TAXATION – Professor Coverdale Fall 2009
Note: “M” = Thousands
“MM” = Millions
“B” = Billions
“T” = Trillions
a) Purpose of Taxation
i) Oliver Wendell Holmes: “Taxes are the price of a civilized society.”
ii) Are taxes necessary – what should taxes support
(1) National defense – historically, this was the main reason.
(4) Provide retirement benefits and social services
iii) While there is an anti-tax mentality in the US, the US per capita tax burden is much lower than any other industrialized nation – Europe has a different mindset.
b) Alternative tax systems to the Income tax – tax “who” and “how”?
i) Head tax or poll tax
(1) Charge “x” amt. for every person – i.e. charge every person $4.00 tax.
(2) Relation to the ability to pay/fairness?
(i) Keeps the system simple
(ii) Everyone pays the same amount
(i) Doesn’t reflect the ability to pay – some people couldn’t afford it.
(ii) Problem – how do you check on it?
(c) Adverse effect on family planning – could be viewed as an attack on the poor to discourage them from having children.
ii) Tax based on level of education
(a) M.D. and J.D. $50M
(b) MBA $45M
(c) Ph.D. $15M
(d) Drop out $0
(2) Problem: creates a disincentive for education
(3) Positive: there is a relationship to the ability to pay (in theory)
iii) Tax based on the car driven
(1) Administratively easy – could track through the DMV
(2) Economic Effects
(a) Impact on unemployment in the automobile industry
(b) Will affect where you live (city vs. rural)
iv) Property Tax
(1) Administratively difficult – problems in valuation in liquidation in order to pay.
(2) Fairness – probably a fair system b/c it reflects ability to pay – reflects true wealth.
v) Consumption – Sales Tax
(1) Creates a disincentive to purchase
(2) Tends to be regressive – creates a greater tax burden on lower income individuals
(3) Can cure regressiveness by creating exemptions – however, by creating exemptions, the tax base is eroded.
(4) Then to offset reduction in the tax base caused by exemptions, rates will rise creating a significant economic effect.
(5) Compare to Forbes’ flat tax
(a) Forbes has a flat tax on income minus savings which effectively was a tax on consumption.
(b) Key then is establishing what the base will be – the most important aspect of increasing or reducing the revenue is the base.
(c) Least important aspect of a flat tax is the rate – the biggest factor is how to define the base.
c) The tax system chosen by the government reflects the value choices (e.g. chosen incentives, administrative costs)
d) The Income Tax
i) Why income tax and not others?
(1) Tax system should be fair and based on a person’s ability to pay.
(2) Income is an objective method to measure ability to pay despite the fact that it isn’t perfect.
(3) Goals of a good income tax.
(i) Horizontal equity
1. Taxpayers who are similarly situated should bear the same tax burden
2. Same ability to pay / pay the same!
3. Requires a definition of income
(ii) Vertical Equity
1. Relative amounts of taxes paid by people with different incomes
2. Progressivity: as one’s income rises, the proportion of income that one pays as a tax rises – people with higher incomes pay greater proportionate tax at a higher rate.
3. Flat Tax – proportionate tax system pay as a percentage of income
a. Single rate on what is taxed
b. But taxable income is often significantly reduced because of exclusions which often include investment return
c. Because of these exclusions, flat tax ends to be regressive.
d. Regressive taxes – lower a taxpayer’s ability to pay, the higher the percentage of income paid in taxes.
(b) Administrative Feasibility
(i) Goal is to have government cost of enforcement and taxpayer’s cost of compliance be as low as possible.
(ii) Objectivity is also an important goal – tax economic benefits with as little government subjectivity and intrusiveness as possible.
(iii) Our system, despite complexity, is administratively easy – costs low relative to revenue collected.
(iv) Administratively feasible because of 3rd party reporting
1. Employer – wages
2. Banks – interest
3. Brokerage – investment
4. Realtor – reports money earned on sale of house
(c) Economic rationality – sound economic effects
(i) Historically, scholars endorsed tax provisions that had neutral effect on the economy
(ii) Modern day – recognize that taxes affect choices made by taxpayers and therefore, tax laws are used to create incentives or disincentives.
(iii) Use exclusions, deductions, deferrals, & credits to provide incentives for various kinds of activities and investments – is this better than a direct subsidy?
e) History of the Income Tax
i) In the beginning, the largest source of revenue was the tariff.
(1) Most goods in the country were imported and tariffs protected the growing domestic industry.
(2) Tariffs were consumption taxes
(3) Tariffs came to be regarded as regressive – lower income level, the greater percentage of income used to pay taxes – ability to pay wasn’t reflected.
ii) Income taxes were first used to finance the Civil War – abolished after the war and return to the tariff as the primary source of revenue.
iii) A Populist revolt in 1894 led by William Jennings Bryan resulted in the passage of an income tax perceived to be a “soak the rich” campaign.
(1) A 2% tax was levied on $4000 of income
(2) $4000 would be $75M in 1998 and thus wealthy people threatened to leave.
iv) Income Taxes were struck down after one year when the Supreme Court found them unconstitutional.
v) In 1909, Republican President Taft gave in to Populism and endorsed a corporate income tax and proposed the 16th Amendment. “The Congress shall have the power to lay and collect taxes on incomes, from whatever source derived, and without regard to any census or enumeration.”
vi) In 1913 the Constitutional Amendment was ratified and the individual income tax was adopted by Congress.
vii) Up until WWII, no more than 6% of the population paid income taxes
viii) However, WWII increased the need for money – at that point 75% of the population began to pay income taxes.
