She files her own income tax return declaring the income she earns each year. Because she doesn't make a huge amount of money, her top marginal tax rate is usually 10% or 15% on her work income.
Suppose she writes a great senior thesis and wins a prize of $3,000 for it.
Aha! Gotcha! Her marginal tax rate on that senior thesis prize could be a lot higher than 10% or 15%. It could wind up as high as her parents' top marginal tax rate, potentially as high as 35%. She isn't going to be able to keep as much of that $3,000 as she thought she could.
Who and what does she have to thank for that? Congress and PAYGO.
"What's PAYGO?" you might be asking yourself. "And what does it have to do with the taxes on Jane's senior thesis prize money?"
In tomorrow's public finance class, we'll be discussing the history of Congress's many attempts to discipline itself to restrain deficit spending by imposing various constraints on itself requiring legislation to be "revenue neutral." Sometimes these constraints are referred to as PAYGO rules. Here's an example of a PAYGO resolution Congress imposed on itself in January 2007:
It shall not be in order to consider any bill, joint resolution, amendment, or conference report if the provisions of such measure affecting direct spending and revenues have the net effect of increasing the deficit or reducing the surplus for either the period comprising the current fiscal year and the five fiscal years beginning with the fiscal year that ends in the following calendar year or the period comprising the current fiscal year and the ten fiscal years beginning with the fiscal year that ends in the following calendar year.
What does this mean? It means that the House of Representatives (where all tax and spending bills must originate, according to the Constitution) would not allow any bill to come to the floor for a vote if it increased the deficit. If a bill had a provision that cut taxes or increased spending in some area, the same bill had to include other provisions that increased taxes somewhere else or decreased spending in some other area.
The Congressional Budget Office (CBO) is the scorekeeper. If the CBO says the bill will increase the 5-year deficit or 10-year deficit, then a PAYGO rule says it has to go back to the drawing board before it can come to a vote.
Professor James Maule of Villanova Law School provides a great example of how that January 2007 PAYGO rule wound up reallocating tax burdens that hit home for some college students like Jane.
Public Law 110-28. It’s called the U.S. Troop Readiness, Veterans' Care, Katrina Recovery, and Iraq Accountability Appropriations Act, 2007, though people are calling it the Iraq Appropriations Act. Buried in it is the Small Business and Work Opportunity Tax Act of 2007. Isn’t it absurd how Congress puts Acts within Acts? I suppose it’s some sort of Russian doll syndrome.
Why should this hit home for college students?
As Prof. Maule points out, the Small Business and Work Opportunity Act allowed small businesses increased opportunities for first-year tax deductions when they invest in capital equipment for their businesses.
What does this have to with college students?
Stay with me here.
Guess what they decided to do as part of the way to make up for the tax loss in order to satisfy PAYGO?
They expanded the "Kiddie Tax," which means that college students up to age 24 can now wind up paying taxes on their unearned income at their parents' top marginal tax rate, rather than at their own marginal tax rate. This rule can sometimes apply even when the student is not even a dependent of the parent, even if the parent gives the student no money at all.
What counts as "unearned income"? For Kiddie Tax purposes, unearned income is defined as any income other than wages or self-employment income.
Of course, that includes interest, dividends, and capital gains income, all of which were intended targets of the Kiddie Tax.
However, the Kiddie Tax also applies to other types of income a college student might receive including prizes (everything from game show winnings to academic prizes such as Jane's prize for a great senior thesis), unemployment benefits, jury duty pay, hobby income.
Later in 2007, Congress gave up on trying to adhere to PAYGO when they were trying to patch the Alternative Minimum Tax (AMT).
But college students under age 24 are still subject to the Kiddie Tax. You might be paying your own marginal tax rate of 10% or 15% on your wage income, but the rate you pay on your unearned income could be as high as your parents' topic marginal tax rate.
And college students like Jane have PAYGO to thank for that.
Why is it called PAYGO, by the way? Jane might think that PAYGO means that some of her "PAY" for her senior thesis prize is GOing to the government.
But actually PAYGO is short for "PAY as you GO." It means that if the government wants to spend money and/or cut taxes, it has to find a way to PAY for that spending or cuts as they GO, i.e., within the same legislative bill.
But it's still not enough to address the growing deficits, because Congress is free to vote to bypass PAYGO rules whenever they feel the need to do so.