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Income Taxation
University of North Carolina School of Law
Thomas, Kathleen DeLaney

Income Tax – Thomas – Spring 2016

Introduction to our Federal Income Tax System

Taxation: The process by which the government collects revenues from the private sector to the public realm (private resources for public use)

Tax system is designed to encourage people, through lower tax incentives, to spend their money on things deemed socially desirable (charity, education, retirement savings)
Allowing deductions is a way of govt. spending (i.e. govt. foregoes revenue they would have otherwise collected)

US Tax System

Congress designed the US tax system – only they have the power to tax
Purpose of taxes: to fund federal programs (highways, health care, defense, schools, national parks, etc.)
Congress spends about $3.5 trillion on those things. Each year, the federal government collects about 3 trillion in taxes

The remaining $500 billion we get through loans
Of the $3 trillion in tax revenue

40% comes from individual income tax
35% comes from Payroll Taxes
8% Corporate tax
1% Estate and gift taxes
9% Misc.

Difference between tax revenue and what we spend
Amount we owe to our lenders

Different Tax Systems

Head tax/Poll tax – everyone pays the same thing

Pros: it is easy, no need to file tax return, hard to cheat on it because there is no debate on what is owed
Cons: it doesn’t take into account differing incomes/wealth; it seems unfair

Consumption Tax – taxed on what you spend

This is a regressive tax. High income ppl generally have lower tax rate because they will send lower percentage of their income. Low income people will generally spend a higher percentage, or all of their income and would be taxed on all of their money (would look like a federal sales tax)
Pro: Encourages savings
Con: Poor people would be spending more on taxes because they would spend more of their money, and the rich would spend less on taxes; Would discourage spending; tax evasion

Wealth Tax – taxing on savings/assets

Pros: Looks at a taxpayer’s big picture
Cons: Inability to pay based on the illiquidity of the assets; discourages people from saving and encourage spending; Appraisalà tough to value the assets each year; Would potentially be an annual tax on the same assets; Enforcement problem because the IRS may not know about people’s assets (easy for people to hide assets, i.e. storing cash in a show box)

Goals of our Tax System:

Fair tax system

Taxing the ability to pay
Horizontal equity, do people with same ability to pay, pay the same amount?
Vertical equity, do people with more ability to pay, pay more taxes?

Administrable, enforceable

Goal is to be able to administer the tax: liquidity, ease of taxing that way, and enforcement; i.e. reason why we have standard deductions


We do not want the tax code to influence behavior too much
Exe: At a tax rate of 10% you are cool with your tax rate and keep working! Uh oh, now your tax is 90%. Your take home pay is shit. You will quit.

1) No income for gov now!
2) No services from this person, loss to society

What Should we Tax?

We aim to tax some variant on the ability to pay!
But how?? We rely on a proxy measure when what we want to tax isn’t measurable


What about decisions to hold wealth instead of consuming it?

Income I = C + S (income = consumption + savings)

The Haig-Simons Definition: income is the sum of the taxpayer’s consumption plus change in net worth (defined in terms of market value during a specified period of time)

I = C + ΔW (Income = consumption + change in net worth (aka savings))
Everything you consume + everything you save

Tax Terminology

Tax Terminology

Tax Base – not part of IRS vocabulary. Refers to a general concept used by lawyers and economists to describe the items that are to be taxed under whatever system of taxation one adopts, determining the amount to which the appropriate tax rate is applied
The tax base is a specialized amount called taxable income
Tax Base (taxable income) x Tax Rate = Tax Debt
Taxable income is defined by reference to certain other statutory terms!

Tax Systems

How does a tax system address income distribution by requiring some people to pay not just more tax than others, but relatively more as a percentage of income? Differential tax rates!

Progressive Income Tax- average tax rates rise as income rises (higher amount and higher proportion) (US has this)

Horizontal Equity: This system tries to equally tax people who have the same increase in economic power (whether through cash or property)
Vertical equity: This system aims to tax those who earn more at a higher rate of tax than those who earn less

Progressive Rate structure Pro v. Con:

: People making more money don’t “feel” the tax as much (marginal utility of the dollar is less at the top

Goes to notions of fairness—redistribution of wealth to ease growing disparities of wealth

: may discourage increasing net wealth (if tax rate gets too high, people may actively try NOT to earn/invest that next dollar)

Regressive Income Tax- the average tax rates decline as income rises (the amount still keeps increasing)

Lower income people are paying a greater percentage

Proportional Tax- flat tax rate

Tax Rate Options

Marginal rate structure – we pay our rate for income OVER the threshold! Not on everything.

