Introduction to Tax Law (Quiz 1)

2015 Tax Brackets and Example

In 2015 the 400 people in the US who made the most in salaries averaged $335.7 million dollars in income.

Estate Taxes as Share of Total Federal Income (1917 - 2007)

John D. Rockefeller died in 1937. By many measures, he was the richest American in history. He was the first man in history to accumulate over $1 billion in nominal dollars. His $1.4 billion estate in 1937 was 1/65th of the US GDP; a person today with 1/65th of the US GDP would be worth $317 billion (as of 1/30/19). According to Forbes, the richest man in the US (and in the world) today is Jeff Bezos, worth $138 billion (less than 43% of Rockefeller's share of GDP). Spikes such as the one above won't be as large, but the deaths of Gates, Jeff Bezos, Warren Buffet, the Koch brothers, the Walton family, etc. would make a significant impact on total federal tax receipts.

Tariffs as Percentage of Federal Income

Not sure about all the earlier dips; 1803 was from sale of some of the land bought in the Louisiana Purchase; next dip may have come from similar sales after acquisition of Florida under the Adams-Onis Treaty in1819; the third from similar sales of land following the Mexican Cession of 1848 under the Treaty of Guadalupe Hidalgo and the Gadsden Purchase of 1854; but Lincoln imposed the first income tax in 1862. It was repealed in 1872 and declared unconstitutional. "Anteil der Zoelle am US-Bundeshauhalt" means "share of customs duties on the US federal budget"

Tax Rates, Payroll Taxes & Income Taxes

Note that there are no deductions, offsets, credits, or rebates for payroll taxes. These only apply to income taxes. About half of Americans pay any income tax (49% in 2006, 54% in 2011 median income around $39,000, so that's about the income needed before income taxes start to kick in). Why? Because they earn too little money (note that this includes, minors, students, the disabled, and many retirees). When someone says that they will increase tax deductions (say for healthcare spending accounts) this will have absolutely no effect about half of Americans. The only things that help people in the lower half of the income distribution are "refundable tax credits" which can result in actual income to them, rather than payments of taxes to the government.

US Aggregate Income by Quintile

Note the change after 1980, when the Reagan tax reform happened. Prior to this time, increases in productivity were shared pretty much equally among all Americans. Since then, the wealthiest have claimed virtually all the benefits of increased productivity.

Federal Tax Revenue a Percent of GDP

Similar information, but normalized to % of US GDP (Information on other countries given for comparison purposes - data for 2018 from https://www.oecd.org/ctp/tax-policy/revenue-statistics-united-kingdom.pdf

Percentage Share of All US Income

This is just a different way of looking at the previous slide

Social Security Trust Fund

a federal fund that saves excessive social security tax revenues received in one year to meet social security benefit obligations that exceed social security tax revenues in some subsequent year

Capital Gains vs Ordinary Income what does ordinary income include? what do capital gains include? how can you qualify for capital gains? Capital Gains Tax on sale of assets is based on........

•"Ordinary Income" such as wages and interest received is taxed at the prevailing marginal rate -In 2019 there are 7 ordinary income tax brackets with rates ranging from 10% to 37% •"Capital Gains" in income from investments held for a minimum amount of time and usually is taxed at a preferential (i.e., lower) rate -Currently need to hold the investment for at least 4 months to qualify for capital gains on it -Capital Gains Tax on sale of assets is based on value received minus amount paid at time of acquisition (i.e., tax is on the "appreciation" of the asset) -In 2019 there are 3 capital gains tax brackets ranging from 0% (applies to first $39,375) to 20% (on amounts over $434,551) The only justification for treating Capital Gains differently from Ordinary Income is to incentivize people to maintain their investments in enterprises. This incentivization seems to run counter to most economic theory, i.e., that society benefits most if assets are sufficiently liquid to move to those investments that provide the largest returns; the incentives given by capital gains distort this liquidity. Money you make from the "sweat of your brow" is thus taxed at a higher rate than money you make from investments. The greater the proportion of your income that comes from selling your investments, the lower the overall tax rate that you pay. Note that there is a proposal in congress to actually decrease the effective tax paid on capital gains by allowing a "step up" of the basis, i.e., the amount you initially paid for the taxed asset to adjust for inflation since the time of purchase.

