Chapter 13
The Theory of
Income Taxation
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Income Taxes
Income Taxes were introduced as an
emergency measure during the U.S.
Civil War.
An attempt in 1894 to introduce a regular
income tax was declared unconstitutional.
In 1913 the 16th Amendment to the U.S.
Constitution allowed for personal and
business income taxes.
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The First Regular US Income Tax
The initial income tax exempted the first
$3,000 for singles and the first $4,000
for married couples.
It imposed a 1% rate on income up to
$20,000 and higher rates at higher
levels of income.
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Comprehensive Income: The
Haig-Simons Definition
It is “the exercise of control over the use of society’s
scarce resources.”
Algebraically it is defined as
I = C + NW
Where
I = Income
C = Consumption
NW = The Change in Net Worth
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Implications of the Haig-
Simons Definition
If a person borrows to consume, there is
no increase in income because the
change in net worth is negative.
If a person sells an asset so as to
consume, there is no increase in
income.
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Capital Gains
Capital gains are the increased value of
assets that a person holds.
If a person owns a stock that has gone up in
value, their net worth increases and therefore
they have an increase in income by this
definition.
This is true whether or not they actually sell
the asset and see the money in their bank
accounts.
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Realized and Unrealized Capital
Gains
Realized Capital Gains are those gains
that a person has received by selling an
asset.
Unrealized Capital Gains are those
gains that a person has not yet received
by selling an asset but exist only on
paper as the market price of the asset
they hold has increased.
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An Income Statement
Sources of Funds:
Earnings from Sale of Productive Services
Transfer Payments Received
Capital Gains (or Losses)
Uses of Funds:
Consumption
Taxes
Donations
Gifts
Saving (Increases in Net Worth)
Sources = Uses
So
Earnings + Transfer Payments + Net Capital Gains =
Consumption + Taxes + Donations + Gifts + Saving
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Modifications to the Income
Definition
The cost of acquiring income needs to be
accounted for in the definition.
Earnings + Transfer Payments + Net
Capital Gains – Cost of Acquiring Income
=
Consumption + Taxes + Donations + Gifts
+ Saving – Cost of Acquiring Income
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Problems with Measuring
Income using the Haig-Simons
Definition
How do you measure unrealized capital gains on
an asset that is not regularly traded?
Is the cost of an automobile used to drive to and
from work a “cost of acquiring income?” Are child
care expenses? Union Dues? Education
expenses?
How do you distinguish what part of an expense
is a cost of acquiring income and what part is
merely consumption?
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In-Kind Income in the Haig-
Simons Definition
Under the comprehensive income
definition, all income should be treated
equally whether it is paid in cash or in-
kind.
Many jobs offer free parking, subsidized
medical insurance.
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Home Production
Home production is any activity that is
performed by people in the home.
Most of the things we do for ourselves
can be purchased.
If you earn the money to have things
done for you, then you are taxed on that
income. If you do it yourself, you are not.
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The Home Itself
Under a Haig-Simons definition of
income, whether or not you own your
home you are consuming housing
services and it is therefore income.
Economists call the money that
homeowners do not have to pay for the
housing services they consume imputed
rent.
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The Impracticality of Taxing In-Kind
Income, Home Production, and
Imputed Rent
It would be impractical to tax any of these kinds of
income because the value that is being received by
the consumer depends upon the tastes of the
consumer.
Suppose the market value of a parking space for a year
is $1000. Suppose it is given to a person as a part of
their job. Taxing a person as though they earned that
$1000 would be inappropriate if they did not value the
parking space at $1000 and could not sell the rights to
that spot for $1000.
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A General Tax on
Comprehensive Income
Suppose there is a flat-rate income tax
on all income. What are the effects on
the labor-leisure trade-off and the
savings decision?
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Figure 13.1 The Impact of a Flat-Rate Income Tax on
the Work-Leisure Choice
J
Income per Day
J'
I1 E
IG
T B U2
IN E'
U1
H
0 L1 L 2
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Leisure Hours per Day
The Algebraic View
Individuals maximize welfare where
w = MRSLI
The after-tax wage is wN = wG(1 – t)
Income is then I = wG(1 – t)(24 – L)
Which means that individuals maximize their
welfare in response to the tax by choosing labor
such that
wG(1 – t) = MRSLI
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Capital Gains in the Rest of the
World
U.S. reduced rate for assets held more
than 18 months.
