SAN JOSÉ STATE UNIVERSITY
ECONOMICS DEPARTMENT
Thayer Watkins
The Personal Income Tax is a major source of revenue for the
Federal and state governments, and for a few local governments,
mainly major cities. The effect of these income taxes depends
not only up on the tax rates but also the definition of taxable
income. Tax payers are only concerned with a definition of
income that reduces their income tax but economic analysis must
be concerned with the logical basis of such definitions.
First we will consider the definition of taxable income according
to the Internal Revenue Service (IRS) code. This changes from
time to time; the following definition pertains to the definition
in the mid-1990's.
Taxable Income, according to the IRS, is Adjusted Gross Income
(AGI) minus Personal Exemptions and Allowed Deductions. Adjusted
Gross Income is defined as Gross Receipts from Taxable Sources less
Adjustments. Gross Receipts from Taxable Sources include:
- Earned Income (wages, salaries, tips and fringe benefits
not exempted from tax)
- Income from Property (rents, dividends, interest, royalties
and net realized capital gains)
- Pensions and retirement allowances
- Some transfer payments (unemployment compensation, part of
social security benefits, and some disability payments)
- Prizes and awards, unless exempted
- Alimony other than for child support
The allowed adjustments include:
- Reimbursed employee expenses
- Contributions to Keogh retirement plans
- Part of health insurance expenses for the self-employed
- Alimony paid
The personal exemption was $2550 in 1996 for the taxpayer,
spouse and each eligible dependent. The allowed deductions can
be the standard deduction (in 1996, $4000 for single taxpayer,
$6700 for married taxpayers filing jointly) or itemized deductions.
The itemized deductions include:
Charitable donations (up to 50% of AGI)
- Interest payments on mortgages and home equity loans
- State and local income taxes
- State and local property taxes
- Uninsured medical expenses (in excess of 7.5% of AGI)
- Property losses (in excess of 10% of AGI)
Up to the 1980's state and local sales taxes were deductible.
In contrast to the above definition of taxable income there is
the following definition that attempts to formulate a theoretically
correct definition of income.
Personal and Business Income in Principle
Personal Income in Principle is called Haig-Simon Income
Haig-Simon Income over a time interval is equal to:
- the value of goods and services consumed during that interval
- plus
- the change in net worth (assets less liabilities) between the beginning
and end of the interval.
Business Income in Principle
Business income in principle (BIP) is defined as:
- the receipts of the firm, R
- less the sum of
- the cost of inputs, W
- the real interest payments to creditors, rB
- economic depreciation, D
BIP = R - W - rB,
where B is the firm's debt and r is the real interest rate,
the nominal interest rate minus the rate of inflation
Economic Profit
Economic Profit is:
- the receipts of the firm, R
- less the sum of
- the cost of inputs, W
- the user cost of capital, C
Econ Profit = R - W - C,
where C = r(B+E)+D and E is the firm's equity and D is depreciation.