A phasein is the opposite of a phaseout, a tax benefit is increasing with increasing income. It sounds too good to be true, but in fact the EITC works exactly like this. The EITC is a refundable credit that increases together with an increase in income, reaches a plateau and finally decreases in a phaseout range.
The EITC is such a special mechanism that it is also probably abused. Rather incredible amounts of non compliance were reported in the past by the IRS "Despite these efforts, the IRS has been unable to significantly reduce noncompliance. The most recent compliance study (of TY 1999 returns), reported that between $8.4 and $9.9 billion in EITC claims (27% to 32%) had been improperly paid. Based on “significant compliance problems” associated with the EITC, the General Accounting Office has listed the administration of the credit as a “high risk area for the federal government.”
For our purpose, a phasein results in a decrease in the marginal rate. In fact because the EITC applies to income ranges with very low statutory rates, the marginal rate may become negative. This rather strange behavior is apparent on the figure shown on the first post of this blog. Understanding how the marginal rate could ever become negative was a reason I wanted to understand in more detail the tax mechanisms in the US.
Thursday, April 19, 2007
Sunday, March 25, 2007
Smooth phaseout
As shown before sharp phaseouts of deductions may introduce the annoying problem of your tax income decreasing even as your before tax income increases. The solution to that problem is to define a smooth instead of a sharp transition. The simplest method and the one chosen by the IRS is to linearly spread the phaseout, i.e. the deduction decreases linearly until 0 above the phaseout boundary. The previous example can be reworked, showing three different linear transition slopes.
As shown in the figure, a smooth transition makes the curve continuous, but it is still possible for the income after tax to be locally decreasing, depending on how fast the deduction is phaseout. This is illustrated by the red dashed curve in the figure.
There are two ways to define a linear transition phaseout, either fixing the slope of the phaseout, or fixing the end point of the transition. The two methods are equivalent when the deduction amount is fixed, like for the tuition fee example, but they are not equivalent when the deduction amount is a variable dependent on one's situation. In that case, fixing the slope is better because the slope is directly related to the increase in marginal rate. Fixing the slope insures that the change in marginal rate is also fixed. This is probably why this is the form universally selected by the IRS when it defines smooth phaseouts.
The IRS always uses similar text to describe the transition. The example below is taken from Publication 17 (2006): "If your itemized deductions are subject to the limit, the total of all your itemized deductions is reduced by ... some details removed at this time ... 3% of the amount by which your AGI exceeds $150,500 ($75,250 if married filing separately)."
The impact on the marginal rate can be summarized like this. If not for the phaseout, the tax close to the income of interest can be expressed by a simple linear relation, with r the marginal rate
Adding the phaseout results in a modified tax equation, with s the slope of the reduction (would be 3% for the IRS example above)
The new marginal rate can be found by differentiating the modified equation
This shows that controlling the slope as specified results in a predictable increase of the marginal rate. It is then a simple matter to specify the slope such that the phaseout doesn't introduce unwelcome effects, especially limiting the increased marginal rate in the transition region to (well) below 100%.
As shown in the figure, a smooth transition makes the curve continuous, but it is still possible for the income after tax to be locally decreasing, depending on how fast the deduction is phaseout. This is illustrated by the red dashed curve in the figure.
There are two ways to define a linear transition phaseout, either fixing the slope of the phaseout, or fixing the end point of the transition. The two methods are equivalent when the deduction amount is fixed, like for the tuition fee example, but they are not equivalent when the deduction amount is a variable dependent on one's situation. In that case, fixing the slope is better because the slope is directly related to the increase in marginal rate. Fixing the slope insures that the change in marginal rate is also fixed. This is probably why this is the form universally selected by the IRS when it defines smooth phaseouts.
The IRS always uses similar text to describe the transition. The example below is taken from Publication 17 (2006): "If your itemized deductions are subject to the limit, the total of all your itemized deductions is reduced by ... some details removed at this time ... 3% of the amount by which your AGI exceeds $150,500 ($75,250 if married filing separately)."
The impact on the marginal rate can be summarized like this. If not for the phaseout, the tax close to the income of interest can be expressed by a simple linear relation, with r the marginal rate
Adding the phaseout results in a modified tax equation, with s the slope of the reduction (would be 3% for the IRS example above)
The new marginal rate can be found by differentiating the modified equation
This shows that controlling the slope as specified results in a predictable increase of the marginal rate. It is then a simple matter to specify the slope such that the phaseout doesn't introduce unwelcome effects, especially limiting the increased marginal rate in the transition region to (well) below 100%.
