Bed buffaloes in your tax code

Tax season 2012 in upstate New York

2012-01-28T08:05:00.000-08:00

Cows down the road from us from two days ago

Not much snow yet this season.

There's a farm down the road from our house. In over two decades of living here, we have never seen the cows out in January before! That's because there is usually far too much snow cover for them to graze outdoors. Normally they disappear inside the barn by early December and do not reappear again until June, by which time new grass has reestablished strong enough roots to stand up against their trampling. So we have never seen cows during tax season before. My husband was sufficiently surprised to see the cows out in late January that he shot the photo above.

So it was funny to see today's Google doodle:

Today's Google doodle!

However, snow does not deter the hardy buffalo from grazing. See here and here.

Warren Buffett's secretary does NOT have to make $30,000 to pay a higher effective average federal tax rate than he does!

2012-01-26T07:53:00.000-08:00

My very distinguished former colleague, Professor Paul Gregory of the University of Houston, believes that Warren Buffett's secretary probably makes $200,000 to $500,000 in salary in order for Warren Buffett's claim to be true that she pays a higher average effective federal tax rate than he does.

More unadulterated nonsense!

VITA sites serve taxpayers with incomes under $50,000 and we see many taxpayers who pay more than 20% of their incomes in federal income and payroll taxes.

$20,000 in pay would make Buffett correct!

Yes, taxpayers with young children often pay much less than that and retired taxpayers pay much less than that, but working taxpayers who do not have young children living with them pay much higher rates. With all due respect, Warren Buffett's secretary looks like she is past the age where she is likely to have young children living at home.

Warren Buffett clearly stated that his claim was about the total amount of federal income and payroll taxes paid on his income compared to that paid on his employees' income.

Warren Buffett has stated that his Adjusted Gross Income was $62,855,038 in 2010, producing an income tax liability of $6,923,494 and a payroll tax bill of $15,300. That adds up to an effective average combined tax rate 11% of his adjusted gross income.

Of course, privacy rules do not allow me to discuss the tax situations of the particular individual real life individual taxpayers who use our VITA site. But I can say that VITA sites like ours see many taxpayers with incomes in the $20,000 to $50,000 range who pay more than 11% in combined federal income and payroll taxes.

Let's take the very first case study in the VITA workbook, Rose Hudson. (The picture below comes from the IRS website.) Rose is hypothetical but very representative of the single most common type of taxpayer we see at a VITA site, a single taxpayer with no dependents, with income primarily from wages reported on a W-2.

Rose Hudson: AGI $32,000 combined effective federal tax rate 24% of AGI

Rose is a waitress, with wages and tips of $31,915 last year. She also earned $36 in savings accounting interest. Using standard Congressional Budget Office (CBO) assumptions about the incidence of payroll taxation, which assumes that both portions of the Social Security tax burden fall on the employee, the payroll tax bill was $4,873. Rose's income tax liability was $2,946. Adding those two figures together gives us an average effective federal combined tax rate of 24% of AGI.

Of course, we could quibble about the denominators. When Warren Buffett originally stated his effective tax rate, he quoted 17% for his own tax rate, which used taxable income as the denominator rather than AGI. If we use the same denominator of taxable income for Rose's effective average tax rate, we get 35% for her!

Ideally, we would actually use a much broader measure of income than either AGI or taxable income, the Haig-Simons definition of income. For Rose, her Haig-Simons income might include some tax-free fringe benefits. Warren probably gets some of those as well, but he likely has an even bigger component of Haig-Simons income which is missing from his AGI, namely his UNrealized capital gains.

Anyway you slice it, a secretary or waitress earning a modest amount of income ($30,000 or so), pays a much larger combined effective federal tax rate than Warren Buffett does, unless she lives with "qualifying children".

Union College VITA team 2012

2012-01-22T15:18:00.000-08:00

This year's Union College VITA students have set new standards of excellence. All have passed both the basic and intermediate level IRS certification exam for VITA preparers in record-breaking time. This is the first time ever that 100% of our students were intermediate level certified one full week before our VITA site officially opens. All of them have also completed the core economics classes in intermediate microeconomics and econometrics. Collectively, they bring a great deal of energy and a wonderful diversity of talents, interests, backgrounds, and perspectives to our service-learning class in tax policy and practice this year.

First row in photo:

Katie Manko, senior majoring in Asian studies and economics, from Winchester, Massachusetts.

Yohanny Vargas, senior majoring in managerial economics, with a minor in anthropology, from Brooklyn, New York. Yohanny's campus leadership roles include serving as president of Union's economics club as well as leading the Circulo Estudiantil Latino Americano (CELA). She has interned at Merrill Lynch's Private Wealth Management division. For more about Yohanny, see here.

Brian Karimi, senior majoring in economics and philosophy, from Hingham, Massachusetts. Brian is on the editorial staff of Union's student newspaper, Corcordiensis. His articles can be read here.

Lawrence Hung, senior majoring in economics, from Queens, New York.

Yiran Zhang, senior majoring in managerial economics, from Suzhou, China.

Dandan Zhang, junior majoring in arts, from China.

(Yiran and Dandan continue a wonderful tradition of Union VITA students from China, launched by Christina Yu Chen in 2009.)

Second row in photo:

Sam Solomon-O'Connell, junior majoring in managerial economics, from Suffern, in Rockland County, New York. Sam spent the fall term on Union's term abroad in Belgium.

David Sorensen, junior majoring in economics, from Mount Kisco, New York. David is the latest in a long dynasty of great members of the Union College swimming team to be part of our VITA program, starting with Ashley Braniecki in 2008, followed by Sarah Yergeau in 2010, and Andrea Marois in 2011.

Matt Petrone, junior majoring in economics, from Utica, New York. Matt is a member of Union's basketball team, continuing a great tradition of excellence in juggling the demands of the basketball season and tax return preparation started by Lauren McCormick two years ago.

Habib Kamara, junior majoring in managerial economics, from Poughkeepsie, New York.

Colin Knox, junior majoring in economics.

Jigme Norbu, sophomore planning a double major in math and economics, with a minor in Japanese. Jigme is from the Himalayan kingdom of Bhutan.

Jacob Berman, a senior majoring in psychology, from Scarsdale, in Westchester County, New York.

And the prize for "least helpful error diagnostic message" goes to:

2012-01-21T14:48:00.000-08:00

The screenshot above is the entire TaxWise error message for New York State efile error code 0911. How reading the word "Reserved" is supposed to help me "find and fix errors" is beyond me.

Our VITA site submitted six efiled tax returns late Thursday night/early Friday morning. They went to the IRS as "Modernized e-file" (MeF for short) and to New York State as "Legacy" (the euphemism for "not yet modernized.)

The IRS promptly accepted and acknowledged all six returns, within a few minutes of submission. Yay! The federal refunds are working their way through the system. Direct deposits should go to taxpayer bank accounts in less than two weeks. Paper checks to those taxpayers who requested them should go out about a week after the direct deposit date.

New York acknowledgements came through about 36 hours after submission. New York State accepted two of the returns and rejected four returns, all with the mysteriously inscrutable "error code 0911."

This is unprecedented. We have never had more than a very occasional or isolated reject in the past, certainly never two-thirds of the returns! Indeed, we typically go weeks without getting rejects and then--once in a blue moon--we get one.

And on the rare past occasions where we have gotten rejects, there has been a clear explanation of the error code. The most common cause of past rejects is that another taxpayer had already--wrongly--claimed the same dependent on his/her return that our client had rightfully claimed. If the wrongful claimaint beats the rightful claimant in the race to efile, the rightful claimant is forced to paper-file the return, and eventually the IRS sorts it all out.

In the case of the 0911 efile coded rejects received today, I am sure that dependents are not the issue, since some of the rejected returns did not have even claim any dependents, and moreover all of the returns in question had already sailed through the IRS. (New York State does not even track the SSNs of dependents on its returns, so it apparently relies on the IRS to catch double-claimed dependents.)

After checking with the TaxWise user discussion boards, I found reports from several other sites getting the same message.

Update: I found a very helpful link to a complete set of NYS reject explanations online here. That PDF on the NYS Tax Department website contains a much more helpful explanation of the 0911 error code (screenshot below) than TaxWise shows in its error screen (screenshot above):

What I believe is happening is that when the preparer clicks the button to "Deposit the NYS refund to the same bank account where the federal refund was deposited," TaxWise is somehow not transmitting that bank account information in a way that the New York State tax department computers can understand.

TaxWise reports that they are "aware of the problem and working on it," according to a user message posted on the TaxWise discussion boards. My guess is that there is an easy fix for the problem.

It is a bit ironic, though, because New York State is really trying to push taxpayers to get their refunds by direct deposit these days, and yet the returns that requested a paper check sailed through through the acceptance process, while the returns requesting direct deposit were held up.

Still, I feel reasonably confident that the problem will be resolved quickly and taxpayers who requested their refunds via direct deposit will still get them sooner than those who requested a paper check.

Unadulterated nonsense!

2012-01-18T20:40:00.001-08:00

The Tax Foundation's Scott Hodge writes:

The table also shows the average, or effective, tax rate that taxpayers in each income group pay. For the entire universe of American taxpayers, the average tax rate is 11 percent of our AGI. The highest average tax rate paid by anyone earning under $100,000 is 8 percent. That shows the power of the sundry tax credits available to the "middle-class."

The first two sentences are correct, if we accept the legitimacy (and practical necessity, in most cases) of using AGI as the appropriate denominator for measuring effective average tax rates, and if we focus solely on income taxes, rather than payroll taxes.

But the third sentence is unadulterated nonsense.

It is simply not true that "The highest average tax rates paid by anyone earning under $100,000 is 8 percent."

There are many, many individual taxpayers earning under $100,000 who pay more than 8% of their AGI in federal income tax. A taxpayer earning that amount who does not own a home (and therefore does not itemize) and who is unable to claim dependent children (even though he may be supporting elderly relatives and/or paying large amounts of his income in child support for children who live with a former spouse) can easily have an effective tax rate much higher than 8%.

As an illustration, lets take the case of Rose Hudson, the very first taxpayer in the VITA workbook this year, a simple scenario meant to be representative of a taxpayer who might use the services of a VITA site. She had an AGI of $31,951 and federal income tax liability of $2,946. That is an effective tax rate of 9.2%. Give her a $10,000 raise and her effective average tax rate goes to 10.6% on an income of $41,951. Give her a $20,000 raise and her effective average tax rate goes to 13% on an income of $51,951. Give her a $40,000 raise and her effective average rate goes to 16% on an income of $71,951. Give her a $60,000 raise and her effective average rate goes to 18.2% on an income of $91,951.

Warren Buffett has said that his effective average tax rate (for federal income and payroll taxes combined) is only 11% of his AGI. Rose pays that even before she hits $50,000 in income. And we have not even considered the additional 13% of her income that Rose Hudson pays in federal payroll tax on top of her federal income tax (using standard CBO incidence methodology.) If we include payroll tax, Rose's effective federal tax rate (payroll and income rates combined) exceeds Warren Buffett's rate even before she hits $20,000 in income.

And of course, we have not considered the myriad of other taxes that low and moderate income Americans disproportionately pay--either directly or indirectly (embedded in other taxes), including federal and state excise taxes on gasoline, airline tickets, alcohol, and tobacco; general sales taxes; state and local income taxes; and property taxes (borne partially by renters in the form of rents that are higher than they otherwise would be.)

But returning to the federal income taxes that were the subject of the article that spurred this post, many low and moderate income taxpayers with incomes well below $100,000 pay more than 8% of their income in taxes.

Even if we give our workbook example of Rose Hudson a couple of elderly relatives as dependents, her tax rate will be higher than 8% as soon as her income gets close to $40,000.It is complete nonsense, therefore, to say that "The highest average tax rates paid by anyone earning under $100,000 is 8 percent."

There is an enormous amount of variability in effective average tax rates among taxpayers earning under $100,000. Some taxpayers have extremely negative average effective income tax rates (around -40% for the lowest income working taxpayers, if they have a few "qualifying children" in their home), while others with incomes under $100,000 pay effective average federal income tax rates of close to 20% (even if they are the ones actually supporting those "qualifying children.")Taxpayers in the latter group are understandably aggrieved when they read inaccurate statements that nobody in their income group pays more than 8% of their income in taxes.

The original statement would be true if reworded more carefully--to refer to any "aggregated income group category" rather than to "anyone".

There is a huge amount of unacknowledged horizontal inequity hidden within group averages.

Eighth commandment: Thou shalt beware that not all dependents are created equal!

2012-01-07T12:32:00.000-08:00

There are four types of exemptions included in the total number of exemptions on Line 6 of the 1040, but some types of dependent exemptions are worth more than other types of dependents.

Beware! Not all dependents are created equal!

Let's take a closer look at the right hand side of the exemption section of the 1040 to see the different possible types of exemptions.

Personal exemptions for the taxpayer (and spouse, if applicable) go in the top box.

"Qualifying Children" dependent exemptions who lived with the taxpayer go in the second box.

"Qualifying Children" dependent exemptions who did NOT live with the taxpayer go in the third box.

"Qualifying Relatives" dependent exemptions go in the fourth box.

Now, there is EXACTLY one defining thing that ALL people listed on the exemptions section of the return have in common: each and every exemption listed in Line 6 qualifies the taxpayer to subtract $3,700 from the computation of his 2011 taxable income.

But there are many other types of tax benefits associated with the people listed in Line 6 that differ greatly depending on the category of exemption.

So--who wins the "Most Valuable Exemption" prize? Take a guess and then read on to find out:

And the winner is:

Qualifying Children who lived with the taxpayer win the MVE (Most Valuable Exemption) award!

Let's see why:

Qualifying Child who lived with the Taxpayer gives the following tax benefits to the taxpayer claiming the child:

Dependency exemption of $3,700 subtracted in computing the taxpayer's taxable income
$1,000 Child Tax Credit/Additional Child Tax Credit (if child is under 17)
"Qualifying Person" for Head of Household filing status
Child & Dependent Care Tax Credit (if child is under 13 or disabled)
"Qualifying Child" for Earned Income Credit

Qualifying Child who did NOT live with the Taxpayer (due to the special exception for divorced or separated parents) gives the following tax benefits to the taxpayer claiming the child.

Dependency exemption of $3,700 subtracted in computing the taxpayer's taxable income
$1,000 Child Tax Credit/Additional Child Tax Credit (if child is under 17)

Qualifying Relative gives the following tax benefits to the taxpayer claiming the dependent.

Dependency exemption of $3,700 subtracted in computing the taxpayer's taxable income
"Qualifying Person for Head of Household" (if sufficiently related and other tests are met)
Child & Dependent Care Tax Credit (if QR dependent is under 13 or disabled)

Personal exemption:

Dependency exemption of $3,700 subtracted in computing the taxpayer's taxable income
Child & Dependent Care Tax Credit for taxpayer's spouse (if spouse is disabled)

As you can see, it is very complicated and the consequences of making a mistake could be severe for the taxpayer. The rules are tricky with many surprising twists and turns--remember that "QC children" are not necessarily young (e.g., if they are disabled) nor are they always the son or daughter of the taxpayer eligible to claim them as their "child" (e.g., if they live with a grandparent, aunt, big brother rather than with their parents.) And "Qualifying Relatives" are not always related in the usual sense of the word.

For my students and other VITA volunteers using TaxWise, please be aware that TaxWise does NOT know what type of dependent you have! You need to tell TaxWise when you enter the dependent's information in the main info screen. And you need to be very careful to give it the right information, because you know the old saying--GIGO. Use your Tab C tables carefully BEFORE you enter any information into TaxWise.

Here is a handy guide:

Now, those of you who have been using TaxWise for a while have probably noticed that TaxWise has a fourth code in the main info screen ("Code 4: Non-dependents.") You might be wondering what use it is to enter a person who is not any kind of dependent into TaxWise. The answer is that if the custodial parent allows the noncustodial parent to claim the taxpayer as his "Code 2 QC", then she retains the remaining tax benefits associated with the child (HoH qualifying person, credit for daycare expenses, and Earned Income Credit), so you would use Code 4 to enter the child in her return. The child would not show up on the mom's Line 6, but could show up in other places on the return. Check out the special exception in my "No King Solomon" post for more information.

Seventh commandment: Thou shalt not try to memorize all the details of the tax laws!

2012-01-02T01:15:00.000-08:00

Dear students,

You are probably feeling more than a bit overwhelmed and daunted and confused at the immensity of the studying and memorization you think you need to do before the VITA certification test on Wednesday, not to mention working with actual taxpayers in a few short weeks. Yes, you do need to work on practice returns to prepare to develop fluency and comfort in this strange new language, but don't even think that you can accomplish much by mass memorization.

1) It's impossible. The tax code was over 1.4 million words in 2001. Less than a decade later, in 2009, it had more than doubled--to 3.7 million words. And the IRS has supplementary regulations spelling out the manifold operational details that Congress neglected to consider, which increase the total number of words by an order of magnitude.

2) The tax code is a frustrating moving target, because Congress is constantly tinkering with it. Even if you could memorize it, by the time you finished memorizing it, it would have changed.

3) The exam is open book and open note. You will have access to all the same resources during the exam as you will have when working with actual VITA clients (except that you will not be able to ask me questions). But the exams are restricted to very simple in-scope basic tax returns, similar to the first five returns in the Pub 4491w workbook. Most of what you need to know for in-scope VITA returns is handily organized into flow-charts in Pub 4012 and/or in Pub 17. The 1040 Instruction booklet may also be informative. Your paper copies are handy, because you can highlight them and put sticky notes in them, but the electronic copies are also useful because you can use the ^F search function to search for key words.

Go slowly and carefully through the logic of the questions in the flow charts, and you can reason your way through all the questions in the workbook, all the problems on the certification exam, and you will also be able to deal with 95% of the questions that are likely to come up at our VITA site. I may be able to help with a few of the questions you can't handle, and our IRS relationship manager, Joanne Passineau may be able to help use deal with a few more, but others will simply be out of scope for a VITA site and we will need to refer those taxpayers to tax professionals.

The most important thing is for us to know what we don't know--to recognize situations where we need to ask for help or to refer our taxpayers elsewhere. When you see a new wrinkle you've never dealt with before in the practice exercises, don't guess about how to handle it--bring it to my attention.

4) The Intake and Interview Sheet is a key part of our toolkit. Going over all the questions on the sheet (as well as the New York supplement to the intake sheet) with your client is a great way to catch a number of important issues.

5) Quality Review, teamwork and cross-checking each other are an essential part of our strategy. Remember that nobody is perfect--we are all human and make mistakes (and that includes your professor!) So double-check/triple-check/quadruple-check everything--even if the professor prepared the return, it could be wrong!

Baruch College has a huge and long-established VITA program, and their Quality Review training slides make excellent and inspirational reading. But bear in mind that their challenges are greater than ours, because they have to deal with NYC local income tax returns, which have their own complications, on top of those in the federal and NYS rules.

Most importantly of all, we need the taxpayer on our team! Our VITA site has gotten an awesome reputation as the "Go-to" place for taxpayers who want to stay on the right side of the law and play it straight with the IRS, so most of our taxpayers are eager to provide whatever information we need to make sure their return is accurate as possible. (For the small minority who are not, well, it is their prerogative to take their business to more accommodating preparers if they can find them. We will not knowingly prepare a return for a taxpayer who is less than forthright with us in answering our questions. We have so much demand from honest taxpayers that we have no interest in wasting time with anyone who does not want us to prepare an accurate return.)

6) The TaxWise software can help (and is essential for e-filing, so our clients can get their refunds promptly), but it's important not to let the software become a "black box," where you type numbers in and get numbers out and don't really understand at all what is going on to transform those inputs into the output.

Spend some time just looking through the 1040 and trying to figure out the lay of the land there, abstracting away from the myriad of details. I know it looks like a mish-mosh patchwork quilt of random odds and ends joined together, a sad artifact due to the fact that Congress has a tendency to cram last minute changes into tax laws many years, with little time to rationalize the forms. Moreover, there is a tendency to constantly add new doodads to the tax code and it's rare that old doodads get subtracted. And yet the 1040 has remained two pages long for decades, even as the tax code has gotten more and more complex. (Yes, there are a growing number of supporting forms and schedules, but ultimately they all have to flow somewhere into the Form 1040.)

I have created a color-coded version of the 1040 to show the basic layout schema. The first part of the1040 (lines 1 through 6) contain just basic but critical demographics and identifying information (name, SSNs, addresses, filing status, and dependents.) Errors here can be disastrous for our taxpayers, so it's really important to get them right.

Lines 7 through 22 (highlighted in green) are the various types of income which taxpayers need to break out separately: wages, interest, dividends, capital gains, self-employment income, unemployment benefits, pension income, etc. You may be wondering why it is broken out this way, instead of all lumped together.

The original tax form (which will be 100 years next year) did not break income out in such detail. (You might find it amusing to contemplate--the entire set of tax forms, including a supporting schedule and instructions was only 4 pages long!)

There are a couple reasons why the IRS requires more detail in breaking down income than it used to. One is that part of the increasing complexity of the tax law is that some types of income are treated more generously than other types of income. Very low income people with children are better off if their income comes in the form of wages rather than investment income, due to the refundable Earned Income Credit. Higher income will be taxed more lightly if their income comes in the form of capital gains rather than wages, because such gains are taxed at preferential rates compared to the tax on "ordinary income." Another reason for the more detailed breakdown is that the IRS increasingly uses "document matching" to compare third-party reporting of different income components to what the taxpayer has reported on the return.

Lines 23 through 36 (highlighted in red) are so-called Adjustments to Income or "above the line deductions." If you are going to have deductions, above-the-line deductions are as good as it gets for the taxpayer for a couple of reasons: a) they reduce both Adjusted Gross Income (AGI) and taxable income and b) they are useful to everyone, not just itemizers. The below-the-line deductions (highlighted in pink) at the top of page two of the form are not nearly as good a deal, for reasons I will explain.

I'll elaborate here. Obviously, you can see why folks would want to reduce their taxable income--it will generally reduce their taxes. But why should they care about AGI? Well, it turns out that AGI is an important "gateway" to qualifying for many other tax benefits. If your AGI is too high, you may not be able to qualify for certain tax credits or to invest in a deductible IRA, for example, even if your taxable income is quite low. Having too high an AGI can also make your Social Security taxable--again, even if your taxable income is quite low.

It's not really obvious to me why Congress decided that AGI (or its closely allied relative, MAGI, which have been multiplying like Rabbit's friends and relations) should be the gatekeeper of so many tax benefits. It is not as if the type of deductions allowed "above the line" are necessarily any more deserving than those allowed "below the line." (It's worth noting that many taxpayers in our area will have very large below the line deductions this year for casualty losses incurred as a result of the devastating floods which hit very close to our VITA site four months ago. That will reduce their taxable income, but not their AGI. It is not obvious to me why their casualty loss deductions, which are below the line, deserve less weight than somebody else's IRA or student loan interest deduction, which is above the line.)

Here is a Daily Gazette photo of Schenectady's historic Stockade neighborhood taken during the Irene floods, within easy walking distance, less than a mile away from our VITA site. Other areas just a bit farther away were hit even harder. Unfortunately, casualty loss deductions are a complex topic, which is out of scope for VITA sites, so we will be unable to prepare returns for affected homeowners who need to claim such losses on their returns. We will need to refer any such taxpayers to professionals. I did hear that some kind-hearted tax pros offered their services pro bono with free advice to taxpayers at the time of the late summer floods, so hopefully they will continue to help them with followup.

I digress, but my point is that many things about these colorless lifeless tax forms will come to life when you deal with how they impact the lives of real people, and you will have a new understanding for the trials and tribulations of a tax code with incoherent mixture of good intentions not always well executed, mixed with a random dose of politics and lobbying.

Moving back to our color coded tax return, we have finished with the deduction stage once we subtract our below-the-line deductions and personal and dependent exemptions (speaking of which, any new babies who arrived by midnight Saturday secured a whole year's worth of tax benefits for their parents. This local "first baby of 2012" just missed out. A Buffalo couple had twins born half an hour apart--one will appear on their tax return in 2011, while the other will have to wait until next year.)

