Tax Base: The tax base is what it is we tax. The tax base of the federal income tax is not all income, but rather “taxable income.” “Taxable income” is “gross income” minus deductions named in § 62, minus either a standard deduction or itemized deductions, minus personal exemptions. Only the amount remaining after these subtractions is subject to federal income tax.
The Tax Formula
MINUS deductions named in § 62
EQUALS (adjusted gross income (AGI))
MINUS (standard deduction or itemized deductions)
MINUS (personal exemptions)
EQUALS (taxable income)
Compute income tax liability from tables in § 1 (indexed for inflation)
MINUS (credits against tax)
Learn this formula.
Notice that in the accompanying box (“The Tax Formula”), there is a line. We frequently refer to this as “the line.” The figure immediately beneath the line is “adjusted gross income” (AGI). In a very rough sense, § 62 deductions are for obligatory expenditures or for deferring income that will be subject to income tax at the time of consumption. Subtractions may be “above the line” or “below the line.” Taxpayer is entitled to § 62 deductions irrespective of and in addition to itemized deductions or the standard deduction.
When a subtraction is “below the line,” what happens above the line might be very relevant. The Code limits certain itemized deductions to the amount by which an expenditure exceeds a given percentage of a taxpayer’s AGI. For example, a taxpayer’s deduction for medical expenditures is only the amount by which such expenditures exceed 10% of a taxpayer’s AGI. Congress can use such a limitation to do some customization of such deductions. A 10%-of-AGI-floor on deductibility of medical expenses provides some rough assurance that the amount of a medical expense provides some rough assurance that the amount of a medical expense deduction requires a common level of “pain” among high- and low-income taxpayers.
Progressive Tax Brackets, Progressive Tax Rates, or Progressive Taxation: Not all dollars have the same worth to different taxpayers. To a person whose annual taxable income is $10 million, one dollar more or less has far less value (as gain or loss) than the same dollar has to a person whose annual taxable income less is than $1000. 1 Hence, the person with $10 million of income who receives one more dollar might feel the same level of sacrifice if s/he must pay $0.90 of it in federal income tax – and so keeps only $0.10 of it – as the person with $1000 of income who receives one more dollar of income might feel if s/he must pay $0.05 of it in federal income tax and so keeps $0.95 of it. The Tax Code endeavors to require equal sacrifice by establishing progressive tax rates. Look at § 1 of the Code – preferably the latest table that the IRS has promulgated in a Revenue Procedure that adjusts tax rates for inflation. An understanding of the tax formula should lead you to conclude that the first dollars of a taxpayer’s income are not taxed at all. The next dollars above that threshold – and only those dollars – are subject to a tax of 10%. The next dollars above the next threshold – and only those dollars – are subject to a tax of 15%. And so on – at rates of 25%, 28%, 33%, 35%, and 39.6%. Tax brackets that increase as taxable income increases are “progressive” tax brackets. The highest individual tax bracket is 39.6%, but no taxpayer pays 39.6% of his/her taxable income in federal income taxes; do you see why?
Progressive Rates and Income Redistribution
An argument favoring progressive tax brackets – aside from the declining marginal utility of money – is that the effect of progressive tax brackets is to redistribute income in favor of those who have less. After all, Government has only to spend the many dollars contributed by higher-income taxpayers for the benefit of those less well-off – and there will be income redistribution. Any person who is even slightly aware of current social conditions knows that the Tax Code has not proved to be a particularly effective instrument of income redistribution. Inequality in wealth distribution is at near historically high levels. Perhaps high-income taxpayers are able to keep more of their incomes and to pay less in taxes than serious efforts at redistribution require. Perhaps Government has become, for whatever reason, reluctant to spend tax revenues on (more) programs that benefit the poor. Or perhaps both.
A regressive tax is one where the percentage that taxpayers pay decreases as their income increases. A flat tax is one where the percentage that taxpayers pay is equal at all income levels. Some flat taxes are regressive in effect, e.g., a flat sales tax imposed on necessities, infra.