Income Tax Calculation

•Add all sources of income, segregating Capital Gains from Ordinary Income •Subtract deductions (standard or itemized) to Ordinary Income to determine AGI •Calculate/look up taxes •Calculate Capital Gains taxes, add to previous taxes owed to determine total taxes owed •Subtract credits to arrive at taxes owed •Compare total taxes owed with amount previously paid or withheld to determine refund or payments due to IRS •Note: any amount refunded to you has essentially been an interest-free loan to the government! Rationally, you want to owe little or no taxes (so you don't get hit with a penalty) rather than get a tax refund. Nobody is that rational - we all want a tax refund, even though it actually constitutes an interest-free loan to the government.

"Progressive" Income Taxes what occurs as income increases? what is this distinguished from? what are the consequences? why a progressive tax?

•As incomes increase, the rate of taxation increases -Distinguish from a "flat tax" which would apply the same rate to everyone regardless of income level •Consequences: -"Marginal" taxes (taxes increase at "margins" as income increases) -"Effective rates" - differ from taxpayer to taxpayer, defined as (taxes paid)/(total income), increasing as your income crosses through higher and higher marginal rates Why a progressive tax? If you make $10,000 per year you spend all of it (and more) just to live. If you make $150,000 per year you probably spend about $120,000 of it per year and invest the remainder. If you make $10 million per year, you probably don't spend more than $4 million of it on living expenses. Assuming that everyone is taxed at the same flat rate, which is determined based on government outlays. In terms of real dollars remaining after taxes, taxation forces more poor and middle class people toward poverty while only slightly inconveniencing the very wealthy. So far Americans have resisted allowing this to happen. In other words, a tax on consumption will virtually always hit the poor and middle class harder than the wealthy.

What Do We Tax ? what are the different types of taxes we have? do we ever tax people based on wealth? what is income defined as?

•Basically three things -Transfers of value across geographical borders, i.e., tariffs -Consumption of some items (e.g., alcohol, tobacco, gasoline) - called "excise taxes" -Transfers of value from one person to another •Sales Taxes •Income Taxes (including forgiveness of debts) •Corporate Taxes •Estate Taxes •But we DO sometimes directly tax wealth held by individuals, primarily via a property tax. Income is defined as "Any accession to wealth, clearly realized, within the dominion and control of the taxpayer." Taxes apply when money changes hands - the IRS also taxes bilateral exchanges such as barters when it can prove that they occurred. The forgiveness of a debt is also treated as taxable income (mortgage forgiveness and student debt forgiveness can have very large consequences for the taxes of the individual whose debt is forgiven). If you had $100,000 in student loans that were forgiven, you would have to pay income taxes on $100,000.

Early Attempts at Federal Income Taxes during the civil war? 1898? why was it unconstitutional?

•Civil War - Congress imposed a 3% tax on individuals making over $600 (this exempted most people), rising to 10% for incomes over $10,000 - it was declared by SCOTUS to be unconstitutional in 1872 •1898 - Congress made a second attempt to tax individuals' incomes to finance the Spanish American War. Again, SCOTUS declared it unconstitutional. •Why was it unconstitutional? Because it was not apportioned among the States in proportion to census enumeration (Article I, Section 2 of US Constitution) Taxes in proportion to census enumeration - in other words a per person ("per capita") tax that did NOT reflect the income or economic value of individuals; this was the ONLY type of tax that was allowed under the Constitution as originally written.

Corporate Taxes how are corporations taxed? how are individuals taxed? what do some people claim corporate taxes amount to? what is the usual answer to this?

•Corporations are taxed on income as are "natural persons" -Individuals are taxed on "adjusted gross income", corporations taxed on "net income" (types of allowable deductions differ between individuals and corporations) •Some people claim that corporate taxes amount to "Double Taxation" and ask "why tax corporations and then tax the dividends paid to shareholders?" -Usual answer: because the corporation is a different "person" than the shareholders We tax distributions from corporations to shareholders because they are different "people." If I give you $50, it is taxed because you are a different person from me. We usually do not tax transfers from one spouse to another because in some aspects spouses are treated as the same person (this is why we have a tax bracket for "married filing jointly"). A transfer from a corporation to a shareholder is a transfer of wealth from one "person" to another, and is taxed the same as any other transfer of value from one person to another.

what are Credits? EX? what are some credits and what are some others not? when does a non-refundable tax credit do you no good? refundable credits can result in what?