So we have now arrived at taxable income. It is time to apply our marginal tax rate schedule to compute the amount of income tax. The chart of marginal rates below comes from Jon Gruber's Public Finance and Public Policy, published a couple years ago, so the breakpoints are slightly different for 2011 returns, due to the automatic indexing for changes in the Consumer Price Index, but the graph below does give you the basic idea of how our tax code works. The current rate schedule is available here, which shows that the key breakpoint for our MFJ taxpayers is $17,000. That is, their first $17,000 of taxable income will be taxed at 10% and any income amounts beyond that will be taxed at 15%. So, for example, a married couple with $20,000 in taxable income would pay 10%*(17000) +15%*(3000) = 1700 +450 = $2,150. The important thing to realize is that once the couple enters a new bracket, only their incremental income over that threshold is subject to tax at the higher rate. Since our VITA site serves taxpayers with gross incomes up to $50,000, we do not expect to see any married taxpayers with federal statutory marginal brackets higher than 15%. It is possible, however, that we will see a few single or MFS taxpayers in the 25% statutory bracket.

But, as they say on late night television, "Wait, there's more!" We have not yet begun to apply credits. Notice that my colored-coded 1040 has a hot pink highlighted section right below the income tax computation. Those represent nonrefundable tax credits. If our hypothetical married couple have a few kids under age 17, or if they paid for daycare in order to work, or if they put in new high efficiency home energy projects, those hot pink nonrefundable credits might wipe their tax bill all the way down to zero. (But not lower than zero--that is why they are called nonrefundable.)

And--again--as they say on late night TV, "Wait, there's even more!" The gold highlighted section at the very end represents the refundable credits. Those can actually knock the taxpayer's liability into negative territory, so that the taxpayer could wind up with refund greater than the amount of withholding.

Don't try to absorb it all right now--just immerse yourself in thinking through this incredibly complex world. There's lots to learn and absorb, and we'll also learn that there can be a big difference between the statutory marginal tax rate schedule sketched above and the actual effective marginal tax rate schedule shown below.

What is going on there, you may be asking yourself? And what are the effects on incentives of such high marginal rates? Tune in next week--after the VITA certification exam--and we'll talk more about it.

But take heart if this all seems like hopelessly confusing gobbledigook at the moment--and come to my helping hours tomorrow so you can work through practice examples which are similar to those on the exam--and to 95% of the situations that come up in practice at our VITA site. You will be prepared before our class begins--with a bang! with the always challenging and bracing VITA certification exam on Wednesday.

I voted for you, Gov. Cuomo, but ...

2011-12-31T11:56:00.000-08:00

I still don't like the idea of the NYS Tax Department telling me to "like" you on Facebook.

Governor Cuomo, you are not perfect (then again, none of us is), but I have to say that in your first year as governor, you have been more effective and constructive than any governor we have had since your dad left office in 1994. I have no regrets about voting for you--the alternative was completely unacceptable. You inherited a dreadfully dysfunctional state and you have accomplished a great deal more than I could have imagined possible. You and I are in agreement that a great deal more needs to be done.

But that doesn't mean that I think it's right for the NYS Tax Department to use 20% of the prime real estate on their front page to promote your administration (screenshot above taken 12/31/2011, with closeup of the right-hand portion at right.)

And I especially don't think it's right for the NYS Tax Department to tell me to "Like" you on Facebook.

I can only imagine that outrage that would ensue if the irs.gov website devoted 20% of its front page to promoting President Obama's administration and if irs.gov instructed American taxpayers to "Like" President Obama on Facebook.

So I think the same ought to be true at the state level. The tax department website is for helping citizens comply with their tax obligations, not for promoting the chief executive's Facebook page.

Governor Cuomo, I think it is just fine and dandy that you have your own website, and Facebook page as Governor (where over 17,000 folks already like you), and Facebook page as politician (where over 88,000 folks already like you), and Twitter feed (where almost 17,000 folks are following you.)

We know where to find information about you and your administration when we need it. You are not exactly a publicity-shy guy. We don't need the NYS Tax Department spending its limited resources helping us to find you.

Update [Tuesday 1/3/12]: The NYS Tax Department has changed the language on their website. The link image now reads "Connect to Governor Cuomo on Facebook," instead of "Like Governor Cuomo on Facebook."

H&R Block Pricing this year

2011-12-27T19:37:00.000-08:00

H&R Block has posted its tax preparation prices for the 2012 filing season. Since they are the leading tax preparation franchise (nationwide as well as locally), and many of our VITA site clients have used them in the past, we can get a sense of how much the free tax prep services our students provide are saving our taxpayers, who are low-income working families and senior citizens with relatively simple returns.

Of course, there are NO fees for any returns prepared at our VITA site. All our VITA preparers at the Union College site are certified on Basic and Intermediate level returns, which include virtually all returns in the first four categories listed below. I am certified at the Advanced level, and I encourage the student preparers to consult with me whenever they are not sure to handle a particular issue.

Most returns in the fifth category are outside the scope of a VITA site, so we would refer such taxpayers to a professional preparer. I do not hesitate to refer taxpayers to professionals when I feel that the complexity of their situation might be beyond our ability to deal with it correctly. If I have any doubt at all, I prefer that we refer out to a professional. We don't do our taxpayers any favors if we prepare a return incorrectly. Note that we are not permitted to make specific recommendations of particular tax preparers or firms, but we can refer taxpayers to this IRS advice for choosing a paid preparer page.

With that as preface, it is interesting to examine the H&R Block pricing schedule. [Update: I just read the "fine" print on the H&R Block Schedule and discovered that they list a separate add on charge for Earned Income Credit (EIC) returns, $40 with no dependents and $55 with dependents, so I have added those in red below to the most common types of returns that include EIC. Block is apparently blaming this fee on the costs of IRS compliance.]

H&R Block Pricing Schedule:
1040EZ /no dependents

(standard deduction, no credits, filing status is single or MFJ)
$39 (Federal) + $39 (State) = $78 + $40 (for EIC) = $118

1040A/no dependents

(standard deduction, all federal credits, any filing status)
$99 (Federal) + $39 (State) = $138 + $40 (for EIC) = $178

1040A/with dependents

(standard deduction, all federal credits, any filing status)
$109 (Federal) + $39-$79 (State) = $148-$188 + $55 (for EIC) = $203-$243

1040 (moderately complex)

(itemized and above-the-line deductions, all federal credits)
$119-$299 (Federal) + $39-$89 (State) = $158-$288

1040 (complex)

(investments, small business/self-employed, rental property, partnerships/corporations)
"Starting at" $149 (Federal) + $39 (State) = $188 and up

My comments:

Last year, Block was promoting loss-leader "Free" pricing on 1040EZ returns. That strategy might have been profitable last year, because once the taxpayer was in the door, they could attempt to "upsell" him on their very profitable ancillary services including Refund Anticipation Loans (RALs). Most Block customers whom I have had the occasion to talk to in previous years have told me that they wound up spending a lot more than Block's "list" price for very simple returns, primarily due to opting for a RAL in conjunction with their tax return. However, federal bank regulators have been tightening the screws and it appears that Block will no longer be able to market RALs. Maybe that is why Block is raising their "list" prices on the simplest returns this year. Of course, they still have several other profitable ancillary services, including "Peace of Min d®" audit insurance and their "Second Look®"program.

It is also interesting to compare Block's fee schedule for their more complicated returns to their charges for what are perhaps the most famous returns they have ever prepared, Sarah Palin's 2006 and 2007 returns. Those were definitely in the most complex category. Their 2006 Form 1040 return had four qualifying children (QC) dependents, three of them eligible for the child tax credit. Their income included wages, interest, dividends, income from two separate Schedule C self-employment business returns involving depreciation expenses, capital gains on the sale of land, and "kiddie tax" on their youngest daughter's dividend income from the Alaska Permanent Fund. Their deductions included home mortgage interest, state and local taxes, gifts to charity, union dues for the First Dude, and tax prep fees.

Given the complexity of the Palin tax returns, the tax prep fees charged by H&R Block seem surprisingly modest, even though they did not have to file a state tax return (because Alaska has no state income tax). The Palin 2007 Schedule A lists only $178 as their tax prep fee; their 2006 Schedule A listed a charge of $213. However, tax law professors have raised a number of issues with the Palin tax return, which you can read about in Tax Profs Agree: Governor Palin's returns are wrong, so perhaps the Palins would have been better advised to seek a professional preparer knowledgeable enough to ask a few more probing questions than the H&R Block preparer appears to have done.

Governor Palin's running-mate, John McCain, had a tax return roughly comparable in complexity to the Palin return (different forms, but a roughly comparable number of pages) and he paid $3,500 in tax prep fees in 2007 (and $3,450 in 2006). However, Senator McCain and his wife filed separate returns. Mrs. McCain's return was far more complicated and reported far more income than her husband's return. Mrs. McCain did not disclose the detail of her Schedule A itemized deductions, but it is safe to infer that she spent far more on tax prep than her husband.

All the returns released by Presidential and Vice Presidential candidates and office-holders are available here. Sarah Palin appears to be the only candidate to have used H&R Block, and also the only candidate to efile her return.

Additional thoughts: H&R Block famously made mistakes on their own corporate tax return a few years ago--in early 2006 Block put out a press release acknowledging that the company had understated their true tax liability by $32 million on their own state corporate tax returns and their financial statements to shareholders and the public for 2004, 2005, and the first quarter of 2006.

It's not only H&R Block that screws up tax returns, of course. I have previously written about the errors made by Treasury Secretary Timothy Geithner (who used TurboTax to prepare his own returns) and former House Ways & Means Chair Charles Rangel (who hired high-priced accounting firms.) Hiring a CPA--or a Treasury Secretary--or a Congressman who wrote much of the tax code himself--is no guarantee that the return will be prepared more correctly than a H&R Block franchise employee will prepare it. Some H&R Block employees I know are excellent. And a CPA once told me that it was common knowledge among CPAs that taking the H&R Block in-house tax class was a great way to help prepare for the nuts and bolts tax part of the CPA exam.

And, sadly, many VITA sites have inexcusably high error rates as well.

That is why our VITA site has a four-step Quality Review process that goes beyond IRS minimum requirements. At H&R Block, taxpayers have to pay an extra fee if they want a second employee to take a "Second Look" at the return. At our VITA site, we believe that all tax returns deserve at least a second look by a quality reviewer, and a third look by the original preparer walking the taxpayer line by line through the logic of the tax return before we ask him to sign, and a fourth look by me before the return is efiled.

Who is preparing those very peculiar (mathematically impossible?) tax returns in Manhattan zipcode 10004?

2011-12-05T14:05:00.001-08:00

Zipcode 10004 outlined in purple above

Strangely enough, the taxpayers in zipcode 10004 appear to have been massively OVERpaying their federal income taxes, based on IRS reported data for 2008 tax year returns.

That zipcode is just a stone's throw away from Zucotti Park! (Maybe the OWS folks were secretly occupying the tax prep shops in that area before they occupied the park?)

Yes, that's silly, but it's really hard to figure out other reasons why the tax bills in that zip are so extraordinarily high.

Overall, the 1,967 returns filed for Tax Year 2008 from that zipcode paid over 39% of their AGI in taxes! If we focus only on the subset of the 529 taxpayers with incomes over $200,000, those taxpayers supposedly paid 43.5% of their collective total AGI in federal income taxes. As a proportion of taxable income, taxpayers in that zip with incomes over $200K reportedly paid 45.7% of their taxable income in federal income taxes.

This seems to be a mathematical impossibility, given that the top federal bracket was 35% in 2008. Even subtracting out the much maligned AMT, the data still leaves the over $200K-bracket taxpayers paying over 44% of their taxable income in federal income taxes. This rate is completely implausibly high, especially since those taxpayers had a big chunk of their income in the form of relatively lightly taxed capital gains.

Thanks to Nick Kaspar of the Tax Foundation for passing along the IRS Statistics of Income consolidated datafile he used to create the map I blogged about in my last post. Warning: the file is big! (37 megabytes) The big datafile is here. Short explanatory files describing the data in each field are here and here.

I put the 10004 zipcode data in a conveniently sized and labeled spreadsheet below for anyone who wants to double check my figures. One tab just has selected fields from the IRS database, but you can also take a look at the tab with all the IRS figures for 10004 zipcode as well.

2008 Tax Year return data for zipcode 10004

Here's the story behind my coming across the weirdly anomalous data in zipcode 10004.

After seeing the mystifying Tax Foundation map I blogged about in my last post. I went poking around to try to find one of those bright blue zip codes, where taxpayers are--in the aggregate--supposedly paying more than 25% of their income in federal income taxes.

I figured I would start with my home state of New York, since I have a bit more sense of "What's what" in my own state.

There did not seem to be any clearly bright blue zipcodes in my own neck of the woods (i.e., the Albany-Schenectady-Troy-Saratoga Springs region of upstate New York), so I figured I would look at Manhattan zipcodes, where there appeared to be a lot of bright blue on the Tax Foundation map.

Bingo! I started at the lowest zipcodes in New York, and it did not take long before I came across the zipcode with completely bizarre numbers, 10004.

The obvious discrepancy in the 10004 zipcode makes me reluctant to do much more work investigating this dataset---and it also makes me highly reluctant to put much credibility into the other bright blue spots on the Tax Foundation map.

So--unless I get some sort of reasonable explanation for how the 529 taxpayers in zipcode 10004 with incomes over $200K managed to wind up paying 43.5% of their total 2008 AGI in federal income tax, I am not going to spend a lot of time investigating these numbers further in other zip codes.

But if you do have such an explanation, feel free to leave it in the comments.

Am I color-blind? How can this tax map be correct?

2011-12-05T08:14:00.001-08:00

This mind-boggling Tax Foundation map came through my RSS feed this morning.

Although the American public might well be inclined to accept it at face value, I don't see how this map can possibly be right, unless there is something extremely weird going on in residential segregation patterns when broken down by zipcodes.

Perhaps I am colorblind, but it appears to me there are many zipcodes showing up in maximally bright blue on the map. I'd really like to see the data behind this map, because it is very hard for me to discern the variations in subtle colorations.

According to the map legend, taxpayers in each of those bright blue zipcodes paid an AVERAGE of over 25% of their adjusted gross income (AGI) in federal income tax in 2008.

But--according to the IRS, in 2008, every single income bracket paid an average of LESS than 25% of its AGI in federal income tax. The bottom 50% paid 2.6% of their AGI in federal income tax. The top 10% paid 18.7% of their AGI in federal income tax. The top 1% paid 23.3% of their AGI in tax. The top 400 taxpayers in the country paid 18.11% of their AGI in tax.

Now, it is true that there are wide variations in effective tax rates WITHIN each income category, for a variety of reasons. For example, at any given income level, there are some taxpayers with more tax preferences than others (some have more children than others; some have a large proportion of their income in lightly taxed capital gains and dividends rather than in more heavily taxed labor income, some have large amounts of itemized deductions such as mortgage interest, state & local taxes, charitable donations, etc.)

So, for sure, there must be a few individuals who paid more than 25% of their AGI in federal income tax. For example, President Obama and his wife paid 29.6% of their AGI in tax in 2008.

But it is completely inconceivable to me that there could be a large number of zip codes where all taxpayers in the zipcode collectively paid total taxes averaging over 25% of their AGI. This is especially true for the apparently bright blue zipcodes in New York and New Jersey, because itemized deductions tend to be large there (high state taxes and big mortgages lead to big Schedule A deductions in those places.)

A maximally bright blue zipcode could only happen if all taxpayers in the zip were clustered as follows: (1) extremely segregated by income (no low-income working families living in the zip to pull the average down) AND also (2) extremely segregated by unwillingness (or inability) to take advantage of tax preferences taken by most folks in their respective income brackets.

This seems unlikely to me--as I said above, I'd really like to see the source data behind the map, because it is very hard to discern shades of bright blue.

(It's also important to note that a graph of total federal taxes paid divided by AGI would look VERY different from the above! And a graph of total taxes divided by AGI by zip code would look even more different! And, if we used a theoretical ideal denominator, one based on Haig-Simons income rather than AGI, it would look still more different.)

UPDATE: Originally, all that came through my RSS feed was the unadorned graph. I have now found a blog post giving more details. Using their cited datasource, I tried to come up with some numbers for zipcodes near me (where I have some idea of the income distributions), but for some reason the NY file does not list any zipcodes higher than 10502. (Albany-Schenectady-Troy zips are up in the range starting with 12xxx, so I'll have to figure out why they are missing.)

UPDATE 2: I received the following response from the IRS statistics division replying to my query about why there were no zipcodes above 10502 reported for New York.

In response to your request, there was a change in the number of returns needed to be included in the Tax Year 2008 ZIP code data. If a particular ZIP code has fewer than 250 individual income tax returns, data from that particular ZIP code is not included.

This response is completely mystifying, since there are plenty of zipcodes above 10502 in New York with more than 250 returns. For example, my own zipcode (12309) had over 14,000 returns in 2008.

UPDATE 3: Still no further word from the IRS statistics division, but thanks very much to Nick Kasprak at the Tax Foundation, who helpfully provided a complete datafile of the entire database, including upstate New York. I'll see if I can make sense of the patterns that emerge in interpreting the data in nearby communities I know well.

Update 4: A short amount of investigation quickly turned up a very bizarre anomaly in the IRS data for a Manhattan zipcode. For more details, see my next post, here.

The difference a decade made!

2011-10-13T19:22:00.000-07:00

A little over a decade ago, the government actually managed to report a budget surplus for a couple of years, --at least according to the way it keeps the books, which would not pass muster with Generally Accepted Account Practices (GAAP), in a private sector firm (as Eco 339 students will remember from their study of Gruber, chapter 4.)

As you can see from the graph above, back in early 2001, the Congressional Budget Office (CBO), was actually projecting that continued budget surpluses would drive down the US government debt all the way down to zero by 2008 and then even push the government into a net creditor position, with a massive and unprecedented amount of net assets amounting to 15% of GDP by this year. Of course, as we all know the reality turned out to be quite different, and the Pew Foundation graph shown here does a nice job of tracing out the sources of the growth in the US government's debt position.

Hat tip: Linda Beale

Contests in the public sector

2011-10-08T18:50:00.000-07:00

My former colleague, Steve Kelman, has been blogging about the federal government's use of contests in procurement:

I have been writing for years in support of the government making greater use of contests as a procurement tool -- announcing a performance objective and a prize for the first successful solution to the problem, where anyone can submit an entry. Aside from being a dramatic form of performance-based contracting, it opens up the procurement process and puts the emphasis on doing good work, not just filling out proposal paperwork. As with every off-the-beaten-path procurement technique, it is not suitable for everything, but like many unconventional approaches, it is underused.

I agree with Steve that there is a lot to be said for the government's increased use of contests. An especially heartening note: Steve reports that Innocentive, a business that helps both private sector and public sector organizations to sponsor contests, suggests that government-sponsored contests will elicit more interest with lower prize awards than private business-sponsored contests require. As Steve wrote:

Interestingly, Innocentive advised the Air Force to lower the prize -- their experience is that challenges that seem to promote a public good get more entries at lower prize levels than ones just being done for companies.

In the past, it seems that government use of contests was largely confined to the rather undesirable state-run lottery sector, while the private sector has been using contests far more extensively and creatively. As Steve points out, the government has been starting to follow the lead of the private sector in using contests more creatively, and there is a lot of potential there.

So it's worth looking at how the private sector has used contests.

Of course, there are the classic promotional contests, conducted by businesses such as McDonalds, Publishers' Weekly, Readers' Digest, and other businesses seeking to raise public awareness of their products and ultimately to increase sales. Entering those contests can be as simple as mailing in an entry form or buying a hamburger. TurboTax and other companies have updated the classic (tell us why you like us in "25 words or less") contest format by asking contestants to submit homemade videos promoting their products.

A variation on those purely promotional contests are the academic contests, the oldest and most famous of which is the Scripps National Spelling Bee, sponsored by local newspapers around the country. Others in that vein include the National Geographic Bee, sponsored by the publisher of National Geogaphic, and MATHCOUNTS, sponsored by the National Society of Professional Engineers along with other sponsors including NCTM, CNA, Raytheon, Northrup Grumman, Conoco Philips, Texas Instruments, ThinkFun, and 3M. There are countless others, including one for which I serve as co-director, the Math Prize for Girls. Those academic contests have dual goals: like the classic promotional contests, they raise public awareness and promote the brand image of their sponsors, but they also have a broader societal goal as well, to encourage students all over the country to spend more of their time in enjoyable academic activities.

Tax bloggers have also offered promotional contests on their blogs. During tax season, Don't Mess with Taxes blogger Kay Bell has run contests giving away free tax software to encourage readers to comment on her blog.

Earlier this week, TaxGirl Kelly Phillips Erb ran a contest at Forbes.com soliciting suggestions for improving the design of the IRS website. I happen to think the new design launched by the IRS earlier this month was a substantial improvement over the old one [full disclosure: one of my former students had a lot to do with overseeing this!]. Even so, I thought Kelly's contest was an extremely cool idea, because there is always room for improvement. Unfortunately her deadline passed without any entries. Perhaps that is not too surprising, given the overwhelming and Sisyphean task of designing a site that can efficiently help taxpayers keep up with a tax code that constantly grows in scope and complexity. Still, I think the opportunity for fame, if not fortune, might motivate an ambitious and currently underemployed web designer to come up with some nice ideas for a better design. Then again, Kelly didn't offer much time.

Designing a better IRS website would make a great web design contest project for students--they would learn something about our convoluted, inefficient, and sometimes inequitable tax code as they get practice in creating a design. Even if the IRS decides not to adopt design ideas from public submissions, well-designed alternative web skins that link to key IRS forms and instructions could be a great way for aspiring web designers to showcase their design skills on the web, while providing a useful public service. After all, it is impossible for the IRS to choose a color scheme that pleases everyone (like Kelly, I am not a big fan of the color orange!), and--more significantly--different types of taxpayers have different needs, so one could envision different specialized niche web skins designed to help different types of taxpayers navigate the parts of the IRS website most important to them.

I can imagine all sorts of other creative possibilities for government use of contests. For example, Treasury Inspector General for Tax Administration (TIGTA) and Government Accounting Office (GAO) employees have been conducting secret shopper visits to VITA sites and commercial tax preparers in order to monitor their accuracy. Instead of simply reporting the bad news, why not also promote excellence by awarding prizes (or at least recognition) to the most outstandingly accurate and diligent preparers they happen to discover in the process of looking for the bad apple preparers. Or adopt my idea of a national tax bee?

The US Department of Interior ran a logo design contest this summer. For $1,750 they received 617 design concepts from 174 designers. I am happy to report that all three winning designs had buffalo in them:

Tax model analysis

2011-10-04T13:26:00.000-07:00

For the benefit of students preparing for tomorrow's exam, here is a model analysis.

1) Consider a free market with demand equal to Q_D = 1200 - 10P and supply equal to Q_S = 20P. Draw a clearly labelled graph of this market, showing equilibrium price, quantity, consumer surplus, and producer surplus on your graph.

Answer:

Setting Q_D = Q_S gives us 1200-10P = 20P, so the equilbrium price P* is $40/unit and the equilibrium quantity Q* is 800 units.

Graphing the supply and demand curves gives us the following picture:

The consumer surplus is shown on the graph in the diagonally shaded upper triangle, the area between the demand curve (reflecting the consumers' valuation of the good) and the horizontal line drawn through the price the consumer actually pays for the good, $40/unit.

The value of the consumer surplus is given by the formula for the area of the triangle (1/2)*(base)*height, where the base of the triangle is 800 units of the good and the height of the triangle is ($120/unit - $40/unit)= $80/unit. Thus, the value of the consumer surplus is $32,000.

The producer surplus is shown on the graph in the diagonally shaded (in the other direction) lower triangle, the area between the supply curve (reflecting the producers' marginal cost of producing the good) and the horizontal line drawn the price the producers actually receive for the good, $40/unit. The value of the producer surplus is given by the formula (1/2)*base*height, where the base of the triangle is 800 units of the good and the height of the triangle is $40/unit. Thus the value of the producer surplus is $16,000.

In the absence of externalities, standard economic analysis would say that the value to society of the production and consumption of the 800 units of the good created at the competitive market equilibrium is the "social surplus," the sum of the consumer and producer surplus values, or $32,000 + $16,000 = $48,000.

