#11516 - Introduction - U.S. Income Tax Law

Introduction

1. Goals of Tax System

   1. Raise revenue to fund govt operations

      1. But note some see this primarily as distortionary and bad

      2. But if you believe fixed amounts needed to fund govt, then every $ we cut somewhere has to come from elsewhere.

   2. Simplicity

      1. Rule complexity: Don’t want rules to be so complex that people can’t follow them

         1. But, note that the downside to simplicity is that if it’s easy to understand the rules, it can be easy to work around them!

      2. Compliance complexity: Don’t want enforcement costs to erode tax revenues

      3. Transactional complexity: need lawyers and accountants (transaction costs)

   3. Administrability Generally

   4. Efficiency

      1. Efficient system maximizes welfare

      2. Neutrality: Neutral taxes (e.g., head taxes or taxes on perfectly inelastic goods) don’t affect behavior.

         1. DWL: Individuals are worse off, but the public is no better of.

      3. Distortions to labor/leisure tradeoff (could go either way).

         1. Income affect: people might work more to make up for income lost to taxes.

         2. Substitution affect: People might substitute more leisure for work as they get to keep less of the wages (Romer paper shows this is not as pronounced as you might think).

      4. Capitalization: tax advantages of one product vs another are often priced in.

   5. Fairness

      1. Vertical Equity: Does not literally mean equality. Vertical equity is concept that those with greater ability to pay should pay more.

         1. **Income used as a proxy for ability to pay. Note, could also use wealth.

         2. Progressive: higher earners have higher tax burden

            1. Utilitarians prefer progressive system b/c of declining marginal utility of income.

         3. Regressive: lower earners pay higher percentage rates

         4. Flat (proportionate): Everyone pays the same percentage.

      2. Horizontal equity: Even-handedness in application. Similarly-situated people (e.g., same income) should be treated similarly. This is couples equality that leads to marriage penalty/bonus.

         1. Imputed Income problem: p 118 has nice illustration where different treatment of imputed income vs child care/petcare/homecare will lead her to choose homemaking even though working would create more social benefits, and we as society generally gain from specialization and trade (e.g., paying dog walkers so you can go be a lawyer). DWL

      3. Theories:

         1. Utilitarianism (Bentham, Mill): Maximize the pie.

         2. Liberalism (Rawls): From behind the veil of ignorance, we would all want to protect those least well off. Militates toward progressive system.

         3. Libertarianism (Nozick): Property is only justly held if it is obtained justly (original distribution) or through just transfer. Applies to govt too, so he doesn’t want gov’t taxing and redistributing. Certainly OK with some taxation, as long as $ is used for things that the taxpayer benefits from (defense, but arguably not Medicaid).

   6. Achieve Social Goals

      1. Correct externalities (Pigouvian taxes)

      2. Redistribute income

         1. Watch out for phaseouts

         2. Upside-down nature of tax credits

         3. Refundability of tax credits

   7. Tax Penalties

2. Sources of Tax Law

   1. Internal Revenue Code

      1. Treasury Regulations that interpret the code

         1. Published and unpublished guidance like PLRs

            1. Published revenue rulings are vetted by IRS policymakers, and Treasury officials, may be cited as precedent and tapayers can rely on them.

            2. Officially unpublished rulings: IRS often releases redacted versions of other docs, like letter rulings, determination letters, general counsel memoranda, and technical advice memoranda. These cannot be cited as precedent or relied on.

   2. Tax Treaties with other countries

3. Choice of Tax Base and Tax Rates

   1. What is Income?

      1. Haig/Simons: I = C (value of rights exercised in consumption) + W (store of property rights)

   2. Why Tax Income and Not Wealth?

      1. Europe mainly uses consumption

   3. The Basic Structure of Tax Liability is:

   • Adjusted Gross Income (§62) =

     • Gross income (§61) minus

     • Above the line deductions (§62)

   • Taxable income is AGI minus these Below the Line Deductions:

     • Itemized deductions (§67) other than those in §62, OR

     • Standard deduction (§63c)

     • Personal exemptions (§151 and 152)

   • This gets you Tentative Tax Liability

     • Subtract Tax credits (EITC and various others)

     • Get Final Tax Liability

   4. Important Code Sections

   • §1: Sets out the rates and brackets for married individuals, singles, heads of households and married filing separately (e.g., first $36,900 of income is taxed at 15%); §1(f) instructs Treasury to issue regs each year updating these numbers based on cost of living adjustment

   • §61: Gross Income Defined: all income from whatever source derived, including (but not limited to) the following items: compensation for services, including fees, commissions, fringe benefits, and similar items; gross income from business or dealings in property; interest; rents; royalties; dividends; alimony and separate maintenance payments; annuities; income from life insurance and endowment contracts; pensions; income from discharge of indebtedness; distributive share of partnership gross income; income in respect of a decedent; and income from an interest in an estate or trust;

     • Not an exhaustive list

     • §101 contains items excluded from income.

     • Regs under §61 for certain businesses, including merchandising and manufacturing, say to subtract cost of goods sold from gross income, so its not claimed as a business expense.

   • §62: Adjusted Gross Income: Means Gross income, minus

     • trade and business deductions

     • expenses reimbursed by employer under §161

     • performing artist expenses; army reserve-related travel expenses

     • losses from sale or exchange of property

     • expenses associated with property held for the production of rents or royalties

     • certain deductions of life tenants and income beneficiaries of property

     • higher education expense and interest on education loans

     • retirement savings

   • §63 Taxable Income: Means gross income minus deductions allowable (other than standard deduction)

     • 63(b): For those who do not itemize—taxable income means gross income minus standard deduction and personal exemptions

       • Standard deduction (63(c)): Is specified annually by reg; married couple is double the single amount; there is additional $600 ($750 if unmarried) deduction for aged and blind under 63(e). 63(c)(5) reduces the amount for someone who is claimed by another as a dependent.

     • 63(d) Itemized Deductions: Means deductions other than those allowable in arriving at AGI (§62), and exemptions.

   • §67: Miscellaneous Itemized Deductions: An individual can only claim miscellaneous itemized deductions to the extent that they exceed 2% of AGI. Miscellaneous itemized deductions do not include:

     • §163 interest; §164 state & local taxes; §165(a) casualty/theft losses; §170 charitable contributions; §213 medical expenses; §691 estate tax for decedent; deductions for personal property short sale;

   • §151: Personal Exemptions:

     • Amount adjusted for inflation each year

     • Self, plus for spouse if filing separately and the spouse does not pay tax and is not claimed by anyone else as a dependent

     • Dependents: One exemption per dependent

     • Phase-outs: 151(d)(3) provides that amount is reduced by 2 percentage points for every $2500 by which AGI exceeds the threshold amount ($150K for joint return, $125K for HH; $100K for single, adjusted up annually for inflation); does not apply in 2010-12.

4. Theories of Voluntary Compliance

1. IRS Definition of voluntary compliance: “A system of compliance that relies on individual citizens to report their income freely and voluntarily, calculate their tax liability correctly, and file a tax return on time.” Examples include income reporting, claiming deductions, filing tax returns

2. Raskolnikov self-adjusting penalty: He argues that people cheat by under-reporting slightly in areas where its hard to detect, rather than claiming entire extra credits that they aren’t entitled to. Thus, proposes to complement existing sanctions with a new penalty equal to a fraction of the legitimate subtraction item (such as a deduction, credit, or...