•Credits are fixed offsets against taxes owed and are available in some situations -Example: $2,000 credit per child for households making less than $400,000 Adjusted Gross Income annually -Some credits are refundable; others are not -If you owe no money in federal income taxes, a "non-refundable" tax credit does you no good -Refundable credits can result in a "negative income tax" (i.e., the government sends you more money than you paid to it in income tax) As a general rule, as your wealth increases the value of deductions outweighs the value of credits. If you make $50,000 per year, a $2,000 credit is significant; if you make $1 million, the $2,000 credit is almost insignificant. If you owe no money in federal income taxes a non-refundable credit does you no good, nor does a deduction. A refundable credit can actually result in a "negative income tax" in which the government sends you more money than you paid in taxes. In the 1970's under Nixon there was serious consideration given to providing "negative income taxes" - in other words, a guaranteed minimum income - to people who made less than a certain amount. The idea has not completely gone away.

Deductions: what are they? EX? deductions can be...... what does everyone qualify for?

•Deductions are reductions in AGI based on situation -Example: Can deduct mortgage interest paid to banks -Deductions may be either capped (mortgages on houses worth less than $1 million) or uncapped -Everyone qualifies for the "standard deduction"; if the sum of all other deductions for which you qualify (e.g., medical expenses, mortgages, State taxes, etc.) exceeds the standard deduction, then you deduct that sum instead (called "itemized deductions"). The 2017 tax bill made significant changes such as increasing the standard deduction (which makes other deductions, such as mortgage interest, less appealing), eliminating the personal exemption, and capping the deduction of state and local taxes. This makes it difficult to generalize whether the tax changes benefit or penalize individual taxpayers.

Distinguish: Direct Tax from Indirect Tax what are examples of each? what is the biggest difference b/t the 2?

•Direct Tax: one that imposes liability on an individual in his capacity as an individual, i.e., the individual pays the tax directly to the government -Example: Income taxes •Indirect Tax: one that imposes liability on someone other than the individual responsible for the activity -Example: Sales taxes (imposed on the merchant, who in turn passes the cost on to the purchaser), Value Added Tax (VAT tax) (imposed on manufacturers) The big difference is that most people never directly see an indirect tax on their purchases - they are hidden in the price of the goods or services purchased. When Europeans come to the US, they are frequently shocked to discover that the price listed on the store shelf does not include the sales tax.

Income Taxes can be distinguished from what? How so? social security tax and medicare tax?

•Distinguish between "income tax" and "payroll tax" -Income tax is a direct tax; currently unlimited -Payroll tax is an indirect tax, part of which is limited •Social Security tax (6.2% taxpayer, 6.2% employer, does not apply to incomes over $132,900 in 2019, or $137,700 in 2020) •Medicare Tax - 1.45% taxpayer, 1.45% employer (no cap); additional 0.9% tax for individual incomes over $200,000 as part of Affordable Care Act Income Tax is a tax on the income you receive. Payroll tax is a tax on the fact that you are paid, and is based on the amount you receive. Because it is capped, the SS tax is not a flat tax. Affordable Care Act increases taxes paid on incomes over $200,000 for individuals or $250,000 for couples by 0.9%. It is clearly wealth redistribution from the wealthy to the less well off.

Excise Taxes and Sales Taxes (usually levied by States) what are excise taxes and what do they apply to? what are examples of them? what do sales taxes apply to? EX?

•Excise Taxes are taxes that apply to specific goods. -Gas taxes - usually used specifically to support upkeep of roads and bridges -"Sin" taxes (e.g., liquor and tobacco) - great variation among the states about size of "sin" taxes and for what this income is used. •Sales Taxes apply to sales of all goods unless specifically excluded -Food and clothing (some states tax, others don't) -Distinguish between food eaten at restaurants vs. carry out - usually different tax rates (higher for food that you eat in the restaurant) -Large discrepancies between states on taxation of carbonated drinks North Carolina's sales taxes have increased drastically since 2013. For instance, parts used for auto repairs have always been taxed. Now labor is also taxed. Dry cleaning, HVAC repairs, rug repairs, water treatment systems, car washes, sign painting, and many other "services" became taxable. These sales taxes compensated from a decrease instate income taxes which formerly ranged from 6% to 7.75% and are now a flat 5.25% with a recent constitutional amendment capping state income tax at 7%

1913 - Passage of the 16th Amendment what did it do? what established income taxes?

