1. THE IMPORTANCE OF THE INCOME TAX
a. Raising Revenue to Finance the Govà estimate: Income tax produces 59% of Fed Rev and over 40% of State Rev; Individual Income tax finances 49% of Fed Rev.
i. High percentage of total tax comes from the wealthyàThose in the upper 1% of population account for 30% of nations’ wealth and 15% of its income.
1. Criticism of tax system: Unfair amongst rich and poor. How progressive should it be?
ii. Another way we fund the Gov is through debt.
b. Politicsà Tax reforms are used to promote policy.
c. Tax Considerations Affect Every Part of Our Livesà it is key to whether we purchase or not; real estate; alimony/child support; corporate/partnership; personal injury; criminal tax evasions; wealth test to conduct investigations.
d. Malpracticeà Basically, you have to know when to call a tax specialist.
e. Economic Consequencesà Inc tax has enormous effect on allocation of resources in our country.
i. Home ownership vs. rentingàownership is encouraged
ii. Health care reformàhealth insurance can be provided tax free under certain circumstances.
1. Much of the complexity of tax law is attributable to provisions and tax breaks designed to encourage particular kinds of economic activity. Tax cuts, and tax breaks are politically smart ways to allocate funds to certain areas of society without having to take the politically unpopular move of approving a huge tax increase & allocation to that area.
a. Tax Expenditure Budget: quantifies how much potential revenue the gov. has lost by allowing these deductibles by equating tax benefits with direct subsidies. Doing things through tax codes is more appealing to Congress than direct spending (it’s all a matter of getting political votes). Tax expenditures are a more politically viable way for politicians to allocate funds to certain areas of society than raising actual expenditures
f. Finally, its important b/c we are all taxpayers!
2. GOALS OF THE INCOME TAX
a. Raising Revenue (see above)
b. Fairnessà Taxes are based on “ability to pay” (less from poor, more from rich—declining marginal utility. The wealthier you are, the less higher taxes will affect you). Involves 2 concepts:
i. (1) Vertical Equity: Wealthier should pay more in taxes (or proportionally), in either actual dollars or in a greater percentage. A flat tax is not enough. A progressive rate structure is needed to achieve vertical equity.
1. Progressive Rate Structure §1: reflects principles of vertical equity. As one’s income increases, the proportion of income that one pays as a tax also rises. Progression is designed to reduce the inequalities of income associated with our free market system.
ii. (2) Horizontal Equity: People similarly situated should be taxed alike—equal incomes should pay equal amounts. Income comes from different kinds of sources and may be taxed differently. Ex. TP1 makes $100k as salary. TP2 makes $75k plus use of car for $25k. They should be taxed the same since they are similarly situated.
c. Economic Rationality: Economic Effects/Incentivesà Certain types of economic activity are encouraged by the tax structure—like buying homes through deductions for interest payments. Goal is to avoid perverse incentives. Ex. Tax breaks for parking could encourage people to move to suburbia, leading to urban sprawl, disuse of mass transit and pollution. Another goal is to increase reliance on income tax to provide incentives for various kinds of special activities and investments.
d. Administrative Feasibilityà Government cost of enforcement and taxpayers cost of compliance with the tax laws should be as low as possible.
e. Relianceà People rely on the form of the current tax code—“old taxes are good taxes.” Makes it tough to change to a new form of taxation b/c there is so much reliance on the current system.
