Part 5 – The United States Revenue SystemCopyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-HillEducation.17-1 Chapter 17 – The Personal Income TaxBrief Outline1. Basic Structure2. Defining Incomea. Items Included in H-S Incomeb. Some Practical and Conceptual Problemsc. Evaluating the H-S Criterion3. Excluded Forms of Money Incomea. Interest on State and Local Bondsb. Some Dividendsc. Capital Gainsd. Employer Contribution to Benefit Planse. Some Types of Savingf. Gifts and Inheritances4. Exemptions and Deductionsa. Exemptionsb. Deductionsc. Impact on the Tax Based. Tax Expenditurese. The Simplicity Issue5. Rate Structurea. Effective versus Statutory Rates6. Taxes and Inflationa. How Inflation Affects Taxesb. Tax Indexing7. The Alternative Minimum Tax8. Choice of Unit and the Marriage Taxa. Backgroundb. Analyzing the Marriage Tax9. Treatment of International Income10. State Income TaxesSuggested Answers to End of Chapter Questions1. The Haig-Simons definition of income is the net change in the individual’s power toconsume during a given period. This criterion suggests the inclusion of all sources ofpotential increases in consumption and also implies that any decreases i n an individual’s power to consume should be subtracted in determining income. Overall, it reflects thebroadest possible base of income. Allowing greater capital losses to be deductibleagainst other forms of income would move the tax system more in the direction of theHaig-Simons criterion.2. It is not clear that this is a meaningful measure of average income. The Haig-Simmonsdefinition of income used to calculate taxable income excludes many types of income,such as interest on state and local bonds, some dividends, capital gains, employercontributions to benefit plans, some types of saving, and gifts and inheritances. Further,Chapter 17 – The Personal Income TaxCopyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-HillEducation. 17-2the H-S income is subject to exemptions and deductions before arriving at “taxableincome,” which significantly reduces the denominator of the calculation from actualincome.3. Suppose Singh buys the oil stock for $1,000 at the start of period 0. At the start ofperiod 1, he has two options: A) hold the oil stock one more period, then sell or B) sellthe oil stock, buy the gold stock, and hold it for one period. In both cases, it is assumed that all assets are sold, and any taxes paid at the end of period.What are the returns to Option A? At a 10 percent rate of appreciation, the oil stock isworth $1,210 after period 2, the capital gain is $210 and assuming a 28 percent rateapplies to capital gains, the capital gains tax is 28 percent of $210 or $58.80. Thus, Singh is left with $1,210 - $58.80 or $1,151.20 after tax.If Singh follows Option B, the value of the oil stock at the start of period 1 is $1,000, the capital gain is $100, and the tax $28. Thus Singh has $1072 left over to proceeds (V)from selling the gold stock at the end of period 1.V = Value of gold stock – taxes= (1+r)($1,072) –(.28)[(1+r)($1,072)-($1,072)]= (1+r)($1,072) –(.28)r($1,072)= $1,072 + .72r($1,072)Setting V = $1,151.20 (same as oil stock):$1,151.20 = $1,072 + .72r($1.072) r=10.26%Thus the gold stock must pay a “premium” because the unrealized capital gains in the oil stock are treated preferentially by the tax code. This is the “lock -in” effect.4. Forgiving mortgage debt is essentially giving the recipient a free house (or part thereof),which is a gift in kind. According to the Haig-Simmons criterion income in kind isincome.5. For an itemizer, a $500 tax deduction lowers the tax bill by t*deduction . Thus, for anitemizer with a 30% marginal tax rate, the tax bill is lowered by 30%*$500, or $150. A (refundable) tax credit, on the other hand, directly lowers the tax bill by that amount, in this case, $500.6.a. With a tax rate of t=0.35, and a nominal interest rate of i=0.13, the nominal after-tax rate of interest is (1-t)i=(1-0.35)0.13=0.0845. With an expected inflation rateof π=0.08, the real after-tax rate of interest is (1-t)i-π=(1-0.35)0.13-0.08=0.0845-0.08=0.0045.b. If the expected inflation rate increased by 3 percentage points to π=0.11, and thenominal interest rate also increases by 3 percentage points to i=0.16, then the realafter-tax rate of interest is now (1-t)i-π=(1-0.35)0.16-0.11=0.104-0.11=-0.006.The real after-tax rate of return falls from 0.45% to -0.6%. This is because the taxPart 5 – The United States Revenue SystemCopyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-HillEducation.17-3 system taxes nominal , not real, returns. A person actually loses money in realterms.c. In general, consider two rates of inflation, π<π’. The key question is when taxesare present, by how much must the nominal interest rate increase in order to havethe same real rate of return. This is calculated by equating real rates of returnunder different inflation rates (holding constant taxes): (1-t)i-π=(1-t)i’-π’. Onecan rearrange this equation: (π’-π)=(1-t)(i’-i), or (i’-i)= (π’-π)/(1-t). This can inturn be expressed as: Δi=Δπ/(1-t). Intuitively, the left-hand side of this finalequation is the change in nominal interest rates that keeps the real after-tax rate ofinterest unchanged. It is equal to the change in the expected inflation rate dividedby (1-t). Thus, returning to part 6b , for a 3 percentage point change in theinflation rate and a marginal tax rate of t=0.35, nominal interest rates would haveto increase by approximately 4.6 percentage points.7. The Haig-Simons definition of income provides no rationale for reducing or eliminatingthe tax rates on certain types of income. Winning an Olympic gold medal is a form ofwork, therefore the income should be taxed according to the Haig-Simmons.8. The Haig-Simons definition of income provides no rationale for reducing the tax rates oncertain types of income. Some economists believe that increased tax rates on dividends and capital gains will weaken incentives to work, save, and invest. Others are notconvinced, and there are many arguments on both sides of the issue.9. A tax expenditure is a loss of tax revenue because some item is excluded from the taxbase or accorded some other preferential treatment. In this case, private school tuitioncan be granted a tax credit, meaning that tax revenue cannot be collected on income spent on this tuition. Because this is revenue loss, not government spending directly, theSupreme Court ruling seems appropriate. The initial ruling specifically refers togovernment spending. This is lower government revenues, not direct spending.10. The domestic partners who divide their incomes and report on the individual tax formwould have a lower tax liability. Married couples must pay taxes on the full amount and because of higher marginal tax rates, will end up paying a higher average tax rate.11. Of the $4,000 of earnings that Sanchez has, he is able to invest (1-t I )*earnings in themarket, or (1-0.25)*$4,000=$3,000. Assume that when she saves the money in a taxable account, she has to pay taxes each year on the capital gains, and that those capital gains are treated as ordinary income and taxed at 25%. In this case, her after-tax rate of return is (1-t I )*r, or (1-0.25)*8%, or 6%. Thus, after 10 years of investment, the amount of money in the taxable savings account is $3,000*(1.06)10=$5,372.54. If she invests the money in a Roth IRA, the money accrues at the before-tax rate of return, and there is no tax liability at the end. Thus, the amount in the Roth IRA is $3,000*(1.08)10=$6,476.77.。