The Personal Income Tax in the United States. Figure 15.1. Defining Income. Which forms of income are taxed? Wages and salaries Rents Dividends Business profits Capital Gains Interest Income Transfers, gifts, etc. Excludable Forms of Income.
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Defining Income • Which forms of income are taxed? • Wages and salaries • Rents • Dividends • Business profits • Capital Gains • Interest Income • Transfers, gifts, etc.
Excludable Forms of Income • Interest earned on bond issued by a state or a local municipality is untaxed (while interest earned on the bond of a private company is taxed). • In 2003, legislation was passed which lowered the maximal tax rate on dividends to 15%.
Capital Gains • The maximum capital gains tax rate (in 2004) is 15%, while the maximum federal tax rate on ordinary income is 35.0%. • Capital gains held for less than 12 months are taxed as ordinary income. • Capital losses offset capital gains, and can be subtracted from ordinary income (up to a cap of $3,000).
Realized versus Unrealized Gains • One interesting aspect of the treatment of capital gains is that only realized capital gains are taxed. • As the illustration below dramatically shows, the timing of realizations can matter greatly for total portfolio wealth, even holding the composition of assets fixed.
Capital Gains: An Example • Example: • Asset with principal of $100,000 • r=12% • Time horizon is 20 years • Tax rate = 15%
Capital Gains • Capital gains not realized until end of 20 years: • Value of investment is $100,000x(1+.12)20 = $964,629. • Capital gain is $964,629-$100,000 = $864,629 • Tax owed is 15%x$864,629 = $129,694 • Wealth = $964,629-$129,694 = $834,935
Capital Gains • Capital gains realized each year • After tax rate of return is not 12%, but rather (1-.15)x12% = 10.2% since taxes are paid along the way rather than at the end • Value of investment is $100,000x(1+.102)20 =$697,641. • Wealth = $697,641
Capital Gains and Lock-in Effect • Wealth is more than $137,000 lower by realizing capital gains along the way rather than deferring tax payments until the end. • Deferral allows the money to grow geometrically at the before-tax rate of return. • “Taxes deferred are taxes saved” • Investors may be less likely to change their portfolios, known as the lock-in effect.
Employer Health Care Contributions • If an employer pays premiums for a health insurance plan, those contributions are not taxed. • If the employer instead paid the employee in the form of higher wages, the wages would be taxed.
Retirement Saving • There are numerous tax-deferred or tax-free savings vehicles. • Although they have different names, they usually share a number of characteristics. • In all of these plans, the investment accrues at the before tax rate of return, and do not suffer from the lock-in effect.
Exemptions and Deductions • Once AGI is determined, subtract certain exemptions and deductions to arrive at taxable income.
Exemptions • Family allowed an exemption for each member • Exemption in 2003 was $3,050 per family member, so a husband and wife with three dependent children could claim five exemptions and subtract $15,250 from AGI. • Exemptions phased out for households with high AGI’s.
Deductions • The other subtraction from AGI is a deduction. There are two types: • Standard deduction – a fixed amount that requires no documentation • Itemized deduction – subtractions for specific items cited in the law, must list each item separately, and be able to prove the expenditures were made • Taxpayers would choose whichever one minimized their tax liabilities.
Standard Deductions • Standard deduction in 2003 was $4,750 for single individuals, and $7,950 for joint filers. • Around 67% of tax returns take the standard deduction.
Unreimbursed Medical Expenses • Must exceed 7.5% of AGI • Only medical expenses above the threshold are deductible • Creates incentives to “stack” medical procedures in one calendar year. • Time medical procedures for years when AGI is low
State and Local Income and Property Taxes • In 2000, these deductions amounted to $290 billion. • Sales taxes are not deductible. • For those who itemize, lowers the effective costs of paying these taxes. • State and local taxes vary substantially within the U.S.
Some Types of Interest Payment • Interest on home equity loans • Interest on conventional mortgages • Interest on some student loans • Not interest paid on consumer debt like credit cards
Charitable Contributions • Charitable deductions cannot exceed 50% of AGI • In 2000, $134 billion in deductions for charitable contributions • Tax deductibility lowers the effective “price” of giving. Elasticity estimates around 0.5, which mean that lowering the effective price from $1 to $0.7 increases giving by 15%.
Tax Credits • A tax credit is a subtraction from tax liability (not taxable income). • Unlike deductions, the value of the credit is independent of the tax rate. • Number of credits in the tax system, including the “kiddie tax credit” which is $1000 per child, and credits for college expenses.
The Cost of Tax Loop Holes • Tax expenditures are the revenues forgone due to preferential tax treatment. • The revenue loss for 2004 will exceed $600 billion. • Deductions and Exemptions lead to higher marginal tax rates.
Rate Structure • The taxable income scale is divided into segments, and the law specifies the marginal tax rate that applies to income from each segment. • Four different schedules • Single • Married, filing jointly • Married, filing separately • Heads of household
Historical Overview • In 1913, bracket rates ranged between 1-7% • In 1945, rates ranges between 23-94% • In mid-1980s, rates ranges between 11-50%, with 14 brackets • 1986: Two brackets, 15% and 28% • Rates crept up in 1990s • Trend was reversed in 2001/03
Married Filling Joint: 2006 • $0 -15,100 mtr=10% • $15,100-61,300: mtr=15% • $61,300-123,700: mtr=25% • $123,700-188,450: mtr=28% • $188,450-336,550: mtr=33% • >$336,550: mtr=35%
Single Tax Payer: 2006 • $0-7,550 $: mtr=10% • 7,550 30,650: mtr=15% • 30,650-74,200: mtr=25% • 74,200-154,800: mtr=28% • 154,800-336,550: mtr=33% • >$336,550: mtr=35%
Statutory versus Effective Tax Rates • Official statutory marginal tax rates may not correspond well to actual marginal tax rates because of various deductions and credits. • Figure 15.2 illustrates actual marginal tax rates for a family of 4 that takes advantage of various education credits based on the 2001 tax law.
Alternative Minimum Tax • Compute taxable income without most deductions and exemptions • AMT exemption for joint filers: $58,000 • Taxable income <$175,000: mtr=26% • Taxable income >$175,000: mtr=28% • AMT is not indexed by inflation. • By 2010 92% of all households with incomes over $100,000 will pay AMT, 52% of all households with income below $100,00 will pay AMT.