1 Public Finance Seminar Spring 2017, Professor YingerIncome Taxes

2 Public Finance Seminar Income TaxesClass Outline Income Taxes Design of the Federal Tax Link to State Income Taxes Design of Local Income Taxes Selected Issues in Federal Tax Policy

3 Income Taxes The Federal Income Tax We start with the federal income tax because most state taxes are linked to it. We will discuss the broad issues in the design of the federal income tax. Then we will turn to state and local income taxes.

4 Federal Income Tax DesignIncome Taxes Federal Income Tax Design Comprehensive Income - Exclusions = Adjusted Gross Income - Exemptions - Deductions (Itemized or Standard) = Taxable Income × Tax Table = Gross Tax - Tax Credits = Net Tax

5 Exclusions & ExemptionsIncome Taxes Exclusions & Exemptions Exclusions Interest income on municipal bonds Implicit rent on owner-occupied housing Exemptions Personal exemptions ($4,050) Exemptions for dependents Exemptions for age and some categories of disability

6 Deductions Itemized Deductions Standard Deduction Income TaxesMortgage interest on primary residence (and some secondary) Property taxes on primary residence (and some secondary) State income taxes (or state sales taxes—but not both!) Charitable contributions Excess medical expenses Standard Deduction Fixed amount (used by most taxpayers) $12,600 for joint return.

7 Federal Tax Expenditures Income Taxes Federal Tax Expenditures Relating to State and Local Government, FY2007 Tax Expenditure for: $(billions) State and Local Tax Deductions 44.1 Real property 13.8 Income 26.2 Sales 3.0 Personal property 1.1 Tax Exempt Bonds 36.3 General 27.9 Private Activity 8.3 Total 80.5 From: Gravelle and Gravelle, NTJ, Sept. 2007

8 Tax Calculations Tax Tables Tax CreditsIncome Taxes Tax Calculations Tax Tables Separate tables for married and single (but a marriage penalty for equal-earning couples—more later). Alternative minimum tax to ensure that average tax rate does not fall too low. Affects a growing number of taxpayers. Tax Credits Earned income tax credit (more later).

9 Tax Table, Joint Returns, 2014Income Taxes Tax Table, Joint Returns, 2014 Taxable Income Marginal Rate 10% 39.6% $18,550 $466,950

10 Marginal to Average RatesIncome Taxes Marginal to Average Rates Translation from marginal to average rates is complicated. Marginal rate tables are highly misleading due to phase outs. All the other features of the tax code affect average rates. Deductions are particularly powerful at the highest income levels.

11 Tax Table for Joint ReturnsIncome Taxes Tax Table for Joint Returns Possible Marginal Rate Schedule with Phase Outs Taxable Income Marginal Rate 10% 39.6% $18,550 $466,950

12 Income Taxes

13 Income Taxes

14 Possible Average Rate FigureIncome Taxes Possible Average Rate Figure Comprehensive Income T Y Itemized Deductions, AMT Zero Income Amount (Exemp. + Std. Deduction) EITC ?

15 Income Taxes Source: IRS. Note that negative rates form the EITC cannot be identified in the IRS data.

16 Income Taxes Tax Reform Act of 1986 (TRA) TRA was a remarkable bi-partisan reform that closed loopholes (favored by liberals) and lowered marginal rates (favored by conservatives). These two are linked—broadening the base makes lower rates possible. This reform also shifted the burden from individuals to corporations. Since TRA loopholes have been added at a rapid rate!

17 Link to State Income TaxesMost state income taxes either A. use federal taxable income and their own tax tables, or B. set their tax as a percentage of federal tax. The “A” states gained from base broadening in the 1986 TRA. The “B” states lost from the shift away from individual income taxes in TRA.

18 Progressivity in State TaxesIncome Taxes Progressivity in State Taxes The “A” States, the ones with federal taxable income, have less progressive rate structures than the federal tax. These taxes are even less progressive than they seem because of federal (or federal and state) deductibility of income taxes paid. Progressivity is limited by the ability of rich individuals to move to another state in response to a high state income taxes—but this effect is small.