2) Now assume that the government imposes a $10/unit tax on the sale of the good. How much of the tax will be paid by the buyer and how much by the seller? How much tax revenue is raised? What happens to the quantity of the good, consumer surplus, producer surplus. How much is the deadweight loss?

Standard economic analysis says the incidence will be the same whether the statutory incidence is imposed on the buyer or on the seller.

For the sake of this example, we will place the statutory incidence on the buyer, so that every time he purchases the good, he must hand over $P/unit to the seller and $10/unit to the government.

As a result, his demand curve in terms of P, the price paid to the seller, shifts vertically down by $10/unit. We get a new demand curve, parallel to the original one, with a vertical distance of $10/unit between the original and the new demand curves.

The equation for this new demand curve is given by Q_D = 1200 - 10*(P+10).

We solve for the new equilbrium by setting the new demand curve equal to the original supply curve, yielding 1200 - 10(P+10) = 20P.

Rounding to the nearest whole penny, we get P' = $36.67/unit as the new equilibrium price that the consumer hands over to the seller. Rounding to the nearest whole unit, we get Q' = 733 as the new equilibrium quantity. We also note that the consumer is actually out of pocket $46.67/unit for each unit of the good that he buys, due to the $10/unit tax that he must remit to the government.

Thus, the economic incidence of the tax is that the consumer pays $6.67 per unit more than before, while the producers receive $3.33 per unit less than they did before. This is exactly what we would predict based on their relative elasticity of demand and supply computed at the original equilbrium point of (40,800).

Noting that elasticity is a unit-free measure and applying the formulas that define elasticity of demand and supply yields:

ε_D = (∆Q_D/∆P)*(P/Q) = (-10)(40/800) = -1/2

ε_S = (∆Q_S/∆P)*(P/Q) = (20)(40/800) = 1.

Because supply elasticity is twice as great as demand elasticity (in absolute value terms), we expect that buyers will bear twice as much of the tax as suppliers do, which is in fact the case!

Government tax revenue is shown in the graph by the unshaded rectangle, with a height of $10/unit, the amount of the tax, and a width of 733 units, so government tax revenue is approximately $7,330.

Consumer surplus has shrunk to (1/2)*(120-46.67)*733 or approximately $26,890.

Producer surplus has shrunk to (1/2)*36.67*733 or approximately $13,445.

Total social surplus = Consumer surplus + government tax revenue + producer surplus or approximately $47,665.

Notice that this is less than social surplus was before the tax was imposed by $335, which is the approximate amount of the deadweight loss caused by the tax, the area defined by the unshaded triangle in the center of the graph above, with height of $10 and width of approximately 67 units.

Suggested exercises to check your understanding:

A) Redo the analysis in part 2 above with the statutory incidence placed on the producer rather than on the consumer. You should get the same answers (up to rounding error) for the total gross of tax price paid by the buyer, the net of tax price received by the seller, the new equilibrium quantity of the good, the amount of tax revenue collected, the consumer and producer surplus, and the deadweight loss.

B) What happens if you put a $10 subsidy on the good, instead of a $10 tax?

The teacher or the Prez: who pays more in taxes?

2011-09-29T09:49:00.000-07:00

The answer is: it depends! Specifically, it depends on whether the teacher has "Qualifying Children."

This makes a great case study for my fall term public finance class, because it illustrates how much tax bills can differ for a person with "Qualifying Children" versus other types of dependents (e.g., a teacher supporting elderly relatives or other adult dependents gets far fewer tax benefits--and possibly none at all.)

Joe Kristan reports:

Echoing Warren Buffett's complaint that he isn't paying enough tax, President Obama said that he pays lower tax rates than a $50,000-per-year teacher.

Factcheck.org says that isn't quite so:

President Obama’s claim that he pays a lower tax rate than a teacher making $50,000 a year isn’t true. A single taxpayer with $50,000 of income would have paid 11.9 percent in federal income taxes for 2010, while the Obamas paid more than twice that rate — 25.3 percent (and higher rates than that in 2009 and 2008). And if the $50,000-a-year teacher were in Obama’s tax situation — supporting a spouse and two children — he or she would have paid no federal income taxes at all.

Adding FICA taxes doesn't get the teacher up to the President's tax rate, even if you include both employer and employee taxes. So now the President has joined Warren Buffett on the list of celebrities who you shouldn't have prepare your tax returns.

A few thoughts from someone who has overseen the preparation of a number of tax returns for teachers and other folks earning less than $50,000 at our Union College VITA site.

0) It is almost surely true that if the teacher is eligible to claim a spouse and two "Qualifying Children" on her federal and state tax returns, then her effective average tax rate (from all taxes combined, federal, state, and local) will be lower than President Obama's tax rate. However, it's important to note that supporting dependents does not guarantee that the taxpayer can claim those dependents. For example, non-custodial parents paying child support often do not get any of the tax benefits normally associated with children. It's also the case that "Not all dependents are created equal," under tax law. As noted above, if the teacher is supporting elderly relatives or other adult dependents, her tax bill will be much higher than if she can claim "Qualifying Children" as dependents.

1) I have not seen any analyses that include the employer FICA payroll tax share, even though the CBO standard tax incidence analysis assumes that the effective burden of both shares actually falls on the employee. [Update: it appears that the Fact Check and Tax Policy Foundation analysis do use the CBO incidence assumption.] If the teacher is single and not eligible to claim dependents, her effective average tax rate for federal income and both halves of FICA payroll taxes in 2010 would certainly be in the same ballpark as President Obama's effective average tax rate, and possibly a tiny bit higher, considering only those two taxes. [Update: the Fact Check and Tax Policy Foundation analysis come up with 25.3% in combined federal income and payroll tax for the teacher, and 26.5% for President Obama's combined rate for those two taxes.]

2) No analysis that I have seen takes into account other federal taxes. The typical teacher surely pays a higher share of her income in federal excise taxes on gasoline and airline tickets than President Obama does. If she is a non-smoker, he pays more in federal tobacco taxes than she does. Alcohol taxes and firearms taxes, well, we don't have enough data to go there. On average, however, people with incomes in the $50,000 range pay about 1% of their income in federal excise taxes, while those in President Obama's income bracket pay a much lower percentage than that.

3) The biggie: state and local taxes.

3a) State & Local Income taxes: President Obama's 2010 tax return says he paid $52,527 in state and local income tax last year. That is about 3% of his gross income ($1,795,614). A teacher who lives in Washington DC (again, earning $50,000 and single with no dependents) would pay 5% of her income in DC income tax. That same teacher living in New York City would pay 8% of her income in NYS/NYC income tax.

3b) Property taxes: President Obama's tax return says he paid $25,742 in property tax last year. That is about 1.5% of his 2010 income. How much our teacher pays in property taxes is going to vary all over the map, depending on local property taxes and housing values, but it's almost a sure thing that she pays more than 1.5% of her income in property taxes. (For my public finance students, remember that even if she is a renter, economic incidence analysis leads us to conclude that her rent includes some or all of the property taxes paid by her landlord.) In Schenectady, where our college and VITA site are located, it is frequently the case that moderate income taxpayers pay far more in property tax than they do in income tax.

3c) Sales taxes: using the handy-dandy IRS sales tax calculator, we can estimate that our teacher paid about 1% of her gross income in sales tax if she lived in DC (unless, of course, she bought a car or other big ticket item last, in which case she paid considerably more.) The same calculator estimates that President Obama spent less than 0.1% of his gross income on sales tax.

Bottom line: It all comes down to the "Qualifying Children."

If the teacher is eligible to claim qualifying children on her tax return, her federal, state, and local income tax rates go way down. In that case, President Obama probably pays a higher total combined effective tax rate than she does.

If the teacher is NOT eligible to claim qualifying children on her tax return (because she doesn't have any, or because her dependents are too old, or because her children live with their other parent or with a grandparent--even if she supports them!), then she most likely DOES pay a higher total effective average tax rate (federal, state, and local) than President Obama does.

The world has been changing too fast for public finance textbooks to keep pace

2011-09-07T06:22:00.000-07:00

In my public finance class, we use Gruber, Public Finance & Public Policy, 3rd edition, which was published in 2009, but the graphs were last updated based on data published in 2008, before the TARP bailout and subsequent events.

The principles of public finance remain the same, but the economic picture is very different now, as these CBO graphs show.

The graphs in Gruber's textbook essentially stop right before the steep climb in the first graph and the steep drop in the second graph.

The CBO website is a good source of updated information.

The Economist also has good updated coverage of debt developments in the US and worldwide here.

On taxing Warren Buffett and Jennifer Anniston?

2011-08-16T10:49:00.000-07:00

Warren Buffett is once again pleading for higher taxes on wealthy folks like himself.

Peter Reilly's column in Forbes puts an interesting spin on the topic with his post, We won't get ahead by taxing Warren Buffett more--Jennifer Aniston, Maybe.

The first part of his post does a good job laying out the many complex, conflicting, and emotion-laden issues that arise in discussing tax policy, including many of the issues and arguments that I will address in my upcoming fall term public finance class.

The second part of his post makes the case that taxing Warren Buffett and other extremely wealthy folks more would be a bad idea for society, because he says it is the job of wealthy people to allocate capital, and if we tax them, then they will have less capital to allocate.

He closes by saying how difficult it is to speak out on tax policy issues, because they are so complex and multi-faceted and will inevitably be viewed as wrong-headed by others with a different perspective, but I still applaud the efforts of those like Peter Reilly who do so, because it is a dialog worth having.

Here is my response to his post:

I agree that there are so many issues (most of them laden with emotion) tangled together when one talks about taxation that it is hard to say anything that won't sound foolish when viewed through another lens.

A few observations (through another lens, which will surely strike some as foolish as well):

1) Warren Buffett and other wealthy folks with a reputation for smart investment decisions (whether deserved or not, e.g., Bernard Madoff) allocate more than their own capital.

So the amount of capital that wealthy folks like Warren Buffett have to allocate is not purely a function of their own personal after-tax income, because other entities with funds to invest (e.g., public and private pension funds, insurance companies, college endowments, small investors) are happy to give them their money to invest as well.

2) There is also the question of who judges how well the capital allocators are doing their jobs. Do we think the market and the judgment of investors at large as reflected in market prices is a good metric for that? Classically the answer is yes, but the subprime mess raises questions about the wisdom of markets and whether their judgments are always right. (But then what is the alternative?)

3) It is not always clear that higher taxes discourage work, saving, investment, and risk-taking. In some cases, higher taxes could actually spur people to work more, in order to be able to afford the lifestyle to which they have become accustomed. That is what economists call the "income effect" of a tax. But there is also a substitution effect of a tax, which goes in the opposite direction, because the after-tax payoff for an hour of work has declined while the value of an hour of leisure is not taxed. It is an open empirical question as to which effect predominates in any given situation.

Moreover, there may be other reasons apart from financial rewards why people choose to work, become entrepreneurs, and do other socially productive things. The huge number of volunteers in this country demonstrate that many folks find meaningful work inherently rewarding.

On that point, it is worth noting that Warren Buffett does not allocate all his capital based on the purely financial rewards it earns. He and other wealthy people give a great deal of their capital away to various charitable causes, presumably for benefits that can't be measured in purely dollar terms.

In some cases, taxes do discourage work, saving, investment, and risk-taking. In some cases they apparently do not discourage it. Again, it is an open empirical question, endlessly fascinating to economists, which can only be resolved by looking at the data.

For an example of some interesting data suggesting that higher state taxes does not discourage entrepreneurship, see my recent blog post here. (Interesting coincidental note: the measure of entrepreneurship used in my analysis was developed by economists in Warren Buffett's home state of Nebraska.)

Mary O'Keeffe
Union College
Schenectady NY

Parenthetical addition--another irrelevant but fun coincidence: Warren Buffett spent his teenage years growing up in the same Washington DC neighborhood where I grew up several decades later. His dad was a Congressman, as were some of the dads of my classmates.

More on business tax friendliness and entrepreneurship

2011-08-14T18:03:00.000-07:00

At the request of Calvin Johnson (University of Texas Law School), I have added a trendline to the plot of state datapoints on tax friendliness and entrepreneurship indicators in my last post. As you can see from the graph, the overall relationship is negative but very weak. (When I first eye-balled this, it seemed likely to be statistically insignificant, but to my surprise, after I quickly crunched the numbers, ~~I discovered that it is in fact technically statistically significant~~, though I think measurement error problems and omitted variables likely rule out any meaningfully practical significance. Correction: after a further check, the negative slope is, as I suspected originally, statistically as well as practically insignificant.)

There are clearly many omitted variables that influence entrepreneurship, some of which are likely correlated with the business tax climate. For example, states with higher business taxes might spend more on education than other states, which may be an important concern for some entrepreneurs.

There are also serious methodological difficulties in constructing any index to measure entrepreneurship. As my colleague Chris Chabris (Union College Psychology Department) pointed out, the use of patent data is problematic. Because patents are expensive to file and defend, a disproportionate share of patent filings are made by large established companies rather than small entrepreneurial businesses. So it is possible that there are many entrepreneurial inventions which are not showing up in patent data. In addition, it is possible that New York may be getting credited for patent filings made by New York City law firms, IP (intellectual property) specialists, on behalf of their client inventors located outside New York State, perhaps even outside the Unites States. Such inventors might find it convenient to give their address of record for patent filing purposes as an address "care/of" their New York attorneys.

The bottom line remains the same: the data provides no support for the conventional wisdom that "business-friendly" tax climates encourage entrepreneurship.

Does "business tax climate" affect entrepreneurship?

2011-08-14T09:59:00.000-07:00

Perhaps a little, but not in the direction that most folks would expect.

My own state of New York is the poster child for demonstrating that the conventional wisdom on this is wrong. We are perennially ranked as worst in business friendly tax climates, but a national study has also consistently ranked our state as first in entrepreneurship in recent years. (And yes, the study uses per capita statistics to adjust for population, so we don't get any breaks on that score!)

Here's a graph that puts the picture in perspective. (Click on the graph for a higher resolution view.)

<--Less Business Friendly - Tax Climate - More Business Friendly -->

The horizontal axis in the graph above shows the "State Business Tax Climate Index" computed by the Tax Foundation. As you move from left to right on the horizontal axis, the Tax Foundation asserts that the tax climate gets more and more business-friendly.

The vertical axis in the graph above shows the State Entrepreneurship Index, computed by the University of Nebraska-Lincoln's Bureau of Business Research (UNL-BBR), recently featured in an article in Bloomberg Business Week. Here is how the UNL-BBR describes their index:

The State Entrepreneurship Index combines five key components -- a state's percentage growth and per capita growth in business establishments, its business formation rate, the number of patents per thousand residents and gross receipts of sole proprietorships and partnerships per capita -- to build its state-by-state rankings.

States near the top of the graph above (plotted in green) had the highest levels of entrepreneurship, while states near the bottom (plotted in red) had the lowest levels of entrepreneurship.

My own state of New York is at the top left corner of the graph--tops in entrepreneurship, but worst in "business friendly tax climate."

As you can see, there are many factors other than business tax climate that affect entrepreneurship, but--if there is any relationship at all--it appears to be a negative one. The correlation coefficient between the tax climate index and the entrepreneurship is -.13. Thus, on average, the more "business friendly" the tax climate, the lower the entrepreneurship index in the state.

Of course, there are many deviations from that rather weak relationship. Variations in business tax climate account for less than 2% of the variations in the entrepreneurship index.

And, to be sure, the old saw applies: "Correlation does not establish causality." I am certainly NOT making the case that states should go around making their tax systems deliberately less business friendly purely on the grounds that it will encourage entrepreneurship.

But there appears to be little support for the opposite proposition--that is, there is no evidence that states with business friendly tax systems (as measured by the Tax Foundation) encourage entrepreneurship (as measured by the UNL-BBR). Other factors appear to be more important.

Update: I have added more thoughts in a followup post here.

Soda taxes again

2011-06-15T12:22:00.000-07:00

A year ago, I wrote:

Cornell nutritionist Jennifer Wilkins writes in today's Albany Times Union that she asked her economist colleague, Professor Robert Frank, and was surprised by his answer:

I asked my friend, Cornell economics professor Robert Frank, at a recent dinner party, what he thought of proposals to tax soda. I prepared myself to settle in, eyes glazed over, for some dense econ-speak about why it shouldn't be done and why it wouldn't work. Instead, I was surprised.

Without missing a beat and with a calm, matter of fact demeanor, Frank responded, "We have to tax something. It might as well be soda."

...

The beverage industry promotes statistics from polls saying that Americans don't want soda taxes, but the polls cited by the beverage industry never seem to ask participants what specific alternative tax increases or budget cuts they would prefer to a soda tax. The results of polls about soda taxes can be very different depending on how the questions are worded.

It's easy for New Yorkers to adapt to a soda tax. Soda is not a necessity, and if the cost becomes a burden, there are inexpensive substitutes readily available. Minor cutbacks in soda consumption are an easy way to hold down costs without forcing a drastic change in lifestyle. Property taxes, by contrast, are a heavy and inflexible burden on many taxpayers. It's difficult for taxpayers in the short run to do much to adjust to that burden without a major change in lifestyle. To a lesser extent, the same is true of increases in the broader-based sales and income taxes that Professor Mankiw advocates.

Although Harvard's Professor Mankiw apparently prefers a gas tax to a soda tax, I suspect that very few of those questioned in the beverage-industry-touted polls would agree--nor are New York's legislators (all of them up for reelection in the fall) likely to agree to pass increased gas taxes any time soon.

Professor Mankiw's colleague, Edward Glaeser, has warned that "All soda drinkers, even the rail-thin ones, suffer when soda consumption is either taxed or demonized."

The reality is that all taxes cause "suffering," and I don't think soda needs to be "demonized," but the net "suffering" imposed by a soda tax seems relatively small compared to the alternatives realistically available, given our dysfunctional legislature.

I acknowledge there could be implementation challenges, as Villanova Professor Maule has pointed out, but those seem to be surmountable. There's already considerable infrastructure in place for soda sold in bottles and cans.

Although a soda tax may not be a first-best solution, but we're far from in a first-best world, we're not likely to get there any time soon, and it strikes me as an experiment worth trying. If the alternative is closing state parks and public libraries, or laying off teachers, or raising our (already relatively high) broad-based taxes, a penny per ounce soda tax looks like a relatively less painful way to raise a billion dollars a year in revenue for a cash-strapped New York State.

A Quinnipiac poll conducted earlier this year suggests that a soda tax is a tax that has broad public support, when framed primarily as a revenue-raising measure. It's hard to imagine any other taxes would get the kind of public reception the Quinnipiac poll found.

Now it appears that tax lawyer Kelly Erb, who blogs as TaxGirl for Forbes, agrees with me. Earlier today, she blogged:

Realistically, to keep Philly schools open in any kind of worthwhile way – meaning, of course, that we actually have enough teachers and books to give our kids an education – funds are going to have to come from the City. The deadline for that commitment is almost here: Council must pass a budget by June 30.

There’s no money under any sofa cushions. And it’s pretty late in the game to talk other cuts. Mayor Nutter has suggested, and I think rightly so, that the alternative is to create revenue – in other words, tax more. Mayor Nutter has proposed two options: increasing property taxes or the imposition of a tax on soda and sugary drinks.

Property tax increases are pretty much a nonstarter in any municipality or state. Interestingly, Philadelphia is a relatively low property tax city to begin with, especially as compared to our suburban neighbors in southeastern Pennsylvania and New Jersey, but an increase would be politically difficult.

A soda tax has a better chance of passing because of what it represents: it’s killing us (or so they say). And that makes it evil. And thus, taxable.

Mayor Nutter proposed a similar tax on soda last year that failed. At the time, the tax was pitched as an anti-obesity measure. Studies have subsequently shown that combating obesity by increasing taxes on sodas and sugary drinks could only happen if the tax increases were big. Economist Roland Sturm said about that study:

Small taxes will not prevent obesity.

But the bigger the taxes, the more it disproportionately affects the poor and the middle class, right?

That’s what Harold Honickman, owner of the Canada Dry Delaware Valley Bottling Co. in Pennsauken, told reporters, claiming:

The problem is it’s a discriminatory tax against the poor and the middle class.

Oh Mr. Honickman. Goodness knows I love me some Canada Dry but this isn’t about discrimination. It’s not a targeted hit on the middle class. It’s a tax on soda. Let’s keep this in perspective.

I’m not a fan of sin taxes. I think taxes focused on specific products are silly and quite frankly, judgmental. What I think constitutes bad behavior and what you think may be very different. I worry about where we draw the line… What’s next? Video games? Coffee (note to legislators: don’t even consider this one or there could be serious problems)? Candy?

But in this case, I’m also not a fan of an uneducated population. Something has to give.

The bottom line: although Kelly and I agree that there's not much statistical evidence that taxing soda will decrease consumption, it will certainly increase tax revenue and it does seem to be one of the few potentially politically viable (dare I say--politically palatable?) sources of tax revenue left.

As for the effect on the poor, the Pennsylvania Department of Revenue says that sales tax may not be charged on items purchased with food stamps, so apparently imposing a sales tax on soda would not affect low income folks on food stamps.

Of course, that begs the question as to whether the laws should change to prohibit the use of food stamps for soda purchases, as New York City Mayor Bloomberg has proposed. I imagine THAT policy change might have a much bigger effect on soda consumption than taxing it would, given that one-seventh of the population currently receives food stamps.

Offshore taxes and corporate borrowing: Google as poster child?

2011-05-17T09:28:00.000-07:00

Today's Wall Street Journal reports that Google is borrowing $3 billion, despite the fact that they are sitting on $37 billion in cash already.

Greg Mankiw thinks this makes little sense to him:

Does this make sense for Google? I have no idea, and I am ready to concede that those guys are a lot smarter (and financially successful) than I am. But there is reason to be skeptical.

...

But ponder this question: If you had a friend with a paid-up house, would you suggest that he now take out a long-term mortgage in order to deposit the proceeds in a money-market fund? If not, does it make sense for Google to be doing much the same thing?

Later today, Greg posted an update from a reader suggesting a tax motivation for Google to borrow money rather than using its large cash hoard to fund future projects and acquisitions:

Update: A smart reader sends in the following plausible explanation:
While it's true that Google has $37 billion in cash and equivalents, almost all of that $37 billion is in non-U.S. accounts (an artifact of funneling most of their profits through low-tax Ireland). They cannot spend that $37 billion in the U.S. without incurring a tax rate of 35 percent; thus, the borrowing is to finance spending in the U.S. (as opposed to abroad). All the big tech companies do the same thing (Microsoft was in the news for the same thing some 6 months ago). Thus, Google is not trying to play the yield curve so much as intertemporally arbitrage the U.S. tax code. By not repatriating the $37 billion now, they are betting that the U.S. corporate tax rate on repatriated foreign profits will be appreciably lower in the future than it is now.

However, a Morningstar article report says:

The firm doesn't have the same issue with overseas cash that many of its large-cap technology peers do. Of Google's $37 billion in cash, only about $17 billion is sitting outside the U.S. Microsoft, by contrast, has no net cash remaining in the U.S., while nearly 90% of Cisco's cash is sitting outside of the country.

So perhaps Greg's "smart reader" is overstating the case when he says that Google has "almost all" its cash sitting outside the US.

Still, the financial markets apparently like Google's bet--their stock rose sharply this morning. As of this writing, Google stock is up 1.93% for the day--on an otherwise generally gloomy trading day--the Dow, S&P 500, Technology stocks in general, oil, gold, etc. are all down.

I do think there are some other intriguing tax angles to this story. Google's decision to issue debt may be tax-smart for a number of other interesting tax policy reasons besides the profit repatriation issue. More on those later.

How much are your kids worth on your tax return?

2011-05-02T08:56:00.000-07:00

As Facebook would say, "It's complicated." It depends on the amount of your income, the type of your income (earned vs. unearned), your filing status, the age of your children, whether they are enrolled in daycare or college, whether they have earned and/or unearned income of their own, whether you have set up tax-favored savings accounts earmarked for their education, just to name a few factors.

Want more? It can also depend on how much you are paying for their daycare, college, or health care expenses; whether they are full-time students for at least five months of the tax year; if they are students, it can make a difference whether they are in preschool, K-12, undergraduate, or graduate school.

