B.       Efficiency
Neutrality: a tax that has no effect on behavior is neutral. A neutral tax is an efficient tax. The more a tax changes behavior, the less efficient it is. Both income taxes and consumption taxes affect behavior: they encourage people to engage in leisure activities that do not cost money; thus, escaping tax that would be levied on either earning (income tax) or spending (consumption tax).
o        Elasticity (demand for goods that are not necessities): Whether a person actually responds to a tax by changing her behavior depends upon the elasticity of her response. If her response to the tax is highly elastic, then a small tax would lead to a large change in behavior.
o        Inelasticity (demand for goods that are necessities): If her response is highly inelastic, then even a large tax might not affect her decision to engage in that behavior. Ex: A heroin addict’s demand for heroin is highly inelastic; thus, the addict would buy heroin even if a tax on heroin made it very expensive. Tax on inelastic goods is an efficient tax and does not change TP behavior; however, there may be other reasons why we may not want to tax certain inelastic goods.
o        Income Effect: This occurs when an income tax encourages a person to work more than they would have if there had been no tax in order to have the same amount of money left after tax that they would have had it there had been no tax.
o        Substitutions Effect: This occurs when a substitutes non-taxed leisure for work; thus, earning less money in order to pay less tax.
 
Incidence: Who really bears the burden of a tax?
o        Real Incidence of Tax: This falls on the person who bears the burden.
o        Nominal Incidence of Tax: This falls on the one who pays the tax.
                The Government has a choice to collect it from either person.
Ø       For instance, when the price of a good rises to cover the amount of the tax, the burden is shifted from the merchant to the consumer.
 
Capitalization: The market affects who really bears the burden of a tax; it can shift the burden of a tax by affecting an item’s price.
 
Deadweight Loss: This occurs when consumers forego the purchase of a good that has a tax in an effort not to pay the tax; thus, causing the government not to receive revenues for the tax. This is an overall loss = excess burden = deadweight loss. It leaves individuals worse off, and the public is no better off as a result of it. An efficient tax system must minimize deadweight loss. As a tax becomes more onerous, it can produce deadweight loss at the expense of revenue. Policymakers must consider whether the deadweight loss produced by a tax is worth the revenue collected. Still, the government might choose to tax an undesirable activity heavily with the express purpose of making the activity prohibitively expensive; subordinating revenue considerations to other goals. (In order to further their social goals.)
 
Simplicity: Simplicity is related to efficiency. Tax reform proponents often rally around the idea of simplifying the tax law.
Ø       Pros: In avoiding complexity is allowed for: (1) a tax system that does not have enforcement costs greater than the revenue collected through enforcement; (2) TPs can understand the law and comply; (3) Eliminates hiring attorneys and accountants to find loopholes in a complicated tax     system.
Ø       Cons: It can be oversimplified by getting rid of deductions and exclusions and by refusing to make distinctions between different kinds of TPs and different kinds of income.
C.       Fairness
Theories of Distribution Justice
·         Some believe that a fair tax should be based on an individual’s ability to pay so that all people with equivalent abilities to pay should pay the same amount of tax. A fairness ideal based on ability to pay underlies the income tax.
·         Some people believe that a fair tax should be based on an individual’s standard of living so that people with equivalent spending should pay the same amount of tax. A fairness ideal based on standard of living underlies consumption taxes.
·         Utilitarianism focuses on maximizing utility, variously described as well-being, happiness, and preference satisfaction, and whether rules and actions will produce desirable consequences.
·         Utilitarians argue that the goal of the state should be to provide the “greatest good for the greatest number” with each person’s utility counting equally in determining society’s overall level of utility. They have a principle of “declining marginal utility of income” – that people derive less utility from each dollar as they have more dollars – which provides the theoretical justification for progressivity.
Ø       Progressive Tax: Is one in which TPs pay a greater proportion in tax as the tax base (such as income, consumption or wealth) increases.
Ø       Proportionate Tax: Is one in which the percentage of the base paid in tax stays constant even as the base varies.
Ø       Regressive Tax: One in which the percentage of the base that is paid in tax decreases as the base increases.
·         Some critics of utilitarianism reject utility maximization as a legitimate societal goal. Others question utilitarianism’s attempt to reduce all social values into a single metric or doubt that there really is declining marginal utility of income.
·         John Rawls’ followers believe that economic justice requires improving the situation of the least well-off group in society. They might favor a tax system that significantly redistributes resources from the rich to the poor, even if that redistribution produces a loss in overall societal utility and reduces the well-being of the rich compared to no redistribution.
·         Libertarians reject redistribution on fairness grounds.
 
Horizontal Equity: Demands that we consider whether two TPs are the same in some relevant respect; thus, should be taxed the same.
 
Vertical Equity: Considers the differences in tax burdens on people in different economic situations. It depends on a belief about what justifies greater or lesser taxation of individuals.
_____________________________________________________________________________________________Class Notes
1.       Ideal Tax
2.       What we tax
3.       Why we’re here
 
Ex: Coffee Tax – $.50 tax on 12 oz. coffee -> proceeds will go to the state of NJ
 
Effects: Customers may seek a substitute – would not impact government revenue
                Customers could purchase smaller ounces or more ounces to avoid tax
                Customers could purchase coffee out of state
                Customers could make their own coffee
 
Efficiency – Key Attribute of the tax system
When is “efficiency” present?
Low cost = Goal is for people to have as much utility as possible.
Utility = high satisfaction
When the gov. interferes with the tax system it impacts utility.
The goal is for the tax to have as little effect on the tax system as possible.
Is it ever good for the tax system to have an impact on utility?
Benefits – tax breaks (mortgage int. being deductible)
Good to discourage a type of behavior
 
Neutrality – if we impose a tax, behavior does not change.
Ex: Window tax in England
Some “bricked” their windows to avoid the tax
Some did not purchase houses with windows
 
Elastic – the change in quantity demanded due to a change in price is large.
 
