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Public Finance and Public Policy Jonathan

CopyrightGruber
2010 Fourth
WorthEdition
Publishers
Copyright 2012 Worth Publishers

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Taxation in the United States


and Around the World

18

18.1 Types of Taxation


18.2 Structure of the Individual Income Tax in
the United States
18.3 Measuring the Fairness of Tax Systems
18.4 Defining the Income Tax Base
18.5 Externality/Public Goods Rationales for
Deviating from Haig-Simons
18.6 The Appropriate Unit of Taxation
18.7 Conclusion
P R E PAR E D B Y
Dan Sacks
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C H AP T E R 1 8 TAXAT I O N I N T H E U N I T E D S TAT E S AN D AR O U N D T H E W O R L D

Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright 2012 Worth Publishers

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18.1

C H AP T E R 1 8 TAXAT I O N I N T H E U N I T E D S TAT E S AN D AR O U N D T H E W O R L D

Types of Taxation

Taxes on Earnings
o Payroll tax: A tax levied on income
earned on ones job.
Taxes on Individual Income
o Individual income tax: A tax paid on
individual income accrued during the
year.
o Capital gains: Earnings from selling
capital assets, such as stocks, paintings,
and houses.

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18.1

C H AP T E R 1 8 TAXAT I O N I N T H E U N I T E D S TAT E S AN D AR O U N D T H E W O R L D

Types of Taxation

Taxes on Corporate Income


o Corporate income tax: Tax levied on
the earnings of corporations.
Taxes on Wealth
o Wealth taxes: Taxes paid on the value
of the assets held by a person or family.
o Property taxes: A form of wealth tax
based on the value of real estate.
o Estate taxes: A form of wealth tax
based on the value of the estate left
behind when one dies.
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18.1

C H AP T E R 1 8 TAXAT I O N I N T H E U N I T E D S TAT E S AN D AR O U N D T H E W O R L D

Taxes on Consumption

Consumption tax: A tax paid on individual


or household consumption of goods (and
sometimes services).
Sales taxes: Taxes paid by consumers to
vendors at the point of sale.
Excise tax: A tax paid on the sales of
particular goods, for example, cigarettes or
gasoline.

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18.1

C H AP T E R 1 8 TAXAT I O N I N T H E U N I T E D S TAT E S AN D AR O U N D T H E W O R L D

Tax Revenue by Type of Tax in the United States


(2010, % of Total Tax Revenue)

42%

State
and
Local
20%

35
13
3
0
7

0
4
34
33
9

Federa
l
Individual income taxes
Social insurance
contributions
(payroll tax)
Corporate taxes
Consumption tax
Property tax
Other

Tota
l
34%
24
10
14
11
7

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18.1

C H AP T E R 1 8 TAXAT I O N I N T H E U N I T E D S TAT E S AN D AR O U N D T H E W O R L D

Taxation Around the World

OECD
Norw Denma
Averag
ay
rk
e
Individual income taxes 24%
55%
25%
Social insurance
contributions
(payroll tax)
23
2
27
Corporate taxes
22
5
8
Consumption tax
26
30
31
Property tax
3
4
5
Other
2
4
4

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18.2

C H AP T E R 1 8 TAXAT I O N I N T H E U N I T E D S TAT E S AN D AR O U N D T H E W O R L D

Computing the Tax Base

Income tax is assessed on adjusted gross


income minus deductions and exemptions.
Gross income: The total of an individuals
various sources of income.
Adjusted gross income (AGI): An
individuals gross income minus certain
adjustments.
Taxable income: The amount of income
left after subtracting exemptions and
deductions from adjusted gross income.

