CHAPTER

14
Personal Income Taxation
in the United States
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe

Brief History of U.S. Income

Tax System
First

income tax - 1861-1871

Financed

Civil War
Relatively low tax rate
Federal

Income Tax - 1913

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

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Withholding
Employer

withholding established during

WWII
Portion of employees pay sent directly to
federal government
Government able to collect more in
income taxes

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

14-3

Tax Reform in
1964, 1986, and 2002
1964
Tax

cut to stimulate aggregate demand

Keynesian principles
1986
Tax

Reform Act
Concerned excess burden of taxation
2002
No

clear motivation

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

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Calculating Taxable Income

Computation

of Income
Taxable income includes:
Wages
Salaries
Tips
Interest
Dividends

Capital

gains taxed at lower rate

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

14-5

Exemptions
Personal

exemption
Individual retirement accounts
Alimony
Adjusted gross income = total income
minus exemptions

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

14-6

Deductions
Standard

deduction fixed amount

Itemized deduction addition of
allowable deductions
Medical

and dental expenses

State, local, and property taxes
Home mortgage interest
Charitable contributions
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe

14-7

Tax Computation
Taxable

Income = Total income minus

exemptions and deductions
Compute tax due on taxable income

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

14-8

Marginal Rates in 2003 for a

Single Individual
Table 14.3 Marginal Tax Rates in 2003 for a
Single Individual
Taxable Income
Up to $7,000
$7,001 to $28,400
$28,401 to $68,800
$68,801 to $143,500
$143,501 to $311,950
Above $311,950

Marginal Tax Rate

10%
15%
25%
33%
33%
35%

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

14-9

Tax Credits
Can

subtract certain items from tax

liability
Credits more beneficial than
exemptions/deductions

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe
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Broadening the Tax Base

Exemptions,

deductions, and credits

narrow tax base
Broader base
Allows

lower marginal rates

Reduces excess burden

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

14-11

Comparison of Broadly Based

and Narrowly Based Taxes

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe
14-12

Alternative Minimum Tax

Created

in 1969
Targets upper-income taxpayers using tax
preferences to avoid federal income tax
Must calculate taxes without most tax
preferences and pay AMT if higher than
calculating tax burdens by regular
method
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
14-13

Tax Expenditures
Reductions

in taxation
Designed to further some goal of social
policy
Create loopholes making tax structure
less efficient

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe
14-14

Inflation, Indexation, and

Bracket Creep
Indexation
Tax

rates adjusted for inflation

Bracket

creep

When

nominal tax structure remains the

same but taxpayers pay more in real taxes
because of inflation

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe
14-15

Individual Retirement
Accounts (IRA)
Money

contributed to IRA does not count

as taxable income
Tax paid on withdrawals from IRA
Eliminates double tax on saving
Can only contribute limited amount

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe
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Roth IRA
Allows

no deduction for deposits

Principle and earnings can be withdrawn
tax-free

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe
14-17

Other Tax-Deferred Savings

Methods
Keogh

plans

401(k)
403(b)
Company

pension plans

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe
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