All working Americans are familiar with the April 15 deadline for filing personal income tax returns. Taxes on personal income accounted for 44 percent of total revenue raised by the federal government in the United States in 2009. All but seven state governments also tax personal income, which now accounts for 30 percent of state revenue. Many view income as a good measure of ability to pay taxes, and the income tax enjoys broad political support in the United States. However, it is also reviled as having become incredibly complex, and there are continual calls to reform the income tax to make it fairer and simpler and to reduce the distortions it causes in economic decision making.
To understand the impact of the income tax on our decisions and the way its burden is distributed among taxpayers, it is first necessary to define the concept of income.
I. What Is Income?
II. A Flat Rate Income Tax
III. The Personal Income Tax in Practice
IV. Issues and Problems in Income Taxation and Prospects for Reform of the Tax Code
What Is Income?
Income is a flow of purchasing power from earnings of labor, capital, land, and other sources that a person receives over a period of one year. The most comprehensive definition of income views it as an annual acquisition of rights to command resources. Income can be used to consume goods and services during the year it is received, or it can be stored up for future use in subsequent years. Income stored up for future use is saving, which increases a person’s net worth (a measure of the value of assets less debts). The most comprehensive measure of income views it as the sum of annual consumption plus savings, where savings is any increase in net worth that can result from not spending earnings and other forms of income or from increases in the market value of such assets as stocks, bonds, or housing that a person might own. The annual increase in the value of a person’s existing assets are capital gains, which can either be realized (converted to cash) by selling an asset or unrealized (not turned into cash in the current year).
A comprehensive income tax would be levied on the sum of a person’s annual consumption plus savings. Consumption plus savings in a given year would represent the uses of the taxpayer’s earnings and other sources of income.
A Flat Rate Income Tax
The simplest form of an income tax would be a flat rate tax. Individuals would report their income based on the comprehensive definition discussed previously, and a flat rate would be levied to collect the tax. For example, if, through the political process, it was decided to raise all revenue from the income tax and that a 15 percent rate on income would raise enough revenue, then every citizen earning income would have to pay 15 percent tax on that income to the government to finance public services. All income, irrespective of its source or use, would be subject to the tax. Tax forms would be very simple, with only three lines: one to report income, one to indicate the tax rate, and the other to show the product of the tax rate when multiplied with income. If your income was $30,000 this year, you would multiply that income by 0.15 if the tax rate was 15 percent, and your tax bill would be $4,500.
Under a flat rate comprehensive income tax, those with higher income would pay proportionately higher taxes. For example, a person with $10,000 annual income would have a tax bill of $1,500. A person with an annual income of $100,000 would pay $15,000 in taxes, while a person with $1 million in income would pay $150,000 in taxes. So under a flat rate income tax, the rich would pay more than the poor, even though the tax rate is the same for all taxpayers.
Under a comprehensive income tax, there would be no need for a separate tax on corporation income. Corporations are owned by their stockholders. A corporation’s net income would simply be allocated to shareholders in proportion to their share of ownership. For example, suppose the XYZ Corporation has 100,000 shares of its corporate stock outstanding and earned $1 million in profit this year. If you own 10,000 shares of the outstanding stock, amounting to a 10 percent share in the ownership of the corporation, then 10 percent of the $1 million profit, or $100,000, would be allocated to you, and you would have to include this amount in your personal income. Under a 15 percent flat rate tax, your tax liability on your share of the corporation’s profit would be $15,000 this year.
The flat rate income tax would be easy to administer. Time spent figuring taxes and keeping records would be minimal, and there would be no need for an army of tax accountants and lawyers to help people wade through complex tax laws.
However, even a flat rate income tax can cause distortions in behavior that could impair the efficiency of operation of the economy. The tax would reduce the net return to work and to saving and investment. This is easiest to see if taxes are withheld from earnings as those earnings are received during the year. If you earn $3,000 per month from your job, and the 15 percent income tax is withheld from your paycheck, then your net earnings from work after tax would be $3,000 minus $450, to give you net pay of $2,550. When deciding how many hours to work, you will base your choice on your net pay rather than the gross amount actually paid by your employer. The reduction in the net wage or salary due to the income tax could impair incentives to work.
The flat rate tax would also reduce the net return to saving and investment. All interest earned on savings, all corporate profits, capital gains, and any other income from use of capital would be taxable. The net return to saving and investment would fall below the actual gross return earned. Because saving and investment decisions are made on the basis of the net, after tax, return, there is the potential for a decline in saving and investment below the amounts that would prevail without taxation.