19 Top Rates for State Income Taxes (from Urban Institute)

20 State Income Tax Thresholds for Two-Parent Families of Four, 2011Income Taxes State Income Tax Thresholds for Two-Parent Families of Four, 2011 Rank State Threshold Below Poverty Line Above Poverty Line 1 Montana 12,500 16 North Carolina 23,400 2 Alabama 12,600 17 Arizona 23,600 3 Illinois 13,100 18 North Dakota 26,400 4 Georgia 15,900 Colorado 5 Ohio 16,600 20 Idaho 26,500 6 Hawaii 17,800 21 Utah 26,900 7 Missouri 18,300 22 Wisconsin 27,500 8 Iowa 19,300 23 Virginia 27,700 9 Mississippi 19,600 24 Oklahoma 28,400 10 Oregon 20,200 25 Massachusetts 29,500 11 Indiana 20,500 26 Maine 29,700 12 Louisiana 21,300 27 Michigan 30,800 13 Arkansas 22,200 28 Kansas 31,200 14 West Virginia 22,400 29 Pennsylvania 32,000 Kentucky 30 Delaware 32,100 Average Threshold $18,313 31 District of Columbia 32,800 32 South Carolina 32,900 33 Nebraska 33,700 34 New Jersey 35,200 35 Maryland 37,300 36 Rhode Island 39,000 37 Minnesota 39,300 Vermont 39 New Mexico 40,000 40 Connecticut 40,500 41 New York 40,700 42 California 49,400 $32,674

21 Income Taxes State Income Tax Thresholds for Two-Parent Families of Four, 2011 (Notes) Note: A threshold is the lowest income level at which a family has state income tax liability. In this table thresholds are rounded to the nearest $100. The threshold calculations include earned income tax credits, other general tax credits, exemptions, and standard deductions. Credits that are intended to offset the effects of taxes other than the income tax or that are not available to all low-income families are not taken into account. Source: Phil Oliff, Chris Mai, and Nicholas Johnson, "The Impact of State Income Taxes on Low-Income Families in 2011," Table 1B, Center on Budget and Policy Priorities (April 2012).

22 Income Taxes Local Income Taxes A few cities (e.g. Baltimore, Detroit, New York) have income taxes of their own, usually linked to their state tax. Most local income taxes are limited to wages and salaries and take the form of either an earnings tax (with legal incidence on workers) a payroll tax (with legal incidence on firms)

23 Income Taxes Commuter Taxes A few cities (e.g. Newark, San Francisco, Cleveland, Philadelphia) collect taxes on the wages and salaries earned by non-residents within the city. Payroll taxes do this automatically.

24 Income Taxes Commuter Taxes, 2 Commuter taxes only work if cities have access to them but suburbs do not. The first claim on taxable resources goes to the jurisdiction of residence. So if a city passes an income tax, the suburbs can pass one and claim all the taxes paid by their commuting residents—with no increase in the tax on those residents! This happened in Pittsburgh.

25 Income Taxes Commuter Taxes, 3 Commuter taxes have the advantage that they can help satisfy the benefit principle— people who benefit from the services in the city where they work help pay for these services. Commuter taxes have the disadvantage that they may encourage firms (not households) to leave a city, although the evidence on this effect is mixed.

26 Selected Issues in Federal Tax PolicyIncome Taxes Selected Issues in Federal Tax Policy The “Marriage Penalty” The EITC Tax Deductions for Homeownership

27 Income Taxes The Marriage Penalty The U.S. tax code has several tax schedules. The main two are: Tax rates for single people. Tax rates for married people filing joint returns, which have wider tax brackets (e.g. $0 to $15,000 for the first bracket instead of $0 to 10,000). The idea is not to penalize people for getting married. But neither the brackets nor the standard deduction are doubled for two people who get married.

28 The result: Marriage penalties and marriage bonuses.Income Taxes The Marriage Penalty, 2 The result: Marriage penalties and marriage bonuses. A “marriage penalty” is defined as a situation in which a couple pays more income tax filing jointly than they would if they had remained single. A “marriage bonus” is defined as a situation in which a couple pays less tax filing jointly than they would if they had remained single. Marriage bonuses are more common.

29 The Marriage Penalty, 3 Income TaxesCouples most likely to face a marriage penalty are those in which the spouses have similar incomes. Couples most likely to receive a marriage bonus are those in which one spouse earns most or all of the couple’s income. Recent legislation reduced marriage penalties and increased marriage bonuses by Raising the standard deduction for couples to twice that for single filers Setting the income range of 10 and 15% tax brackets (but not higher ones) for couples to twice that for individuals. These changes became permanent a few years ago.

