Ch.1 Taxation of Individuals and Business Entities

Federal Taxes

-Income taxes -Employment and unemployment taxes -Excise taxes -Transfer taxes

Implicit Taxes

-Indirect taxes that result from a tax advantage the government grants to certain transactions -Defined as the reduced before-tax return that a tax-favored asset produces because of its tax advantaged status -Difficult to quantify but important to understand in evaluating the relative tax burdens of tax-advantaged investments

Estate and Gift taxes (federal)

-Levied on the fair market values of wealth transfers upon death or by gift

Describe the three different tax rates discussed in the chapter and how taxpayers might use them.

-Marginal Tax Rate -Average Tax Rate -Effective Tax Rate

Income taxes (state and local)

-Most states impose income taxes on individuals and corporations who either reside in or earn income within the state. -Does Texas have a state income tax?NO Most state taxable income calculations largely conform to the federal taxable income calculations, with a limited number of modifications.

Property taxes (state and local)

-Property taxes are ad valorem taxes, meaning that the tax base for each is the fair market value of the property. -Real property taxes consists of taxes on land and structures permanently attached to land. -Personal property taxes includes taxes on all other types of property, both tangible and intangible.

Income taxes (federal)

-Represents approximately 56.5% of all tax revenues collected in the United States (Individuals 47.3% and Corporations 9.2%) -Levied on individuals, corporations, estates, and trusts

State and local taxes

-Sales and use taxes -Property taxes -Income taxes -Excise taxes

Employment and Unemployment taxes (federal)

-Second largest group of taxes imposed by the U.S. government -Employment taxes include the OASDI (Social Security tax), and the MHI tax (Medicare tax). -Unemployment taxes fund temporary unemployment benefits for individuals terminated from their jobs without cause.

Sales and Use taxes (state and local)

-Tax base for a sales tax is the retail sales of goods and some services. -Tax base for the use tax is the retail price of goods owned, possessed, or consumed within a state that were not purchased within the state. (Poor compliance/difficult to enforce - currently several bills before Congress to modernize Internet taxation)

Excise taxes (federal)

-Third largest group of taxes imposed by the U.S. government -Imposed on the producer of the goods, not the consumer -Levied on the quantity of products sold rather than a monetary amount

What is an ad valorem tax? Name an example of this type of tax.

An ad valorem tax is a tax based on the fair market value of property. Real and personal property taxes are examples of ad valorem taxes.

What are the differences between an explicit and an implicit tax?

An explicit tax is a tax that is directly imposed by a government unit and easily quantified. Implicit taxes are the reduced rates of pretax return that a tax-favored asset produces (e.g., the lower pretax rate of return earned by tax exempt municipal bonds). Although implicit taxes are real and equally important in understanding our tax system, they are difficult to quantify.

Arnold and Lilly have recently had a heated discussion about whether a sales tax is a proportional tax or a regressive tax. Arnold argues that a sales tax is regressive. Lilly counters that the sales tax is a flat tax. Who is correct?

Arnold and Lilly are both correct. A sales tax by definition is a proportional tax - i.e., as taxable purchases increase, the sales tax rate (i.e., the marginal tax rate) remains constant. Nonetheless, when you consider that the proportion of one's total income spent on taxable purchases likely decreases as total income increases, the sales tax may be considered a regressive tax.

Types of revenue forecasting (sufficiency)

static and dynamic Static: Forecasting revenue ignores how taxpayers might alter their activities in response to a tax law change Dynamic: Forecasting which tries to predict possible responses by taxpayers to new tax laws. -Income Effect: as tax rates go up, people will work harder to maintain same after-tax income. -Substitution Effect: as tax rates go up, people will substitute non-taxable activities because the marginal value of taxable ones has decreased.

economy

should minimize the compliance and administration costs associated with the tax system.

How to Evaluate Different Tax Systems?

1. Sufficiency 2. Equity 3. Certainty 4. Convenience 5. Economy

Progressive tax rate structure

A progressive tax rate structure imposes an increasing marginal tax rate as the tax base increases. In other words, as the tax base increases, both the marginal tax rate and the taxes paid increase. Common examples of progressive tax rate structures include federal and most state income taxes and federal estate and gift taxes.

Dontae stated that he didn't want to earn any more money because it would "put him in a higher tax bracket." What is wrong with Dontae's reasoning?

