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Chapter 13

The Theory of Income Taxation

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Income Taxes Income Taxes were introduced as an

emergency measure during the U.S. Civil War.

An 1894 attempt to introduce a regular income tax was declared unconstitutional.

In 1913, the 16th Amendment to the U.S. Constitution allowed for personal and business income taxes.

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The First Regular US Income Tax The initial income tax exempted the

first $3,000 for singles and the first $4,000 for married couples.

It imposed a 1% rate on income up to $20,000 and higher rates at higher levels of income.

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Comprehensive Income: The Haig-Simons Definition

It is “the exercise of control over the use of society’s scarce resources.”

Algebraically it is defined as

I = C + NW Where

I = Income

C = Consumption

NW = The Change in Net Worth

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Implications of the Haig-Simons Definition

If a person borrows to consume, there is no increase in income because the change in net worth is negative.

If a person sells an asset so as to consume, there is no increase in income.

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Capital Gains Capital gains are the increased value of

assets that a person holds.

If people own stocks that go up in value, net worth increases and therefore they have an increase in income by this definition.

This is true whether or not they actually sell the assets and see the money in their bank accounts.

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Realized and Unrealized Capital Gains Realized Capital Gains are those gains

that a person has received by selling an asset. 

Unrealized Capital Gains are those gains that a person has not yet received by selling an asset, but which exist only on paper as the market price of the asset they hold has increased.

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An Income Statement Sources of Funds:

Earnings from Sale of Productive Services Transfer Payments Received Capital Gains (or Losses) 

Uses of Funds: Consumption Taxes Donations Gifts Saving (Increases in Net Worth) 

Sources = Uses, So Earnings + Transfer Payments + Net Capital Gains =

Consumption + Taxes + Donations + Gifts + Saving

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Modifications to the Income Definition The cost of acquiring income needs to be

accounted for in the definition.

Earnings + Transfer Payments + Net Capital Gains – Cost of Acquiring Income

=

Consumption + Taxes + Donations + Gifts + Saving – Cost of Acquiring Income

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Problems with Measuring Income using the

Haig-Simons Definition How do you measure unrealized capital gains on

assets that are not regularly traded?

Is the cost of an automobile used to drive to and from work a “cost of acquiring income?” Are child care expenses? Union Dues? Education expenses?

How do you distinguish what part of an expense is a cost of acquiring income and what part is merely consumption?

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In-Kind Income in Haig-Simons Definition

Under the comprehensive income definition, all income should be treated equally, whether it is paid in cash or in-kind.

Many jobs offer free parking, subsidized medical insurance.

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Home Production Home production is any activity that is

performed by people in the home.

Most of the things we do for ourselves can be purchased.

If you earn the money to have things done for you, then you are taxed on that income. If you do it yourself, you are not.

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The Home Itself

Under a Haig-Simons definition of income, whether or not you own your home, you are consuming housing services and it is therefore income.

Economists call the money that homeowners do not have to pay for the housing services they consume imputed rent.

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The Impracticality of Taxing In-Kind

Income, Home Production, and Imputed Rent It would be impractical to tax any of these kinds

of income, because the value that is being received by the consumer depends upon the tastes of the consumer.

Suppose the market value of a parking space for a year is $1000. Suppose it is given to a person as a part of their job. Taxing a person as though they earned that $1000 would be inappropriate if they did not value the parking space at $1000 and could not sell the rights to that spot for $1000.

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A General Tax on Comprehensive Income

Suppose there is a flat-rate income tax on all income. What are the effects on the labor-leisure trade-off and the savings decision?

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Figure 13.1 The Impact of a Flat-Rate Income Tax on the Work-Leisure Choice

J

H

J'

0

Inc

om

e p

er

Da

y

Leisure Hours per Day L2

IN U1

E'

L1

I1

U2

E

IG B T {

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The Algebraic View Individuals maximize welfare where

w = MRSLI.

The after-tax wage is wN = wG(1 – t).

Income is then I = wG(1 – t)(24 – L).

This means that individuals maximize their welfare in response to the tax by choosing labor such that

wG(1 – t) = MRSLI…

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Income and Substitution Effects of a

Tax on Labor Income It is possible for a tax to increase or decrease

the amount of work effort, depending on whether leisure is a normal good. If people target the amount of money they must take

home to meet a standard of living, then a tax may increase work effort.