Sunday, March 4, 2007
Sharp boundary phaseouts other problem
An other problem introduced by sharp boundary phaseout is linked to an other desirable property of the tax equation that was not stated yet: the income after tax should be a monotously increasing function of the income before tax.
In simple terms, an increase in your income before taxes should always result in an increase of your income after taxes. Mathematically this means that the marginal tax rate must be smaller than 1 everywhere, and this is clearly not the case at a sharp phaseout boundary.
If income is defined as a continuous variable, the marginal rate is infinite, i.e. there is a positive impulse in the marginal rate at the position of the boundary. Income is of course quantized, and the marginal rate in that case is always finite, but significantly greater than one. In the example discussed in the previous article, the marginal rate was $500 in tax increase divided by $10 of income increase = 50 or 5,000%.
We can visualize that using a graph showing the income after tax in function of the income before tax, based on the characteristics of the fee deduction for an individual filer. The sharp phaseout boundary introduces a negative step into the curve, the highlighted areas correspond to ranges of income where an increase in income before tax can result in a decrease of income after tax as shown below.
The vertical step is simply the difference in deduction times the underlying marginal rate. The range of income affected is the vertical step divided by the slope, and the slope is 1 minus the underlying marginal rate. For the example, the vertical step is $2000 * 0.25 = $500, and the affected range $500 / ( 1 - 0.25) = $667.
Of course, the problem is only apparent when looking closely, when looking at a scale much larger than the range calculated above, the bumps in the curve become much less significant, but still present and somehow disturbing.
In the next article we'll see how to avoid these ugly steps, providing a rationale for the solution favored by the IRS.
In simple terms, an increase in your income before taxes should always result in an increase of your income after taxes. Mathematically this means that the marginal tax rate must be smaller than 1 everywhere, and this is clearly not the case at a sharp phaseout boundary.
If income is defined as a continuous variable, the marginal rate is infinite, i.e. there is a positive impulse in the marginal rate at the position of the boundary. Income is of course quantized, and the marginal rate in that case is always finite, but significantly greater than one. In the example discussed in the previous article, the marginal rate was $500 in tax increase divided by $10 of income increase = 50 or 5,000%.
We can visualize that using a graph showing the income after tax in function of the income before tax, based on the characteristics of the fee deduction for an individual filer. The sharp phaseout boundary introduces a negative step into the curve, the highlighted areas correspond to ranges of income where an increase in income before tax can result in a decrease of income after tax as shown below.
The vertical step is simply the difference in deduction times the underlying marginal rate. The range of income affected is the vertical step divided by the slope, and the slope is 1 minus the underlying marginal rate. For the example, the vertical step is $2000 * 0.25 = $500, and the affected range $500 / ( 1 - 0.25) = $667.
Of course, the problem is only apparent when looking closely, when looking at a scale much larger than the range calculated above, the bumps in the curve become much less significant, but still present and somehow disturbing.
In the next article we'll see how to avoid these ugly steps, providing a rationale for the solution favored by the IRS.
Thursday, March 1, 2007
Phaseouts: sharp boundary
Phaseout is the process of decreasing some tax benefits, usually based on an increase in income. This can take the form of reducing the amount of a specific deduction, or to decrease some tax credit.
Phaseouts can take different form, the simplest form is a sharp boundary: if your income exceeds a threshold, then some deduction or credit is no more allowed. This form of phaseout is easy to describe and understand but has unwelcome consequences: it introduces a discontinuity in the tax equation. Most of the phaseouts defined by the IRS have a more elegant form that will examine in a future article, but unfortunately a few sharp boundaries do exist in the tax code.
But why is continuity of the tax curve important? Because otherwise small changes in income can create large changes in tax liability. This can be illustrated by the following scenario: John Tuition has carefully entered all the needed information in some tax preparation software, its total tax comes to X dollars. A little later, he receives an updated 1099 form, where after correction its income increases by $10. No sweat, John opens the saved tax file, updates the relevant field, and sees his tax liability jump by $500!! While unlikely, this scenario is not impossible and obviously rather disturbing
The problem is that John was deducting tuition fees. The phaseout for tuition expenses as defined in Chapter 6 of Publication 970 (2006) goes like this (in the typical IRS verbal description)
So the phaseout has two sharp boundaries that depend on your filing status. If you cross a boundary, the deduction may decrease by $2,000, as it happened to John. The increase in tax liability is the $2,000 step multiplied by the marginal tax rate, 25% for incomes close to the boundary. So John may have reasons to curse who wrote that tax provision, but calling the customer support for the tax preparation software will be fruitless.