And wait, there's more! There are multiple different tax breaks for education and daycare expenses, but there are also some complicated "no double-dipping" rules for each of those so the value of your kid-related spending on those categories can depend on whether you are using tax credits vs. a tax-favored account to pay for those expenses. (And, of course, it's not always easy to figure out in advance which of these will be most advantageous. And, to make matters worse, there are actually some circumstances in which using a "tax-favored" flexible spending account to pay for daycare could be worse than forgoing all daycare-related tax breaks.)

And the list goes on: if you have investment income, the taxable value of your kids can depend on whether that income comes from capital gains and qualified dividends versus other types of investment income, as well as whether your circumstances have pushed your return into alternative-minimum-tax (AMT) territory. (And, believe it or not, having too many kids can indeed be the straw that pushes your tax return into AMT.)

Elaine Maag of the Tax Policy Institute captures one dimension of that complexity in this graph:

The graph above is based on a single parent of two children under age 13. The graph's construction also assumes that the only household income are the taxpayer's wages, and presumably also makes some other simplifying assumptions about the amount spent on daycare for the children, the use of the standard deduction, etc.

Even in that relatively simple and straightforward scenario, it is clear that the tax value of children has a rather incoherent roller-coaster shape.

There is a wealth of additional details in her recent article with her TPC colleagues Stephanie Rennane and C. Eugene Steuerle, A Reference Manual for Child Tax Benefits, which is highly recommended reading for anyone interested in this topic.

One very notable omission from that article, however: there is very little discussion of the fact that virtually all the tax benefits associated with children go to the custodial parent of the child.

At our VITA site, we see a number of non-custodial parents paying significant amounts of child support (NYS law has a formula based on the number of children which can be 17% to 35% of income) and yet they typically get none of the federal tax benefits associated with the children they are supporting. (In a small number of cases, the custodial parent has chosen to exercise her option to sign over a few of the tax benefits she is allowed to yield to the non-custodial parent, but this is quite rare. Some divorce agreements may require the custodial parent to sign over those tax benefits, but many VITA taxpayers have no such provisions. In some cases, they do not have the means for a formal divorce; in other cases, they have never been married to their child's other parent, so there is no possibility of a divorce decree.)

One additional wrinkle: many states, including New York State, have state income tax provisions that amplify the tax benefits shown in the graph above. For example, New York State has a "piggy-back" EIC, which can add 30% to the EIC amounts shown in the graph above. (In an especially noteworthy departure from federal rules, New York also has a special additional EIC for some non-custodial parents who make all required support payments.) In addition, New York State has a generous child care tax credit which--unlike the corresponding federal credit--is refundable, an especially valuable provision at the bottom end of the income scale.

New York leads the way? Efile mandates for self-prepared returns too!

2011-04-10T19:47:00.000-07:00

You know how the New Hampshire license plates have a tagline that reads: "Live free or die." Maybe New York State should have a tagline "Efile or die"--well, that's really too strong, but "Efile or pay a fine" is not snappy enough to fit on a license plate.

Efile mandates for paid tax preparers are nothing new. New York State started requiring them last year, and the IRS has begun requiring tax pros to efile federal returns also. (With a few exceptions for adamantly artisanal professionals like the Wandering Tax Pro.)

But New York State recently decided to go a step further and apply the mandate to do-it-yourselfers as well: starting in September of this year, New York State taxpayers who use tax software to prepare their own returns, even without a tax pro, MUST efile them.

Albany Times Union reporter Rick Karlin posted a link to the NYS Tax Department's Summary of Tax Provisions in the newly enacted 2011-2012 budget, which was passed in the wee hours of the morning March 31.

Check out page 2 of that document:

Part U, Sections 13 through 17-b, of Chapter 61 of the Laws of 2011 create several changes to the requirements for electronic filing of tax returns.

If a tax return preparer prepared more than five original tax returns during any calendar year beginning on or after January 1, 2011, and if in any succeeding year that preparer prepares one or more returns using tax software, then all tax documents prepared by that preparer must be filed electronically. ...

If a taxpayer does not use a tax return preparer, but instead prepares its income tax return using tax software, those returns must be filed electronically.

Ahem, first off, I am not too thrilled with the New York State Tax Department's choice of pronouns: "its income tax return," indeed! Taxpayers who prepare their own returns, with or without software, are not neuter! A better way to express this: "Taxpayers who use tax software to prepare their own returns must file those returns electronically."

Taxpayers who refuse to comply with the efile mandate for self-prepared returns will face fines of $25, unless they can show their paper filing was due to reasonable cause. Professionals who violate the mandate are subject to a $50 fine. Also, taxpayers who violate the mandate can be denied interest to which they might otherwise be entitled on late refunds.

I don't know about this particular policy.

There are lots of taxpayers who currently use software to prepare and print out nicely formatted and legible paper returns with some degree of arithmetic and logic checking as well as scannable 2-d barcodes that make those returns easy to process.

If this policy goes into effect, then those New York taxpayers who are adamantly opposed to efiling will no longer use software. Their returns may be less legible, may have more transcription errors, and certainly will not have 2-d scannable barcodes.

Interestingly, the provision will not go into effect if voluntary efiling exceeds 85% this year. So, if most New York returns get efiled, a small minority of dyed-in-the-wool semi-Luddites who "v-code" their tax returns will be allowed to continue to do so without incurring penalties. (The term v-code refers to the practice of filing a paper return prepared using tax software.)

Kudos to NYS Tax Department

2011-03-28T09:48:00.000-07:00

As I posted earlier this month in Ground Hog Day: Time for Another Tax Audit, my husband and I were audited by NYS Tax Department for the second consecutive year on the same issue. (This time it was our 2007 tax return; last year it was our 2006 tax return; even though the state has acknowledged we were correct both years, we expect yet another audit on the same issue on our 2008 tax return!)

However, we got a very pleasant surprise this year.

The folks at the New York State Tax Department have enormously streamlined their audit process by allowing taxpayers to respond electronically to their audit notices.

A lot fewer trees died this year--both on their end and on our end--we had zero postage costs and the tax department's postal costs were also much lower, not only because we used the efile option, but also because they eliminated the redundant notices sent last year (every document they sent us last year arrived in two identical copies in separate envelopes, one to my husband and one to me, even though we have filed joint returns from the same address for decades. This year, they just sent one notice addressed to both of us.)

Elapsed time last year from the day we mailed our response to the day New York State acknowledged we were right: eight weeks.

Elapsed time this year from the day we efiled our response to the day New York State sent a (postal mail) that we were right: three weeks.

Keep up the good work!

On-line poker winnings

2011-03-09T12:25:00.000-08:00

A reader (who wishes to remain anonymous and who is NOT a VITA client) writes:

I have a quick tax question in honor of my darling off-spring. Do you have to pay taxes on money won through on-line poker, and if so what's the amount you need to "earn" to pay taxes, and if you don't file taxes, will anyone ever figure this out?

My answer:

Yes, darling offspring absolutely does need to pay taxes on money won through on-line poker. It's no different than winning a state lottery or winning a year's worth of dog food on a game show--it is taxable income.

The general principal is "All income, from whatever source derived," is taxable unless there is an explicit provision in tax law exempting it."

There is no provision in tax law exempting on-line poker winnings, so it's definitely taxable.

If the offspring in question can be claimed as your dependent, he can earn up to $5,700 in wages on a W-2 before s/he needs to file a tax return. However, unearned income (which is probably what the IRS would consider his gambling winnings, since I gather he is not a professional gambler) has a much lower minimum filing requirement. Over $950 in unearned income, and your dependent offspring definitely needs to file a return.

But, bear this in mind: once he has enough income to be required to file a return for any reason, then even $1 of gambling income needs to be reported on it. So...let's say offspring makes $6,000 in wages and thus has to file a return, and he wins a $1 on-line poker bet. Then the IRS will expect to see total income of $6,001 reported on the return.

As for whether anyone would ever figure that out, I would not hazard a guess on that. For years, people thought that if they kept their money in Swiss bank accounts, the IRS would never find out because Swiss banking laws kept the info out of IRS hands. Well, that information is no longer protected--foreign banks, including Swiss banks, have come under pressure to share information about their depositors with the IRS. Some folks are in a lot of trouble going back years and years--trouble they never dreamed of at the time they put the money in those foreign bank accounts. The amounts of taxes, interest, and--especially--penalties can be huge, far greater than any original tax owed.

On-line gambling is a highly visible target for the IRS--and rules on accounting for losses and offsetting them against gains are really tricky--you really need to keep excellent documentation especially if you had losses as well as wins. The IRS is very quick to assess tax on gross income but the other side of the coin--allowing deductions for losses is much trickier. As the tax law rulings say, "Deductions are a matter of legislative grace," and that means that you need to cross all the t's and dot all the i's in adhering to the rules to get the benefit of any of those deductions to potentially offset some of the gambling winnings.

There are technical aspects of gambling tax law that go beyond my IRS VITA certification. We can handle small routine gambling winnings, like a state daily numbers win, but I would tell any prospective VITA client who had a complicated ledger of wins and losses in on-line poker that s/he is out-of-scope for us, and needs to consult a professional tax preparer knowledgeable in gambling tax law.

I would also advise such a person NOT to wait until tax season to think about these issues. They need to maintain meticulous records to stay out of trouble. Enrolled Agent Russ Fox specializes in gambling tax issues and has some useful background perspectives in these articles.

The bottom line: get thy darling offspring to a knowledgeable tax professional if s/he has been engaging in on-line poker games for money.

Some things are better than a tax deduction!

2011-03-05T09:43:00.000-08:00

A month ago, I blogged about my former student, Sarah Yergeau, who has been spending this year teaching English and math in Uganda at a school with no books in English. Sarah launched a campaign to get contributions of books which has been very successful so far. The first two shipments of books and a storage cabinet have arrived, and many more books are due to be shipped off soon.

Understandably, there was no time or easy way to get 501(c)-3 status, so the contributions are not deductible for tax purposes.

That didn't stop me and a number of others from donating*--there are some benefits to donation that transcend tax benefits--such as the good feelings I get from looking at photos of Sarah, the students, and the staff of the school as they build the cabinet and stack the treasured books on the shelves.

For a closer look at those photos, go here.

I designated my contribution to purchase copies of Eric Carle's The Very Hungry Caterpillar, a book that my own children enjoyed enormously and read many times, over and over, when they were young. Reading over the list of other authors on the school's "wish list" brought back many happy memories of reading with my children when they were young. (Priceless!) To see a list of the books on the school's wish list, and which ones have been donated so far, go here. It's not too late to get involved. There are still more books on the wish list and donations of funds to help with shipping costs are also welcome. See here for more.

*Footnote: by the same token, many taxpayers do not itemize and therefore get no tax benefit from donations, even when donating to an organization with 501(c)-3 status, but a surprising number of them are still quite generous. As previously mentioned, a good survey of the literature is available in this paper.

Honey, I efiled the audit (I think!)

2011-03-02T12:42:00.000-08:00

There was one big difference between last year's New York State audit and this year's New York State audit: the opportunity to respond electronically!

Last year, the audit notice suggested I could resolve the issue by phone. That turned out to be 24 minutes of entirely wasted time, at the end of which I was told that we needed to mail in our response. So I typed up a response and hied myself off to the post office to send it off in a way that gave us proof of delivery. The post office notified us of delivery two days later but the NYS tax department took seven weeks to acknowledge receipt of our letter and an additional week to actually respond in a substantive way.

This year, the audit notice suggested we could respond using our Online Service Account at www.nys.gov.

Nice interface! I just took last year's letter of response and updated it by changing references to "2006" to "2007" and cut and pasted it into the electronic submission box. I had up to 1,000 characters for my response, which was plenty, but if I'd needed more room, or if I'd needed to attach supporting documents, I could have done so by attaching document files to my response.

Advantages of electronic audit response:

1) No trip to the post office
2) No postage
3) Immediate acknowledgement with a confirmation number from NYS tax department

So....we'll see what happens next.

Stay tuned.

David Williams: take note--New York is leading the way here! The IRS should definitely be doing something like this!

Ground Hog Day: Time for another audit!

2011-03-02T12:30:00.000-08:00

In February 2010, my husband and I had the experience of a NYS audit on our 2006 New York return. You can read the details of that audit experience here. It was successfully resolved in our favor.

Fast forward to February 2011, well, it's just like in the Groundhog Day movie: we got an almost identical audit notice on the exact same issue on our 2007 New York tax return.

But, there's one big difference--stay tuned for my next post.

Full service tax prep business?

2011-02-15T20:10:00.001-08:00

This place is apparently for real. Source [highlighting added] The IRS lists an authorized efile provider at this address.

Here's a list of their business "products and services."

Interested? They even have coupons.

They even offer live music in their Candlelight Lounge--if you come in next Friday, February 25, to do your taxes, you can catch this band's gig while waiting for your preparer:

Who takes out those "instant refund loans"?

2011-02-15T11:36:00.001-08:00

Answer: a lot of folks! One in seven taxpayers who filed a 2008 return took advantage of a "bank product," the euphemistic name for a Refund Anticipation Loan (RAL) or a Refund Anticipation Check(RAC).

A newly released Treasury Department study has some answers, based on analysis of millions of tax returns by the Tax Policy Center:

Not too surprisingly, users of RALs and RACs were more likely to be:

lower income
young adults
single head-of-household filing status
recipients of Earned Income Tax Credit
users of paid preparers

However, the study found that the balance has been shifting in recent years, as more taxpayers have switched from the very high cost RALs to the lower cost RACs:

The shift was especially marked among active duty military taxpayers, after recent legislation put a cap limiting the APR interest rates that could be charged to military families, which drastically reduced the profitability of offering RALs to such families.

The decrease in RALs is likely to continue as bank regulators make it clear that they take an increasingly dim view of such products, and the IRS discontinued its facilitation of that business by removing the "debt indicator" from the acceptance reports it issues to efile providers.

There are fascinating geographic differences in the prevalence of bank products, as the map below shows:

In general, the study found that a low-income taxpayer living in a high-density poverty area is more likely to use a RAL than a similarly low-income taxpayer living in an area with lower poverty rates.

Hat tip: Trish McIntyre

Full service tax prep business?

2011-02-15T06:13:00.000-08:00

Some paid tax preparers are all about the "one stop shopping" concept.

A GAO report noted that many used car dealers will do your taxes (and apply your refund as a down payment to the purchase of a car) and there's a shoe store that will give you a free pair of shoes with every tax return they prepare. Pawn shops are also big on tax preparation.

And this morning, I encountered new heights in the full service/one-stop shopping concept.

Here are excerpts from an exchange on a discussion forum for users of professional tax software:

Tax Pro 1: Where are you sending your customers with large refund checks to have them cashed? ...

Tax Pro 2: We do it ourselves charge 2%. ...

Tax Pro 3: I didn't know that an Income Tax Preparation Firm was allowed to cash client's checks.

Tax Pro 4: We have a check cashing license. We are also a liquor store.

Keeping Twitter in San Franscisco and GE in Schenectady

2011-02-13T14:16:00.000-08:00

Today's New York Times reports on the dilemma facing San Francisco as it considers the use of tax incentives to keep Twitter in a troubled neighborhood in their fair city.

San Francisco did something last week that most economists say cities should never do, but that most do all the time, anyway: it offered a special tax deal to keep an important local business, in this case Twitter, from leaving town.

The effectiveness of such tax breaks has always been in doubt. And new scrutiny of development subsidies statewide, spurred by Gov. Jerry Brown’s attempt to eliminate redevelopment agencies and enterprise zones, suggests they are largely ineffective — and costly. In many cases, subsidies don’t ultimately affect a company’s location or investment decisions. Moreover, local incentives are by nature beggar-thy-neighbor games that funnel public funds to private companies.

Yet it may make good sense to bring Twitter to the forever-down-on-its-heels Mid-Market district of San Francisco. Frankly, I suspect the company wants to stay in the city anyway, for the obvious cultural reasons. But if it can be persuaded to go to Ninth and Market, it might be a catalyst for the revival of a desperate neighborhood. And such catalysts don’t come along very often.

Today's Daily Gazette reports that departing Schenectady Mayor Brian Stratton has successfully faced the same issue with GE:

Financial turnaround

When he won office in 2003, he learned, to his shock, that the city was nearly out of money. Minutes after being sworn in on Jan. 2, 2004, he delivered a sobering speech in which he warned that the city would run out of cash by May unless he took drastic steps.

Residents questioned his figures, but an audit found the city had a $6.6 million deficit, which the state Comptroller’s Office predicted would grow to $10.2 million by the end of the 2004 if nothing was changed.

Stratton’s administration turned the city’s finances around in less than two years.

The deficit was wiped out in 2005 and replaced with a $4.9 million surplus.
It wasn’t easy. The biggest steps were the sale of the city’s money-losing parking garage, to the Metroplex Development Authority, and convincing the state to let Schenectady sell its unpaid tax liens to a private collections company.
Selling those liens — millions of dollars in unpaid taxes owed to the city — was the main solution.

Democrats said Stratton’s work put the city in the best possible position for the budgetary crisis it faces today, with reductions in state aid and rising pension and health costs.

“We were in trouble,” said Richard Naylor, the city Democratic committee chairman.

“Let the record show, look what we’ve done — it’s a miracle.”
Moody’s Investors Services agreed. In 2006, the highly-regarded risk analysis firm said Stratton had “restored fiscal stability to the city.”

In a four-page report about its decision to move the city back to an investment-grade credit rating, the agency wrote, “Schenectady’s financial condition is significantly stronger than it’s been since before 2000.”

Stratton also joined forces with county Legislature Chairwoman Susan Savage to rebuild the relationship with General Electric, trying to erase years of distrust and tax battles.

“It was a very intensive, round-the-clock effort,” Metroplex Chairman Ray Gillen said. “Brian worked very hard to improve the relationship.”

Relations were so strained in 2003 that General Electric managers vowed not to add anything to the campus and instead began demolishing buildings, slowly reducing its taxable value.

But the new atmosphere led GE to begin building its Renewable Energies Headquarters here in 2008 and to add its battery plant last year, which will more than double the amount of taxes it pays the city.

If Watson loses, Uncle Sam and New York State win!

2011-02-12T07:57:00.000-08:00

If Federal and New York State officials worried about ballooning deficits tune in to Jeopardy this coming week, they should be cheering for the humans! The US and New York State Treasury will collect four to five times as much income tax revenue if the computer comes in last.

The grand prize for this competition will be $1 million with second place earning $300,000 and third place $200,000. Rutter and Jennings will donate 50 percent of their winnings to charity and IBM will donate 100 percent of its winnings to charity.

Source: IBM Press release

IBM can easily afford to be generous if it wins the big million dollar prize. The favorable publicity associated with winning first place is worth far more than a million dollars. Donating the money will give its corporate image an additional boost. Moreover, it's likely that IBM will be able to deduct the full million dollars from its taxable income. IBM had almost $15 Billion in taxable income last year, and although it has a track record as a generous corporate giver, it is very unlikely that an additional million dollars of corporate giving will put IBM over the 10% limit on deductible corporate contributions.

On the other hand, human beings like Ken Jennings and Brad Rutter, would be far more likely to hit the limit on deductible donations if they were to donate the full amount of their winnings to charity. Those rules are complicated and depend on the type of charity, so Ken Jennings and Brad Rutter should definitely read those IRS rules in Pub 526 carefully before deciding which charities should get their donations. (Ken Jennings may also want to make use of his free lifetime tax advice from H&R Block by asking their opinion as well.)

Here are some back-of-the envelope calculations, using 2010 federal and NY tax rates. (As usual, we will make some simplifying assumptions. We'll ignore other income and deductions aside from charitable donations and state tax that Mr. Jennings and Mr. Rutter might have, assuming their other deductions will wipe those out. To make life simple, we will also assume they both use married filing joint tax status. I believe that Mr. Jennings is married. I am not sure if Mr. Rutter is married, but--if not--he still has until December 31 to get married to a spouse with no taxable income of her own if he'd like to minimize his taxes. These assumptions are reasonable first approximation assumptions. Refining those assumptions would most likely strenghthen the argument even further.)

Million dollar winner:

If Watson wins:
million dollars goes to charity of IBM's choice
zero tax revenue to US and NYS

If human wins:
$500K goes to charity of winner's choice
approximately $140K goes to US Treasury
approximately $70K goes to New York State Treasury
human takes home about $290K after donation and tax

Second place prize: $300K

If Watson takes second:
$300K goes to charity of IBM's choice
zero tax revenue to US and NYS

If human takes second:
$150K goes to charity of 2nd place winner's choice
approximately $25K goes to US Treasury
approximately $10K goes to New York State Treasury
human takes home about $115K after donation and tax

Third place prize: $200K

If Watson takes third:
$200K goes to charity of IBM's choice
zero tax revenue to US and NYS

If human takes third:
$100K goes to charity of 3rd place winner's choice
approximately $14K goes to US Treasury
approximately $6K goes to New York State Treasury
human takes home about $70K after donation and tax

Bottom line:

If Watson comes in first, US government gains about $40K in revenue while New York State gets about $16K in revenue.

If Watson comes in last, US government gains about $165K in revenue while New York State gets about $80K in revenue.

So Watson losing will generate four to five times as much tax revenue as Watson winning.

VITA preparers are awesome even when they are not preparing tax returns

2011-02-04T11:59:00.000-08:00

Sarah Yergeau was an awesome VITA student in my Eco 391 Tax Policy and Practice service-learning class last year. She is spending this year as a Minerva Fellow teaching English and math in an elementary school in Uganda. Her blog is here.

Sadly, the children in her school spend years studying English but have no actual books to read, so Sarah has constructed a "Wish List" of classroom sets books she would like to collect and leave behind at the school as a legacy for years to come.

As I read over her wish list, I saw many familiar and fondly remembered family favorites: Eric Carle, Roald Dahl, and Dr. Seuss. If you are near Union College, you can drop off donated books at Dean McEvoy's office. You can also donate cash via PayPal. Details are here.

To answer the inevitable question: I do not see any evidence on the website that donations are tax deductible. (That is not surprising, since completing the paperwork for a tax deductible project is daunting, especially if you are in Uganda.)

However, it still sounds like a wonderful cause--and one that is near and dear to my heart, since my dearly beloved dad was a librarian, so I didn't let the lack of deductibility deter me from making a donation.

[Parenthetical obligatory tax policy note: there is a rich and fascinating economics literature on elasticity of charitable giving with respect to the tax deduction. It turns out that low-income taxpayers give a larger percentage of their income to charitable causes than the rich, despite the lack of any tax incentives to do so. For a recent survey of this literature and some intriguing empirical evidence from a field experiment, see here.]

More on corporate effective tax rates

2011-02-03T12:00:00.000-08:00

David Leonhardt in today's New York Times:

The Paradox of Corporate Taxes

The Carnival Corporation wouldn’t have much of a business without help from various branches of the government. The United States Coast Guard keeps the seas safe for Carnival’s cruise ships. Customs officers make it possible for Carnival cruises to travel to other countries. State and local governments have built roads and bridges leading up to the ports where Carnival’s ships dock.

But Carnival’s biggest government benefit of all may be the price it pays for many of those services. Over the last five years, the company has paid total corporate taxes — federal, state, local and foreign — equal to only 1.1 percent of its cumulative $11.3 billion in profits. Thanks to an obscure loophole in the tax code, Carnival can legally avoid most taxes.

It is an extreme case, but it’s hardly the only company that pays far less than the much-quoted federal corporate tax rate of 35 percent. Of the 500 big companies in the well-known Standard & Poor’s stock index, 115 paid a total corporate tax rate — both federal and otherwise — of less than 20 percent over the last five years, according to an analysis of company reports done for The New York Times by Capital IQ, a research firm. Thirty-nine of those companies paid a rate less than 10 percent.

Arguably, the United States now has a corporate tax code that’s the worst of all worlds. The official rate is higher than in almost any other country, which forces companies to devote enormous time and effort to finding loopholes. Yet the government raises less money in corporate taxes than it once did, because of all the loopholes that have been added in recent decades.

Later in the article, Leonhardt reports: ‎"G.E. is so good at avoiding taxes that some people consider its tax department to be the best in the world, even better than any law firm’s."