3. HISTORY OF THE INCOME TAX
a. Jefferson to Civil Warà There was no income tax. Federal money was raised by Tariffs. An income tax was passed during the Civil War, but then repealed. Replaced again by tariffs and excises on tobacco and liquor.
b. 1894 Income Tax Reinstatedà by 2nd administration of Grover Cleveland. Taxed mostly the rich—reinstated after bitter fight and pressure from democrats representing farms and labor groups. Bitterly opposed by northeastern republican businessmen who saw income tax as communism.
i. Pollack v. Farmers Loan & Trust: attacked constitutionality of America’s tax in 1844. SCOTUS struck down the income tax based upon Constitution’s ban on apportioned “direct” taxes on rent, dividends, and interest. Individuals then turned their efforts to the 16th Amendment:
1. “The Congress shall have the power to lay and collect taxes on incomes, from whatever source derived without apportionment among the several States, and without regard to any census or enumeration.”
c. World War Ià Led to a dramatic expansion of income tax to create war $. Post WWI, rates dropped as federal spending dropped.
d. World War IIà The income tax became and remains a mass tax—one imposed on all persons
e. Marginal Rate High Water Markà in early 60s some levels of income were taxed at 91% with deductions.
f. Income Tax as Social ToolàUsed to achieve particular economic and social policies. Ex. tax breaks for the purchase of business equipment to stimulate economy.
g. Tax Reform Act of 1986à Reduced minimum marginal rate to 28%. Today, 2003, top marginal rate is 35%.
4. WHY INCOME?
a. The “Ability to Pay”à term used to describe attribute that might justify requiring people to pay more tax than others.
i. Narrow viewà focus on convenience in paying—tax only liquid assets (case) not illiquid ones (house).
ii. Intermediate viewà tax people’s material well-being without regard to liquidity.
iii. Broadest viewàtax people’s ability to earn money (wage rate), whether they do so or not.
b. The Tax BaseàImplements the “ability to pay.” Describes the amount that is to be taxed under whatever system of taxation one adopts—that is, the amount to which the appropriate tax rate is applied. Ex. Under sales tax, the base is sales. Under Income tax, Income is the base. The following 3 systems all depend upon observable transactions—which prevent imputed income from being taxed. NOTE: imputed income is increases in wealth through non-market transactions. Ex. cleaning your own home vs. hiring a cleaning service. Can be thought of as goods or services one provides themselves.
i. Consumption Taxà the more you can afford to spend, the more you pay in taxes. Implemented by taxing an individual on GI but allows a deduction for income that is invested. Can implement a progressive rate structure. Savings are not taxed and therefore encouraged. Similar to 401(k), IRA accounts, etc. These are consumption based; they only become taxable once you withdraw them from these plans. Also, analogous to unrealized appreciation (of real estate); isn’t taxable until you realize the value through sale.
1. FormulaàGI – all savings/Investments + Withdrawn Savings Used for Consumption = Net Consumption (GI – Savings + Spending=Net Consumption
2. Sales Taxà a form of consumption tax. Puts savers and spenders on equal footing—savings are not taxed twice. Can be imposed 2 ways:
a. Retail Sales Tax: Imposed at the retail consumer level. Used by states (NYC).
b. Value Added Tax: Imposed at the business level. VAT is levied on the value added to the goods and services by those who manufacture, distribute, and sell those goods or services. Each link in the chain of production pays a tax equal to the difference b/w its costs of materials and its sales proceeds (Europe).
3. Objections to the Consumption Taxà law income households spend most/all of their earnings on food/rent. Upper income houses save a lot. Consumption tax hits poor harder in percentage of terms than it does rich.
a. Possible Solution:
i. Flat Tax: a VAT with a rebate to lower-income income households. Achieves result by (i) allowing firms a current deduction for their outlays, including capital expenditures, and (ii) taxing individuals on wages & salaries but not investments.
1. Objection to Flat Tax: It’s politically hard to propose new tax plans b/c of the reliance factor.
ii. Wealthà a tax based upon a “snapshot” of one’s ability to pay at any given moment—evaluates the value of one’s entire assets. Ex. Property tax, estate tax, gift tax.
1. Apart from estate and gift tax, which fall on wealth transfers, wealth taxation has not been seriously considered at the federal level. However, state and local governments impose property taxes of various kinds.
iii. Incomeà the (intermediate) system used today. Best reconciled with supporting limited degree of wealth taxation. A mix of pure income tax when money is earned (wages, fees, salaries), and a wealth tax on savings, dividends, rents, capital gains, etc. This amounts to a double tax for the saver and investor. John Stuart Mill felt this was unjust.