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18.2

C H AP T E R 1 8 TAXAT I O N I N T H E U N I T E D S TAT E S AN D AR O U N D T H E W O R L D

Computing the Tax Base

Adjustments vary over time, but as of 2009


they include:
Some contributions to retirement savings
Alimony paid to a former spouse
Health insurance premiums paid by the selfemployed
One-half the payroll taxes paid by the selfemployed
Educator expenses and interest paid on
student loans
Contributions to Health Savings Accounts
Expenses for job-related moves
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18.2

C H AP T E R 1 8 TAXAT I O N I N T H E U N I T E D S TAT E S AN D AR O U N D T H E W O R L D

Computing the Tax Base

To form AGI from gross income, subtract


exemptions and deductions.
Exemption: An amount tax payers
subtract from AGI for dependent household
members, self, and spouse.
Taxpayers can take one of two kinds of
deductions:
o Standard deduction: A fixed deduction
that a taxpayer can take.
o Itemized deduction: Taxpayer deducts
all qualifying expenses.
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18.2

C H AP T E R 1 8 TAXAT I O N I N T H E U N I T E D S TAT E S AN D AR O U N D T H E W O R L D

Computing the Tax Base

Deductible expenses include:


Medical and dental expenses exceeding
7.5% of AGI
Other taxes paid, such as state or local
income tax
Interest paid on investments and home
mortgages
Gifts to charity
Casualty and theft loss
Unreimbursed employee expenses

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18.2

C H AP T E R 1 8 TAXAT I O N I N T H E U N I T E D S TAT E S AN D AR O U N D T H E W O R L D

U.S. Federal Income Tax Rate Schedule, 2012

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18.2

C H AP T E R 1 8 TAXAT I O N I N T H E U N I T E D S TAT E S AN D AR O U N D T H E W O R L D

Tax Rates and Taxes Paid

Tax credits: Amounts by which taxpayers


are allowed to reduce the taxes they owe to
the government through spending, for
example, on child care.
Withholding: The subtraction of estimated
taxes owed directly from a workers
earnings.
Refund: The difference between the
amount withheld from a workers earnings
and the taxes owed if the former is higher.

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18.2

C H AP T E R 1 8 TAXAT I O N I N T H E U N I T E D S TAT E S AN D AR O U N D T H E W O R L D

Computing Jacks Taxes

Gross income
Deductions
= Adjusted gross income (AGI)

= Taxable income
Find taxes owed from tax schedule
= Total tax payment
= Final payment (refund) due
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18.2

C H AP T E R 1 8 TAXAT I O N I N T H E U N I T E D S TAT E S AN D AR O U N D T H E W O R L D

APPLICATION: The Coming AMT Timebomb

In 1969, Treasury Secretary Joseph W. Barr


found that 155 high-income households had
earned over $200,000 in 1966 but paid zero
income taxes.
The alternative minimum tax was meant to
correct make sure high-earners still paid
taxes.
o Alternative Minimum Tax: A tax
schedule applied to taxpayers with a
high ratio of deductions and exemptions
to total income.
Requires that income (before subtracting
exemptions and deductions) be taxed at
26% or more.
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18.2

C H AP T E R 1 8 TAXAT I O N I N T H E U N I T E D S TAT E S AN D AR O U N D T H E W O R L D

APPLICATION: The Coming AMT Timebomb

The AMT allows a single deduction of


$33,750 for individuals and $45,000 for
joint filers
but these numbers are not indexed for
inflation, so many households end up facing
the AMT.
The AMT add dramatic complexity to the
tax code, so repealing it has broad
support
but it is an important source of revenue;
repeal would cost at least $1.3 trillion
between 2011 and 2012.
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18.3

C H AP T E R 1 8 TAXAT I O N I N T H E U N I T E D S TAT E S AN D AR O U N D T H E W O R L D

Measuring the Fairness of Tax Systems

Two key features of any tax system:


o Marginal tax rate: The percentage that
is paid in taxes of the next dollar earned.
o Average tax rate: The percentage of
total income that is paid in taxes.
In the United States, the marginal tax rate
rises with income, from 10% to 35%.

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18.3

C H AP T E R 1 8 TAXAT I O N I N T H E U N I T E D S TAT E S AN D AR O U N D T H E W O R L D

Vertical and Horizontal Equity

Two goals are in measuring tax fairness:


Vertical equity: The principle that groups
with more resources should pay higher
taxes than groups with fewer resources.
Horizontal equity: The principle that
similar individuals who make different
economic choices should be treated
similarly by the tax system.