And things can go even worse. The increase in tax liability may cascade because this could result in John crossing an other sharp boundary. The IRS starts to assess penalties for underpayment of estimated tax based on a sharp boundary. The underpayment rules are a model of complexity that I may tackle in more detail later on, but the boundary is defined for most people like this in Chapter 4 of Publication 505 (for 2005, no change in 2005 as far as I know)
So the $10 increase in John's income can result in an increase of about $500 in tax liability. That increase can possibly trigger the estimated tax underpayment penalty. Calculating the underpayment penalty is complex, in general you let the IRS figure that out, but it will be a positive value :-). If anybody can provide an estimate for the above scenario, that would be great.
Hopefully the bad consequences of sharp phaseout boundaries are now clear, and the tax code has a solution, tapered phaseouts, with less drastic impact on the tax equation. This will be the subject of the next article
Phaseouts can take different form, the simplest form is a sharp boundary: if your income exceeds a threshold, then some deduction or credit is no more allowed. This form of phaseout is easy to describe and understand but has unwelcome consequences: it introduces a discontinuity in the tax equation. Most of the phaseouts defined by the IRS have a more elegant form that will examine in a future article, but unfortunately a few sharp boundaries do exist in the tax code.
But why is continuity of the tax curve important? Because otherwise small changes in income can create large changes in tax liability. This can be illustrated by the following scenario: John Tuition has carefully entered all the needed information in some tax preparation software, its total tax comes to X dollars. A little later, he receives an updated 1099 form, where after correction its income increases by $10. No sweat, John opens the saved tax file, updates the relevant field, and sees his tax liability jump by $500!! While unlikely, this scenario is not impossible and obviously rather disturbing
The problem is that John was deducting tuition fees. The phaseout for tuition expenses as defined in Chapter 6 of Publication 970 (2006) goes like this (in the typical IRS verbal description)
If your modified adjusted gross income (MAGI) is not more than $65,000 ($130,000 if you are married filing jointly), your maximum tuition and fees deduction is $4,000. If your MAGI is larger than $65,000 ($130,000), but is not more than $80,000 ($160,000 if you are married filing jointly), your maximum deduction is $2,000. No tuition and fees deduction is allowed if your MAGI is larger than $80,000 ($160,000).
So the phaseout has two sharp boundaries that depend on your filing status. If you cross a boundary, the deduction may decrease by $2,000, as it happened to John. The increase in tax liability is the $2,000 step multiplied by the marginal tax rate, 25% for incomes close to the boundary. So John may have reasons to curse who wrote that tax provision, but calling the customer support for the tax preparation software will be fruitless.
And things can go even worse. The increase in tax liability may cascade because this could result in John crossing an other sharp boundary. The IRS starts to assess penalties for underpayment of estimated tax based on a sharp boundary. The underpayment rules are a model of complexity that I may tackle in more detail later on, but the boundary is defined for most people like this in Chapter 4 of Publication 505 (for 2005, no change in 2005 as far as I know)
In general, you may owe a penalty for 2005 if the total of your withholding and estimated tax payments did not equal at least the smaller of:
1. 90% of your 2005 tax, or
2. 100% of your 2004 tax. (Your 2004 tax return must cover a 12-month period.)
So the $10 increase in John's income can result in an increase of about $500 in tax liability. That increase can possibly trigger the estimated tax underpayment penalty. Calculating the underpayment penalty is complex, in general you let the IRS figure that out, but it will be a positive value :-). If anybody can provide an estimate for the above scenario, that would be great.
Hopefully the bad consequences of sharp phaseout boundaries are now clear, and the tax code has a solution, tapered phaseouts, with less drastic impact on the tax equation. This will be the subject of the next article
Tuesday, February 27, 2007
Digression: first comment
I got my first comment, but unfortunately it is rather scathing. Obviously, I missed my goal, possibly even achieving an effect contrary to the expected one: obfuscating instead of enlightening :-(
The strange thing though is that researching the subject has unearthed different papers that essentially use the approach I want to follow. I guess this is not the approach per se that is wrong, but my own take on it. I'll try to realign my presentation towards a more concise and elegant approach as suggested by the anonymous scholar.
