Flat Rate Tax
Based on consumption or value added basis, therefore savings interest not taxed. This favors the wealthy.
Tax burden depends on where income is earned (i.e. investments or labor) and how the income is spent (i.e. purchases or savings)
Replacing income tax w/ national sales tax would be more stable than income tax (as income goes up, consumption levels out and eventually down as % of income.
Self-assessed system on worldwide income from whatever source to raise revenue
Both savings and consumption is taxed
Affects behavior, economic and personal spending, not just generates revenue.
Hybrid between tax on income and consumption – it does encourage some forms of consumption (i.e. home purchase for mortgage interest deduction)
Progressive tax – rate of tax applied on income is increased as income increases
Those with AGI over $100k pay 61% of taxes on 40% of income – i.e., 7% of taxpayers pay 61% of taxes.
Until Kennedy years, top tax bracket was at 91%, then reduced to 71%, then down to 50%, then to 28%, then up, then down (no clear answer what is right).
Criterion for evaluating tax policy:
Feature of any tax system that is both equitable and efficient
Simple to understand, calculate, comply with – should be so in a self-assessed system – today probably an impossible goal and flat tax will not meet this goal either.
Requires a determination of what are “similar economic circumstances”
(a) Horizontal equity “fairness”
Those that earn equal amounts of income should pay same amount of tax – similarly situated should be treated alike.
(b) Vertical equity “unequal income = unequal tax”
Supports notion of progressive taxation – those with unequal income should be taxed unequally (perhaps even proportionately more)
Simplicity will suffer – different rules and rates- therefore there is an incentive to try to lower the family’s tax burden – assignment of income section (later)
Tax systems should not influence economic behavior or individual decision making
Today we are not doing a good job with this principle – sometimes taxes are consciously used to affect behavior
Another view is whether it affects economic growth (yes = efficient)
Example: Employer gives a choice, I’ll pay for your health insurance, or I’ll give you the money, and you take care of your health insurance. Is there a difference in tax consequences? YES. Should there be a difference in tax consequences? NO.
Note: ignorance of law is actually a defense. However, remember section 7206(2) person aiding or assisting tax fraud is guilty of a felony (e.g. lawyer).
Exclusions, Income and Deductions
Section 1 – Individual income tax is imposed on taxable income
Section 63 – Defines taxable income
AGI less the higher of:
Standard deduction or itemized deductions
Less personal exemptions
Section 62 – Defines AGI:
Gross Income less above the line deductions
AGI is only a definitional term – Section 62 does not authorize any deductions it only describes those which are authorized elsewhere
Section 61 – Defines gross income
Lines 7 through 22 on 1040
Except for line 8(b) we do not report excludible items (e.g. muni interest)
First start with exclusions then GI per Section 61(“except”)
“except” as otherwise provided (in this subtitle – i.e. Subtitle A) GI is all income from whatever source derived including but not limited to…then there is a list of specifics – but it is NOT all inclusive
Items of GI are included even if they are not listed
“except” means mainly exclusions from GI (Section 101, 102, 103, etc.)
Section 101 – life insurance benefits
Section 102 – gifts and bequests
Section 103 – municipal bond interest
Section 104 – damage awards for personal injury
TAXABLE INCOME multiplied by tax rate = TENTATIVE TAX LIABILITY
Exclusions (listed on return, except line 8(b)) (101-135, see page 7)
Gross Income (Lines 7 thru 21)
Less: Above the line deductions:
Lines 23 to 31(a) and those inherent elsewhere (e.g.: business deductions)
They are authorized elsewhere – deductible even though do not itemize
E.g.: student loan interest, medical savings, moving, SE tax, alimony
Many are not listed between these lines (E.g.: business income per line 12 also includes business deductions) – also deductible in arriving at AGI (business interest, rent, utilities, wages) – Schedule C, E, etc.
AGI – Line 33 and 34
Less: Below the line deductions – higher of (Line 36):
Itemized deductions – Schedule A
May be limited as income increases (Line 28) at $137,300 or $68,650
Standard deductions (MFJ – $7,850)
Personal exemptions – Line 38 ($3,000)
Taxable Income – Line 39
Tentative tax – Line 40
Per tax rate schedules (up to $100,000) or tax tables (up to almost 39.6%)
Less: Tax Credits
Reduces taxes dollar for dollar
Note: Value of a deduction depends upon the taxpayer’s marginal tax rate, and a tax credit is always the same
E.g.: Withholding taxes (Line 58), estimated taxes, earned income credit, foreign tax credit, child care expenses, elderly or disables, etc.
Tax due or overpayment – Line 69 or 66, respectively
Note: if you get too much benefit from deduction, Congress decided that people should still pay some tax (AMT – alternative minimum tax).
Tax investment in property
Section 1012 – COST basis
Investment to be recovered before reporting any gain
Eg: home improvements
Income is reported when it is realized
G/L reported when asset is disposed of (inc. if becomes worthless)
Section 1001(a): the gain from the sale or other disposition of property shall be the excess of amount realized over the basis.
Reg 1.1001-1(a): except as otherwise pro
lso is a source for interpreting the IRC
Start with law and if it has gaps must interpret, committee reports, hearing transcripts, floor debate transcripts, blue book
Executive Branch – Administration of tax law:
Treasury Department governs the IRS
Treasury Dept delegates to IRS the task of administering the tax laws
IRS administers the law on a day to day basis
Judicial Process: route of a tax case:
Return filed with IRS processing center
Return is logged and checked for mechanical errors, then notice is issued accordingly
Then, there is a process of cross checking data received from other parties (employers, banks, brokerage houses). If mismatch then a notice is issued assuming it is based on innocent errors (i.e., 1099’s, W-2’s, etc.)
An audit notice may be sent if IRS does not believe the errors are innocent
Special Agents handle suspicions of criminal activity
IRS then compares to return to a “profile” to determine if it will be audited
High income, high deductions
If profile met then computer will pick for audit and a notice is sent
If agent decides there is a deficiency then an “30 day notice” will be issued allowing you to pay or protest
May appeal w/ audit office itself or may ask for appeal by appeals office – when review is within audit staff there is limited discretion on part of agent or those reviewing to make compromises (they go by the book)
If TP appeals to appeals office it is part of the office of the chief counsel
Agent, data processing
Office of Chief Counsel
After appeals then TP does not pay then IRS will issue a “90 day letter” which gives taxpayer 90 days to file in Tax Court
Not many other countries follow this process – in most countries you have no choice but to pay and then sue for refund
File an appeal for “Re-determination of tax liability” in Tax Court
Tax Court is located in DC but they travel around country to hear tax cases
Other 2 venue choices both involve paying deficiency first and then suing:
heard by either Federal District Court or Claims Court (Claims court in DC and must to there to litigate)
Depends on factors:
Can taxpayer pay the deficiency
Decisions of the respective courts (i.e. favorable decision in particular court on pertinent issue)
If complicated then Tax Court may better understand.