Chapter 1

THE PERSONAL INCOME TAX *

Overview of the Chapter

Structure

Exemptions and Deductions

Objectives of the Chapter

To understand the structure of income and to compute individual income tax liability.

To compute the amount of extraction from taxable income.

Contents of Chapter
BASIC STRUCTURE
Three major steps in the calculation of income tax liability:
1.

Compute adjusted gross income (AGI) - total income from all taxable sourcess less certain
expenses incurred in ear ning that income.

2. Conver t AGI to taxable income the amount of income subject to tax by subtracting
exemptions and deductions from AGI.
3.

Calculate the amount of tax due.

THE HA IG-SIMON (HS) INCOME

Haig-Simons (H-S) criterion: Income is the money value of the net increase in an individuals
power to consume during a period, whether or not the consumption takes place.

The H-S criterion requires the inclusion of all sources of potential income in consumption,
regardless of w hether the actual consumption take place, and regar dless of the form in w hich
the consumption occurs.

Items included in H-S income:

Based on Har vey S. Rosen, Public Finance Chapter 15, 6 th Edition, 2002.
Chapter 1 - 1

Wages and salaries

Business profit

Rents royalties

Employer contributions for employees insurance

Dividends

Transfer payment

Interest

Capital gains

Income in kind

Employer contributions to pensions and other

retirement plans

Difficulties in attempts to use H-S criterion as a basis for constr ucting a tax system
1)

Income must be measured net of the expenses of earning

2)

Unrealized capital gains and the imputed income from durables measurement are not
easily.

3)

In kind ser vices are har d to value.

Figure 1.1
Computation of federal personal income tax liability

Step 1
ADD
Income from all taxable
source:

Wages

Interest

Rents dividends

Business profits

Realized capital gains

Unemployed
compensation

SUBTRACT
Certain business expenses

Step 2

Step 3

SUBTRACT

APPLY

Certain business expenses

Certain business expenses

SUBTRACT

SUBTRACT

Eligible itemized deductions:

Charitable contributions

Certain medical expenses

State income taxes

Property taxes

Certain net interest

payments

..

Tax credits

TAX LIABILITY

or

SUBTRACT
Standard deduction

ADJUSTED GROSS INCOME

(AGI)

TAXABLE INCOME

Chapter 1 - 2

EXCLUDA BLE FORMS OF MONEY INCOME

Several forms of income that would be administratively relative easy to tax are partially or
altogether excluded from adjusted gross income:

Interest on State and Local Bonds

Capital gains

Employer contributions to benefit plans

Gift and inheritances

EXEMPTIONS A ND DEDUC TIONS

Exempt ions
Exemptions are fixed amount per family member.

Suppose:
In 2001, the exemption = $2,900 is adjusted annually for inflation.
So, for a husband and wife with 3 children, could subtract $14,500 fr om AGI.
Exemptions are phased out for people with AGIs above certain levels.
For joint returns, personal exemptions are reduced by 2 percentage points for each $2,500
(or fraction thereof) by which AGI > $199,450.
Suppose:
AGI = $250,000
($250,000-$199,450)/$2,500 = 21
Hence,
the family loses = 21*2% = 42% of its exemptions.
42%*14,500 = $6,090.
Thus,
the family can subtract $8,410 in determining its taxable income.
More generally, the greater the exemption level, the greater is the progressivity with respect to
average tax rates. This effect is reinforced when exemptions are phased out for high-income
families.

Deduct ions
There are two kinds of deductions:

(a) Itemized deductions

Chapter 1 - 3

Subtractions for specific expenditures cited in the law. The taxpayer must list each item
separately on the tax return and be able to prove (at least in principle) that the expenditures
have been made.

(b) Standard deductions

Reduces taxable income by a fixed amount.

Deduct ibility and relative prices.

Suppose:

The price of Z is = PZ

Individuals marginal tax rate = t

Hence,
Zs effective price lower from PZ to (1-t)PZ

Important facts:

Because deductibility changes the relative price of the commodity involved, in general, we
expect the quantity demanded to change.

The higher the individuals value of t, the greater the value to the individual of a given dollar
amount of deductions and the lower the effective price of the good.

Itemized deduct ions

Itemized deductions are permitted for expenditures on par ticular goods and services.

They are phased out at a high-income level.

Itemized deductions change after tax relative prices, w hich often affects economic behavior.