•Modified the US Constitution to allow direct taxes on individuals based on income without regard to census or enumeration -"The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration." •Tax Act of 1913 established income taxes Interestingly, income taxes were supported primarily by the Southern and Western states which were less prosperous than the Northeast; poorer people were hit harder by the higher prices imposed by tariffs. Today the western and southern states are among those most opposed to income taxes. Some people have claimed that the 16th amendment is defective. Some argue that because it does not specifically include the word "repeal" it does not override Article 1, Section 2 of the Constitution. Others say that "income" is not defined and should not include wages because wages are exchanged for labor, thus leaving the parties in the same relative positions with neither being enriched and hence no income. Others argue that the wording of the amendment passed by the States was different from the wording passed by congress, and that Ohio was not a State when it approved the amendment so that the required number of states approving the amendment was never achieved (they also argue that Congress did not pass an official proclamation of Ohio's statehood until 1953, so its admission to the Republic in 1803 was improper). People who argue this way (and act on their arguments) end up in jail for tax evasion (for example, Wesley Snipes).

Historical Perspective pre-civil war and taxes? who was it proposed by and when? purpose? theory?

•Pre-civil war - the vast majority of all federal income was from tariffs (taxes on imports or exports) -Was proposed by Alexander Hamilton in his "Report on Manufactures" in 1791 -Purpose - to grow US manufacturing strength -Theory: if the production cost for an item in Great Britain was $5 and production cost for the same item in the US was $20, then add a $15 import tax to "level the playing field" Note that tariffs were only imposed on goods that the government wanted to be manufactured in the US. For example, there were not sandalwood trees in the US at the time, so carved sandalwood had no tariffs imposed.

Three Reasons for Taxation?

•Raise income for the government -Some taxes are earmarked - property taxes for schools, gas taxes for roads •Induce specific behaviors -Example: large taxes on tobacco to reduce consumption -Example: tax deductions on home mortgages to induce home ownership -May lack rational basis (e.g., oil depletion allowance) •Reallocate societal resources - which can either reduce or increase economic inequality -Highly controversial

Proposed Alternative: Consumption Tax what is the rationale behind it? open question? net effect?

•Rationale: spread the tax base on everyone, only tax what people spend rather than what they make -Should incentivize saving rather than spending •Open question: if market is demand-driven, do we want to incentivize reduced spending? •Net effect (mathematically forced): this will lower taxes on those with very high incomes (because spending does not rise linearly with income), therefore will shift burden to the middle class and poor No one knows what the federal consumption tax would need to be in order to replace the income tax, but the Atlantic magazine and billionaire Steve Forbes estimate it around 25%.

Estate Taxes are sometimes called what? what is this tax on?

•Sometimes called a "death tax" -Term polls well but is misleading •Tax is not on "death" but rather is on income to the heirs - it is a tax on a transfer of wealth, not on the event of dying -Note: For several years New York City actually had a tax on death Would the "estate tax" be more popular if we called it the "Paris Hilton Tax"? People frequently invoke farmers losing the family farm as a reason to repeal the death tax. In reality on 0.42% of farms faced any tax liability in 2016, and the average effective rate on small farms that were subject to the estate tax was only 11%. (from https://www.washingtonpost.com/news/powerpost/paloma/the-finance-202/2017/08/23/the-finance-202-here-s-how-louise-linton-could-change-the-tax-debate/599c773030fb0435b8208f83/?tid=ss_tw&utm_term=.9a730571675a); same figures from https://www.washingtonpost.com/news/wonk/wp/2017/09/07/trump-called-the-estate-tax-a-tremendous-burden-on-family-farmers-heres-the-truth/?utm_term=.2a958ed5095f No one has been able to identify ANY family farms that have been lost due to estate taxes. The value of the farm must exceed $1.1 million dollars to be subject to estate taxes, and any taxes owed can be spread out over 15 years (interest free after the first five years).

Income Tax taxes for individuals are based on what? Non-taxable sources of income include..... Allowable deductions include.....

•Taxes for individuals are based on "Adjusted Gross Income" ("AGI") -AGI is gross income from taxable sources less allowable deductions -Non-taxable sources of income include some government-issued bonds; unless a source is specifically excluded from the tax laws, it is taxable -Allowable deductions include business expenses, medical expenses, deductible retirement plans (many of these deductions are capped - for instance, you can't shelter $1 million a year in a 401(k) plan)

Distinguish: Taxes and Fees what is the theory behind them? why are they practiced? semantics?

•Theory: -Taxes raise revenue -Fees recoup cost of providing a service •Practice: Fees raise revenue -What should the cost of a fishing license (a "fee") be? •Semantics: Many politicians claim to not raise "taxes" when they in fact raise "fees" Mitt Romney bragged that he balanced the budget when governor of Massachusetts without raising taxes. He did it by raising fees - $1.5 billion by increasing fees on drivers licenses, fishing licenses, hunting licenses, milk dealer licenses, fee permits for milk pasteurization plants, mental health counselor registrations, etc.