Note that all the resources (i.e., the time of very smart people) devoted to avoiding taxes legally (or evading them illegally) are a deadweight loss from an efficiency point of view.

A simpler and fairer tax code would free up the time of all those smart folks who are currently assigned to inventing clever new strategies for tax avoidance for pursuits of genuine productivity.

Mistakes! Everybody makes them! All returns deserve a "second look"! And a third! And a fourth!

2011-02-01T06:57:00.001-08:00

Philadelphia tax lawyer Kelly Erb, who blogs as TaxGirl, posted about the advertising/PR/legal war going on between the two big tax prep chains, H&R Block and Jackson Hewitt.

Much of it centers on H&R Block's Second Look campaign, in which Block says they will take a "second look" at your tax return for $29. If they find mistakes, they will advise you on the next step to take, which is to prepare an amended return. According to Block, they find mistakes in a majority of the returns they review under this program.

This is not very surprising. It is easy to make mistakes in tax prep. Some may not be fault of the previous tax preparer. The taxpayer may have misunderstood an interviewer's question or may have neglected to bring a document with them to the preparer.

That is why it is essential that ALL TAX RETURNS, including those prepared by Block itself, should get a "second look."

In fact, the IRS effectively has a "second-look" mandate for all VITA-site prepared returns. They don't call it a second-look. They call it a quality review.

Our VITA site carries the "second-look" process much farther than the IRS rules require.

1) First look: an IRS-VITA certified tax preparer interviews the taxpayer, examines the taxpayers' documents, annotates the IRS required VITA intake and interview form, prepares a pro forma paper estimate of what the taxpayers' return should look like, and then begins entering the data into a computer in TaxWise. The taxpayer is looking over the preparer's should as the preparer enters the data. At several points, the taxpayer is asked to double-check information as it is being typed in, especially critical information like the taxpayer's address and bank account information (if it's a direct deposit return.) If the preparer has any questions while preparing the return, s/he asks for help from the site coordinator (me!) After completing the computer return, the preparer "reality-checks" it against the pro forma paper estimate. The preparer also runs the TaxWise diagnostics command to check for certain types of technical errors that could prevent efiling.

2) Second look: An IRS-VITA certified Quality Reviewer comes to the table, sits down with the printed out draft return and the source documents and works through a detailed checklist to search for any errors in the return. The client is still sitting at the table and available to answer any questions that arise in the Quality Reviewer's mind. The Quality Reviewer checks with the site coordinator (me!) if s/he has any questions.

3) Third look: The original preparer walks the taxpayer line by line through every item on the federal and state returns to make sure that the taxpayer understands and agrees with the accuracy of the documents we have prepared. Again, they check with the site coordinator (me!) if they have questions.

4) Fourth look: Prior to efile, I sit down in a quiet place with all the source documents and preparer notes. If any questions arise in my mind, I contact the preparer, the quality reviewer, and/or the taxpayer for any additional information I feel is needed to make sure the return is accurate prior to submitting the efile.

After all this, are there still errors on the returns we prepare?

Indeed there are. It is unavoidable. Taxpayers and preparers are fallible. A common source of error is that after efiling, the taxpayer receives another W-2 in the mail for a small side job held early in the tax year that he'd forgotten all about. Perhaps it arrived late because it had been sent to an old address and required mail forwarding.

That is what amended returns are for. But we try to minimize the need for those as much as possible. It is best to interview the client carefully and try to help jog their memories as much as possible so we can get the return right the first time. The returns we prepare are only as good as the information we get from our clients. (In case you are wondering, if we feel the taxpayer is deliberately not providing accurate information, we will politely decline to prepare their return and refer them to a professional preparer. We also do this when the taxpayer's situation is sufficiently complicated that it falls outside the scope of our certification.)

But if the taxpayer is willing to work with us to provide accurate information and if the return falls within the scope of our certification and training, our VITA site will happily provide as many "looks" as we feel we need to make sure the return is right.

And we do it for free.

Sign of the times: last year's refunds went UP over 5% but the number of returns filed went DOWN over 1%

2011-01-30T13:56:00.001-08:00

Tax journalist Kay Bell has been running a series of posts about the recently released IRS statistics on last year's filing season.

It's interesting to note that the average refund grew by 5% last year, but the number of returns filed was down 1% over the previous year.

It's easy to come up with explanations for the increase in the average refunds: the big home buyer tax credits and the new American Opportunity education credit likely increased refunds for many taxpayers. In addition, the economic downturn may have increased the number of taxpayers eligible for the Earned Income Credit.

As to the decrease in the number of returns filed, that also may be due to the economic downturn. Fewer people may have had enough income to incur a filing requirement in 2009, and/or fewer people may have had tax withholding to justify filing a return even in the absence of a filing requirement.

Two histories of tax rates

2011-01-30T08:25:00.000-08:00

These two graphs paint very different pictures of the history of our federal tax system.

The first graph, which shows STATUTORY MARGINAL income tax rates, looks like a roller coaster. It comes from the Wall Street Journal, where it accompanies a fascinating article, Soaking the Wealthy: An American Tradition, written by tax historian Joseph Thorndike. The article gives a great bird's eye view of how the progressivity embedded in our country's tax system has changed over time.

The second graph, with a green line that shows EFFECTIVE AVERAGE federal tax rates, looks far smoother over the past six decades. It comes from Jon Gruber's Public Finance & Public Policy 3rd edition, the textbook I use in my fall term public finance class.

What is going on? Why is there such a disconnect between the two graphs?

A few big things:

1) When statutory marginal rates were high, there were far more "loopholes" available and also far more incentive for taxpayer to take advantage of those loopholes. This is most true for the highest income taxpayers, who have the means, motive, and opportunity to seek out the best possible tax treatment for their income. The latest IRS statistics of income study showed that the wealthiest 400 taxpayers in the country were paying less than 17% in effective average tax rates in 2007, which is less than the average American paid that year. Even some taxpayers eligible for VITA services paid a higher percentage of their income in federal taxes than 17% that year.

2) The roller coaster graph shows only the statutory individual INCOME tax rates. The green line in the second graph depicts all federal tax revenues, including payroll taxes, corporate income taxes, and excise taxes. Payroll tax rates have grown in recent decades, somewhat offsetting the decline in income tax revenues. (Corporate income taxes and federal excise taxes have also declined in importance relative to payroll taxes.)

NYT on divergence between statutory and effective tax rates

2011-01-28T18:54:00.000-08:00

From an editorial in today's New York Times:

Satisfying business interests can be tricky. Mr. Obama wants, for example, to reduce the 35 percent top corporate tax rate. That might sound like music to corporate ears, but it could easily run into powerful opposition. That’s because the president has rightly linked the reduction in the marginal tax rate to closing the loopholes in the tax code that allow many corporations to pay much less in taxes than they should.

Despite the high corporate tax rate, taxes on corporate income only raise an amount equal to 2.1 percent of the gross domestic product. That is way below the 3.5 percent of G.D.P. raised, on average, across the Organization for Economic Cooperation and Development.

If you are 64, the IRS has a Valentine for you!

2011-01-28T12:34:00.000-08:00

The Beatles sang:

When I get older losing my hair,
Many years from now.
Will you still be sending me a valentine
Birthday greetings. Bottle of wine....
... When I'm 64

Here's the answer: if you are 64, the IRS has a valentine for you!

The TaxWise blog reports:

IRS Quick Alert: Reject 204 Update

Please be advised that the correction to Error Reject Code 0204 will be implemented nationwide on February 14, 2011 for the 6:00 p.m. drain. The correction will allow the age 64 of the primary and/or spouse to be accepted on the return.

We apologize for any inconvenience this may have caused.

This is rather cryptic, but it seems to mean that we will not be able to efile tax returns for taxpayers who are age 64 until February 14.

This is a bit mystifying--hard to imagine how this particular delay can be blamed on Congressional procrastination.

Why should 64-year-olds be singled out for this delay in processing their efiles?

It is also not clear if this is just true for efiles via TaxWise (the software program used by many commercial tax preparers as well as VITA sites) or if this is true for all efiles. [Update: As I suspected, this appears to true for ALL efiles. See, e.g., the Intuit community here.]

Fortunately, we have apparently not had any 64-year-old taxpayers at our VITA site thus far this year.

If we get any 64-year taxpayers this coming week, I am not looking forward to having to explain why their refunds are going to be delayed for over two weeks longer than everyone else.

Maybe we should play this video for them:

After all, the song ends:

Give me your answer, fill in a form
Mine for evermore
Will you still need me, will you still feed me,
When I'm sixty-four.

A hat tip to my husband for suggesting this song!

effective vs. statutory rates duke it out

2011-01-28T08:11:00.000-08:00

What does it take to get folks interested in a discussion of effective vs. statutory rates? I can see your eyes glazing over already.

Let's try this.

Schenectady is full of colorful characters. Shown above "duking it out" are Carl Strock, a sharp-tongued long-time Menckenesque columnist for our awesome local newspaper, The Daily Gazette, and former Schenectady Mayor Frank Duci, a legend in his own time. (Among former Mayor Duci's more "creative" ideas for local public finance: he once proposed buying lottery tickets in hopes of winning enough to close the gaping hole in the city budget. When asked why he appointed his stepson, an unemployed apprentice tile-layer, to run the Municipal Parking Authority, our former mayor cited the aforesaid stepson's 200 bowling average as evidence of his powers of concentration. Fortunately, Schenectady is no longer counting on such lottery luck or bowling scores. Our current Mayor, Brian Stratton, received a national award for excellence in public-private partnerships at last week's National Conference of Mayors, right before President Obama traveled with him up to Schenectady to speak at the newly revitalized GE turbine plant.)

But I digress: now that I've got your attention, I will quote from Carl Strock's Daily Gazette column today, because it does a great job of highlighting the important distinction I keep talking about with my students, the distinction between statutory and effective rates:

I did take note of Rep. Bachmann’s warning that the United States has “the highest corporate tax rate in the world,” and that we should “look no further to see why jobs are moving overseas.”

A ho-hum line that would be at home in any Republican stump speech, you might say, but it made a nice, if unintentional, fit with President Obama’s recent appointment of GE leader Jeff Immelt to chair an economic advisory council.

Nice because GE is one shining example of how not to pay taxes, regardless of what the corporate tax rate might be, and also one shining example of moving jobs overseas.

Republicans, Tea Partiers and Angry Ones in general have an affection for big corporations like GE that is hard to fathom, and President Obama might have seemed to be playing to them — moving to the center, as the commentators say — by appointing the head of GE to advise him on rescuing the American economy.

But what a choice.

GE last year paid a lousy 3.6 percent on $10.3 billion in profits; the year before it paid nothing and instead got a $1.1 billion credit.

Never mind the official tax rate of 35 percent that conservatives deplore. No multinational corporation with an accountant on its staff pays that. It moves its money around, putting profits on its books in countries where tax rates are lower and losses on its books in countries where tax rates are higher.

Everyone knows that except possibly Rep. Bachmann and the Tea Party Express. I bet the president knows it.

The statutory corporate tax rate cited by the Tea Party is 35%.

The effective corporate tax rate actually paid by GE last year was 3.6%, roughly one-tenth of its statutory rate!

But it's hard to fault GE for this. It is the fault of the tax code, not GE. GE's responsibility to its shareholders is to maximize their profits using all legal provisions in the tax code.

Google and Facebook pay even lower corporate tax rates than GE. Much of that effective tax rate manipulation can be done through accounting tricks that do not require actually moving jobs overseas, just manipulating paper profits through clever transfer pricing schemes that move the locus of accounting profits to low-tax countries where little or no actual production takes place, such as Bermuda or the Cayman Islands. Such strategems have colorful names like the "Double Irish" and the "Dutch sandwich."

It is not just low-income working families with children eligible for refundable credits who have effective tax rates lower than their statutory rates.

However, it is important to note that the huge divergence between effective and statutory rates all over the spectrum of individuals and corporations raises many issues of horizontal equity and vertical equity.

In the corporate sphere, the divergence also raises "level playing field" problems, since companies able to hire the most effective lobbying advocates for tax expenditure loopholes that favor them will have an advantage in generating after-tax profits.

Explaining the "Refund Anticipation Check" product

2011-01-28T06:06:00.001-08:00

The Wandering Tax Pro Robert Flach asks:

I do not understand the “Refund Anticipation Check” being offered by Henry and Richard in replacement of a Refund Anticipation Loan (RAL).

I just heard an ad that says it takes 15 days to get a Refund Anticipation Check from H+R Block (granted it was a Jackson Hewitt ad).

If you submit the return electronically, as H+R will, and choose Direct Deposit you should get your refund in 15 days or earlier.

Why would anyone in their right mind pay Henry and Richard a ridiculous fee to give them a check when the IRS will have the money in their account in the same amount of time or sooner absolutely free?

Here is the rationale for the Refund Anticipation Check (RAC) offered by Block (and many small tax preparers as well.)

Many taxpayers they serve simply do not have the cash to pay for their tax return preparation up front. The RAC product allows Block to deduct their tax prep fee from the refund. That way Block is sure of getting its fee.

The RAC product (like its cousin the RAL) also reduces the transparency of the transaction--the taxpayers may not notice how much they are paying for tax return prep because it is buried in a huge stack of paperwork as an item subtracted from their refund.

To my Eco 391 students: this is what behavioral economists mean when they talk about the "salience" (i.e., visiblity) of a price. Effectively, the RAC allows the tax preparer to reduce the salience of the price they are charging for their product.

Government officials can and do exploit salience just as private business people do. For example, fewer people realize how much they pay for tolls now that many folks use EZ-pass. Many people have no idea how much they pay in gas taxes, because it is buried in the price of the gas they buy. Many people also have no idea about how much they pay in taxes due to payroll withholding--they focus on the "refund" they get rather than all the money that was withheld from their paychecks throughout the year.

For more about salience, see the following three papers:

"E-ZTAX: Tax Salience and Tax Rates," Amy Finkelstein The Quarterly Journal of Economics, MIT Press, vol. 124(3), pages 969-1010, August 2009

"Schmeduling" Jeffrey Liebman and Richard Zeckhauser, 2004

Raj Chetty & Adam Looney & Kory Kroft, "Salience and Taxation: Theory and Evidence," American Economic Review, American Economic Association, vol. 99(4), pages 1145-77, September 2009.

800 on math SAT and master's degree but baffled about taxes?

2011-01-27T12:13:00.000-08:00

From a comment by "Mike" in the New York Times last year:

I graduated in the top 10% of my high school class. I have a master’s degree. I scored an 800 on my math SATs.

It absolutely BAFFLES me how people manage to buy homes and do their taxes.

I have a 401k account, a Roth IRA account, stock options and grants from my employer, stock holdings worth a few grand via at least one trading website, school loans, a car payment each month, a bank account with my debit & credit cards, and an online savings account.

There is no way I can keep track of all of that at once. Smith Barney could steal $5,000 from me tomorrow – just pull it out of the balance of my 401k or Roth IRA or something – and I’d never know it was gone. I don’t even know who I owe my student loan repayment to… all I know is I pay them $170 per month, and they pull it right out of my checking account. I *think* the balance is $10k or so, but if I somehow managed to log into their website (assuming someone told me what it is) and I saw I owed $13k, I wouldn’t be surprised and I wouldn’t complain.

Stop and Shop could randomly charge my credit card $52.64, or $111.09, on a day I never even went there, and there’s probably an 80% chance I would never notice.

And this is before we even get into the fact that I have NO idea what a mutual fund is, what a bond is, or what the hell Smith Barney is doing with my money. The financial system is so utterly complicated and ridiculous, I think it only serves to keep the number of people who “understand” it very low, so they can continue to take advantage of those who don’t.

— Mike

The comment from "Mike" was posted in a Freakonomics column last year--see comment #13 here.

Despite all his education and credentials, Mike seems clueless about his finances. He is far from alone. I have heard many highly educated people make similar comments.

The challenges faced by many taxpayers at our VITA site are even greater. We serve immigrant taxpayers whose first language may not be English, disabled taxpayers including some who have visual or cognitive disabilities which makes understanding IRS forms and instructions very difficult.

Government officials have made errors in their own taxes. There is no excuse for our government to maintain such a dysfunctional and unnecessarily complex tax code.

Zelenak: Complex Tax Legislation in the TurboTax Era

2011-01-26T12:17:00.000-08:00

Here is the abstract of Prof. Zelenak's fascinating article on Complex Tax Legislation in the TurboTax Era.

When tax returns were prepared with pencil and paper—in an era now gone forever—Congress did not impose income tax provisions of great computational complexity on large numbers of taxpayers, in the belief that it was unreasonable to require average taxpayers (or their paid preparers) to struggle with computationally complex provisions. As return preparation software gradually replaced the pencil in recent decades, the complexity constraint weakened and eventually disappeared. Congress has responded by imposing unprecedented computational complexity on large numbers of taxpayers—primarily through the expanded scope of the alternative minimum tax and the proliferation of phase outs of credits, deductions, and exclusions. This response would not be problematic, if the only objection to computational complexity were the difficulty of performing the calculations—a difficulty overcome by the widespread adoption of software. Unfortunately, computationally complex provisions generally constitute bad tax policy, even apart from computational concerns. For taxpayers faced with a welter of computationally complex provisions, the income tax is a black box, the inner workings of which are beyond their comprehension. This undermines both the political legitimacy of the tax system and the ability of taxpayers to engage in informed tax planning. In response to the demise of the complexity constraint, argues this Essay, Congress should develop a self-imposed constraint against the enactment (or survival) of computationally complex provisions of widespread applicability.

The entire text is available here.

If you need more inducement, check out this fascinating excerpt:

The earliest tax return preparation software was developed by a handful of small companies in the late 1970s and early 1980s. The early adopters were overwhelmingly paid preparers, rather than taxpayers preparing their own returns. For example, in 1982 Jackson Hewitt—now the nation’s second largest tax preparation service, but then just a small business in Virginia—took the radical step of using self-developed software to prepare all its customers’ returns.

By 1987, about a quarter of all paid preparer returns were being produced on computers. Newspaper and magazine stories about the possibility of self-preparers using software did not appear until 1983. Data do not exist on the extent of software use by self preparers in the 1980s, but according to a leading expert on the growth of the use of return preparation software “[i]t is reasonable to infer that very few self-preparers used software” even towards the end of the decade.

The greatest growth in the use of return preparation software occurred from the mid-1980s to the mid-1990s. Only 13% of all individual returns had been prepared on computers in 1987, but 67% of all returns for tax year 1997 were computer-prepared.

This included 87% of paid preparer returns and 45% of self-prepared returns.

Much of the growth in software use during this period was attributable to the pencil-to-software transition by industry giant H&R Block. Block did not use return preparation software at all until 1990, and did not complete the transition to software until 1993.

By tax year 2006 (the most recent year for which data are available), 89% of all individual returns were prepared on computers. This included 98% of paid preparer returns and 71% of self-prepared returns. In light of the seemingly inexorable trend, it is very likely that the data for returns for tax year 2008, when they become available, will indicate that fewer than one return in ten is now being prepared using pencil and paper.

Although our tax system is complex, many people have very simple tax returns. It doesn't always take a rocket scientist or computer software to prepare some tax returns. It would be good if more folks at least attempted a rough draft of their tax returns with paper and pencil as a "reality check" BEFORE they start crunching the numbers.

Or folks could even use a simple self-designed computer spreadsheet. That is what I used in the 1980s before commercial tax software was available.

Many people might be pleasantly surprised that their taxes are actually more understandable than they previously realized. And for those who discover they aren't in that happy state, that their taxes are truly byzantine--they should contact their Congressional representatives and read them the riot act.

It shouldn't take a PhD in math from Berkeley to understand your income taxes, nor should it require mysterious and opaque "black box" software.

Income inequality on parade

2011-01-25T05:28:00.000-08:00

Jan Pen, a Dutch economist who died last year, came up with a striking way to picture inequality. Imagine people’s height being proportional to their income, so that someone with an average income is of average height. Now imagine that the entire adult population of America is walking past you in a single hour, in ascending order of income.

The first passers-by, the owners of loss-making businesses, are invisible: their heads are below ground. Then come the jobless and the working poor, who are midgets. After half an hour the strollers are still only waist-high, since America’s median income is only half the mean. It takes nearly 45 minutes before normal-sized people appear. But then, in the final minutes, giants thunder by. With six minutes to go they are 12 feet tall. When the 400 highest earners walk by, right at the end, each is more than two miles tall.

Source: Economist

In recent decades, those two-mile high giants have seen their incomes grow much faster than the general population. Because their incomes have grown, their tax bills have grown, but their tax bills have grown much more slowly than their incomes. This graph from seeking alpha.com shows the trend in their effective average tax rates.

If we consider federal income and payroll taxes combined, there are many taxpayers eligible for VITA services (under $49,000 household income) who pay higher effective tax rates than the 400 highest income Americans.

Kudos to the IRS ...

2011-01-22T09:44:00.000-08:00

... for once again doing the best to deal with an increasingly messy tax code and Congressional procrastination.

Our VITA site opened this week and our first batch of efiles have been promptly acknowledged. Year in and year out, we efile 99% of the tax returns my students prepare, and taxpayers generally get their refunds direct deposited within 10 to 14 days of visiting us. (If they request a mailed check rather than direct deposit, you can add an additional 10 days or so.) Modernized efile may further speed up those numbers, but TaxWise will not be allowing Modernized Efile for a few more weeks.

However, there are still a few exceptions to the near-universal efiling which we experience at our site.

1) Taxpayers who want to claim homebuyer credits on Form 5405 must still file paper returns, because they need to attach documents providing acceptable evidence that they did, in fact, buy a home qualifying for the credit. David Williams, IRS Director of Electronic Filing and Refundable Credits, says that--within a few years--efiles will be able to include PDF attachments, but we are not yet there.

2) Some efiles are rejected due to the fact that another tax return has already claimed the same Social Security Number (SSN) that our taxpayers claimed. Important note: for privacy reasons, the IRS will NOT reveal the name of the other taxpayer who has claimed you or your dependent on their return. The IRS will only inform you that the same SSN has already been claimed on a different taxpayer's return.

In those cases, the taxpayers' only option to secure the refund to which they are rightfully entitled is to file a paper return, and eventually the IRS will contact them to get the information they need to sort it out.

Eventually, the rightful taxpayers will get the refund to which they are entitled. If the delay is very lengthy, they may also get a small amount of interest to partially compensate for the delay.

The speedy taxpayers who beat the rightful taxpayers to the punch and collected refunds to which they were not entitled will be required to pay back those wrongful refunds--plus interest and possibly substantial penalties, especially if there is clear evidence of fraudulent intent and/or serious negligence on the part of the wrongfully-filing taxpayer.

Tax Reform "writing on the wall graphs"

2011-01-20T09:42:00.000-08:00

Thanks to Iowa CPA Joe Kristan for calling my attention to these VERY salient graphs prepared by the Joint Committee on Taxation (whose chief economist is my former classmate, Tom Barthold) for today's tax reform hearings.

Connecting the dots between these graphs is a great way for my students to take a step back and look at the "big picture" behind the tax returns they are preparing.

Commentary will follow soon! No time to write more right now. We open for business tonight!

Statutory vs. Effective marginal tax rates

2011-01-16T11:21:00.000-08:00

As you've probably noticed, I have been posting a number of VITA workbook taxpayer scenarios on this blog. I'll be posting a few more. I'll also be posting a few "celebrity taxpayer" scenarios, namely those of politicians who have made their tax returns public, including Sarah and Todd Palin, Joe and Jill Biden, and Barack and Michelle Obama.

We will be looking at their statutory and effective marginal tax rates, as well as their effective average tax rates.

This post is about statutory vs. effective marginal tax rates, which are key for economic decision-making.

Basically, a marginal tax rate answers the question: if my income goes up by a thousand dollars, how much will my tax bill go up? (Or, alternatively, how much of that thousand dollars do I actually get to keep, after taking the tax increase into account.)

There are two ways to answer that question: the statutory answer (i.e., the tax law states quite precisely how the tax on line 44 of the 1040 will respond to a thousand dollar increase in the taxable income on line 43) or the real bottom line answer, which we call the effective marginal income rate.