Major itemized deductions in the US tax code:

Unreimbursed medical expenses that exceed 7.5 percent of AGI.

State and local and property taxes.

Certain interest expenses.

Charitable contributions

Deduct ions versus credits

The higher individuals marginal tax rate, the greater the value of a deduction of a given
dollar amount.

A tax credit is a subtraction from tax liability (not taxable income) Its value is independent
of the individuals mar ginal tax rate.

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The choices between deduction and credit should depend at least in the part on the purpose of
the exclusion:

If the motivation is to correct for the fact that a given expenditure reduces ability to pay
deductions.

If the purpose is mainly to encourage certain behavior it is not clear whether credits or
deductions are superior.

A credit reduces the effective price of the favored good by the same percentage for all
individuals.

A deduction decreases the price by different percentage for different people.

Itemized deduct ion phaseout.

Example:

Deductions 3% if AGI> $118,000

AGI = $130,000

Mortgage interest $15,000

Local property taxes $5,000

In the absence of the phase out : deductions = $20,000

Itemized deduction : ($130,000-$111,800)*3% = $546
Hence,
Deduction are allowed = $19,454.

The standard deduct ion

Introduced to simplify tax returns. (Itemized deduction are listed separately on individuals
tax retur n, and in principle each one requires documentation to prove that the expenditure
has indeed been made).

Adjusted annually for inflation.

RATE STRUCTURE
Actually, there are four different rate schedules, one each for married people who file together
(joint returns), married people who file separately, unmarried people, and single people who are
heads of households.

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Table 1.1
Official statutory tax rate schedule, 2001
Single Returns

Taxable Income

Joint Returns

Marginal Tax Rate

Taxable Income

Marginal Tax Rate

$0 - $27,050

15%

$0 - $45,200

15%

$27,050 - $65,550

28

$45,200 - $109,250

28

$65,550 - $136,750

31

$109,250 - $166,500

31

$136,750 - $297,350

36

$166,500- $297,350

36

$297,350 and over

39.6

$297,350 and over

39.6

Rates under the AMT

Certain types of income such as interest on state and local bonds are treated prefentially by the
tax system. It is therefore possible for some households to have rather high incomes, yet pay
little or no tax.
The alternative minimum tax (AMT) is an attempt to ensure that people who benefit from some
of these preferences pay at least some tax. AMT is essentially a shadow tax system with its own
rules for computing the tax base and its own rate schedule.
The calculation of the alternative tax base requires taking AGI and adding to it some of the
income not taxed at ordinary rates.
Clearly, AMT is an ad hoc method for adjusting the tax burdens of upper -income individuals.
Effect ive versus Statutory Rates
In general, there is a tendency for the rate of return on tax-preferenced items to fall by an
amount that reflects the tax advantage. Because of this tendency, high-income individuals face
higher tax rates on their capital income than their tax bills would sugge st. They are taxed

implicitly in the form of lower rates of retur n.

A statute with lower mar ginal tax rates but a broader base would lead to a system with incidence
as progressive as that of the current system, and perhaps more so. At the same time, a system
with lower mar ginal tax rates would reduce excess burden and perhaps lower tax evasion.
To restructure the income tax Flat tax.

A flat tax has tw o attributes:

It applies the same rate of tax to everyone and to each component of the tax base.

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It allows computation of the tax base with no deductions from total income except personal
exemptions and strictly defined business expenses.

Proponent of the flat tax:

Lowering marginal tax rats would reduce both excess burden of the tax system and the
incentive to cheat.

The simplicity gained would cut down on administrative costs and improve taxpayer morale.

Opponents of the flat tax:

It would probably redistributive more of the tax burden from the rich to the middle classes.

There will be never be a simple income tax code.

Summary of Chapter

Computation of federal individual income tax liability has three major step: measuring total
income (adjusted gr oss income), converting total income to taxable income, and calculating
taxes due.

A traditional benchmark measure of income is the Haig-Simons definition: Income during a

given period is the net change in the individuals power to consume.

The two principal subtractions from income are exemptions and deductions. Exemptions are
fixed amount per family member. It phased out at high-income levels.

Deductions are either standard or itemized. A standard deductions reduces taxable income by
a fixed amount. Itemized deductions are permitted for expenditures on particular goods and
services. They are phased out at high-income levels. Itemized deductions change after-tax
relative prices, which often affects economic behavior.

Chapter 1 - 7