30 Income Taxes The Marriage Penalty, 4 Marriage penalties and bonuses are not good policy, but they are expensive to eliminate. Keeping the marriage penalty reductions is estimated to cost more than $130 billion over 7 years. Fixing other sources of these penalties (such as high- income brackets that are not twice as wide for joint returns) would cost even more. These policies cut taxes by about 1 percent across all income levels, which means they are worth more in dollar terms to the richest taxpayers.

31 The Earned Income Tax CreditIncome Taxes The Earned Income Tax Credit The largest “welfare” program in the U.S., called the Earned Income tax Credit, is run through the income tax. The EITC provides a tax credit based on income, up to maximum, with a higher credit for families with children. It was implemented in 1975 and has been greatly expanded since. The EITC is “refundable,” which means that it is paid even to households with no tax liability.

32 The Earned Income Tax Credit, 2Income Taxes The Earned Income Tax Credit, 2 The EITC increases with income up to a certain amount, then holds steady up to another income level, then phases out. For example, the EITC for a single parent with 2 children in 2016 was 40% of earned income up to an income of $13,931 Exactly $5,572 for incomes between $13,931 and $18,190. Phased out between incomes of $18,190 and $44,648. See:

33 Income Taxes Source: Tax Policy Center

34 The Earned Income Tax Credit, 3Income Taxes The Earned Income Tax Credit, 3 The EITC’s principal goal is to help low-income households by rewarding work. The EITC increases the incentive to work in the phase- in range (up to $13,931 for a single parent). However, the EITC discourages work in its phase-out range ($18,190 to $44,648 for single parent, 2 kids), which involves more workers. Stretching the phase-out range would weaken this work disincentive for those currently affected, but would also bring in more workers and raise the program’s cost.

35 The Earned Income Tax Credit, 4Income Taxes The Earned Income Tax Credit, 4 Many studies look at the work impact of the EITC. My reading of this literature is that it Encourage some people in the phase-in to take jobs. Encourages some secondary earners in the phase- out range to stop working. Has little impact on hours worked for those with jobs.

36 The Earned Income Tax Credit, 5Income Taxes The Earned Income Tax Credit, 5 The EITC may also discourage marriage. The design of the program creates a huge marriage penalty. But empirical studies find little change in marriage rates due to this penalty.

37 Deductions for HomeownershipIncome Taxes Deductions for Homeownership The U.S. tax code gives 4 major benefits to homeowners: 1. Homeowners who itemize deductions are allowed to deduct interest paid on their mortgage. 2. Homeowners who itemize deductions are allowed to deduct their property taxes.

38 Deductions for Homeownership, 2Income Taxes Deductions for Homeownership, 2 3. The implicit rent on a house, unlike the return on other investments, is excluded from taxable income. 4. When a homeowners sells her house, she may exclude up to $500,000 of capital gains if she (a) has maintained the home as her principal residence in two out of the preceding five years and (b) has not claimed this exclusion for the sale of another home during the previous two years.

39 Deductions for Homeownership, 3Income Taxes Deductions for Homeownership, 3

40 Deductions for Homeownership, 4Income Taxes Deductions for Homeownership, 4 Because these deductions favor high-income individuals, they mainly lead to larger homes or second-homes, not more homeownership. Because they lead to larger homes, they actually raise the price of housing. Many low-income homeowners do not itemize deductions and therefore do not benefit from these deductions at all.

41 Deductions for Homeownership, 5Income Taxes Deductions for Homeownership, 5

42 Deductions for Homeownership, 6Income Taxes Deductions for Homeownership, 6 Possible Reforms: 1. Replace the mortgage interest and property tax deductions with a tax credit. This would give benefits to low-income homeowners, even if they do not itemize. This would eliminate the extra subsidy to high-income homeowners. Moving to a credit of up to $1,400 for property taxes instead of a deduction, for example, would shift about half of the benefits to the bottom two-fifths of the income distribution, with no impact on federal revenue.

43 Deductions for Homeownership, 7Income Taxes Deductions for Homeownership, 7

44 Deductions for Homeownership, 8Income Taxes Deductions for Homeownership, 8 Possible Reforms: 2. Lower the limit on the allowable size of a home mortgage. Right now, homeowners can deduct interest on up to $1 million of mortgage debt,. Lowering this limit to $400,000 would lower the subsidy to the highest-income individuals. Recent estimates indicate that this change would have increased federal revenue by $30 billion between 2008 and 2012 and would yield nearly $60 billion over the subsequent five years.