The two graphs below give some idea of how much those two concepts can differ.

The graph above comes from Chapter 18 of Jonathan Gruber's Public Finance and Public Policy textbook, which we used in my fall term public finance class. It shows the statutory marginal tax rates, and looks nice, neat, and tidy--and progressive. Here is a link to a complete listing of the statutory marginal tax rates for all filing statuses, both current and historical (going back to the 1940s.)

The economic reality of taxation, however, is about far more than the statutory rates, due to the many intersecting complications of the tax code. The graph below comes from an article by Urban Institute economist Greg Leiserson, showing the effective marginal tax rates on working families.

But even this graph just scratches the surface of the complexity in the tax code. To keep the analysis simple, the graph above assumes all income comes from wages and considers only a limited number of credits and deductions. As soon as we start to look at other kinds of income, credits, and deductions, there are even more possibilities for marginal tax rates all over the map.

For example, consider the VITA workbook case study of Odessa Parks, whose circumstances are typical of many VITA/AARP clients. Her datapoint is off the charts above: at an income of $35,000, her effective marginal federal income tax rate is a whopping 67%. If we add in her payroll taxes (Social Security & Medicare) as well, the combined effective federal income and payroll marginal tax rate goes to 82%.

And wait, there's more! If we assume she's a New York State resident, her effective state marginal tax rate is an additional 18%.

The bottom line: for a taxpayer like Odessa Parks, a thousand dollar raise could easily make zero impact on her after-tax income, because her effective marginal tax rate is so high. Statutory marginal tax rates are only part of the story. You need to look at the entire tax situation to figure out exactly how much of that raise a taxpayer can keep.

Workbook Case Study 5: Maurice Washington

2011-01-15T15:21:00.000-08:00

Maurice Washington
computer technician
income $29,481
supports and lives with his 11-year-old son, Willie
paid for daycare for Willie and continuing professional education for himself
contributed to a 401(k) plan
flex spending plan for daycare

Workbook Case Study A: Quincy & Colby Bennett

2011-01-15T15:05:00.001-08:00

Quincy and Colby Bennett
machine operator and school counselor
married filing jointly
income $36,939
income sources: wages, interest, unemployment benefits, gambling
support a college student daughter,
a young granddaughter, and a disabled brother

Workbook Case Study 4: Windsor & Teena Clark

2011-01-15T15:02:00.000-08:00

Windsor & Teena Clark

supervisor and office assistant

newlywed in October 2010
married filing jointly

income: $68,242

live with and support Windsor's 12-year-old daughter from a previous marriage

Workbook case study 3: Charlotte Cunningham

2011-01-15T13:38:00.000-08:00

Charlotte Cunningham
dental assistant, age 52
income $40,404
married filing separately
lives with & supports her 20-year-old college student daughter

Who pays a higher tax rate?

2011-01-14T05:44:00.000-08:00

Rose Hudson
college student, waitress
Income $7,935
Effective average tax rate 18%
(combined federal income & payroll tax)

Sean & Stacey Graham

retired CIA agent/tutor and high school teacher/waitress
Income $61,922
Effective average tax rate 1%
(combined federal income & payroll tax)

These two case studies from the VITA workbook provide a good illustration of how the complications in our income tax system affect its progressivity.

Rose Hudson qualified for very little in the way of income tax breaks, due to the fact that she is a dependent of her parents. She paid 3% of her income in federal income tax. She also paid payroll taxes (FICA contributions for Social Security and Medicare) on her wages. Using the standard Congressional Budget Office incidence methodology (which assumes that the effective burden of employer and employee share of payroll tax falls on the worker), her total federal income and payroll tax burden was 18% of her income.

Sean and Stacey Graham qualified for a great many income tax breaks. They support a household of five; paid bills for college tuition, daycare, health care, mortgage interest, a new high efficiency hot water heater, real estate taxes, retirement contributions, student loan interest, and more. Thanks to refundable credits for Making Work Pay, Additional Child Tax Credit, and the American Opportunity college tuition tax credit, their federal income tax rate was actually negative: their federal income tax liability was entirely eliminated by non-refundable credits, and they received 4% of their income in refundable credits. They also paid payroll taxes on their wage and self-employment income, but much of their income was investment, pension, unemployment benefits, or other income not subject to payroll tax. The bottom line: they paid 1% of their income in federal income and payroll tax.

There is a strong case to be made for the idea that Rose Hudson, who is supported by her parents, can afford to pay a higher income tax rate than other taxpayers like the Grahams, who have many more financial responsibilities, but many people would be surprised by the actual magnitude of the tax rate differential.

For more details on Rose Hudson's tax situation, see this post. For more details on Sean and Stacey Graham's tax situation, see this post.

IMPORTANT NOTE: These are fictional taxpayer scenarios created by the IRS to help VITA and AARP volunteers practice. They are designed to be representative of the kinds of taxpayers who qualify for assistance at VITA and/or AARP sites.

Workbook Case Study B: Sean & Stacey Graham

2011-01-13T19:09:00.001-08:00

By contrast to Rose Hudson's return, the Graham return is lot more complicated! They have brought in a pile of documents: two W-2s, a 1099-INT, two 1099-DIVs, a 1099-MISC, three 1099R's, a 1099-G, a Form SSA-1099, a W-2G, a 1098-T, and shoebox full of receipts and cancelled checks.

Sean and Stacey Graham are a married couple who live together with their sons, Joshua and Jeremy. Joshua is 11 and Jeremy is a 21-year-old full time college junior. Stacey's mother, Gail Forsyth, also lives with them.

Sean, age 60, is a retired CIA agent and former police officer who is partially disabled, collects several pensions, and works part-time as a self-employed tutor. He contributed to a traditional IRA.

Stacey, age 53, works as a 9th grade teacher, and has a part-time side job as a waitress, including some additional tips she was not required to report to her boss but is required to report to the IRS. She was also unemployed for a while and collected unemployment benefits in 2010. She won some money on slot machines, and had some gambling losses as well. She served jury duty for which she received jury duty pay and had to pay some of that amount back to her employer. Stacey contributed to a 401(k) at work as well as to a traditional IRA. She put $1,000 into a flexible spending plan designated for child care, but she wound up spending $2,500 for Joshua's afterschool daycare. They also paid for Jeremy's college tuition, as well as interest on Stacey's student loans.

Because Sean and Stacey own their home, they paid mortgage interest and real estate taxes. They also had a large amount of medical bills, donated money to several organizations, paid union dues and safe deposit fees. In addition, they installed a high efficiency hot water heater in their home.

Sean and Stacey provided more than half the support for Stacey's mother, Gail, even though Gail had a small amount of income from a part-time job, bank interest, and Social Security. Gail paid for a course to improve her skills for her part-time job. Sean and Stacey want to know if they can claim Gail as their dependent, and--if so--whether they can claim an education credit for the tuition she paid.

The complete details of their Interview and Intake Sheet, interview notes, and tax documents are available here.

Their filing status is Married Filing Jointly with 5 exemptions. They have three dependents: Joshua and Jeremy are Qualifying Children (QC) dependents and Gail is a Qualifying Relative (QR) dependent.

Their total income on line 22 is $61,922.
(Their Haig-Simons income is arguably even higher than that, due to exclusions.)

Their above-the-line deductions ("Adjustments") are $7,649.

Their adjusted gross income on line 37 is $61,922 - $7,649 = $54,273.

Their itemized deductions total $12,378, and their exemptions total $18,250.

Their taxable income is $54,273 - (12,378 + 18,250) = $23,645

Their tax before credits is $2,691.

Their non-refundable credits ($300 daycare credit, $1,620 education, $675 energy, and $96 in child tax credit) completely wipe out that $2,691.

Then they also get refundable credits of $800 (Making Work Pay), $904 in Additional Child Tax Credits, and $1,000 in the refundable part of the American Opportunity Credit.

So their income tax after credits is negative $2,704.

Their effective average tax rate is -2704/61922 = negative 4%

Their statutory marginal tax rate is 15%.

Their effective marginal tax rate is slightly higher than 15%, approximately 16%. In their particular case, this discrepancy is largely due to the fact that additional income will slightly decrease the amount of their allowable medical deductions. (As we saw in class the other day, the discrepancy can be much greater than this for other taxpayers.)

You can see their complete tax return here.

Because they had $3,605 in federal tax withheld last year, and they owe $604 in self-employment tax, their federal refund will be $5,705.

Workbook Case Study 2: Odessa Parks

2011-01-13T18:22:00.001-08:00

Odessa Parks
customer service rep
income $35,363
effective average federal tax rate 7%
(income & payroll tax combined)
effective marginal federal tax rate 82%
(income & payroll tax combined)

Odessa Parks is divorced and lives with her son and daughter. Odessa pays for all the household expenses, all the support of her children, and most of the support for her elderly mother, Angie, who also lives with them.

Odessa earned $30,612 as a customer service rep and she also collects Social Security widow's benefits of $8,250 based on her first husband's earnings record. She had no other income.

Her complete annotated Intake and Interview form and tax documents are available here.

Her filing status is Head of Household (HoH), due to the fact that she pays more than half of the cost of keeping up the home for herself and at least one qualifying dependent. She can claim four exemptions on her return, one for herself, two for her Qualifying Children (QC) Corey and Asia, and one for her Qualifying Relative (QR), Angie. She will also be able to claim her two children as "Qualifying Children" for Earned Income Credit and for Child Tax Credit.

Before entering the data into TaxWise, I recommend making up a rough pro forma estimate of what the 1040 will look like, which you can use later as part of the quality review. You can see that pro forma estimate here.

Her actual tax return is here.

Odessa's total income on line 22 is $35,363.

She had no above-the-line deductions ("adjustments"), so her adjusted gross income on line 37 is also $35,363.

Her HoH standard deduction is $8,400 and she can also subtract the value of her four exemptions (4 x $3,650 = $17,300) from her AGI to compute her taxable income of $12,363.

The first $11,950 of her income is taxed at 10% and the remaining $413 is taxed at 15%, yielding a tax on line 42 of $1,259.

But...as they say on late night TV, "Wait! There's more!"

She is entitled to $2,000 in child tax credit. The first $1,259 of that credit wipes out her tax liability down to zero, so we enter that in line 51 as a "nonrefundable credit."

Her tax liability is now zero.

But, again as they say on late night TV, "Wait! There's more!"

She qualifies for the remaining $741 as a refundable "Additional Child Tax Credit" on line 65. She also qualifies for $400 in the refundable Making Work Pay Credit and $1,050 in refundable Earned Income Credit, making her tax liability AFTER credits equal to NEGATIVE $741 + 400 + $1,050 = NEGATIVE $2,191.

Thus, Odessa's effective average federal income tax rate is negative $2,191/35,363 = -6%.

If we consider her payroll tax (FICA contributions for Social Security and Medicare) as well, and use the standard CBO assumptions about payroll tax incidence, her total federal effective average tax rate is actually a positive 7%.

Her marginal federal tax rate is far higher than her average federal tax rate.

To see that, let's imagine she got an additional thousand dollars worth of income. If that income came in the form of wages, her total federal tax bill (income and payroll tax combined) would increase by about $820, giving Odessa an effective marginal tax rate of 82%!

As we talked about in class last week, Odessa's effective marginal tax rate is well above her statutory marginal tax rate for several reasons: 1) she is on the phase-out portion of the Earned Income Credit schedule, so her EIC goes down as her income increases and 2) the amount of her taxable Social Security income increases as her other income increases.

Other taxpayers will often have effective marginal tax rates that differ a good bit from their statutory marginal rates--in both directions. We will talk about this more in class.

Workbook Case Study 1: Rose Hudson

2011-01-13T13:27:00.000-08:00

Rose is a 22-year fulltime student at a local college. She lives at home with her parents, who provide most of her support. She worked part-time at Jack's Steakhouse, where she earned $7,914 in 2010. Her savings account at People's Bank paid $21 in interest. She is unmarried and had no other income. You can read her complete annotated Intake & Interview Sheet, tax documents, and interview notes here.

She is a Qualifying Child (QC) dependent of her parents, so she can't claim a personal exemption for herself. (This would remain true even if her parents choose not to claim her on their return.)

Because she can be claimed as a dependent, she is not eligible for the Making Work Pay Credit. (Again, this would remain true even if her parents choose not claim her on their return.)

Her total income on line 22 is $7,935.

Her adjusted gross income on line 37 is also $7,935.

Her taxable income is $2,235.

Her federal income tax before credits is $224.

Her federal income tax after credits is $224.

Her effective average tax rate is $224/7,935 = 3%.

Her statutory marginal tax rate is 10%.

Her effective marginal tax rate is also 10%.

Although Rose's tax liability was $224, her employer only withheld $199 from her paycheck last year. As a result, she has a balance due of $25 and will need pay that amount before April 18, 2011 in order to avoid interest and penalties.

Rose's tax situation is very typical of many students, and quite simple, yet very few college students feel capable of preparing their own tax return. That is not surprising, because there are many mysterious wrinkles in the tax code, most of which do not apply to their particular situation.

Greater Capital Region VITA Kickoff Ceremony today

2011-01-08T13:07:00.000-08:00

Congressman Paul Tonko, Tom Morley from Greater Capital Region United Way, Mary O'Keeffe (accepting the new "Wally" VITA award on behalf of the Union College Kenney Community Center VITA site), Albany County Executive Michael Breslin, and Joanne Passineau (our award-winning Senior Stakeholder Relationship Tax Consultant for the IRS Albany Territory SPEC Office) at today's VITA kickoff ceremony held at Catholic Charities in Albany.

It was a great honor for the Union College VITA program to be honored as the 2011 recipient of the "Wally", a new annual award presented by the United Way CA$H Coalition, named after Wallace "Wally" Donnelly, a very dedicated long-time Albany VITA volunteer who died one year ago. The photo below shows Wally assisting a taxpayer in 2009.

Elected officials, VITA volunteers from non-profit organizations around the Capital District, IRS officials, and Wally's family were all on hand to honor his memory as we launch another filing season.

Congressman Tonko (with me, below) was enthusiastic in his support for the VITA program as an important means of making our tax system more progressive, as well as developing empathy and a shared understanding of the economic challenges that many members of our community experience. Wealthy Americans can afford expensive tax advisors to take advantage of all applicable provisions in the tax law, but VITA volunteers help to make sure that working families and senior citizens receive all the tax benefits Congress has directed specifically towards lifting many families from below the poverty line to above the poverty line, while also encouraging many desirable social goals including work, savings, education, and human capital formation.

My husband, Ross Miller, and our older daughter, Alison, were also there. Unfortunately, our younger daughter Catherine--who is an extraordinary entertainer of taxpayers' children while their parents get their tax returns prepared--was ill and unable to attend. Thanks to my entire family for being so awesomely supportive and understanding about all the nights I spend away from home during tax season. My husband took the photos above. Thanks to Congressman Tonko for grabbing my husband's camera and getting the nice photo of Ross and Alison with me at the ceremony.

The many outstanding Union College students and staff who have contributed to the success of the Union College VITA site were unable to be there today, but I would like to acknowledge them all below:

Student Preparer Hall of Fame

Filing season 2005: Devon Bruce, Erica Chambers, Adrienne Dodge, Michelle Lombard, Adam Pennacchio, Adrienne Ringer, Gregory Shaffran, Ellen Spicer

Filing season 2006: Simi Koshy, Luke Labella, Jared Levy, James Martin, Mudan Liu, Justin Merolla, Mark Susko

Filing season 2007: Michael Alberti, Jason Bye, Dianna Crawford, Lauren Eilberg, Meaghan Horton, Hadley Planting, Lindsey Quereau, Brad Wagoner, Mark Zagata

Filing season 2008: Ashley Braniecki, Fengguan Chen, Allison Dantus, Sarah Ehle, Thomas Haynes, Steve Walker, Christopher Walkley, Alexander Zani

Filing season 2009: Vincent Chau, Yu (Christina) Chen, Jacob Deveney, Moosa Haider, Chelsea Hargis, Karin Santiago, Sarah Scott, Jeremy Taglieri, Ashley Braniecki (alumna at Kenney Center), Meaghan Horton (alumna at YWCA of Schenectady partner site.)

Filing season 2010: Amy Block, Karen Chan, Kelly Fleming, Allison Frederick, Matt Goodrich, Kerry Hanson, Erin Hubbell, Dan Kutner, Christina Liquori, Lauren McCormick, Veronica Mynders, Will Pinkston, Alex Scheier, Mike Spicer, Gabe Webster, Sarah Yergeau, Ashley Braniecki (alumna)

Filing season 2011: Ed Burnam, Ryan Castello, Jared Dickson, Katie Ferrara, Michael Jacobson, David Leavitt, Andrea Marois, Ted McKenna, Sarah Reid, Brett Sussman, Dan Vivian, Zach Weil

We are also very grateful for the many Union College faculty and staff members who have enthusiastically supported the Union College VITA program since Dean Therese McCarty first launched it in 2005, as well as to Bank of America for its financial support.

High profile taxpayers, efiling, tax history, and progressivity

2011-01-05T09:33:00.000-08:00

My students have been working hard to prepare for the IRS VITA certification exams so they will be ready to prepare tax returns for low-income working families and senior citizens who use our VITA site.

It's interesting to consider how the tax system affects other members of society who don't qualify for VITA.

Do US Presidents efile their tax returns?

According to the archived returns released to the public by recent presidential and vice presidential candidates in recent decades, it appears that only one major party candidate efiled his or her tax return. Any guesses who it was? The answer is here.

Looking at presidential tax returns provides a fascinating window into tax history. For more on this, see Joseph Thorndike's Private Returns, Public Rewards: The Politics of Tax Records here .

Finally, for some serious economic theory, check out my post on

A game theorist takes on Mankiw, Joe the Plumber, Obama, Buffett, Atlas Shrugged.

One of the folks who agrees with Warren Buffett that the rich should pay more tax is Bill Gates' dad, who has been lobbying hard for a more progressive tax system.

An entertaining note comes from Bill Gates, who said--a few years ago that IRS computers can't handle his taxes .That article about is four years old, but apparently the problem was the large number of digits required in some of the income fields in his tax return. I wonder if the new modernized efile system my former student, Dave Williams, is bringing on-line can handle Bill Gates tax return.

Seventh commandment: Thou shalt not claim MFS filing status for thy taxpayer who qualifies for HoH.

2011-01-05T08:53:00.000-08:00

Married filing separately (MFS) is the absolute worst filing status for most of our VITA site taxpayers. It makes them ineligible for many important tax benefits, most notably Earned Income Credit and educational tax credits.

Virtually any tax benefit that has an income ceiling is off-limits to MFS taxpayers.

Many of my students wonder why MFS taxpayers can't get those tax benefits allowed to every other filing status.

Here's my answer: consider the case of Bill Gates' wife. Let's suppose she had only a small amount of income in her own name, because she spends most of her time on volunteer work. If the tax laws allowed a MFS filer to qualify for those tax benefits, taxpayers like her would be eligible to receive them, even though they are clearly not the intended audience.

However, IF our legally married taxpayer maintained a home for herself and a qualifying child AND if she did not live with her husband during the last six months of the tax year, she may qualify to be "considered as unmarried" for the purposes of Head of Household (HoH) filing status. In that case, the taxpayer would be eligible for all the low-income taxpayer benefits that would have been denied to her as an MFS taxpayer.

So, the only way that a married person like Melinda Gates could potentially qualify for HoH filing status would be to be live with one or more of her qualifying children in a separate household from Bill for more than the last six month of the tax year AND to have provided more than half the costs of the household herself.

MFS filing status is always a worse deal for the taxpayer than HoH filing status, so it is important to always work carefully through the filing status charts to consider the HoH possibility.

Some taxpayers have no alternative, unfortunately. Suppose, for example, a taxpayer lives by herself, but is legally married, even though she has no absolutely idea where her husband is. Or perhaps she does know where he is, but does not want anything to do with him, because she is a victim of domestic violence. Her only legal filing option might be MFS.

Of course, a legal divorce would solve the taxpayer's problem and allow her to file as Single, which is not as good as HoH but much better than MFS. However, divorce is often an expensive and difficult proposition for low-income taxpayers.

Ages when taxpayers and/or dependents turn into pumpkins

2011-01-03T04:25:00.000-08:00

(My choice of photo might strike you as odd, given the time of year. But I love the wonderfully evocative image of Cinderella's carriage turning into a pumpkin at the stroke of midnight, just as some tax benefits do! Also, my birthday is on Halloween. Also, my sister-in-law Dinah carved this cool giraffe and sent me a set of tools so I can carve cool stuff into pumpkins myself. I have four pumpkins sitting around from Thanksgiving that I will eventually carve. Suggestions for something tax-related to carve are welcome. Or not tax-related, for that matter. Dinah is a psychiatrist and President of the Maryland Psychiatric Society. She and two psychiatrist friends write a highly entertaining and frequently informative blog called Shrink Rap. Both of us like giraffes, even though they have nothing to do with psychiatry or taxes.)

Age 0
(born by midnight December 31, 2010)
Taxpayer claiming dependent of this age get a whole year's worth of tax benefits on their 2010 return.

(Basic tax topic)

Under Age 13*
Taxpayers are eligible to claim child care tax benefits for dependents under 13. If the dependent turned 13 during 2010, only the expenses for daycare before his birthday can be claimed.

(Basic tax topic)

Under age 17
(born AFTER December 31, 1993)
Taxpayer who have Qualifying Child dependents of this age get the Child Tax Credit ($1,000 per child.)
(Basic tax topic)

Under age 19*
(born AFTER December 31, 1991)
Maximum age for a Qualifying Child dependent unless QC is a full-time student.
(Basic tax topic)

Under age 24*
(born AFTER December 31, 1986)
Maximum age for a Qualifying Child dependent who is a full-time student.
(Basic tax topic)

Between age 25 and age 65
(born between January 1, 1946 and January 1, 1986, inclusive.)
Taxpayers of this age are able to claim EITC even if they do not have a QC dependent.
(Note: taxpayers of any age qualify for EITC if they have a QC.)
(Basic tax topic)

Age less than 59 1/2
Taxpayers who withdraw funds from an IRA, 401(k), 403(b) or similar retirement plans before this age may be subject to a 10% penalty for premature withdrawal
(Intermediate tax topic)

Age 65 or older:
(born before January 2, 1946)
Taxpayers of this age can take a higher standard deduction
(Basic tax topic)

Age 70 1/2
Taxpayers must begin mandatory withdrawals from tax deferred retirement plans beginning in the year they turn 70 1/2 and continuing each year for the rest of their lives.
(Advanced tax topic)

IMPORTANT: Age restrictions above marked with a * have exceptions if the taxpayer or dependent are disabled.

WSJ: Taxing Year Brings a Less-Taxing Year

2011-01-03T02:40:00.000-08:00

WSJ reporter Laura Sanders summarizes what happened in tax policy last year--as we came up against a December 31, 2010 "turn into a pumpkin" deadline we'd been anticipating for almost a decade:

In the normally staid world of taxes, 2010 was downright tumultuous. Never was so much done to so many by so few—and for such a short time.

Lawmakers in December finally settled questions on income, capital-gains and other taxes that had been burning for months, lowering rates for nearly all U.S. taxpayers compared with what they were set to be in 2011.

But the legislation amounted to a giant punt: The changes are good only for two years at most, setting up another election-year tax war in 2012. And it will add nearly $1 trillion to the public debt, plus interest.

"The losers of this year's tax battles were those who wanted to face our fiscal issues," says Clint Stretch, an analyst with Deloitte Tax in Washington. "Now tax and debt issues will be at the center of the 2012 presidential campaign."

In short, the "turn into a pumpkin" deadline has been kicked down the road two years, expensively.

Still, the changes do present opportunities for tax planning that wouldn't have been available otherwise. And some certainty, however temporary, is welcome after a year of swirling questions.

This is certainly true--a relief at least for those of us at VITA sites that must figure out how to help our taxpayers comply with the tax laws in as sensible a manner as legally possible--as well as a relief to high-priced tax advisors whose clients have huge amounts of money at stake hanging on many the many decisions for which tax considerations may be make or break.