On a side note, comments are always welcome, even negative ones. You cannot get better if you don't know your bad points. Constructive criticism is obviously preferable to a blanket repudiation, but I'm afraid I'm not the one calling the shots. But in some other ways, a blog can be seen as a form of mental masturbation, so I'll continue even if I fail in my stated goal, I can still enjoy the act of writing itself
My (restated) goal is to construct a simple mathematical expression that calculates the tax owed in function of all necessary parameters. I found in "Effective Federal Individual Income Tax Functions: an Explanatory Empirical Analysis" a citation that summarizes the approach I want to follow in a concise way: "... a tax law is a mapping from a vector whose elements are the income characteristics of the individual (wage income, dividends, capital gains, and all the other items in the income tax form) to tax liabilities. It is supposed to be a well defined function; ..." taken from Arrow, Kenneth J. "Microdata Simulation: Current Status, Problems, Prospects." in Microeconomic Simulation Models for Policy Analysis, New York: Academic Press, 1980.
I want to construct this mapping. This mapping is simple in the sense that it only uses elementary operations, the final form is piecewise linear and mostly continuous, this sounds simple to me and I want to expose this simplicity for everybody to see
The strange thing though is that researching the subject has unearthed different papers that essentially use the approach I want to follow. I guess this is not the approach per se that is wrong, but my own take on it. I'll try to realign my presentation towards a more concise and elegant approach as suggested by the anonymous scholar.
On a side note, comments are always welcome, even negative ones. You cannot get better if you don't know your bad points. Constructive criticism is obviously preferable to a blanket repudiation, but I'm afraid I'm not the one calling the shots. But in some other ways, a blog can be seen as a form of mental masturbation, so I'll continue even if I fail in my stated goal, I can still enjoy the act of writing itself
My (restated) goal is to construct a simple mathematical expression that calculates the tax owed in function of all necessary parameters. I found in "Effective Federal Individual Income Tax Functions: an Explanatory Empirical Analysis" a citation that summarizes the approach I want to follow in a concise way: "... a tax law is a mapping from a vector whose elements are the income characteristics of the individual (wage income, dividends, capital gains, and all the other items in the income tax form) to tax liabilities. It is supposed to be a well defined function; ..." taken from Arrow, Kenneth J. "Microdata Simulation: Current Status, Problems, Prospects." in Microeconomic Simulation Models for Policy Analysis, New York: Academic Press, 1980.
I want to construct this mapping. This mapping is simple in the sense that it only uses elementary operations, the final form is piecewise linear and mostly continuous, this sounds simple to me and I want to expose this simplicity for everybody to see
Sunday, February 25, 2007
Tax credits
While deductions and exemptions reduce your income, credits directly reduce your tax itself. As such credits are better, their effect doesn't depend on the marginal rate. Formally, the effect of credits can be reflected in a new tax equation.
with
* C, a vector of Credits
* T1, the tax equation defined before
The most important credit is the earned income tax credit (EITC). The EITC is a very special tax credit, it is refundable, in other words if you end up with a negative tax, the government will effectively send you back some money. Note that this is different from a refund, the EITC is only valid for low income taxpayers and correspond to a work incentive, in a certain range of income, the government chips in some extra money towards your disposable income. The EITC is one of the largest aid programs, as mentioned in "Behavioral Responses to Taxes: Lessons from the EITC and Labor Supply"
The next figure is extracted from the same document (based on values provided in table 13-14, Green Book, 2004, Joint Committee on Taxation, Ways and Means Committee) and shows the evolution of the EITC. To put things in perspective, the total amount of individual tax liability is about 800 billions in 2003.
As alluded, the EITC increases with an increase in income, mathematically this means negative marginal rates, i.e. your tax decreases (in this case becomes more negative) as your income increases. The exact rates are variable and depend on the phaseout characteristics of the EITC, this will be discussed in the more general article on phaseout effects.
with
* C, a vector of Credits
* T1, the tax equation defined before
The most important credit is the earned income tax credit (EITC). The EITC is a very special tax credit, it is refundable, in other words if you end up with a negative tax, the government will effectively send you back some money. Note that this is different from a refund, the EITC is only valid for low income taxpayers and correspond to a work incentive, in a certain range of income, the government chips in some extra money towards your disposable income. The EITC is one of the largest aid programs, as mentioned in "Behavioral Responses to Taxes: Lessons from the EITC and Labor Supply"
In fact, the EITC is the largest cash transfer program for lower-income families at the federal level. An unusual feature of the credit is its explicit goal to use the tax system to encourage and support those who choose to work.