For example, if you have a savings account in a bank and earn 5 percent interest, then you will have to pay tax on the interest you earn during the year. With a 15 percent flat rate tax, your net interest would amount to 4.25 percent, calculated by subtracting 15 percent of the 5 percent from the gross interest earned:
net interest = gross interest (1 – tax rate).
In this case, your net interest earned is 85 percent of the 5 percent interest rate.
If the lower net interest rate decreases the incentive to save, then total saving in the nation will decline. As saving declines, funds financing for investment will become scarcer, and market interest rates could rise, discouraging investment. Investment could also directly decline because the tax will be levied on all capital income, including corporate profits, rents, and capital gains, decreasing the net return to investment after taxes. A decline in investment could slow the rate of growth of the economy and decrease future living standards by contributing to a decline in the rate of growth of wages and salaries as worker productivity growth slows because of the slowdown in the supply of new capital equipment and technology that investment makes possible.
In short, a flat rate income tax could reduce the size of the economy by contributing to a decrease in work effort. Over the longer term, the tax could also slow economic growth if it adversely affects saving and investment.
The Personal Income Tax in Practice
The personal income tax in the United States does not comprehensively tax all income. Instead, because tax law allows a host of adjustments, exemptions, deductions, and exclusions from income, taxable income falls far short of total income. For tax purposes, gross income includes wages and salaries, taxable interest, dividends, realized capital gains (although long-term gains on many assets are taxed at preferentially low rates), rents, royalties, most pension income, and business income from proprietorships and partnerships. Taxpayers can, to some extent, control their income tax bills by adjusting the sources and uses of their income. This leads to distortions in behavior as people make decisions based, in part, on the tax advantages of engaging in particular economic transactions, such as buying homes; providing employees with compensation in the form of nontaxable fringe benefits instead of cash; or buying municipal bonds, for which interest payments are exempt from federal taxation.
The federal personal income tax uses a progressive tax rate structure. Instead of one flat rate, there are several rates. The tax rate applied to additional income after a certain amount is received is called the taxpayer’s marginal tax rate. Low marginal tax rates apply to lower ranges of income. Each range of income is called a tax bracket, and, as income increases, the amounts falling into higher tax brackets are taxed at higher marginal tax rates. Many citizens believe that a progressive tax rate structure is fairer than a flat rate tax because it subjects those with higher incomes to higher tax rates.
As of 2010, the federal income tax had six tax brackets subject to positive tax rates, with income in the highest bracket subject to a 35 percent tax rate. The lowest positive tax rate was 10 percent. Intermediate brackets were 15, 25, 28, and 33 percent. These tax rates are levied on taxable income. Under a progressive income tax system, marginal tax rates exceed average tax rates. Average tax rates can be calculated by simply dividing taxes due by taxable income. For example, a single taxpayer with a taxable income of $74,200 in 2006 would pay $15,107.50 in federal income tax. This taxpayer’s average tax rate would be $15,107.50/$74,200 = .2036 = 20.36 percent. However, the taxpayer would be at the beginning of the 28 percent tax bracket with that amount of income, and each extra dollar of taxable income would be subject to a 28 percent marginal tax rate. Marginal tax rates are important for determining the impact of taxes on economic decisions, because they influence the net return to going to the effort of earning additional income.
Most taxpayers are entitled to personal exemptions and a standard deduction or can itemize deductions. Tax credits for such expenses as child care can be directly subtracted from tax bills. The standard deduction varies with filing status (single, married filing jointly or separately, or head of household). Adjustments for contributions to retirement accounts and other expenses can also reduce the portion of gross income that is subject to tax. The personal exemption, the standard deduction, and the beginning points for each tax bracket are adjusted for inflation each year. In 2010, a taxpayer could claim a personal exemption of $3,650 if not claimed as a dependent on some other tax return.
Taxpayers can also claim personal exemptions for dependents. A single taxpayer could claim a standard deduction of $5,700 in 2010 or itemize deductions for such expenses as state and local income taxes, property taxes, charitable contributions, interest paid on mortgages, and a host of other expenses eligible to be itemized under the income tax code. If the single taxpayer chooses to take the standard deduction and is eligible for a personal exemption, then $9,350 of gross income would not be taxable. (Under the tax law prevailing in 2010, taxpayers with relatively high incomes have their personal exemptions and itemized deductions reduced, and eventually eliminated, as income increases.)