Inelastic – the change in quantity demanded due to a change in price is small.
 
Deadweight loss – waste; the most inefficient loss
 
Incidence – who bears the burden? Who bears the cost?
 
Equity – Coffee tax falls heavier on people who don’t earn a lot of money
 
Regressive Tax System – someone who has a lower ability to pay, ends up bearing larger tax liability
Flat Tax/Proportionate Tax – everyone pays the same percentage of tax
Progressive Tax System – people will more money, pay more taxes
 
How do you make the tax system one of the previous tax systems?
How do we prefer a Progressive tax system over the others?
The value of a dollar is worth less to someone who has a lot. = Declining marginal utility
 Utility
                          Income
              $ ————–> $$$
 
Utilitarian – the greatest good to the greatest number of people.
How might that theory be exploited?
What kind of society could be set up?
 
John Rawls – liberal theory – economic justice requires improving the situation of the least well-off group in society.
Libertarianism – favoring a tax system that significantly redistributes resources from the rich to the poor, even if that redistribution produces a loss in overall societal utility and reduce the well-being of the rich compared to no redistribution.
 
*When there is an efficient tax, such as the “yacht tax”, the burden shifted from consumers to yacht manufacturers.
 
Tax system should minimize complexity:
Rule Complexity – when the tax rule itself is incomprehensible.
Compliance Complexity – where attorneys help taxpayers comply with the rules
Transactional Complexity – corps that decide they want to pay the lowest amount of taxes.
Effects: Loss in utility
 
Problems with Simplicity:
·         Simple to get around paying the tax – thus, inefficient in regards to increase revenues.
 
Incorporating social beliefs into the tax code* Ex: No tax break to schools that practice racial discrimination.
 
 
Choice of Tax Base and Tax Rates
 
I. Types of Tax Bases
 
Income: the standard justification for using income is that (1) taxes should be imposed on individuals in accordance with their relative abilities to pay, and (2) a person’s income is the best p

                                 __________________                                      _____________________
                                                = TI                                                         = TI
                                                x Rate                                                     x Rate
                                                __________________                      ____________________
                                                = Tentative Tax                                    = Tentative Tax
                                                – Credits                                                – Credits
                                                __________________                      _____________________
                                                = TAX LIABILITY                                   = TAX LIABILITY
 
_____________________________________________________________________________________________
Class Notes
Gross Income – all income from whatever source derived.
Adjusted Gross Income – Gross income minus deductions.
Standard Deductions – the basic standard deduction, plus the additional standard deduction.
Itemized Deductions
 
Misc. Itemized Deductions
 
Bill buys a cd for $10, and chooses to itemize his deductions
His employer reimburses him for the $10.
Bill can still claim a Sec. 62 deduction for the purchase of the cd. The results: $10-$10=0
 
It is possible that Congress okay’d the 2% floor due to itemized claimed for business use, but is possible used for personal use as well.
 
Meanwhile, the Sec 62 deduction includes the employer refunding Bill for the $10 expense. This adds credibility to the purpose of the expense thus, allowing for the total amount of the expense
 
Does Sect 62 need to be offset with Sec 61? Yes.
 
Standard Deduction Sec 63c
Obtained by virtue of being a person.
Basic Standard Deduction
Additional Standard Deduction – if blind, or 65 years old or older
Ex: Single mother that earns $5,000 a year. She will not pay because her income is less than the deduction.
 
§67 – 2% of Adjusted Gross Income
To the extent that the expense exceeds 2% of AGI.
$100 in AGI; $10 expense. $8 is the difference.
 
 
Unit IB – Understanding Tax Rates – Problems
 
Jane is single and childless, and will have a TI of $100k for 2008. Her TI already takes into account Jane’s PE and Itd. Ded. or Std. Ded.
1.       What is Jane’s Total Tax liability?
        §1(c) – Single Individuals
        Over $78,850, but not over $164,550 -> Tax is $16,056.25 plus 28% of the excess over $78,850
        Calculation:
        $16,056.25 + (.28 x ($100k – $78,850)) = $21,978.25
 
        Step 1: Go to Sec (locate the category that the client falls under).
        Step 2: Locate where the client’s income falls
        Step 3: Plug in the numbers to determine the amount of tax liability.
 
2.       What is Jane’s average tax rate?
        Formula: Tax Liability/TI
        Calculation:
        $21,978.25/$100k = 21.9%
 
3.       What is Jane’s marginal tax rate?
        28%
        The marginal tax rate is the rate of tax Jane would pay on an additional dollar of TI (i.e. the extra     tax that  she would owe if her income were $100,001.)
 
        The marginal tax rate will affect Jane’s tax decisions at the margin (i.e., how much an additional dollar of       income or deduction will change her tax liability).
        The next dollar will be taxed at the 28% interest rate; thus, a $280 change.
 
4.       Suppose Jane were offered an opportunity to earn $1k extra this year by doing some consulting work.     In weighing whether or not to take the job, Jane might weigh the value of her leisure time and the time                 needed for her other personal and professional commitments against the after-tax value of the           consulting fee. What is the after-tax value of the consulting fee to Jane?