Here is how Laura Sanders described some of those decisions and concerns:

The controversy began on Jan. 1 of last year, when the estate tax lapsed for the first time since its enactment in 1916, due to Senate inaction in late 2009. All year, as billionaires including George Steinbrenner and others less wealthy died, their anxious heirs and advisers tried to guess what would happen: Would there be a retroactive fix? No tax at all for 2010? Relief for heirs who suffered from the tax lapse because of a corresponding rise in capital-gains taxes?

Others worried about the 2011 return of the estate tax, scheduled to snap back from zero to a low $1 million exemption per individual and high 55% rate. Jokers suggested "throwing Momma from the train" on Dec. 31.

Income-tax turmoil followed, as President Obama and lawmakers sparred over whether to extend the expiring "Bush tax cuts" of 2001-03 to all U.S. taxpayers or only to couples making less than $250,000 ($200,000 for singles). Upper-bracket taxpayers wondered if the top rate would rise to 39.5% from 35%. Investors worried that expiration would spike the top dividend rate to 39.6% from its current historic low of 15%.

Meanwhile, the "patch" adjusting the Alternative Minimum Tax for inflation expired at the beginning of 2010 and threatened to pull an extra 21 million taxpayers onto the rolls of a tax originally meant for the rich and sophisticated. Other popular provisions, such as one for individual-retirement-account donations, also lapsed last January.

The tension built through the year. "My phone started ringing off the hook with panicked business owners who wanted to sell before capital-gains rates went up," says Beatrice Mitchell, a principal at Sperry, Mitchell & Co., a boutique mergers firm in New York that says it has just had the best results in its 25-year history.

Corporate executives and insiders also raced to unload shares at the end of the year, given higher stock prices and looming possible tax increases. According to Trimtabs Investment Research, the value of these shares sold or donated beginning in November topped $23 billion—the highest two-month total since just before the financial crisis began in 2007.

Many private and some public firms, including Progressive Corp., Warner Chilcott Ltd., and Sycamore Networks Inc. also paid higher dividends ahead of the possible tax increase, Other firms, including Kraft Foods Inc. and Altria Group Inc., sent a letter to shareholders urging them to lobby their representatives to vote against the scheduled increase.

And here is what happened:

The drama persisted until an 11th-hour compromise worked out between the White House and Senate Republican leaders. On Dec. 16, the House of Representatives grudgingly passed the Senate's bill, giving payroll managers barely enough time to figure paychecks for this year.

The results were generous beyond what many dared hope: income and investment tax rates maintained at current levels for all; an AMT "patch"; a $5 million-per-individual estate-tax exemption and a 35% rate; most "extenders" extended; and federal unemployment payments for the jobless extended.

The surprise was a one-year, 2-percentage-point cut in the employee portion of Social Security, or Federal Insurance Contributions Act, taxes. Savings will vary according to income, but could be as much as $2,136 for a worker earning more than $106,800, the maximum subject to FICA tax.

The change was the first major payroll tax cut ever. It also was the third time for the year that lawmakers altered payroll taxes, which largely had been exempt from the tinkering the income tax has long been subject to. The March health-care overhaul raised payroll taxes for 2013 for those making more than $250,000, and another temporary change lowered the employer's portion of payroll taxes to encourage some job creation.

So what now?

Many advisers see this year's changes as providing a two-year window to plan for higher taxes that may be coming when lawmakers tackle deficit issues. This is especially true for investors with large capital gains or those who would owe gift and estate taxes, who have far more ability than wage-earners to time their taxes.

Capital gains, gift and estate taxes also are at historic lows, so they could rise more steeply. Already a new 3.8% tax on investment income kicks for those earning over $250,000 in 2013 ($200,000 for singles) to finance the health-care overhaul.

The new estate and gift tax is especially well-suited to those trying to plan around future tax increases. For the first time, one $5 million per-taxpayer exemption applies to estate, gift and generation-skipping taxes. Lawmakers didn't restrict leveraging techniques, such as Grantor-Retained Annuity Trusts, that enable taxpayers to give away many times in real value the nominal amount of a gift.

With proper planning over the next two years, says attorney Joshua Rubenstein of Katten Muchin Rosenman LLP, "Almost no one needs to pay estate tax unless they want to."

Unlike higher-income folks, most low-income working families have little they can do to change their 2010 tax liability at the last minute. They have little discretion over their short-term financial lives.

So we will do our best to help them comply with the 2010 tax law that applies to them, making the best of the circumstances available to them.

But there is a "slot-machine" aspect to the tax code for them. They come in the door of our VITA site, not really sure what to expect. Some will leave with large refunds. Others will get the disappointing news that they owe money, due to the vicissitudes of a withholding system that does not capture the complexity of tax laws and a volatile financial world that makes it hard to predict how many dependents a taxpayer will have until after the year is over.

A simple example: a taxpayer couple might have been expecting to claim a teenage dependent, but perhaps the teenager got a raise or worked more hours at their part-time job in December or used their savings to buy a large amount of "stuff" that counted as self-support. Suddenly, they lose the dependent--who might have been worth thousands of dollars in tax benefits to her parents. The formerly dependent teenager can now claim her own personal exemption--but the benefits she gains from claiming herself are rarely worth as much to her as they would have been to her parents.

As my students will soon see, the marginal tax rates of the poor are far more unpredictable than those of higher income Americans. And although their effective average tax rates may be low (or even negative), their effective marginal rates may be very high, in some cases even higher than those of high income Americans.

We will be talking a lot about the equity and efficiency implications of those average and marginal tax rates this year.

It will probably be a "less taxing year" for many of our VITA site clients, but not for all of them. The vicissitudes of tax law for the poor are surprisingly random.

Sixth Commandment: Thou shalt not claim Head of Household status for thy taxpayer based on his unrelated roommate.

2011-01-01T12:15:00.000-08:00

An unrelated deadbeat (or otherwise down on their luck) roommate who lived with the taxpayer all year can sometimes qualify as the taxpayer's "Qualifying Relative" (QR) dependent. (Check the rules in Table 2 here to be sure.) In that case, the taxpayer would be entitled to claim a dependent exemption for the deadbeat roommate and subtract the value of his $3,700 exemption from his taxable income.

However, unrelated roommates--even if they are QR dependents--are NEVER "Qualifying Persons" (QP) for the Head of Household (HoH) filing status!

HoH filing status requires that the taxpayer support a household containing a sufficiently related "QP". Unrelated roommates, girlfriends, boyfriends, or even distant relatives such as cousins are NOT QP's for HoH status, even though they might be QR's for dependent exemption purposes.

How "closely related" does a QP have to be for HoH status? Check the table on page B-3 here.

Once again, this illustrates that the IRS does not use English the same way the rest of us do. You don't necessarily have to be "related" by blood or marriage to be a "Qualifying Relative" dependent, but you DO have to be closely related by blood or marriage to be a "Qualifying Person" for HoH status.

Fifth commandment: Thou shalt not let tuition tax benefits go unclaimed!

2010-12-30T15:31:00.000-08:00

As this article in today's Times Union mentioned, a recent Treasury Department study suggests that tens of millions of dollars in tuition tax benefits went unclaimed last year.

Senator Schumer, the original sponsor of the American Opportunity Tax Credit, a tuition tax credit worth up to $2,500, came to town last week to raise awareness of the credit at a press conference held at Schenectady County Community College. Pictured above is Rachel Colman, a Union College senior interviewed by the Times Union, who told their reporter that she first learned about the tax credit when she interned for Senator Schumer last summer. She said her mother already knew about the credit thanks to her tax accountant, but not all families are fortunate enough to have tax advisors who are knowledgeable about the credit.

As Senator Schumer put it:

"The bad news is that far too many families don't know that this credit exists, but the good news is that it's not too late to put that cash in your pocket, even if you forgot to take the credit last year,"

"Too many middle-class families are not getting the benefit of this credit because they don't know about it, or their tax preparer failed to tell them about it," he said. "It's like there's a dump truck full of $100 bills sitting across the street."

Tax law is so confusing and labyrinthine and the rules are constantly changing--perhaps it is not surprising that many working families do not take advantage of the credits available to them. There are so many different tax benefits for education, and it can be hard for many families to figure out which one is best for them. There are also decisions to be made as to whether it is better for the child or the parent to take the tax credit. Even the National Taxpayer Advocate, Nina Olson, a tax lawyer and long-time former tax preparer herself, has said in the past that she has had difficulty figuring out which education tax benefit to use for her own college son.

In the past, many families had incomes too high or too low to benefit from tuition tax credits. The American Opportunity credit raised the income ceiling: married taxpayers making up to $160,000 may not realize they are now eligible for the full amount of the credit. In the past, the federal tuition tax credits were not refundable, which meant that they had little or no benefit for low-income taxpayers with no tax liability. The partial refundability of the current American Opportunity Credit means that even taxpayers with no federal income tax liability can benefit from it.

The American Opportunity tuition tax credit and other tax benefits for higher education are an important topic in Intermediate VITA tax law, so we will be tackling that next week, as soon as you finish the Basic tax certification exam.

For those of you who are already solid on Basic tax law, this is a good time to work through the VITA tutorial on Education tax credits, which you can find here. We will also discuss the late-breaking tax law change that extended the tuition tax and fees deduction, which may be a better deal than tuition tax credits in certain cases. An important concept to bear in mind: "the no double benefit" rule.

The IRS annual Pub 970, Tax Benefits for Education, is invaluable reading for parents and students alike. If your family discovers that you missed out on a tuition tax benefit to which you were entitled last year, it is not too late to file an amended tax return to claim it.

Fourth commandment: thou shalt enter each and every box of thy taxpayer's W-2 data faithfully and verbatim.

2010-12-30T06:24:00.001-08:00

Fourth commandment: When thou usest tax software, thou shalt enter each and every box of thy taxpayer's W-2 data faithfully and verbatim.

There is a lot of important tax information embedded in a W-2, including some mysterious items that may not be obvious at first glance, so whenever you use tax software, you need to create a faithful verbatim electronic copy of the data in every box of the W-2.

If you do that meticulously, TaxWise should do the work of putting everything in the correct place on the Federal 1040 and NYS IT-201 tax forms, but it's important to understand WHAT you are doing and WHY you are doing it.

A few important observations:

0) "Verbatim" is a slight exaggeration: you are allowed--and encouraged!--to round dollar amounts to the nearest whole dollar. Also, the IRS computers are apparently allergic to punctuation, so do not include it. (E.g., if the taxpayer or employer's name has an apostrophe in it--like mine--leave it out. Otherwise, as I learned the hard way a decade ago, you run the risk of giving the IRS computers a bad case of indigestion.)

1) Not all W-2s are laid out in exactly the same way. Some W-2s are vertical, some are horizontal, some are large, some are small. What is key is matching up the box numbers, box by box.

2) Be VERY careful to distinguish the words employEE from employER. A common source of problems is mixing up the employEE SSN with the employER tax ID number, or the employEE address with the employER address. (I'm capitalizing those letters distinctively for emphasis here, but the W-2 provides no such help.)

3) Those mysterious letters and codes in Boxes 12 through 14 give important information about contributory retirement plans (e.g., 401(k)'s) and other fringe benefit compensation that may have special tax treatment. As an example, let's consider Quincy Bennett's W-2 above from the IRS Pub 4491W workbook. (You can click on the image to see a larger and clearer view.)

Mr. Bennett's W-2 shows in Box 12a that he contributed $531 to his traditional 401(k) plan at Luther Petroleum. (How do I know that? The mysterious Code D in Box 12a. You can read more about what W-2 codes mean here.) That contribution reduced his wages subject to income tax in Box 1 by $531, but it did not affect his Box 3 and Box 5 wages for Social Security and Medicare payroll tax purposes. It also reduced his Box 16 wages subject to state income tax by $531.

4) The information in Box 2, federal withholding, and Box 17, state withholding, is especially important! It is literally "money in the bank," because it represents money that the employer has withheld from the employee's pay that needs to be credited against his federal and state tax liability. If you accidentally omit that data input (it's especially easy to overlook the Box 17 information), you can literally give your poor taxpayer a heart attack by wrongly telling him he owes a lot of money, when in fact, he actually owes much less or may even be entitled to a refund.

5) A frequently overlooked item: "Advance EIC payment" in Box 9. For example, see Ms. Colby Bennett's W-2 below. (Again, click on the image for a clearer view.) There is $1,200 in Box 9. That tells me that me that--at her request, her employer, the William School District, included $1,200 of Advance Earned Income Credit (EIC) payments in her paychecks during the year. Effectively, her employer gave her an advance on part of her refund, and that advance needs to be subtracted from the refund she will get at the end of the year. If you enter the Box 9 information into the electronic W-2 in TaxWise, you should check to make sure that TaxWise puts that number into line 59 on the 1040.

In effect, "Advance EIC" is a form of negative withholding. This complication rarely happens in real life--only about 1% of EIC recipients choose to collect some of it in advance, but when it does happen, it is essential to take it into account! It comes up far more frequently in IRS workbook exercises (and maybe the the certification exam!) than in real life. In the interests of tax simplification, the provision for Advance EIC is ending with the 2010 tax year, so this should be the last year we need to worry about this.

How the federal government got the money to pay its bills last year:

2010-12-29T07:00:00.000-08:00

Source: page 97 of IRS Instructions for Form 1040 2010

Short answer: we borrowed 40% of it! About a quarter of 2009 government receipts came from individual income taxes, about a quarter of it came from payroll taxes, 4% came from corporate income taxes, and the remainder from excise and miscellaneous taxes.

Where did it go?

Note: the 5% in net interest payments is likely to go up a lot in the future. Interest rates on US government debt have been minuscule in recent years, a situation unlikely to persist indefinitely.

Rock-Paper-Scissors rules for tax law

2010-12-28T13:01:00.000-08:00

Okay--I'm out of hard-and-fast commandments for now, so I'll move on to another analogy: tax law can sometimes be like rock-paper-scissors.

1) When considering dependent status, Qualifying Child (QC) trumps Qualifying Relative (QR). In other words, if the potential dependent is anyone's QC, he can't qualify as a QR for anybody. Do not ever check for QR status without first ruling out the possibility that the potential dependent could be a QC for that taxpayer or for another taxpayer.

2) When considering QC status, relationship and residence trump support. In other words, if the potential dependent is a QC of more than one taxpayer, it does not matter which taxpayer provided more support. The tiebreak rules for QC give priority to relationship and residence. Remember that you don't need to support a QC to claim him! The support test for a QC exemption just requires that the QC does not provide more than 50% of his own support.

3) After ruling out QC status, then--and only then--can you consider the possibility of QR status, in which case support may possibly trump relationship and/or residence. You do need to support a QR to claim him or her, but you may not need to live with him (depending on how closely he is related to you.)

It is complicated! I've read Tax Court cases that make it clear that even IRS auditors have occasionally incorrectly applied the rules. That is why it is important to carefully work through the flowcharts in Tab C of Pub 4012 when determining QC and QR dependents.

For more on that topic, see here.

Third Commandment: All thy income is taxable ... unless tax law explicitly states it can be excluded.

2010-12-28T12:24:00.000-08:00

Commandment #3: Thou shalt report all thy income on thy 1040 unless there is an explicit provision in tax law allowing thee to exclude it from thy tax base.

The general rule: all income is subject to income tax unless there is a provision in tax law explicitly excluding it from taxation.

Do not leave income off a taxpayer's return unless you can find an explicit provision allowing you to do so. Even there--be careful!

For example, even though gifts are excludable from taxable income, not everything called a "gift" is actually a "gift" for tax purposes. If your taxpayer's grandma gave him a gift, it's different from his employer giving him a gift. If in doubt, check with your professor!

And remember, "income" does not have to be in cash to be "income." That year's supply of dog food you won on a game show is income! So is that "designer purse" you won at a charity raffle. Or the Xbox you won in the Microsoft College Puzzle Challenge. So is the bike your employer gave you if you worked at Ikea. (See here for more on that.) Even a scholarship that provided free room or board is income. (See here for more on that.)

For more information on common types of taxable and non-taxable income, see here.

Second Commandment: thou shalt live for over half the tax year with thy EIC Qualifying Child

2010-12-28T11:52:00.000-08:00

Commandment #2: Thou shalt live with thy Qualifying Child for over half the tax year in order to claim thy Qualifying Child for Earned Income Credit purposes.

In modern English: although there are special circumstances in which divorced or separated parents can claim a QC for other tax benefits, the Residence Requirement is an absolute requirement for Earned Income Credit (EIC).

A non-custodial parent with whom the child lived less than half the year NEVER, EVER, EVER gets to claim the QC for EIC purposes!

It doesn't matter if the custodial parent wants to give the EIC away to the non-custodial parent. If the noncustodial parent taxpayer did not live with the kid, the taxpayer is not allowed to claim the kid for EIC purposes!

Ya can't claim the kid for EIC without living with the kid!

Interestingly, you don't need to support your QC to claim him for EIC purposes, but you do need to live with him!

Residence is the sine qua non requirement for EIC QC purposes.

That is really important, because the EIC is by far the largest tax benefit associated with children in low-income working families. As you can see from the graph below, whether a taxpayer has children can make a huge difference in their EIC refund, so it's critically important to get this detail correct, so the EIC goes to the taxpayer actually entitled to claim the QC for EIC purposes.

(Caveat: remember that the IRS does not define "live with" quite the same way as normal people do. If the child was born or died during the year or had temporary absences for college, medical reasons, etc. the IRS may deem that s/he "lived with" the taxpayer for all 12 months of the year for tax purposes.)

For more information about EIC rules, see here.

First Commandment: Dependents shalt have no exemptions

2010-12-28T11:41:00.001-08:00

Commandment #1: Thou shalt have zero exemptions on thy own tax return if thou meetest the qualifications to be a dependent of another taxpayer.

In modern English: if you qualify to be claimed as the dependent of another taxpayer, you may NOT claim a personal exemption for yourself, nor may you claim any dependents of your own on your tax return.

No ifs, ands, or buts: as long as the other taxpayer(s) COULD have claimed you on their tax return, it does not matter whether they actually DID claim you on their tax return--you may not claim yourself on your return nor may you claim any dependents on your return.

For more information about rules for personal and dependent exemptions, see here.

There are some other negatives for taxpayers who can be claimed as dependents. In particular, if you can be claimed as a dependent by another taxpayer, you are NOT eligible for the Making Work Pay refundable tax credit.

This led to some unpleasant surprises for young dependent taxpayers last year. Some of them ended up owing money, when they had been expecting at least a small refund. That's because payroll withholding formulas did not take into account their dependent status, so they had not had enough federal tax withheld from their pay.

Ten (?) Commandments of Basic Tax Law

2010-12-28T09:02:00.000-08:00

My Union College Volunteer Income Tax Assistance (VITA) students are now studying hard for their upcoming IRS Certification Test in Basic tax law, which I'll give on the first day of class, next Monday.

I have annotated and highlighted the key sections of the so-called "bible" of VITA, Pub 4012, the handy reference tool with flow-charts going through the logic of all the bed buffaloes in the tax law applicable to tax returns that are "within the scope of certification" for VITA sites.

You can find my training resource website for students by clicking here.

But there is quite a maze of intersecting logical questions in determining the answers to many tax questions, so I thought I would try to help my students out by coming up with a few hard-and-fast absolute rules--I will call them the "Commandments of Tax Law."

I am not sure if there will be exactly ten of them, but I'll get started with a few and I'm open to suggestions in the comments for more.

The key to being a commandment is that it needs to be a universally true and simple tax rule that has wide applicability in basic tax law.

Stay tuned for the first few.

Checking in on the "competition"

2010-12-27T08:12:00.001-08:00

H&R Block (HRB), by far the largest commercial tax prep firm in the country, saw its stock price fall by 8% over the weekend, while its smaller competitor, Jackson Hewitt (JTX) climbed by over 20%.

The story behind the price move is available in an HRB press release here:

KANSAS CITY, MO -- (Marketwire) -- 12/24/10 -- As a result of a regulatory directive by the Office of the Comptroller of the Currency ("OCC"), HSBC has given notice to H&R Block that it is immediately terminating the parties' long-term contract under which HSBC provided all of H&R Block's refund anticipation loans ("RALs") and some of its refund anticipation checks ("RACs"). As a result, HSBC will no longer provide RALs or RACs to H&R Block clients. At the same time, HSBC's exclusive right to provide such products has also ended, thereby enabling H&R Block to enter into other partnerships for financial products that were previously precluded. The contract termination is the result of a directive from the OCC, HSBC's banking supervisory agency, immediately prohibiting HSBC from offering any form of RALs.

...

Prior to the OCC's recent action, H&R Block and HSBC had reached agreement on a proposal that would have allowed HSBC to honor its contractual obligations to H&R Block during tax season 2011. Under the revised terms agreed upon by both parties, H&R Block would have in effect covered essentially all credit defaults experienced by HSBC, thereby making H&R Block's credit rather than the taxpayer's refund the ultimate source of repayment to HSBC. The proposed new terms would have made it nearly impossible for HSBC to suffer any financial losses.

"Nearly impossible for HSBC to suffer any financial losses" is an interesting phrase for HRB to use in its press release, given the losses their own company has suffered.

Even before this weekend's precipitous drop, HRB stock was already down 44% for the year, and S&P credit raters were not ruling out the possibility that HRB debt (currently rated BBB and teetering precariously just above the "junk" level) might be downgraded. It is easy to see why HSBC might have wanted to find a reason to be excused from the deal it had previously made with HRB.

Meanwhile, Republic Bank apparently remains committed to offering RALs to Jackson Hewitt customers. (It is not clear why the Comptroller of the Currency continues to allow Republic to be involved in the RAL business, but Republic is a much smaller bank than HSBC, so perhaps its failure would be less of a threat to the overall financial system. In addition, Republic is not a national bank, and there is an ongoing controversy over whether national regulators can preempt state bank regulations.)

In other developments, Jackson Hewitt is developing a snazzy-looking new website, MyTaxManager, which will encourage its customers to rely on them for far more than just once a year tax filing. It appears that Jackson Hewitt will be encouraging their customers to upload their tax related receipts and other financial documents to the MyTaxManager website throughout the year, so that JTX preparers will have all the documents organized and at their fingertips when the taxpayer is ready to file.

This is an interesting marketing strategy, especially for taxpayers with disorganized financial lives. In the wake of evictions, foreclosures, and homelessness, it is understandably difficult for taxpayers to hang on to all the financial documents they may need, so a service like this one is a seemingly good idea--in principle. Taxpayers could possibly even use their cellphone to snap a photo of a tax document and upload it to the Jackson Hewitt website.

Unfortunately, the precarious financial state of Jackson Hewitt itself suggests that the company's website may not be the most reliable place to store one's financial documents.

Personally, I would want to be extremely cautious before choosing to store all my sensitive financial documents in a single electronically accessible location--and a company with Jackson Hewitt's financial track record does not inspire my confidence. Their 52-week stock price volatility has ranged from a low of 75 cents per share to a high of $5.14 per share. They have been bleeding money with large operating losses over the past year, and their balance sheet debt currently exceeds their assets, which means they are technically insolvent. At the moment, Jackson Hewitt is operating on a life-support line of credit extended by a reluctant Wells Fargo.

Boxing Day practice questions

2010-12-26T09:10:00.000-08:00

Today is Boxing Day. In Canada, the UK, and other countries, Boxing Day is actually a legal holiday, recognizing a long tradition of helping struggling members of society, so it's a good day for my VITA students to start serious practice for next Monday's IRS certification exam.

Please try the practice questions in the quiz below. Feel free to discuss these questions with friends and family members--they may find these questions challenging and educational too. When I receive your answers, I'll send you feedback, more advice on what to read, and more practice questions.

Here are links to my annotated and highlighted versions of the key pages in Pub 4012, which should be helpful to you as you try the questions below.

Click here for annotated version of Pub 4012 Tab B Filing Status

Click here for annotated version of Pub 4012 Tab C Personal & Dependent Exemption Rules

Remember the IRS does not use English the same way you do! (Click here for more details on that.)

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Who gets to claim Johnny on the tax return?

2010-12-23T14:45:00.000-08:00

The question of who can claim whom on a tax return is the biggest bed buffalo question of them all on tax returns typical of the low-income working families eligible for free tax assistance at VITA sites.

