Economic Memo #29 – Taxes

Now I know you expect a funny Hill story at this point but thanks to Al Capone personal income taxes are not a funny subject. Everyone has to pay. I just paid mine and that’s why there is no Hill funny story.

Tax season is the only time that your assets become liabilities and your liabilities become assets. 
          For my Tea party (aka Fiscal Republicans) friends you will be happy to note this memo will not be politically bent and will simply try to explain what the tax system is all about.
          Let’s start out by explaining economic tax theory.
What is the most efficient tax?
The first thing to note is that the income tax is the most efficient tax. Less than one half of one percent of the tax revenues collected is spent in collecting the tax. The sales tax spends around 2% and the property tax spends 5% or greater in collecting the tax. That means for every 100 dollars collected the collection fee is 50 cents for the income tax, $2 for the sales tax, and $5 for the property tax.
Economic memo 29 -1
What is the theory behind the tax?

The second thing we need to know is that the Federal and State tax systems are loosely based on the Haig-Simons Net Accretion Approach to taxation. (Simons killed himself, so that tells you something). Basically the theory says that if we take all your wealth this year and subtract your last year’s wealth; the result is this year’s net accretion income. Now there are things like growing tomato’s in your back yard and other income-in-kind things that need to be subtracted from your net accretion income. These are called exclusions. In the case of our tax system various other things like the interest on state and local bonds, subsidies to oil and gravel companies, etc. have been thrown into the exclusions.
 As you can see from the table below most of the other loopholes (all the subtractions) are lines or schedules on the current IRS 1040 form.
The net taxable income is the amount that the tax rates are applied to. In the case above I have shown you how a millionaire can legally escape paying any taxes. In 2011, one thousand five hundred millionaires out of 230,000 did not pay any Federal income tax.
Econ Memo 29 -3
At this point you might be thinking about how to cheat on your taxes. The first thing you need to know is that only about one and a half percent of all tax payers are audited by the IRS. The second thing you might want to know is that IRS assigns weights to each of the loopholes.  The IRS sums those up and there is a magic number chosen each day that determines those who will be audited.

For example, if you list your office in your home as a deduction you might get 100 points (they really don’t like offices in homes).  If you are claiming a personal deduction for giving a family heirloom to charity they may give you 200 points. If you are claiming Stonewall (your deceased dog who was like a human) as a personal exemption; they may give 10 points. That particular day anything over 100 points will get audited.
No one person knows the magic number that will cause an audit on any given day.
The general rule is that if you are going to stretch things; then cheat on deductions and do not hide income. Pete Rose can attest to that.
My rule of thumb has always been that I get government services and whether I voted for them or not they are my services so I have to pay for them. In other words I pay a bundle in taxes and don’t cheat.
What are tax rates?
 
          There are two tax terms that you need to understand to understand tax rates. The first is the marginal tax which is the extra tax per extra dollar of net taxable income.
          The second term is the Average rate of tax which is the total tax paid divided by the total net taxable income.
The table below gives you an idea of how each on works.
Econ Memo0
The marginal tax rate and change in taxes per bracket are set by the legislature. There are three types of taxes: progressive, regressive and proportional.

The progressive tax is set so the marginal rate of tax increases as you move up brackets. The proportional tax sets a constant rate so brackets are not important. The rate is the same for every dollar of your income. The regressive tax results in a small rate of tax as your income brackets increase.
 The following tables show each of the types of taxes.
Econ Memo 29
The tax changes listed below are for this year. As you can see we have a progressive tax system at the Federal level. Illinois State taxes are 4.5% for all your income and are proportional.
Econ Memo2

About Larry Hill

Dr. Larry Hill is Chair and Professor of Economics. Areas of interest include economic analysis, energy economics cost benefit analysis and economy. To subscribe to the email list of Dr. Larry Hill's Economic Memos, contact Tracey O'Brien at obrientr@lewisu.edu. Credentials include 1967 B.S., Indiana State University, 1968 M.S., Indiana State University, 1976 Ph.D., Northern Illinois University He is a member of honorary fraternities in economics and social science. He is currently writing a book on Managerial Economics and revising previous book, "The Basic Macroeconomics of the American Economy"

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