Optimal tax rates Essay

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Optimal Labor Income Taxation
(follows loosely Chapters 20-21 of Gruber)
131 Undergraduate Public Economics
Emmanuel Saez
UC Berkeley

1

TAXATION AND REDISTRIBUTION
Key question: Do/should government reduce inequality using taxes and transfers?
1) Governments use taxes to raise revenue
2) This revenue funds transfer programs:
a) Universal Transfers: Public Education, Health Care Benefits (only 65+ in the US), Retirement and Disability Benefits,
Unemployment benefits
b) Means-tested Transfers: In-kind (e.g., public housing or
Medicaid in the US) and cash benefits
Modern governments raise large fraction of GDP in taxes (3045%) and spend significant fraction of GDP on transfers
2

FACTS ON US TAXES AND TRANSFERS
References: Comprehensive description in: http://www.taxpolicycenter.org/taxfacts/ A) Taxes: (1) individual income tax (fed+state), (2) payroll taxes on earnings (fed, funds Social Security+Medicare), (3) corporate income tax (fed+state), (4) sales taxes (state)+excise taxes (state+fed), (5) property taxes (state)
B) Means-tested Transfers: (1) refundable tax credits (fed),
(2) in-kind transfers (fed+state): Medicaid, public housing, nutrition (SNAP), education, (3) cash welfare: TANF for single parents (fed+state), SSI for old/disabled (fed)
3

FEDERAL US INCOME TAX
US income tax assessed on annual family income (not individual) [most other OECD countries have shifted to individual assessment] Sum all cash income sources from family members (both from labor and capital income sources) = called Adjusted Gross
Income (AGI)
Main exclusions: fringe benefits (health insurance, pension contributions), imputed rent of homeowners, unrealized capital gains

4

FEDERAL US INCOME TAX
Taxable income = AGI - personal exemptions - deduction personal exemption = $ 3950 × # family members (in 2014) deduction is max of standard deduction or itemized deductions
Standard deduction is a fixed amount depending on family structure ($12.4K for couple, $6.2K for single in 2014)
Itemized deductions: mortgage interest payments, charitable giving, state and local taxes paid, various other small items
[about 10% of AGI lost through itemized deductions, called tax expenditures]
5

FEDERAL US INCOME TAX: TAX BRACKETS
Tax T (z) is piecewise linear and continuous function of taxable income z with constant marginal tax rates (MTR) T (z) by brackets [draw graph]
In 2014, 7 brackets with MTR 10%,15%,25%,28%,33%,35%,
39.6% (top bracket for z above $458K), indexed on price inflation
Lower preferential rates (up to a max of 20%) apply to dividends (since 2003) and realized capital gains [in part to offset double taxation of corporate profits]
Tax rates change frequently over time. Top MTRs have declined drastically since 1960s (as in most OECD countries)
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Source: IRS, Statistics of Income Division, Historical Table 23

FEDERAL US INCOME TAX: TAX CREDITS
Tax credits: Additional reduction in taxes
(1) Non refundable (cannot reduce taxes below zero): foreign tax credit, child care expenses, education credits, energy credits, and many others
(2) Refundable (can reduce taxes below zero, i.e., be net transfers): EITC (earned income tax credit, up to $3.2K, $5K,
$6K for working families with 1, 2, 3+ kids), Child Tax Credit
($1000 per kid, partly refundable)
Refundable tax credits are now the largest means-tested cash transfer for low income families
8

FEDERAL US INCOME TAX: TAX FILING
Taxes on year t earnings are withheld on paychecks during year t (pay-as-you-earn)
Income tax return filed in Feb-April 15, year t + 1 [filers use either software or tax preparers, huge private industry, most
OECD countries provide pre-populated returns]
Most tax filers get a tax refund as withholdings > taxes owed in general
Payers (employers, banks, etc.) send income information to govt (3rd party reporting)
3rd party reporting + withholding at source is key for successful enforcement
9
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