Marginal Rate – applicable rate of tax at each bracket level
Income is taxed at a series of rates
Within the individual income tax, progression is accomplished by the use of increasing marginal tax rates – increases in rates that apply only to higher increments of income

Effective Tax Rate or Average Tax Rate – the percentage of your income that you actually pay in tax.

Lower than the marginal rate because it is an average of the constantly rising series of marginal tax rates

Asks how much tax did you pay over how much tax did you make?
: [endif]–>

I owe $44k, I made $200k in wages à My effective tax rate is 22%

This is important for the exam! And easier number!

Marginal Rate Structure in Practice:

Fake Tax System

0—$10k à 10%
$10,001—$100,000 à 20%
>$100,000 à 25%

I make $200,000 in wages. $200k x 25% = $50k! NOPE. You have to apply ALL OF THE RATES!

First 10k = $1,000 of taxes
Next 90k = $18,000 of taxes
Only money that exceeds 100k gets taxed next, 100k = $25,000 in taxes
Add it all up: $44,000!

Compliance and Administration

Compliance and Administration

Global v. Schedular

Global- income from all sources is combined and taxed under a rate schedule that applies to the taxpayer’s entire income, net of any allowable losses or deductions
Schedular- a separate rate schedule applies to several different categories of income and losses within each category are allowed only with respect income from that category

US does global but some schedular things, taxing income and some consumption
People self report, compliance rates are highest in the world

Judicial Review Options:

The tax court – Available if the tax isn’t paid yet
Federal District Court – Pay the tax and sue

tax liability

Deduction: 10k, so her “income” is now $90k! 27k in tax liability.

She saved $3k! Real money in her pocket.

Or Credit: $10k, so her tax liability is now $20k

Tax Payer B = 20k of AGI, 10% effective tax rate 2k in tax liability

Deduction: 10k, so “income” is 10k 1k in tax

She saved $1k!

Deductions are worth more to rich people with a higher bracket

Upside-down Effect: rich are subsidized more than the poor
But proportionally, better if you’re poor

Present Value and the Benefit of Deferral

So long as interest rates are positive, it is beneficial to defer taxes into the future
Deferral = present value of a future payment

What is my money worth in the future


The time value of money
1) A tax liability deferred from present to future gives the taxpayer the use in the interim of the amount that would otherwise have been paid presently in taxes
Deferring is beneficial in cases when you don’t necessarily have the cash to pay the tax now (this is why realization events are important)
3) Valuation Issues: Deferral is a good mechanism when the property in question cannot easily be valued before there is a realization event—better to wait until a clear value can be discerned before taxing that value

**GENERALLY the value of an asset is the Fair Market Value (if it can be determined)

Possible Disadvantages:

Deferring tax may push someone into a higher marginal rate situation once the realization event occurs—sometimes it could be advantageous to “split” the tax (some now and some later) to avoid this problem
: T gets 100 shares of stock worth 3 a share. She sells stock after 2 years for 9 a share

Deferring tax until she sells would give her 900 in income in that year—However, if she is taxed upon receipt she will include 300 initially and then 600 when she sells (this could be “better” for her marginal rate (if possible to do)

How does this relate to deductions?

Imagine a $10k deduction at a tax rate of 30%
So this is worth $3k, REAL MONEY ()
You always want to pay tax in the future & pay deductions today and the IRS wants the opposite

Calculating Present and Future Value

Two ways to compute:
FV is future value, PV is present value (the money you have today), r is interest rate, and n is years

Future Amounts Corresponding to Given Present Values

How much do I need to invest today to have $X at Y% for N years?
How much do I need to invest at 6% for one year to have $100?
Present value = $100 /(1+.06) = $94.3
If you invest your $94 dollars today, in 1 year it will grow to 100.

Present Capital Value for Future Amount

How much will $1 paid now purchase in one year?
Example: How much is $1 work in 5 years at a 6% rate?
FV = 1 (1 + .06)5 =1.34