(1) Introduction of withholding of income tax
(2) Introduction of high marginal rates
ix) Therefore, the income tax as we know it is only 50 years old.
f) The Federal Budget
i) On or before the first Monday in February of each year, the President is required to submit a budget proposal to Congress for the fiscal year to begin in October. The proposal sets forth receipts, spending, deficits, and surplus as well as legislation recommendations.
ii) FY 1995 – Overview
(1) Revenues were $1.355T and spending was $1.519T for a $164B deficit.
(2) The deficit is funded by borrowing. This annual budget deficit is then added to cumulative deficit which gives a national debt of approximately $5T.
(3) Interest on the national debt = 15% of national spending.
(4) Balanced Budget Amendment – idea is to halt the growth of the national debt – not necessarily looking to reduce it.
iii) FY 1995 – Outlays
(1) Social Security and Medicare
(a) Entitlement – not need based – largest outlay ($567B – 36% of spending)
(b) Funded through employment taxes – at $30M income level, an individual will pay more in employment taxes than he will in income taxes – 15% of income will go to employment taxes – these taxes are used to fund current social security payments
(c) These outlays are transfer payments – take money from current workers and give it to retirees without needs testing.
(d) Because of perceived inequities, needs testing is being considered.
(2) National Defense / Veterans’ Benefits – 21% ($326)
(3) Interest on National Debt – 15% ($232B)
(4) Social Programs – 18% ($280B)
(a) Area that has experienced the most cutbacks
(b) Includes Medicaid, food stamps, aid to families with dependent children, unemployment benefits, and assisted housing.
(5) Physical, Human, and Community Development – 8% ($128B) – agriculture, environmental programs, aid to elementary and secondary education, direct assistance to college students, FDIC, space programs, science programs, roads
(6) Law Enforcement / general gov’t – 2% ($30B) – judicial activities, federal law enforcement, prisons, costs of government.
iv) FY 1995 – Revenues
(1) Excise, Tariffs, customs – 8% now – smallest source
(2) Personal income tax – 39% largest source
(3) Corporate Income tax – 10%
(a) Do corporations actually pay taxes or do customers bear costs in the form of higher prices?
(b) Question of incidence of tax – who bears the ultimate burden of the tax?
g) The Tax Expenditure Budget
i) It demonstrates the costs of the provision of certain tax benefits
ii) The basic idea is that there are certain provisions of the IRS code, through the use of credits, deductions, exclusions, deferrals, that are not economically neutral, but are intended to induce certain types of behavior.
iii) These reductions, credits, etc. result in a reduced revenue to the government. As a result, in order to induce such behavior, the IRS foregoes revenue and therefore these provisions are in effect an indirect subsidy.
Examples include personal car use, bar dues, bar journals, etc.
(iii) Are deductible only to the extent that they exceed 2% of AGI.
(iv) Because the deduction is limited based on the AGI, it is typically more beneficial for the employer to pick up the benefit and reduce the employee’s income. Then there is no limitation involved.
(v) Note: Itemized deductions get phased out at higher income levels.
(f) Line 36 – Deductions for Exemptions
(i) Recognition of a “0” bracket – recognize a certain level of income that is not taxed.
(ii) The deductions get phased out at an AGI over $88,475.
(iii) Phasing out of exemption deduction is a way the government can increase taxes without raising rates.
v) Taxable Income: Line 37 – This is the taxpayer’s tax base. Remember, the government can increase taxes not only by raising rates. Taxes can be raised by manipulating / expanding the tax base through phasing out or eliminating deductions!
(1) A credit is a dollar for dollar set off against TP’s tax liability.
(2) Very few because they are expensive for the government.
k) Capital Gains and Losses
(1) There are two types of income and losses: ordinary income and losses and capital gains and losses.
(2) A capital gain or loss arises from the sale or exchange of a capital asset.
(3) A capital asset is all “property” with 5 exceptions
(a) Inventory – property held for sale to customers in the ordinary course of a trade or business
(b) Real property or depreciable property used in a business
(c) Copyrights and similar property held by creator (but not copyrights purchased from the creator or patents)
(d) Accounts receivable
(e) US government publications held by someone who received them free or at a reduced price.
(4) Basic idea is to deny capital gain treatment to ordinary gains and losses stemming from the operations of a business.
(5) Key: To determine treatment, focus on the motivation for holding the asset. If the asset is being held for investment purposes and not for business operations, then it is a capital asset.
(6) Example: While for most individuals a house will be a capital asset, for realtors it might be inventory. For most individuals, stocks are held for investment purposes, but for dealers stocks in the dealer’s own account may be considered inventory.
ii) Tax Treatment for Capital Gains
(1) First, make the distinction between short term and long term capital gain. Historically, to be classified long term, the asset had to have been held for more than 1 year. With the tax bill of 1997, the asset must have been held for more than 18 months.
(2) If held for >18 months, then the maximum tax on the gain if the TP is in the 15% bracket is 10%. For any other TP, the maximum tax on the gain is 20%.
(3) Beginning in 2002, is an asset is held for more than 5 years, the top capital gain tax rate for the 15% bracket will be 9% and the rate will be 18% for everyone else.
(4) Short term capital gains are taxed as ordinary income for all taxpayers!
(5) Recapture Income – If you buy an asset (typically personal equipment and machinery like a tractor) that allows you to take a deduction against ordinary income (depreciation) (i.e. a benefit is gained at ordinary rates) then when the asset is sold, the gain at disposition is treated as ordinary income to the extent of prior deductions.
(a) Example: Depreciation. A tractor is purchased for $10M and over the first 3 years, the owner claims depreciation deductions totaling $6M, leaving an adjusted basis of $4M. If the tractor is then sold for $5M, TP has a gain of $1M which would typically be a capital gain. However, under the recapture rules the gain is merely a recovery of ordinary income. If the tractor was sold for $11M, the first $6M would be taxed at ordinary income and the remaining $1M would be a capital gain.
iii) Tax Treatment for Capital Losses