Wh What Youll ll Learn arn Today ay Re Review: how taxation - PDF document

Smoothing Consumption in a World With Taxes Aa Aaron Stevens EC1 EC171 71 13 October 2011 1 Wh What You’ll ll Learn arn Today ay • Re Review: how taxation works. • Do Does it pay to work? • Ho How do taxes affect the lifetime budget con constr strai aint? t? • Ho How can we smooth co consumption in a wo world wi with taxes?

Revi Review ew: Ta Tax Calcul culation on Ex Exampl mple Ma Married couple. Wages of $85,000. Wh What is the taxable income? (line 6 = line 4 4 - line 5) $85, $85,000 000 - $1 $18, 8,700 700 = $66, $66,300 300 Wh What is the tax due? 15 15% of of (66,300 - $16,750) + + $1675 = = 0.15 * * $49,550 + + $1675= = $9107.50 Wh What is the marginal tax rate? 15 15% Wh What is the ef effective tax rate? 11% 11% Thef Theft in n the he Wor orkpl place ce JACKIE: I know in orientation we talked about theft in the workplace, so I would like to report a theft - from my check! Now, I don't know who FICA is, but that bitch stole like 10% of my money.

Pa Payrol oll Ta Taxes JACKIE: I know in orientation we talked about theft in the workplace, so I would like to report a theft - from my check! Now, I don't know who FICA is, but that bitch stole like 10% of my money. FICA: The e Fed eder eral Insurance e Contributions Act You and your emp employer er ea each pay: • 6.2 .2% fo for Social Sec ecurity, on wages es to $1 $106,800 • 1.4 .45% fo for Med edicare, e, on all wages es (no limi mit) This is a total of f 15.3 .3% tax on payrolls. Total & Tot & Ef Effect ective ve Ta Tax Ra Rates es Tax r x rate te on on next $ xt $1 of of in income come Taxe xes Tota otal I Income come Exa xamp mple: Exa xamp mple: $60,000 $60,000 income come $320,000 $320,000 income come

Di Different Types of Income It It’s not what you ea earn, it’s s ho how you ea earn it. Examp Ex mple: e: • Engineer earning $110,000 per year. • Hedge fund manager earning $10,000,000. • Warren Buffet, earning $100,000 per year; change in net worth: $10,000,000,000. Top marginal tax rate on wage (W2) income: 35% Top tax rate on dividends and capital gains: 15% Top tax rate on unrealized capital gains: 0% Di Different Types of Income It It’s s not just what you earn, it’s s how you earn it! Engineer earning $110,000 per year. Federal Tax: $22,728 (20.8% effective rate) Payroll Taxes: $8222 (7.47% effective rate) Total Effective Tax Rate: 28% Hedge fund manager earning $10,000,000 per year. Federal Tax: $1,500,000 (15% capital gains rate) Payroll Taxes: $0 Total Effective Tax Rate: 15% Warren Buffet, earning $100,000 per year. Change in net worth: $10,000,000,000. Federal Taxes: 19,928 Payroll Taxes: $7650 Total Effective Tax Rate: 0.0000027578%

Uncl Uncle e Sa Sam an and Cy Cy + S S = W – Ty Ty + + By By Taxes when Taxes when Benefits Benefits Young Young when Young when Young Co = S Co S + rS rS – T To + + Bo Bo Benefits Benefits Taxes when Old Taxes when Old when Old when Old Uncl Uncle e Sa Sam m Ta Takes es Some Some and nd Gi Gives Some Some  Ai Aid to fami milies with De Dependent Children  Fo Food S d Stamps; E s; Energ rgy A Assi ssist stance ce; H ; Housi sing A Assi ssist stance ce; M ; Medi dica caid. d.  Soc Social al Sec Secur urity ty • re retire rement b benefi fits • sp spousa sal b benefi fits • Wi Widow/widower benefi fits • di disab sability b ty ben enefits efits • Di Divorce benefi fits

Do Does it Pay to Wo Work? "D "Does It Pay, at the he Margin, to Work and Save? Measuring Effective Ma MarginalTaxes on on Americans' Labor Supply and Savings," NBER Volume, MIT Press, Volume 21, 2007 Do Does it Pay to Wo Work? "D "Does It Pay, at the he Margin, to Work and Save? Measuring Effective Ma MarginalTaxes on on Americans' Labor Supply and Savings," NBER Volume, MIT Press, Volume 21, 2007