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18.3

C H AP T E R 1 8 TAXAT I O N I N T H E U N I T E D S TAT E S AN D AR O U N D T H E W O R L D

Measuring Vertical Equity

Vertical equity likely requires progressive


taxation.
Progressive: Tax systems in which
effective average tax rates rise with
income.
Proportional: Tax systems in which
effective average tax rates do not change
with income so that all taxpayers pay the
same proportion of their income in taxes.
Regressive: Tax systems in which effective
average tax rates fall with income.
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18.3

C H AP T E R 1 8 TAXAT I O N I N T H E U N I T E D S TAT E S AN D AR O U N D T H E W O R L D

APPLICATION: The Political Process of Measuring


Tax Fairness
Fairness is ambiguous, and politicians
pick the meaning that bests suit them.
Consider the income tax cuts proposed by
President Bush and signed into law by
Congress in 2003:
o 44% of the tax cuts went to the top 1%
of payers
o but top taxpayers pay 38% of income
taxes.
o but they pay only 30% of all taxes.
o but 34 million families with children
would receive an average tax cut of
$1,549 each.
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18.4

C H AP T E R 1 8 TAXAT I O N I N T H E U N I T E D S TAT E S AN D AR O U N D T H E W O R L D

The Haig-Simons Comprehensive Income Definition

What kind of income should be taxed?


Haig-Simons comprehensive income
definition: Taxable resources are an
individuals ability to pay (i.e. potential
annual consumption).
Potential annual consumption: Total
consumption during the year, plus any
increases in wealth.
Difficulties:
o Defining power to consumption/ability to
pay
o Non-consumption expenditures
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18.4

C H AP T E R 1 8 TAXAT I O N I N T H E U N I T E D S TAT E S AN D AR O U N D T H E W O R L D

Deviations Due to Ability-to-Pay Considerations

Haig-Simons promotes horizontal equity


by treating all income equally.
One reason for deviation is to account for
not associated with desired consumption.
o Deductions for property and casualty
losses
o Deduction for medical expenditures
o Deduction for state and local tax
payments

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18.4

C H AP T E R 1 8 TAXAT I O N I N T H E U N I T E D S TAT E S AN D AR O U N D T H E W O R L D

APPLICATION: What Are Appropriate Business


Deductions?
Hard to determine appropriate business
deductions:
A rabbi claimed as a business expense the
$4,031 he spent on 700 guests who
attended his sons bar mitzvah.
o Tax court found the Rabbi was not
required to invite the entire
congregationas a condition of his
employment.
An exotic dancer claimed breasted implants
as a business expense.
o Tax court agreed since the implants were
far too large for the dancer to derive
pleasure from.
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18.4

C H AP T E R 1 8 TAXAT I O N I N T H E U N I T E D S TAT E S AN D AR O U N D T H E W O R L D

APPLICATION: What Are Appropriate Business


Deductions?
The entertainer Dinah Shore claimed

several dresses as business expenses,


prompting an investigation by the IRS.
o Dinah Shore ruling: A dress may be
deducted as a business expense only if
it is too tight to sit in.
A man tried to deduct $30,000 in expenses
on illegal drugs.
o Allowed to claim deductions, he was
sentenced for criminal charges.
Many OECD countries have traditionally
allowed/ treated foreign bribes as business
expenses.
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18.5

C H AP T E R 1 8 TAXAT I O N I N T H E U N I T E D S TAT E S AN D AR O U N D T H E W O R L D

Externality/Public Goods and Charitable Giving

One reason to deviate from Haig-Simons is


to correct externalities.
Charitable giving likely underprovided.
o People may give to homeless shelters
because of the tax break, but these
would be underfunded otherwise.

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18.5

C H AP T E R 1 8 TAXAT I O N I N T H E U N I T E D S TAT E S AN D AR O U N D T H E W O R L D

Spending Crowd-Out versus Tax Subsidy Crowd-In

Alternatively, the government could it could


provide homeless shelters itself. Why not
do so?
If the government subsidizes homeless
shelters, the amount of private charitable
giving to those shelters would most likely
fall.
When the government tax subsidizes
charitable giving, it may crowd in, or
increase, private contributions.

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18.5

C H AP T E R 1 8 TAXAT I O N I N T H E U N I T E D S TAT E S AN D AR O U N D T H E W O R L D

Marginal versus Inframarginal Effects of Tax


Subsidies
Tax breaks have the marginal and
inframarginal effects.
Marginal impacts: Changes in behavior
the government hopes to encourage
through a given tax incentive.
Inframarginal impacts: Tax breaks the
government gives to those whose behavior
is not changed by new tax policy.