Effective tax rate: Because we have a progressive rate structure, not every dollar of taxable income is taxed at the same rate. Moreover, income derived from some sources is taxed differently than income derived from other sources. For example, an individual taxpayer’s “net capital gain” (essentially long-term capital gains plus most dividends) is taxed at a lower rate than his/her ordinary income. It may be useful for policy-makers to know what certain taxpayers’ “effective tax rate” is, i.e., (amount of tax)/(total income).
The Upside Down Nature of Deductions and Exclusions
A taxpayer pays a certain marginal rate of tax on the next dollar that s/he derives in gross income. Hence, a high-income taxpayer who pays a 39.6% marginal tax rate gains $0.604 of additional spending power by earning one more dollar. The higher a taxpayer’s marginal tax bracket, the less an additional dollar of income will net the taxpayer. The same principle works in reverse with respect to deductions. The same taxpayer might be considering contributing $1 to his/her local public radio station for which s/he would be entitled to a charitable contribution deduction. The public radio station would receive $1 of additional spending power while the taxpayer sacrifices only $0.604 of spending power. On the deduction side, the higher a taxpayer’s marginal tax rate, the more an additional dollar of deduction will save the taxpayer in income tax liability. And the lower a taxpayer’s marginal tax rate, the less an additional dollar of deduction will save the taxpayer in income tax liability. A taxpayer whose marginal rate of tax is 10% must sacrifice $0.90 of spending power in order that his/her public radio station receives $1 of additional spending power. The same principle applies to exclusions from gross income. A high-income taxpayer saves more on his/her tax bill by accepting employment benefits excluded from gross income than a low-income taxpayer, infra. These results might be the opposite of what policy-makers desire, i.e., they are “upside-down.” The magnitude of “upside-downness” depends upon the magnitude of progressivity of tax rates. Raising tax rates on high income earners will increase the “upside-downness” of deductions and exclusion.
Marginal Tax Rate: A taxpayer’s marginal tax rate is the rate at which the next (or last) dollar is taxed. Because we have a progressive rate structure, this rate will be greater than the taxpayer’s effective tax rate. Among the reasons that the marginal tax rate is important is that it is the rate that determines the cost or value of whatever taxable-income-affecting decision a taxpayer might make, e.g., to work more, to have a spouse work outside the home, to incur a deductible expense, to accept a benefit that is excluded from his/her gross income in lieu of salary from an employer.
Tax Incidence: The incidence of a tax is the person on whom the burden of a tax falls. The phrase is used to identify occasions where the ostensible payor of a tax is able to shift the burden to another. 2 For example, a property owner may be responsible for payment of real property taxes, but their incidence may fall on the tenants of the property owner.
Exclusions from Gross Income: We (say that we) measure “gross income” by a taxpayer’s “accessions to wealth.” However, there are some clear accessions to wealth that Congress has declared taxpayers do not count in tallying up their taxpayer’s “gross income,” e.g., employer-provided health insurance (§ 106), life insurance proceeds (§ 101), interest from state or local bonds (§ 103), various employee fringe benefits (e.g., §§ 132, 129, 119). Many exclusions are employment-based. 3 Congressional exclusion of clear accessions to wealth from the tax base creates certain incentives for those able to realize such untaxed gain – and for those who profit from supplying the benefit (e.g., life insurance companies, (some, but not all) employers, providers of medical services 4) in exchange for untaxed dollars.
Deductions from Taxable Income: Congress permits taxpayers who spend their money in certain prescribed ways to subtract the amount of such expenditures from their taxable income. A deduction is only available to reduce income (otherwise) subject to income tax. Hence, the person who gives his/her time to work for a charity may not deduct the fmv of the time because taxpayer is not taxed on the fmv of his/her time. A taxpayer has no basis in wages that s/he never receives. 5 From a tax perspective, this is the critical difference between an exclusion from gross income and a deduction from taxable income (or from adjusted gross income).
