INCOME TAX
A. INTRODUCTION
1. Characteristics of well-designed tax system
a. Fairness (equity):
1) Horizontal equity: people similarly situated (e.g., same income) should pay the same taxes
2) Vertical equity: people with more income should pay more taxes (take into account differences)
b. Efficiency – want tax to impose the least behavioral changes possible
c. Administrable – taxpayers need to be able to understand, compute and pay; government needs to be able to police system
2. Types of Taxes
d. Head tax: everyone pays the same tax (no way around, no behavior distortion, no welfare loss); economists favor
e. Consumption tax: based upon the amount you consume (sales tax)
f. Property / wealth tax: based upon accumulated wealth
g. Income tax
3. The Income Tax
h. People earn Wages – they can Consume (consumption) or Save (wealth creation) [W = C + S]
1) Difference b/w consumption and income tax is that in consumption tax you don’t tax savings
i. Choose a base (wealth, consumption, or income): we choose income
j. We have a progressive structure in place; §1(a) in the code lists rates for married couples
1) Lowest bracket = 0 %
2) Tax rates have been as high as 91%; in 1980, was 70%, and Reagan lowered to 50%
3) In 1986, revision of IR Code, rates lowered to 28%, then slowly back up to 39.6% before recent tax cut
k. Taxable Unit: generally, internal revenue code taxes individuals; however, married people can file joint return
l. Tax Period: we choose calendar year as a default; exceptions:
1) Retailers often use a fiscal year that is not a calendar year (often a year ending 1/31)
2) Ski resorts – if a seasonal business, you want your year to end at the end of a season
3) Schools – academic year
m. Accounting method under GAAP
1) Most businesses use accrual method; individuals use default of cash method – income/deductions recorded when they occur
Tax Formula
Individuals
Income (except exclusion
ome (AGI) as [(GI) – (deductions allowed under §62)] Taxpayer’s gross income less her trade or business expenses.
c. §63 defines taxable income (TI) as [(AGI) – all other allowable deductions)] itemized deductions or Standard deductions
d. Marginal Tax rate: Applicable rate at each bracket level
e. Average or Effective rate: Applicable rate to the taxpayer’s income as a whole
5. Taxable Income [§63]
a. Taxable Income = gross income (§61) – permitted deductions
b. Individuals have two groups of deductions:
1) §62: above the line (related to earnings)
2) Below the line (e.g., mortgage interest, charity, property taxes)
c. After deductions, arrive at Adjusted Gross Income
After AGI, include below the line deductions or standard deduction / personal deduction, arrive at taxable income