Finally, there are provisions of the U.S. tax code that result in some low-income taxpayers, particularly those with dependent children, paying negative tax rates. The provision is called the earned income tax credit (EITC) and allowed as much as $5,666 per year to be paid to a low-income taxpayer with dependent children by the U.S. Treasury in 2010. The EITC is a way of using the tax system to increase the incomes and living standards of low-income workers through a tax credit that is payable to the worker by the U.S. Treasury.
The actual personal income tax in the United States can affect incentives to work, save, and invest, just like the flat rate income tax. However, because of complex provisions allowing taxpayers to influence their taxable income tax bills by adjusting the sources and uses of their income, the income tax in the United States effectively subsidizes some activities over others. Provisions in the tax code allowing homeowners to deduct interest on mortgages and property taxes on homes as well as those exempting up to $500,000 in capital gains from the sale of a principal residence from taxation encourage investments in housing. Reduced taxation of long-term capital gains benefits upper-income taxpayers with assets and could encourage them to invest. Exemption of some fringe benefits, such as employer-provided health insurance, encourages compensation of workers in that form instead of in taxable wages. In addition, the complexity of the tax code imposes a burden on taxpayers to keep up with the tax law, keep records, and pay professional tax consultants to help them in filing their tax returns.
Issues and Problems in Income Taxation and Prospects for Reform of the Tax Code
The federal personal income tax has been reformed many times. Each time, it seems to get more complex. Reforming the income tax code is very difficult because there will be both gainers and losers in the process, and the losers use political action to prevent changes that will make them worse off. The most extreme reform would be to move to a flat rate income tax. If this were done, all exemptions and deductions from income would be eliminated, and the average tax rate could be reduced because a much larger portion of actual income received would be subject to taxation. Under a flat rate tax, the average tax rate is equal to the marginal tax rate. A single lower marginal tax rate could reduce the distortions in decision making that result from the impact of taxes on net returns to work and saving. However, many object to a shift to a flat rate tax, because it would lower the tax rate for upper-income individuals while raising the tax rate for many lower-income taxpayers.
A less extreme approach to tax reform would eliminate some exemptions, deductions, and exclusions from taxable income to allow lower marginal and tax rates while retaining a progressive tax rate structure. For example, the report of the President’s Advisory Panel on Federal Tax Reform in 2005 recommended limiting deductions for interest on home mortgages and eliminating deductions for state and local income and property taxes. Elimination of deductions generates tax revenue and allows tax rates across the board to decrease without tax revenue collected falling. However, such changes could have adverse effects on homeowners. As the tax advantages to homeownership are reduced, the demand for homes could decline, and this would decrease home prices, reducing the net worth of many households. The President’s Advisory Panel on Federal Tax Reform recommended that the mortgage interest deduction be replaced with a tax credit for such interest that would be available to all taxpayers regardless of whether they itemize deductions. The panel also recommended a cap on the amount of interest that could be claimed as a credit so that the benefit to upper-income households with expensive homes and mortgages in excess of $300,000 would be reduced. This could sharply reduce demand for luxury homes but could increase demand and prices for modest homes.
Similarly, the current deduction for state and local taxes cushions those tax bills for those who itemize deductions by, in effect, allowing them to pay some of those bills through a reduction in federal tax liability. If the deduction were eliminated, it would be more difficult for state and local governments, particularly those whose tax rates are already high, to raise tax rates in the future and could result in political action to decrease tax rates.
The personal income tax system has been used as a means of encouraging individuals to favor one activity over another through its extensive use of adjustments, exemptions, deductions, and credits. This, too, has contributed to the complexity of the code. Congress often enacts tax deductions or credits for such activities as child care or education but limits availability to upper-income households. As a result, the amount of the benefits are often reduced as a taxpayer’s adjusted gross income increases, and the tax forms necessary to calculate the reduction in credits or deductions are often quite complex.
Another reform often suggested is to change the tax system to encourage saving and investment. Because of concern about the impact of the current system of income taxation on incentives to save and invest, some economists advocate allowing taxpayers to deduct all of their savings from taxable income and exempting interest from taxation unless it is withdrawn. In effect, such a scheme would tax only consumption, because income less saving is equal to consumption.
The tax reform process is inevitably tied to politics, because it always results in some people gaining while others lose. The prospects for a radical reform of the tax code, such as a shift to a flat rate tax, are remote. Instead, small, incremental changes in tax deductions and credits, and simplification of complex provisions of the tax code are more likely. Elimination of these special provisions that reduce revenue can allow across-the-board decreases in average and marginal tax rates and reductions in the distortions in decision making from the income tax.
David N. Hyman
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