The Right Side Up Nature of Tax Credits
The effect of a tax credit equal to a certain percentage of a particular expenditure is precisely the same as a deduction for a taxpayer whose marginal tax is the same as the percentage of the expenditure allowed as a credit. Thus, if Congress wants to encourage certain expenditures and wants to provide a greater incentive to low-income persons than to high-income persons, it can establish the percentage of the expenditure allowed as a credit at a level higher than the marginal tax bracket of a low-income taxpayer but lower than the marginal tax bracket of a high-income taxpayer. Such a credit will benefit a lower-income bracket taxpayer more than a deduction would and a higher-income taxpayer less than a deduction would. If this is what Congress desires, the effect of a tax credit is “right side up.”
Alternative Minimum Tax: In response to news stories about certain wealthy people who managed their financial affairs so as to pay little or nothing in federal income tax, Congress enacted the alternative minimum tax (AMT) scheme. I.R.C. §§ 55-59. The basic scheme of the AMT is to require all taxpayers to compute their “regular tax” liability and as well as their “alternative minimum tax liability.” They compute their AMT liability under rules that adjust taxable income upward by eliminating or reducing the tax benefits of certain expenditures or of deriving income from certain sources. They reduce the alternative minimum taxable income by a flat standard deduction that is subject to indexing. A (nearly) flat rate of tax applies to the balance. Taxpayer must pay the greater of his/her regular tax or AMT. Congress aimed the AMT at high-income persons who did not pay as much income tax as Congress thought they should. 6
Credits against Tax Liability: A taxpayer may be entitled to one or more credits against his/her tax liability. The Code allows such credits because taxpayer has a certain status (e.g., low-income person with (or without) children who works), because taxpayer has spent money to purchase something that Congress wants to encourage taxpayers to spend money on (e.g., childcare), or both (e.g., low-income saver’s credit). The amount of the credit is some percentage of the amount spent; usually (but not always) that percentage is fixed.
Income Phaseouts: When Congress wants to reduce the income tax liability of lower-income taxpayers for having made a particular expenditure but not the income tax liability of higher income taxpayers who make the same expenditure, it may phase the benefit out as a taxpayer’s income increases. For example, a Code provision might provide a deduction that is reduced by 10% for every $2000 of a taxpayer’s taxable income that exceeds $150,000 of taxpayer’s adjusted gross income. Congress can apply phaseouts to both credits and deductions. The precise mechanics and income levels of various phaseouts differ. Income phaseouts increase the complexity of the Code and so also increase the cost of compliance and administration. They can make it very difficult for a taxpayer to know what his/her marginal tax bracket is – as any change in AGI or deductions effectively changes his/her tax bracket. Income phaseouts are a tool of congressional compromise. Perhaps Congress is so willing to enact income phaseouts because there are many inexpensive computer programs that taxpayers use to perform all necessary calculations. 7
A Word about Employment Taxes: “Employment taxes” are the social security tax and the medicare tax that we all pay on wages we receive from employers. 8 Employers pay a like amount. 9 Self-employed persons must pay the equivalent amounts as “self-employment” taxes. The Government collects approximately 31% of its tax revenues through these taxes – much more than it collects from corporate income taxes, gift taxes, estate taxes, and excise taxes combined. Eligibility to be a beneficiary of the social security program or medicare program does not turn on a person’s lack of wealth or need. In essence, the federal government collects a lot of money from working people so that all persons – rich and poor – can benefit from these programs.
Three Levels of Tax Law
Tax law will come at you at three levels. The emphasis on them in this course will hardly be equal. Nevertheless, you should be aware of them. They are –
- Statute and regulation reading, discernment of precise rules and their limits, application of these rules to specific situations;
- Consideration of whether Code provisions are consistent with stated policies;
- Consideration of the role of an income tax in our society. What does it say about us that our government raises so much of its revenue through a personal income tax? Other countries rely more heavily on other sources of revenue. A personal income tax raises a certain amount of revenue. Some countries raise less revenue and provide their citizens (rich and poor alike) fewer services. Other countries (notably Scandinavian ones) raise more revenue and provide their citizens (rich and poor alike) with more services. The United States surely falls between the extremes – although it provides middle- and high-income persons with more services and benefits than most people realize.