Most nations only tax gains on
realization.
Little evidence exists to support the
conclusion that a lower rate encourages
entrepreneurship.
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Income and Substitution Effects
of a Tax on Labor Income
It is possible for a tax to increase or decrease the
amount of work effort depending on whether
leisure is a normal good.
If people target the amount of money they must take
home to meet a standard of living, then a tax may
increase work effort.
If leisure is a normal good, then the income effect and
substitution effect of a tax on labor income are in the
same direction and a tax decreases work effort.
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Figure 13.2 Income and Substitution Effects of A
Tax Induced Wage Decline
C
Income per Day
I'
E1
E2 E'
U2
U1
B
L1
H
0 L2 L1 L'
L
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Labor Market Analysis of Income
Taxation: Perfectly Inelastic
Supply
Even if the labor supply curve is perfectly
inelastic, this does not imply there is no
excess burden of a tax on labor income.
The labor supply curve that is appropriate for
making such statements is the compensated
labor supply curve (which is almost certain to
be upward sloping even if the regular labor
supply curve is not).
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Figure 13.3 Impact of an Income Tax on Labor
Markets and Efficiency When the Market Supply of
Labor is Perfectly Inelastic
A B
Compensated Labor
S Supply Curve S'
Regular Labor
Supply Curve
Wages
W*
G
tW*
G
WN = W* (1– t)
G
D=W
WN = WG (1 – t)
0 Q* 0 –QSL
Labor Hours per Year
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Labor Market Analysis of Income
Taxation: Wage responsive Labor
Supply
When the regular labor supply curve is
not perfectly inelastic, the excess
burden of a tax on labor income is
understated unless the analysis is
performed with a compensated labor
supply curve.
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Figure 13.4 The Effect of Income Taxes on Labor
Markets When the Supply of Labor is Responsive
SR
SC
W* C
W A
Wages
W tW*
G
W* B
D = WG
Q WN
0 Q3 Q2Q1 Hours Worked
QSL per Year
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Empirical Analysis
Regular labor supply is perfectly inelastic for
men 25 to 55.
Estimates suggest that there is a large
substitution effect that is almost perfectly
offset by an equally large income effect.
The efficiency-loss ratio for these men
suggests that for every dollar raised in
income taxes, 13.5 cents of excess burden is
created.
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Lower Tax Rates, More Work,
Less Excess Burden
Tax changes in 1983 and 1986 lowered
the marginal tax rates facing most
Americans.
Recent estimates suggest that this
lower rate induced a 3% increase in
work by men and a 16% drop in excess
burden.
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Incidence of Payroll Taxes
In the U.S., the FICA tax that funds
Social Security has a legal incidence
that is a 7.65% tax on both employers
and employees.
If the regular labor supply curve is
perfectly inelastic, this implies that all of
this tax is being borne by workers.
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The Payroll Tax
SL
A
Wages
WG
TB + TE WE B
DL = MRPL
WN C
DN D' = MRPL – TB
L
0 QL
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Labor Hours per Year
Taxation of Interest Income and
the Effect on Saving
Just as a tax on earned income can
lead to an increase or a decrease in
work, a tax interest can lead to an
increase or a decrease in saving.
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Figure 13.5 Income Taxation and Intertemporal
Choice
E
Future Consumption
C2 E1
E2 U2
C'
2
U1
0 C1 C’2 D
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Excess Burden of a Tax on
Interest Income
A tax on interest income will also have
an excess burden that will depend on
the magnitude of the tax and the
elasticity of supply and demand for
loanable funds.
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Figure 13.6 Impact of an Income Tax on Investment
Markets and Savings
Supply of Savings
r* B
Interest
G
r1 A
r*
N C
D = rG
rN
S 2 S1
Annual Savings and Investments
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Empirical Estimates
The elasticity of the supply of savings
has been estimated to be in the
neighborhood of .4.
This indicates that the efficiency-loss
ratio for such a tax is .30 (meaning that
for every dollar raised with the tax on
interest income there is a 30 cent
increase in excess burden).
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Supply-Side Tax Cuts of the
1980s
Supply-Siders argued that cuts in tax
rates would increase overall revenues
because of the cuts would motivate
harder work and greater investment.
The cuts in tax rates did not increase
revenues but the decrease was much
less than expected (by the tax cut
opponents).
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