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18.5

C H AP T E R 1 8 TAXAT I O N I N T H E U N I T E D S TAT E S AN D AR O U N D T H E W O R L D

Effects of Tax Subsidies versus Direct Spending

Mathematically, the government should use


a tax break instead of direct spending if:
The increase in charity per $ of tax break >
1 Reduction in charity per $ of government
spending
If this holds, then giving more of a tax
break (and reducing government spending)
increases charitable giving.
Several studies have concluded that for
each 1% fall in the price of charitable
giving, the amount of giving rises by 1%.
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18.5

C H AP T E R 1 8 TAXAT I O N I N T H E U N I T E D S TAT E S AN D AR O U N D T H E W O R L D

Consumer Sovereignty versus Imperfect Information

Direct government provision imposes


preferences about how funds are spent.
Tax subsidies to private individuals
respects the preferences of citizens.
But the private sector may not have the
appropriate mechanisms in place to ensure
efficient distribution of charitable
spending.

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18.5

C H AP T E R 1 8 TAXAT I O N I N T H E U N I T E D S TAT E S AN D AR O U N D T H E W O R L D

Housing

Home ownership is subsidized through the


home mortgage interest deduction.
o Mortgage: Agreement to use a certain
property, usually a home, as security for
a loan.
Rent is not tax deductible.
Home ownership may provide externalities
through responsible citizenship.

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18.5

C H AP T E R 1 8 TAXAT I O N I N T H E U N I T E D S TAT E S AN D AR O U N D T H E W O R L D

EVIDENCE: The Social Benefits of Homeownership

The American Dream Demonstration


subsidized home ownership for a random
treatment group.
Subsidy increased home ownership by
713%.
But no external benefits:
o Treatment and control groups equally
involved in civic activities.
o Treatment group spent more on home
improvements, but only on the inside,
providing no external benefit.
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18.5

C H AP T E R 1 8 TAXAT I O N I N T H E U N I T E D S TAT E S AN D AR O U N D T H E W O R L D

Effect of Tax Subsidies for Housing

Despite wide variation in this tax subsidy,


the home ownership rate has remained
essentially constant since the 1950s, at
about 65%.
The tax subsidy is inducing individuals to
spend more on houses, but not moving
people from renting to buying.

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18.5

C H AP T E R 1 8 TAXAT I O N I N T H E U N I T E D S TAT E S AN D AR O U N D T H E W O R L D

Tax Deductions versus Tax Credits

Tax subsidies can be offered as deductions


or credits.
Tax deductions: Amounts by which
taxpayers are allowed to reduce their
taxable income through spending on items
such as charitable donations or home
mortgage interest.
Tax credits allow taxpayers to reduce the
amount of tax they owe to the government
by a certain amount (e.g., the amount they
spend on child care).
How should the government decide which
to use?
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18.5

C H AP T E R 1 8 TAXAT I O N I N T H E U N I T E D S TAT E S AN D AR O U N D T H E W O R L D

Efficiency Considerations

Consider replacing charitable giving deduction


with a tax credit for up to $1,000.
For people giving less than $1,000, the
credit provides a much stronger incentive to
increase giving up
Once a person gives more than $1,000,
there is no more benefit from the tax credit.
Policy preference depends on:
o The nature of the demand for the
subsidized good.
o How important it is to achieve some
minimal level of the behavior.
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18.5

C H AP T E R 1 8 TAXAT I O N I N T H E U N I T E D S TAT E S AN D AR O U N D T H E W O R L D

Equity Considerations

On vertical equity grounds, tax credits are


more equitable than deductions.
The value of a deduction rises with ones
tax rate, making deductions regressive.
Credits, on the other hand, are available
equally to all incomes so that they are
progressive.

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18.5

C H AP T E R 1 8 TAXAT I O N I N T H E U N I T E D S TAT E S AN D AR O U N D T H E W O R L D

APPLICATION: The Refundability Debate

Should tax credits be refundable?


Refundable: Describes tax credits that are
available to individuals even if they pay few
or no taxes.
Many conservatives object to the notion
that those who owe little or no income
taxes get a refund.
Supporters note that, while low-income
families pay little income tax, they do pay a
large share of their income on other taxes.