Depending on a variety of circumstances, the answer to the question "Who gets to claim Johnny?" could be Johnny's mom, Johnny's dad, Johnny's grandparent(s), Johnny's aunt, Johnny's big brother, Johnny's roommate, Johnny's girlfriend, or possibly Johnny himself.

Getting the answer right could mean securing thousands of dollars in refunds for the taxpayer legally entitled to claim Johnny.

That's why it's essential to get the answers right on dependency issues.

For VITA volunteer preparers, Tab C in your Pub 4012 Resource Guide (click here for PDF version) is the essential go-to reference to resolve these questions.

A few key points to bear in mind:

1) There are two kinds (flavors) of dependents: qualifying children (QC) and qualifying relatives (QR).

2) It is ALWAYS better for a taxpayer to claim a dependent as a QC than as a QR, so you should always apply the test for QC to Johnny first. (Why is it better? Because QC's come with a lot more tax benefits than QR's.) You will find the rules for QC in Table 1 of Tab C of Pub 4012.

3) If Johnny flunks the QC test, then check to see if Johnny meets the QR test. (Table 2 of Tab C of your Pub 4012 Resource Guide (click here for PDF version)">.)

4) Beware! The criteria for QR look deceptively similar. Both have support tests, but the support test is different for a QC than it is for a QR.

5) There are special rules for divorced or never-married parents. In that case, check out Table 3 of Tab 3 of the Pub 4012 Resource Guide (click here for PDF version) .

6) If Johnny qualifies as a dependent (of ANY flavor! QC or QR) of another taxpayer, he can't claim ANY exemptions on his own return.

The IRS Link and Learn website has an excellent interactive tutorial on basic tax law here.

I strongly recommend that you (and any family members and friends who want to play along and try the interactive quiz questions) work through the sections on personal exemptions and dependency exemptions on this page. It will serve you well on the Basic Certification test, and even more importantly, it will serve you well when you work with real taxpayers.

It is very likely that you will make mistakes as you work through the interactive tutorial--and that is exactly what you SHOULD be doing now! Making mistakes in practice will force you to think hard about the rules, and ask for help in figuring out how to apply them appropriately.

Schematic Big Picture of the US Income Tax

2010-12-23T14:33:00.000-08:00

It's easy to get lost in all the "trees" when wandering through the "forest" of income tax returns, so I have pasted above a helpful schematic giving the big picture of how our tax code works. (If you click or double-click on the image below, you will get a bigger and higher resolution picture.)

Yes, I know that TaxWise will do all this for you....but it is important that the software should not be a mysterious black box. I want each of you to understand the logic of what TaxWise is doing--so you don't get into the kind of trouble that Treasury Secretary Geithner got into.

You may want to print out a copy of the brand new form Form 1040, which is hot off the press and newly released by the IRS just yesterday, so that you can refer to it as I discuss the schematic above. I found printable copies of the final version of the Form 1040 here on the TaxProf blog. (Click on the images to blow them up so they are readable, and, if possible, print them out for reference and annotation.)

As you will soon realize, the Form 1040 is a two-page form we can view as the "master document" summarizing a taxpayer's entire situation. Our taxpayers will almost always have lots of attachments to that master document, but the Form 1040 itself really captures the basic logic of the taxpayers situation.

To my students: before reading below, see if you can identify the places on the front and back of the 1040 that correspond to the schematic above.

The top of the first page of Form 1040 has pretty straightforward basic information identifying the name and address of the taxpayer, spouse (if it's a joint return), filing status, and dependents, if any. (But don't be deceived--it can be tricky to figure out filing status and dependency status. Make sure you practice working through the logic of the flow charts in Tabs B and C of your trusty spiralbound Pub 4012.)

Lines 7 to 22 on the Form 1040 give the amounts of the different types of income that make up the Tax Base in the schematic above.

Lines 23 to 36 on the Form 1040 give the amounts of the different types of Above-the-line deductions. (The formal official name for above-the-line deductions is "Adjustments to Income.") As you will see, these turn out to be the best kind of deductions to have.

The bottom line on the front page of Form 1040 is Line 37, the Adjusted-Gross-Income (AGI), which is defined as the difference between the Tax Base "Total Income" on line 22 and the Adjustments to Income Total on line 36. As you will also see, AGI is a very important concept in our income tax system, because so many different tax benefits depend on having an AGI below certain critical cutoff levels.

Okay...that's it for the front page of Form 1040. Conceptually, it's all not all that bad. Add up a bunch of different types of income, then subtract a bunch of deductions to get AGI.

On to the back page of Form 1040.

The back page of the 1040 reminds me of that recurring line on those late-night infomercials: "But wait! There's more!" because the bed buffaloes on the back page seem to go on and on and on.

The first number on the back page is just a repeat of the bottom line on the first page: the AGI. That is, by definition, line 37 at the bottom of the first page equals line 38 at the top of the back page.

Now what next?

We subtract more stuff from AGI in order to reach Taxable Income on line 43.

Now what is it exactly that we are subtracting at this stage?

One thing we are subtracting is "The larger of Itemized Deductions or Standard Deductions (which you can find on line 40). (For the purposes of the Basic Exam you will take on the first day of class, you only need to know the details of the Standard Deduction. I will discuss Itemized Deductions later in the first week of class.) By the way, these are sometimes called "Below the line deductions" because they reduce taxable income but do not affect AGI.

The other we are subtracting at this stage are Exemptions, which is currently defined as $3,650 times the number of people the taxpayer can claim on the return (potentially, himself, a spouse if married filing jointly, and eligible dependents, if any.) Some taxpayers--and you may be one of them if you are a college student supported by your parents--are not eligible to claim any exemptions on their own tax return.

After we've done all that subtraction, we get Taxable Income on Line 43.

Now, time to compute the tax on Line 43. To help you understand what TaxWise is doing when it computes the tax on Line 43, I highly recommend looking at the tax tables on pages 7 though 9 of this IRS publication. As you can see, we currently apply a graduated set of rates ranging from 10% to 35% at this stage.

But wait! There's more!

The schematic chart refers to the "Alternative Minimum Tax, (AMT)" which we can--fortunately--ignore for the purposes of our VITA site. AMT is out of scope for VITA sites, and thanks to the legislation Congress passed last week, it is safe to assume that AMT will not apply to taxpayers with incomes low enough to qualify for VITA services.

But, wait, there's more!

We are not done yet!

Time to deal with Tax Credits, which subtract from a taxpayer's liability.

Tax credits come in two flavors: "non-refundable" and "refundable."

Nonrefundable credits, which you can find on Line 47 to 54 of the 1040, are called nonrefundable because they can only knock the taxpayer's liability down to zero--they can't make it negative. Thus, the lowest number you can get in Line 55 is zero.

But wait, there's more!

We need to give the taxpayer credit for any taxes he paid during the year, either through money withheld from his paycheck (Line 61) or paid as estimated taxes (Line 62).

And, wait, there's more!

We also need to take into account the refundable credits, which are very important to many low-income taxpayers. You will find those on Line 63 to 71. Those are the credits that give many of our taxpayers very large refunds. The most important of these credits for our taxpayers is the Earned Income Tax Credit, which is currently the biggest cash federal antipoverty program--and it is run through the tax code.

Now, we are done--the bottom line, the amount of refund or balance due is at the end of the page, right above the signature lines.

For many of my students, I expect this all seems about as clear as mud right now--there are many mysterious and inscrutable terms on these forms. Fortunately, most of the obscure items are irrelevant for VITA taxpayers, but there is still a good deal you need to learn as you get ready to take the certification tests.

I know it does feel like a foreign language right now. Please feel free to email me your questions, you can get advance class participation credit even before you get back to campus, and I will answer your questions in this blog.

TaxWise Online: good news and bad news

2010-12-21T11:58:00.000-08:00

TaxWise is commercial tax software published by CCH, which refers to itself as "the leading provider of information services, software and workflow tools for tax, accounting, legal and business professionals."

TaxWise is used by many professional tax preparers and the IRS purchases TaxWise software licenses for use at all Volunteer Income Tax Assistance (VITA) sites nationwide. All over the country at this moment, volunteer tax preparers are studying for VITA certification exams. Unlike paid tax preparers, VITA preparers must pass annual certification tests on current tax law prior to preparing even a single tax return. (When testing for paid preparers finally goes into effect next year, they will test on past year tax law, rather than current year tax law. Moreover, once they pass the exam, they will not be required to take future recertification exams, though they will have to take continuing professional education.)

I already passed my 2010 VITA certification exams, which I take each and every year, without the aid of software, but my students will have the option to use TaxWise when they take their certificaton exams in early January, because I want to encourage them to get familiar with the software before they begin using it with real live taxpayers in mid-January.

Good news: The new on-line chat feature built into TaxWise On-line is a massive improvement over the hours I have spent waiting on hold for customer support in previous years.

Bad news: The TaxWise customer support person was unable to give me an answer to my question.

I asked: "When will the training version of TaxWise Online incorporate the new tax law changes signed into law last week?"

Here is the answer I got from Jennifer N at TaxWise:

Our developers are working on getting the changes implemented, but they cannot change anything until it is approved by the IRS. Once the changes go into effect, the IRS changes them on their side first, sends them to us, then our developers change on our end, then have to get the approval by the IRS before they can implement them. Unfortunately, I do not have a time frame as of today, but our developers are working on them.

As far as I can tell, TurboTax incorporated the tax law changes into their software the same day that the tax laws were changed last week, so if any IRS approval was needed for their changes, they got it very fast.

Given that TurboTax implemented the changes so quickly, I don't understand why TaxWise is unable even to predict when they will have last week's tax law changes incorporated into their software.

It also seems to me that, at the very least, the TaxWise On-line homepage "Message Center" ought to warn users that the version of the software they are using does NOT incorporate the changes enacted into law last week.

Score 1 for TurboTax, 0 for TaxWise so far.

To my students: feel free to continue to practice in TaxWise Online, but do not trust that the answers you get are accurate, especially if you are trying to practice by predicting your own tax situation or your family's tax situation.

In fact, that is good advice in general, no matter what tax software you use, professional or consumer, whether you do your taxes yourself or whether you use a paid preparer.

I always double-check the logic of my tax returns before signing--and so should you.

Income taxes and the super rich

2010-12-21T08:06:00.000-08:00

Here is an important new paper I will be reading carefully along with my winter term tax policy students (AFTER they have finished studying for the IRS VITA certification exam I give the first day!):

Jobs and Income Growth of Top Earners and the Causes of Changing Income Inequality: Evidence from US Tax Return Data by Professor Jon Bakija (Williams College), Adam Cole (US Treasury Dept Office of Tax Policy), and Professor Bradley Heim (Indiana University.)

Lots of interesting information about where the big earners have been earning most of their money in recent decades--short answer: the financial industry. It's important to note that this was not always true. The financial industry was not very lucrative (or all that respectable, for that matter) in the 1970s. Also some interesting information about behavioral elasticities of the super-rich.

Check out the colorful commentary from George Mason University economist Tyler Cowen here:

Here is a summary of their broader results:

Our findings suggest that the incomes of executives, managers, supervisors, and financial professionals can account for 60 percent of the increase in the share of national income going to the top percentile of the income distribution between 1979 and 2005. We also demonstrate significant heterogeneity in income growth across and within occupations among people in the top percentile of the income distribution, suggesting that factors that changed in the same way over time for all high income people are probably not the main cause of increasing inequality at the top. The incomes of executives, managers, financial professionals, and technology professionals who are in the top 0.1 percent of the income distribution are found to be very sensitive to stock market fluctuations. Most of our evidence suggests that financial market asset prices, corporate governance, entrepreneurship, and income shifting across corporate and personal tax bases may be especially important in explaining the dramatic rise in top income shares.

I would reword this as a) "it's complicated," and b) "a lot of them made the money in capital markets." It does remain the case that top incomes in finance rose by far most rapidly.

In this very careful and rigorous paper, here is a "scream it from the rooftops" result:

...we find that a one percent increase in the net of tax share is associated with an 0.7 percent reduction in incomes earned by people in the top 0.1 percent of the income distribution, which would imply that if we were to raise top marginal tax rates further on these taxpayers, the increase in deadweight loss would be substantially larger than the increase in revenue raised [emphasis added]. However, we find essentially no evidence at all of any responsiveness of people below the top 0.1 percent...

Check out as well the response to Professor Cowen's commentary by journalist Kevin Drum in Deadweight Losses of the SuperRich.

How do we distribute tax benefits for charitable donations?

2010-12-18T15:12:00.000-08:00

A lot of us, including myself, are hurrying to write those end of year tax-deductible contributions before December 31. I'm personally grateful that our tax system, as imperfect as it is, makes it possible to support my favorite charities at lower out of pocket cost than would otherwise be possible.

But I'm struck by the remarkable generosity of many of the low-income taxpayers at our Union College Volunteer Income Tax Assistance (VITA) site, who rarely get any tax benefits for their donations.

In today's New York Times, University of Chicago economist Richard Thaler gives a thought-provoking description of how our tax system treats the donations of the rich and the poor.

Consider this scenario: Having decided that charitable giving is a worthy cause, the government subsidizes charitable gifts from certain households, and for those chosen to be part of the plan, every dollar donated to a charity is increased by a specified percentage. To qualify, taxpayers must have a substantial home mortgage; the subsidy rate increases with taxable income. Low-income taxpayers receive no subsidy, but donations from qualified high-income taxpayers are subsidized by as much as 40 percent — or more.

At this point, you may be wondering why I’d even mention something so preposterous. After all, why should a family’s eligibility for a donation subsidy depend on whether it has a large mortgage? And why should the government subsidize donations by the rich more than donations by the poor? The idea seems a nonstarter. And it would be, if not for one important detail: it is (approximately) the current law.

The whole article is very much worth reading.

My Union College student volunteer tax preparers see this scenario play out on a daily basis every year during tax season. The overwhelming majority of our taxpayers do not itemize, either because they do not own homes, or because they are elderly homeowners who have paid off their mortgages. Therefore giving a dollar to charity leaves them out of pocket by the full dollar. A tiny minority of our taxpayers are homeowners with mortgages and property taxes sufficient to justify itemizing. Because we are limited to serving taxpayers with incomes below $49,000, they would typically be in the 10% or 15% tax bracket, so the cost of giving a dollar might leave them out of pocket by 85 or 90 cents. Higher income Americans might be in the 35% tax bracket, meaning that the dollar they give to charity effectively costs them only 65 cents.

("But wait!" as they say on late night TV, "There's more!" The highest income Americans may also receive additional tax benefits from their donations: they may be able to escape income on unrealized capital gains by donating appreciated property to charity, as well as doing a variety of clever strategies to reduce their estate taxes.)

Another NYT article earlier this year sheds further light on this issue:

For decades, surveys have shown that upper-income Americans don’t give away as much of their money as they might and are particularly undistinguished as givers when compared with the poor, who are strikingly generous. A number of other studies have shown that lower-income Americans give proportionally more of their incomes to charity than do upper-income Americans. In 2001, Independent Sector, a nonprofit organization focused on charitable giving, found that households earning less than $25,000 a year gave away an average of 4.2 percent of their incomes; those with earnings of more than $75,000 gave away 2.7 percent.

This situation is perplexing if you think of it in terms of dollars and cents: the poor, you would assume, don’t have resources to spare, and the personal sacrifice of giving is disproportionately large. The rich do have money to spend. Those who itemize receive a hefty tax break to make charitable donations, a deduction that grows more valuable the higher they are on the income scale. And the well-off are presumed to have at least a certain sense of noblesse oblige. Americans pride themselves on their philanthropic tradition, and on the role of private charity, which is much more developed here than it is in Europe, where the expectation is that the government will care for the poor.

But in the larger context of “the psychological culture of wealth versus poverty,” says Paul K. Piff, a Ph.D. candidate in social psychology at the University of California, Berkeley, the paradox makes sense. Piff has made a specialty of studying those cultures in his lab at the Institute of Personality and Social Research, most recently in a series of experiments that tested “lower class” and “upper class” subjects (with earnings ranging from around $15,000 to more than $150,000 a year) to see what kind of psychological factors motivated the well-known differences in their giving behaviors. His study, written with Michael W. Kraus and published online last month by The Journal of Personality and Social Psychology, found that lower-income people were more generous, charitable, trusting and helpful to others than were those with more wealth. They were more attuned to the needs of others and more committed generally to the values of egalitarianism.

For more information on this topic, including a revealing graph showing how much it costs, on average, for people in different income categories to give a dollar to charity, see this earlier post on my blog, discussing an article written by Williams College economist Jon Bakija and Treasury Department Office of Tax Analysis economist Bradley Heim, "How does charitable giving respond to incentives and income: Panel Estimates with State Tax Identification, Predictable Tax Changes, and Heterogeneity by Income."

A time to be born ... a time to die

2010-12-16T13:46:00.000-08:00

I recommend playing the video above while you read about the technical papers linked below.

Economists....we look at the elasticities of behavioral responses to taxes everywhere. Birth, death, marriage, work, savings, education, investment, you name it, an economist has studied how taxes influence it.

Taxpayers with a newborn "qualifying child" born before midnight December 31 are entitled to a full year of tax benefits associated with that child. As the child-related tax benefits have increased in recent decades, along with the increased use of planned Caesarian sections, economists have found a small but significant effect on the timing of births, with potential public health consequences.

For details, see Taxes and the Timing of Births, 107 Journal of Political Economy 161 (1999), by Stacy Dickert-Conlin (Syracuse University, Center for Policy Research) & Amitabh Chandra (Harvard University, John F. Kennedy School of Government), available here.

However, the tax benefits associated with children do not seem to have increased overall fertility rates--if anything, the increased tax benefits for children have slightly decreased fertility rates. See The earned income tax credit and fertility by Reagan Baughman and Stacy Dickert-Conlin, available here.

At the other end of life, for some very wealthy taxpayers dying before the end of the year could save millions of dollars in estate taxes, due to the fact that estate taxes are expected to increase in 2011.

Two economists, Wojciech Kopczuk and Joel Slemrod, have studied the effect of tax incentives on the timing of deaths in a paper called "Dying to save taxes", published in the Review of Economics and Statistics in 2006. They estimate that a $10,000 tax break might be enough to change the relative probability of dying in the period before vs. after the tax break by as much as 1.6%. (However, they concede that they can't be sure how much of that effect is due to the timing of the actual death or how much might be due to "doctoring" of the death certificate by an accommodating physician who fills out the death certificate.) The paper is available here.

Bottom line of all this research: the largest effects are on timing of births and deaths, not on the actual total number of births and deaths.

Taxes do not seem to cause people to have more children....nor, in the long run, do they cause more total deaths.

Sooner or later, we are all going to die--notwithstanding the old saying that there's no escaping death and taxes, it is easier to escape taxes than death.

How much are those New Year's Eve babies worth?

2010-12-16T11:29:00.000-08:00

The answer depends on your income--and possibly other factors as well, including the taxpayer's filing status (single, head of household, married filing jointly, married filing separately, qualifying widow), the type of income (earned vs. unearned), whether you lived with the child, and the child's relationship to you.

There is little rhyme nor reason in the graph above, which comes from a paper by Elaine Maag of the Urban Institute Brookings Tax Policy Center. She describes the graph as "a toddler's unevenly written W, with no clear pattern shining through." (Click on the image for a larger and higher res view.)

The graph above assumes the taxpayer is a single parent with two children under age 17, who are her "qualifying children" for the purposes of the dependency exemption, the child tax credit, the additional child tax credit, the earned income tax credit, and the head of household filing status.

As my students have been learning, babies before midnight on New Year's eve can qualify their parents for a whole year's worth of tax benefits. But those tax benefits turn into pumpkins if labor goes past the stroke of midnight.

So, let's say an unmarried taxpayer who supports herself and lives alone is pregnant with twins, has no other dependents, and has an income around $18,000 per year, entirely in the form of earned income, i.e., wages or self-employment income.

If those babies are born before midnight December 31, her federal tax refund might increase by over $8,000 compared to what it would be had they been born after midnight. If she lives in a state like New York, which has an additional (so called "piggyback") earned income tax credit, her combined total federal-state refund could easily be over $10,000.

By contrast, if her income is around $40,000, those two babies are only worth around $4,000 in federal refund. That figure climbs for a while, and then drops off again. What is not shown on the graph above is that, at very high incomes, the babies may be worth very little in tax savings, due to phaseouts and the alternative minimum tax.

Here is how Elaine Maag summarizes the major work-related credits that apply to taxpayers similar to many who use the services of our VITA site at Union College. You can click on the image for higher-res version, or--even better--find a full-size version in her article, Simplicity: Considerations in Designing a Unified Child Tax Credit is available here. The entire article is well worth reading and will be required reading for students in my tax policy class.

It gives a good overview of the system, though--of course, you should rely on your IRS Pub 4012 and Pub 17 for the actual details of the tax returns you will be preparing for real taxpayers.

It should also be noted that there are other important tax benefits associated with children not discussed above, in particular, the higher education tax credits and other tax benefits associated with education.

Bottom line: it is really important to get the details right when figuring out the rules for a qualifying child.

"There's no such thing as a free bike."

2010-12-13T10:16:00.000-08:00

Ikea gave all its employees a "free" bike yesterday.

Those "gift" bikes could turn out to be very expensive, because the IRS does not treat it as a "gift" but as a "taxable fringe benefit."

It raises interesting tax questions.

1) If the Ikea employee uses the bike to commute to work, maybe some would contend that it could qualify for an exclusion from income of $20 per bike commuting month, but the IRS Publication 15-B Employer's Tax Guide to Fringe Benefits just talks about excluding reimbursement for employee bike expenses, and says nothing whatsoever about the employer providing a bike to the employee. And Ikea did not make the provision of the bike contingent on its use for commuting. It doesn't sound like Ikea set up the bike program to qualify for that exclusion.

2) Assuming no exclusion applies, the tax cost of this gift (payroll taxes of 15.3% plus federal and state income marginal rates, which could easily total over 50% for low-income families on the phase-out portion of the Earned Income Tax Credit) makes it a pretty expensive bike for many employees who either (A) don't particularly care all that much for biking or (B) like biking but already have a bike they like better than the one Ikea is giving them.

3) If you win a bike you don't care to keep on a game show or contest, I believe you can just sell the bike immediately for its fair market value (FMV) in an arm's length transaction and just pay taxes on the proceeds of the sale as your income for tax purposes. So, even if the list price of the bike is $400, you only need to pay tax on the fair market value of the bike that you actually realized rather than the list price. (Thanks to Jack Bogdanski of Lewis & Clark Law School for making me clarify the language here.)

4) By contrast to the game show contestant, if an Ikea employee sells their bike immediately, I suspect they are going to have a difficult time getting their tax liability reduced to the FMV realized in the transaction, due to the fact that it's subject to payroll taxation as well as income taxation, reported on a W-2 rather than a 1099, etc.

Bottom line: some (many?) Ikea employees may wind up paying more in tax than this bike is worth to them.

A game theorist takes on Mankiw, Joe the Plumber, Obama, Buffett, Atlas Shrugged

2010-12-11T15:41:00.000-08:00

Two very readable papers on tax fairness issues:

Professor Greg Mankiw (Harvard) wrote Spreading the wealth around: Essays inspired by Joe the Plumber. In short, Greg is on Joe's side. He thinks it's a bad idea to increase taxes on the rich, and that economic theory provides solid support for Joe's concept of fairness.

Professor Jonathan Weinstein, a mathematical game theorist at Northwestern, responds to Greg's arguments with Thoughts on Fair Taxation — Mankiw, Joe the Plumber, Obama, Buffett, Atlas Shrugged, Core Equivalence, and Shapley Value. Jonathan is on Warren Buffett's side, that fairness may indeed require the rich to pay more taxes than they currently pay.

If you are in my winter term tax policy class, read both papers, and keep them in mind as you learn about how our tax system actually works.

CBO: Trends in Federal Tax Revenues and Rates

2010-12-02T17:28:00.000-08:00

The graphs above come from today's presentation by Congessional Budget Office Director Elmendorf to the Senate Finance Committee. These graphs do an excellent job of summarizing federal tax trends in recent decades. The projections for the future depend critically on the assumptions described in the full report embedded below.

Trends in Federal Tax Revenues and Rates

View more presentations from Congressional Budget Office.