Public Finance Dr. Katie Sauer

Figure 18-1

Figure 18-2

Calculating your Federal Income Tax 1. compute gross income - wages, salaries - interest, dividends, rental income

2. compute adjusted gross income subtract off: - retirement savings contributions - alimony - educator expenses - contributions to HSAs - job-related moves expenses - interest paid on student loans - if self-employed: - health insurance premiums - 50% of paid payroll taxes

3. Subtract any exemptions - fixed amount of money that is deducted for the taxpayer, spouse, dependents - indexed for inflation 2011: $3,700 per person - if you are someone¶s dependent, then you cannot claim your own personal exemption - can¶t claim as a dependent anyone who files a joint tax return with a spouse - spouses filing a joint return can claim two personal exemptions

Exemptions used to be ³phased out´ for very high income levels. - personal exemption phaseout (PEP) These limits will not apply for the year 2010, 2011 or 2012. The limits will come back in 2013 (unless further legislation is passed).

Income Range for PEP (2009)

Filing Status Phaseout Begins Married Filing Jointly 250,200 Qualifying Widow(er) 250,200 Head of Household 208,500 Single 166,800 Married Filing Separately 125,100

Phaseout Ends 372,700 372,700 331,000 289,300 186,350

4. Decide on deduction type Standard Deduction: $11,600 for married couples filing jointly $5,800 for singles $5,800 for married individuals filing separately $8,500 for heads of household additional standard deduction for blind people and senior citizens $1,150 for married individuals $1,450 for singles and heads of household

Itemized Deduction: - medical and dental expenses exceeding 7.5% of AGI - other taxes paid (state, local income tax) - interest on mortgage - charitable donations - casualty and theft losses - union dues and job travel expenses

According to the IRS, 2 out of 3 tax payers takes the standard deduction . (IR-2010-127, Dec. 23, 2010)

5. Compute Federal Income Tax Owed Here are the tax brackets for a single person for 2011: Marginal Tax Tax Bracket Rate over but not over 10% $0 $8,500 15% $8,500 $34,500 25% $34,500 $83,600 28% $83,600 $174,400 33% $174,400 $379,150 35% $379,150

Suppose you are single in 2011 and your AGI is $50,000.
Marginal Tax Rate 10% 15% 25% 38% 33% 35% Tax Bracket over $0 $8,500 $34,500 $83,600 $174,400 $379,150 but not over $8,500 $34,500 $83,600 $174,400 $379,150

On the first $8500, you pay 10% in taxes. 8500 x 0.10 = 850

Marginal Tax Rate 10% 15% 25% 38% 33% 35%

Tax Bracket over $0 $8,500 $34,500 $83,600 $174,400 $379,150

but not over $8,500 $34,500 $83,600 $174,400 $379,150

On the next portion of income, you pay 15% in taxes. 34500 ± 8500 = 26000 26000 x 0.15 = 3900

Marginal Tax Rate 10% 15% 25% 38% 33% 35%

Tax Bracket over $0 $8,500 $34,500 $83,600 $174,400 $379,150

but not over $8,500 $34,500 $83,600 $174,400 $379,150

On the next portion of income, you pay 25% in taxes. 50000 ± 34500 = 15500 15500 x 0.25 = 3875

The total amount you pay in taxes is: = (0.10)(8500) + (0.15)(34500-8500) + (0.25)(50000-34500) = 850 + 3900 + 3875 = 8625

The marginal tax rate is the extra taxes paid on an additional dollar of income.

If your AGI is $50,000 and then you earn one extra dollar of income, that dollar is taxed at a rate of 25%. Your current marginal tax rate is 25%.

The average tax rate is the total taxes paid, divided by total income. = 8625 / gross income Suppose your gross income is $60,000. = 8625 / 60000 = 14.4% is your average tax rate

How your Federal taxes are spent

Colorado has a flat 4.63% income tax

The Haig-Simons Comprehensive Income Definition It defines taxable resources as an individual¶s ability to pay taxes. The ability to pay is equal to an individual¶s potential annual consumption. Potential annual consumption is equal to total consumption during the year plus any increase in wealth.

This is how public economists define income. - improves vertical efficiency (high income pay a larger share of income in taxes) - those who have more resources pay more in tax - improves horizontal efficiency (same incomes pay same taxes) - same underlying resources pay same in tax

Difficult to do in practice: On ability-to-pay grounds, we might like to deduct - property and casualty losses - medical expenditures - state and local tax payments

On externality/public goods grounds we might deviate for - charitable giving - housing

Charitable Giving Suppose there are not enough homeless shelters. - government could finance - government could give incentives to private sector to provide When charitable donations are tax deductible, charitable giving is ³cheaper´ relative to other types of consumption. It might be preferred to have tax subsidy crowd-in as opposed to government spending crowd-out.

Ex: Ellie is deciding whether to buy a $1 cup of coffee or to donate $1 to a homeless shelter. To get $1 to spend on coffee, she¶ll have to earn more than $1: $1 / (1 ± tax rate) To get $1 to spend on a donation, she¶ll have to earn exactly $1: $1 / (1 ± 0)

The relative price of charitable giving is: = $1 $1 / (1 ± tax rate)


$(1 ± tax rate)

This type of preferred tax treatment yields a benefit at the cost of deviating from Haig-Simons.

To consider: When the government gives a tax subsidy for an action, it will be giving a tax break to individuals who would have taken the action anyway. - inframarginal impact When the government gives a tax subsidy for an action, some people are incentivized to take the action. - marginal impact

The government should use a tax break instead of direct spending if:

the increase in charity per dollar of tax break


1 ± the reduction in charity per dollar of government spending

Tax subsidies may also be preferred to government spending on consumer sovereignty grounds. - when government spends, it is imposing its preferences - when individuals spend, they express their own preferences

Housing If the mortgage deduction were discontinued, it is estimated federal tax revenues would rise by $80 billion per year. Why subsidize home ownership? - in theory has positive externalities that renting does not - stake in society, neighborhood, town - vote for long run investments - mixed empirical evidence

Effect of housing tax subsidies: - doesn¶t seem to induce people to buy homes - does increase expenditures on housing - for every $1 more of tax subsidies, $1 more is spent on housing

« no real justification to deviate from Haig-Simons « very popular

If we are going to deviate from Haig-Simons, is it better to use tax deductions or tax credits? Tax deductions allow taxpayers to reduce their taxable income. Tax credits allow taxpayers to reduce the amount of the tax that they owe.

Efficiency Considerations:


Consider replacing the current deductibility of charitable donations with a 100% tax credit, up to $1000. If you gave less than $1000: - likely give full $1000 now because your tax bill goes down by $1 for every $1 you give If you gave more than $1000: - less of an incentive to give once reach $1000

Two considerations for efficiency: 1. nature of demand for the subsidized good - elastic « credits may induce more giving 2. importance of achieving a minimum level of the behavior - credit can induce a minimum level

Equity Considerations: Vertical - tax credits are more equitable than deductions - deductions are regressive - credits are progressive

Another consideration: are tax credits refundable? Refundable means available to individuals who owe few or no taxes. - increase refund amount

Tax Expenditures The existing set of deviations from Haig-Simons is a set of tax expenditures. - government revenue losses attributable to tax law provisions that allow special exclusions, exemptions, or deductions from gross income - government revenue losses attributable to tax law provisions that provide a special credit, preferential tax rate, or deferral of liability

Table 18-2

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