Ne Net Margi gina nal Ta Tax Rates As As income increases benefit fits are lo lost, phased out or subject to to ta taxati tion. on. Do Does it Pay To Work? ht http://www.ncpa.org org/pub/st258?p ?pg=4 Uncl Uncle e Sa Sam: m: Your Your Li Lifet etime me Si Silent nt Bus Busine ness Pa Partne ner You You ar are e the the CEO CEO of of You, You, Inc. Inc., a a sol ole pr propr oprietor etorshi hip p with th li lifetime assets, income, and and expens expenses es. Uncl ncle e Sam Sam is your your par partner tner. Cy Cy + + S S = = W – Ty Ty + + By Co Co = = S S + + rS rS – T To + Bo Cy Cy + + Co/( Co/(1+r +r) = W–[Ty Ty+T +To/(1+r)-By -Bo/(1+r)] H Uncle e Sam’s lifet fetime me net et tax take

Ca Case #1: A A Flat Tax H d doesn’t t depend on what you do. Ta Taxes es on on Asset sset Income ncome As Assets are the accumu mulation of sa savings. Assets earn income As me (dividends, interest, cap capital tal gai gains, s, r ren ents) ts) w whi hich i ch is taxab s taxable. e. • Ta Taxes create a disincentive to saving!

Ca Case #2: Cu Current System H c can depend on what you do. Th The e mor ore e you you SA SAVE, E, th the e mor ore e taxes taxes you you PA PAY. Y. Wh Which Co Comes First? What you can spen end (now and later er) dep epen ends on your fu future e taxes es… … but your fu future e taxes es dep epen ends on what you are going to spen end today and how mu much your save. e.

How How do do we sol olve the hese pro probl blem ems? s? Cy + + Co/(1+r +r) = = W– H( H(Cy) How Mu Much Uncle Sam Taxes De Depends On C y Guess! Su Suppose Yo You Want Cy= = Co Keep Cy Cy + + Cy/ Cy/(1+ 1+r) = = W– H( H(Cy) Trying… Gu Guess until RHS= RHS=LHS HS Excel Excel model odel Build Bui d co consum umpt ption smoothi hing g model del in Excel Excel Show: Income taxes: calculated by 1040EZ Labor Labor Incom ncome e is s gi given ven As Assets = accumulation of savings Asset Income = Assets * Interest Rate Savings = Labor Income + Asset Income - Taxes - Consumption Consumption: plug in value, use solver.

Exa Exampl ple: e: Middl ddle e Incom ncome … Exa Exampl ple: e: High gh Incom ncome

Bo Borrowi wing Co Constraints No Notice about hi high- h-income earner: -pays pays a a lot ot of of tax axes es -must save a lot to maintain high standard of living -Consumption is actually only 1/3 or so of final income -In the real world, borrowing constraints limit smoothing! Bo Borrowi wing Co Constraints 2/3 2/3 of Am Amer erican can ho hous useho eholds ds ar are e bo borrowing g co constrai ained ed pr prior to to reti tirement. nt. What t doe oes s th this s mean? n? Budget line is Budget line is ki kinke ked.

Bo Borrowi wing Co Constraints To be borrowing constrained means that you cannot smooth consumption without borrowing. When you have borrowing constraints, no one will lend to you! Some violations of borrowing constraints: - credit cards - pawn shops, car title loans, payday loans - student loans Wh What You Learned Today • Re Review: how taxation works. • Ta Taxes are a drag. • Th The more you ac accumulate savings, the more you pay in taxes! mo • Co Consumption smoothing requires solving mu multiple equations at once. •Bor Borrow owing ng cons onstr trai aints nts ma make it hard to sm smooth co h consu sumption fo for a r all y years. rs.

Announc Announceme ment nts and nd To o Do Do Re Readings: • STTE: E: ch ch 1, 1, 2, 3, 5, 6, 8 (fo for nex ext Tues esday) • Chec eck out ww www.esplanner er.com/ m/basic • we we wi will be begin to discuss in class on Tuesday. • Homew mework 5: Assigned ed 10/18, due e 10 10/25.