1. Possible Solutions:
a. Eliminate wealth taxes—Income tax would then just tax labor income
b. Allow all investments to be deducted currently, and tax spending only
5. PRELIMINARY TERMS
a. Tax Incide
ductions: all deductions other than the personal exemption deduction and the deductions allowable in computing AGI under §62.These include state and local income, property taxes, charitable contributions home mortgage interest, casualty losses, medical expenses, etc.
ii. Tax Rate Schedules: are applied to your taxable income to compute the amount of tax owed (§1). There are 4: (1) Married-Joint (most favorable), (2) Head of Household (less favorable), (3) Single (less favorable), and (4) Married-Separate (least favorable). All progressive with different % of tax on income.
1. Progressive Income Tax: a tax scheme with rates that rise as income rises. The tax on a person with a higher income is not just a greater amount than the tax on a person with lower income; it is a greater proportion of the income as well. Institutes a schedule of rates with increasing marginal rates.
a. 15% rate applies to first $__ of income
b. 25% rate applies to next $__ of income, etc.
i. NOTE: corporations are treated as separate entity, and thus, have a separate schedule of tax rates under §11.
2. Marginal Tax Rate: The rate of tax applicable to the last dollar of income earned by TP.
a. Ex. 15% rate for $0-$20,000; 28% rate for $20,000 +. If income = $30,000, tax on the 1st $20,000 x 15% ($3,000) + 2nd $10,000 x 28% ($2,800)= $5,800 total tax on $30,000/year. The marginal Rate is 28%.
b. Marginal rate is relevant for understanding incentive effects. Ex. a couple with income of $25,000 and a Marginal Rate of 15% gives a gift of $100 to charity. They can deduct that $100 gift from the amount of their income subject to taxation. That reduces their taxable income by $100 and they save $15 in taxes—meaning their gift really cost them $85.
c. B/c increased marginal rates apply in increments and do not exceed 100%, a person is never worse off making money.
3. Effective Rate: is one’s tax liability of the year divided by his taxable income (or AGI) for the year—it is the same as the TP’s average rate.
a. Ex. Effective Rate = (Total tax liability / Taxable Income) x 100
i. Ex. ER = $5,800/$30,000=19.3%
1. The Marriage Penalty: married couples who file jointly and have one primary earner pay less tax. However, married couples with two income earners pay more b/c they are denied from benefitting from lower levels of the progressive rate structure twice, individually. The added money owed is the marriage penalty.
a. Disincentive for Secondary Workerà Married secondary lower income workers are subject to tax rates determined by the primary worker’s higher income. It is a disincentive for this marginal Income.
iii. The Alternative Minimum Rate: An amount payable if it is greater than the tax computed under the normal Tax Schedule rates. Taxable income above $100k is subject to AMT rates.
iv. Capital Gains: gain from the sale of a capital asset. A capital asset is an investment asset as opposed to as asset used in operating a business.
1. Short Term Capital Gains: Capital gains are short term when the capital assets sold were held by the TP for a year or less. These are included in ordinary Taxable Income
2. Long Term Capital Gains: TP’s pay lower tax rates on these gains. Most TP’s in fortune 400 made their money from capital gains.
v. Credits: a direct, dollar for dollar, reduction in tax. Applied after the appropriate tax rates are applied to the TP’s taxable income. A credit reduces the actual tax due—as opposed to a deduction which only lowers the taxable income before application of the rate schedule.
1. Ex. a $1,000 deduction saves a TP in the 30% marginal tax bracket $300 of tax; a $1,000 credits saves the same TP $1,000 of tax.
2. If a credit exceeds the tax due, TP receives a tax refund. If tax due exceeds credit, TP owes tax.