The next figure is extracted from the same document (based on values provided in table 13-14, Green Book, 2004, Joint Committee on Taxation, Ways and Means Committee) and shows the evolution of the EITC. To put things in perspective, the total amount of individual tax liability is about 800 billions in 2003.
As alluded, the EITC increases with an increase in income, mathematically this means negative marginal rates, i.e. your tax decreases (in this case becomes more negative) as your income increases. The exact rates are variable and depend on the phaseout characteristics of the EITC, this will be discussed in the more general article on phaseout effects.
Saturday, February 17, 2007
Deductions and equity
The presence of deductions has a nasty side effects, both the average and marginal tax rates becomes dependent on the deductions one can claim for a given level of income. The new tax equation is easily derived in function of the previous equation
with
* D, a vector of deductions
* E, a vector of exemptions
* T0, the tax equation defined before
The rates at a given income are now dependent on the deductions and exemptions. In other words, two taxpayers with the same income and filling status can be taxed wildly differently, based on which deductions and exemptions apply to them. Obviously also, people are aware of this and may adapt their lifestyle to maximize deductions, at least when possible. This is in some sense, why deductions are introduced in Congress, but sometimes with unintended side effects.
An obvious side effect is to introduce societal tensions between people able to claim specific deductions and people unable to claim them. A second side effect is the complexity of the rules needed to administer the different deductions, impacting both the taxpayer and the IRS.
An extreme example compares the federal tax and corresponding average tax rate for two couples filling jointly in the figures below. The first couple has no kid and don't itemize deductions, the second couple has three kids and itemize major deductions that scale as a percentage of the income: 7% state tax, 25% of mortgage interest and 7.5% of medical expenses (their total medical expenses is 15% of income, the first 7.5% cannot be deducted).
Because in this model the deductions are proportional to the income, the two curves diverge, asymptotically the ratio between the marginal rates is 1 - the total percentage of deductions, or about 0.6 in the example. It is a matter of discussion if such a difference makes sense, i.e. is it equitable to favor specific behaviors though differences in taxation rates?
And the difference is huge, the next figure shows the ratio between the tax paid by the couple with three kids and using aggressive deductions and the tax paid by the couple with no kid and using the standard deduction. The ratio never even reaches 50% for the range of income considered here, with the asymptote at 60% as explained before.
Deductions can so much reduce the tax paid that two different mechanisms are in place to avoid their abusive use: phaseouts and the Alternate Minimum Tax (AMT). Both of these will be discussed later on, after an article on tax credit.
with
* D, a vector of deductions
* E, a vector of exemptions
* T0, the tax equation defined before
The rates at a given income are now dependent on the deductions and exemptions. In other words, two taxpayers with the same income and filling status can be taxed wildly differently, based on which deductions and exemptions apply to them. Obviously also, people are aware of this and may adapt their lifestyle to maximize deductions, at least when possible. This is in some sense, why deductions are introduced in Congress, but sometimes with unintended side effects.
An obvious side effect is to introduce societal tensions between people able to claim specific deductions and people unable to claim them. A second side effect is the complexity of the rules needed to administer the different deductions, impacting both the taxpayer and the IRS.
An extreme example compares the federal tax and corresponding average tax rate for two couples filling jointly in the figures below. The first couple has no kid and don't itemize deductions, the second couple has three kids and itemize major deductions that scale as a percentage of the income: 7% state tax, 25% of mortgage interest and 7.5% of medical expenses (their total medical expenses is 15% of income, the first 7.5% cannot be deducted).
Because in this model the deductions are proportional to the income, the two curves diverge, asymptotically the ratio between the marginal rates is 1 - the total percentage of deductions, or about 0.6 in the example. It is a matter of discussion if such a difference makes sense, i.e. is it equitable to favor specific behaviors though differences in taxation rates?
And the difference is huge, the next figure shows the ratio between the tax paid by the couple with three kids and using aggressive deductions and the tax paid by the couple with no kid and using the standard deduction. The ratio never even reaches 50% for the range of income considered here, with the asymptote at 60% as explained before.
Deductions can so much reduce the tax paid that two different mechanisms are in place to avoid their abusive use: phaseouts and the Alternate Minimum Tax (AMT). Both of these will be discussed later on, after an article on tax credit.
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