If leisure is a normal good, then the income effect and substitution effect of a tax on labor income are in the same direction and a tax decreases work effort.

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Treatment of Capital Gains In the U.S. capital gains on assets held one year pay

a maximum rate of 15% (compared to 35% for ordinary income).

No capital gains taxes are owed: on residences (as long as the gain is less than $500,000), on inherited capital gains, or on unrealized capital gains.

Little evidence exists to support the conclusion that a lower rate encourages entrepreneurship.

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Figure 13.2 Income and Substitution Effects of A Tax Induced Wage Decline

I’

Leisure Hours per Day

0

Inco

me

per

Day

H

I

L1

U2

E1

B

C

L’

L

E’

L2

L1

U1

E2

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Labor Market Analysis of Income

Taxation: Perfectly Inelastic Supply Even if the labor supply curve is perfectly

inelastic, this does not imply that no excess burden arises from a tax on labor income.

The labor supply curve that is appropriate for making such statements is the compensated labor supply curve (which is almost certain to be upward sloping, even if the regular labor supply curve is not).

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Figure 13.3 Impact of an Income Tax on Labor Markets and Efficiency When the Market Supply of

Labor is Perfectly Inelastic

0

Wag

es

Labor Hours per Year

0

A B

S' Compensated Labor

Supply Curve

–QSL

Supply Curve

Q*

S Regular Labor

D = W

WG*

WN = WG (1 – t)

tWG* WN = WG* (1– t)

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Labor Market Analysis of Income Taxation: Wage responsive Labor Supply

When the regular labor supply curve is not perfectly inelastic, the excess burden of a tax on labor income is understated, unless the analysis is performed with a compensated labor supply curve.

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Figure 13.4 The Effect of Income Taxes on Labor Markets When the Supply of Labor is Responsive

SC

0

Wa

ge

s

Hours Worked per Year

W A

Q1

SR

D = WG

Q3

QSL

Q2

Q

C W*

W*

W tW* G

B

WN

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Empirical Analysis Regular labor supply is perfectly inelastic for

men 25 to 55.

Estimates suggest a large substitution effect that is almost perfectly offset by an equally large income effect.

The efficiency-loss ratio for these men suggests that for every dollar raised in income taxes, 13.5 cents of excess burden is created.

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Lower Tax Rates, More Work, Less

Excess Burden

Tax changes in 1983 and 1986 lowered the marginal tax rates facing most Americans.

Recent estimates suggest that this lower rate induced a 3% increase in work by men and a 16% drop in excess burden.

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Incidence of Payroll Taxes In the U.S., the FICA tax that funds

Social Security has a legal incidence of 7.65% tax on both employers and employees.

If the regular labor supply curve is perfectly inelastic, this implies that all of this tax is being borne by workers.

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The Payroll TaxW

ages

0 Labor Hours per Year

WN C

DN

TB + TE

QL

WG A

SL

DL = MRPL WE B

DL' = MRPL – TB

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Taxation of Interest Income and the Effect on Saving

Just as a tax on earned income can lead to an increase or a decrease in work, a tax interest can lead to an increase or a decrease in saving.

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Figure 13.5 Income Taxation and Intertemporal Choice

E

D

F

Fu

ture

Co

nsu

mp

tio

n

Current Consumption

0

E1

C1

C2

U2

C’2

C2'

U1

E2

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Excess Burden of a Tax on Interest Income

A tax on interest income will also have an excess burden that will depend on the magnitude of the tax and the elasticity of supply and demand for loanable funds.

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Figure 13.6 Impact of an Income Tax on Investment Markets and Savings

Annual Savings and Investments

Inte

res

t

rN

rG* B

C rN*

S2 S1

D = rG

Supply of Savings

A r1

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Empirical Estimates The elasticity of the supply of savings

has been estimated to be in the neighborhood of .4.

This indicates that the efficiency-loss ratio for such a tax is .30 (meaning that for every dollar raised with the tax on interest income,excess burden increases by 30%).

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Supply-Side Tax Cuts of the 1980s Supply-Siders argued that cuts in tax

rates would increase overall revenues because the cuts would motivate harder work and greater investment.

The cuts in tax rates did not increase revenues, but the decrease was much less than expected (by tax cut opponents).