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18.5

C H AP T E R 1 8 TAXAT I O N I N T H E U N I T E D S TAT E S AN D AR O U N D T H E W O R L D

APPLICATION: The Refundability Debate

Tax refunds and the child credit:


The child credit was a non-refundable tax
credit for low- and middle-income families.
In 2001 tax cuts, families received a refund
for at most 10% of their income above
$10,500.
2003 tax cuts expanded the credit, and the
President said families would get a $400
check in the mail.
But only high-income families received the
refund because the refund increases with
income.
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18.5

C H AP T E R 1 8 TAXAT I O N I N T H E U N I T E D S TAT E S AN D AR O U N D T H E W O R L D

Bottom Line: Tax Expenditures

Deviations from Haig-Simons are tax


expenditures.
o Tax expenditures: Government
revenue losses attributable to tax law
provisions that allow special exclusions,
exemptions, or deductions from gross
income, or that provide a special credit,
preferential tax rate, or deferral of
liability.
Tax expenditures are enormous, predicted to
be $1.3 trillion in 2013.

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18.5

C H AP T E R 1 8 TAXAT I O N I N T H E U N I T E D S TAT E S AN D AR O U N D T H E W O R L D

Select Tax Expenditures in 2013

Tax Expenditure
Employer-provided health
insurance
Home mortgage interest
deduction

Amount
(Millions)
$180,580
100,910

Exclusion of pension/401(k)
contributions

72,740

Exclusion of net imputed rental


income

51,080

Deductibility of charitable
contributions

39,770

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18.6

C H AP T E R 1 8 TAXAT I O N I N T H E U N I T E D S TAT E S AN D AR O U N D T H E W O R L D

The Problem of the Marriage Tax

How should couples be taxed?


We might like a tax system to satisfy three
principles:
o Progressivity
o Across-Family Horizontal Equity
o Across-Marriage Horizontal Equity
It is impossible to achieve all three goals at
once.

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18.6

C H AP T E R 1 8 TAXAT I O N I N T H E U N I T E D S TAT E S AN D AR O U N D T H E W O R L D

The Problem of the Marriage Tax

Any tax system that tries to achieve


horizontal equity and progressivity have a
marriage tax for some people.
o Marriage tax: A rise in the joint tax
burden on two individuals from
becoming married.
Progressivity, with taxes applied to
individual income, means that two couples
with different earnings distributions have
different tax burdens.
Taxing family incomes leads to a marriage
tax.
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C H AP T E R 1 8 TAXAT I O N I N T H E U N I T E D S TAT E S AN D AR O U N D T H E W O R L D

18.6

The Problem of the Marriage Tax

Individ Individu
Family Tax
ual
al Tax with Individual
Income
Filing
Michell
e

$140,00
0

$32,000

Barack

10,000

1,000

Bill

75,000

13,000

Hilary

75,000

13,000

35,000

26,000

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18.6

C H AP T E R 1 8 TAXAT I O N I N T H E U N I T E D S TAT E S AN D AR O U N D T H E W O R L D

Marriage Taxes in Practice

Very large deductions for married couples


relative to single tax filers would eliminate
marriage tax.
But no set of deductions can make the
system of family-based taxation marriage
neutral.
Marriage Taxes in the United States
o Some families face marriage subsidies
and some face marriage taxes.
o Some families pay marriage taxes.

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18.6

C H AP T E R 1 8 TAXAT I O N I N T H E U N I T E D S TAT E S AN D AR O U N D T H E W O R L D

Marriage Taxes around the World

The United States is almost alone in having


a tax system based on family income.
Of the industrialized nations in the OECD,
o 19 tax husbands and wives individually
o five (France, Germany, Luxembourg,
Portugal, and Switzerland) offer marriage
subsidies to virtually all couples through
family taxation with income splitting.

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18.7

C H AP T E R 1 8 TAXAT I O N I N T H E U N I T E D S TAT E S AN D AR O U N D T H E W O R L D

Conclusion

In this chapter, we set the stage for our study


of taxation by discussing:
The different types of taxation used by the
United States and the rest of the world.
How to measure tax fairness.
The key issues policy makers face in
designing the base of income taxation.

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