Although earning additional taxable income may increase Dontae's marginal tax rate (i.e., put him in a higher tax bracket), the additional income earned does not affect the taxes that Dontae will pay on his existing income. Moving to a higher tax bracket simply means that Dontae will pay a higher tax rate on the additional income earned (not income that he already has).

Benjamin recently bought a truck in Alabama for his business in Georgia. What different types of federal and state taxes may affect this transaction?

Benjamin will have to pay state sales tax in Alabama for the truck purchased. Assuming the vehicle will be registered in Georgia, Benjamin will have to pay use tax on the purchase at a rate representing any difference in the Alabama sales tax rate and the Georgia use tax rate. Benjamin will also have to pay personal property tax annually on the truck. Finally, since the vehicle is used in Benjamin's business, he will be able to depreciate the truck for federal income tax purposes.

Campbell, a single taxpayer, earns $400,000 in taxable income and $2,000 in interest from an investment in State of New York bonds. Using the U.S. tax rate schedule, how much federal tax will she owe? What is her average tax rate? What is her effective tax rate? What is her current marginal tax rate?

Campbell will owe $115,689.50 in federal income tax this year computed as follows: $115,689.50= $45,689.50+ 35% x ($400,000 - $200,000). Campbell's average tax rate is 28.92 percent. Campbell's effective tax rate is 28.78 percent.

Compare the federal income tax to sales taxes using the "certainty" criterion.

Certainty means that taxpayers should be able to determine when to pay the tax, where to pay the tax, and how to determine the tax. It is relatively easy to determine when and where to pay the federal income tax and sales taxes. For example, individual federal income tax returns and the remaining balance of taxes owed must be filed with the Internal Revenue Service each year on or before April 15th (or the first business day following April 15th if the 15th falls on a weekend). Likewise, sales taxes are paid to retailers when items are purchased, and property taxes are typically paid annually to local governments. The ease of "how to determine the tax," however, varies by tax system. Sales taxes are determined with relative ease - i.e., they are based on the value of taxable purchases. In contrast, income taxes are often criticized as being complex. What are taxable/nontaxable forms of income? What are deductible/nondeductible expenses? When should income or expense be reported? For many taxpayers (e.g., wage earners with few investments), the answers to these questions are straightforward. For other taxpayers (e.g., business owners, individuals with a lot of investments), the answers to these questions are nontrivial. Constant tax law changes enacted by Congress also add to the difficulty in determining the proper amount of income tax to pay. These changes can make it difficult to determine a taxpayer's current tax liability much less plan for the future.

Chuck, a single taxpayer, earns $75,000 in taxable income and $10,000 in interest from an investment in City of Heflin bonds. Using the U.S. tax rate schedule, how much federal tax will he owe? What is his average tax rate? What is his effective tax rate? What is his current marginal tax rate?

Chuck will owe $12,439.50 in federal income tax this year computed as follows: $12,439.50 = $4,453.50 + 22%($75,000 - $38,700). Chuck's average tax rate is 16.59. Chuck's effective tax rate is 14.63 percent.

What are some aspects of personal finance that require knowledge of taxation?

Common personal financial decisions that taxes influence include: choosing investments, retirement planning, choosing to rent or buy a home, evaluating alternative job offers, saving for education expenses, and doing gift or estate planning.

Many years ago a famous member of Congress proposed eliminating federal income tax withholding. What criterion for evaluating tax systems did this proposal violate? What would likely have been the result of eliminating withholding?

Eliminating withholding would violate the convenience criterion - i.e., a tax system should be designed to facilitate the collection of tax revenues without undue hardship on the taxpayer or the government (i.e., a tax system should make collection as easy as possible). Eliminating withholding would most likely have slowed collection of taxes and increased taxpayer aggressiveness (or tax evasion). Prior research suggests that taxpayers are more likely to take more aggressive tax positions when they owe additional taxes when filing their return.

What is the tax base for the Social Security and Medicare taxes for an employee or employer? What is the tax base for Social Security and Medicare taxes for a self-employed individual? Is the self-employment tax in addition to or in lieu of federal income tax?

Employee wages is the tax base for the Social Security and Medicare taxes. Net earnings from self-employment is the tax base for the self-employment tax. The self-employment tax is in addition to the federal income tax.

What are unemployment taxes?

Employers are required to pay federal and state unemployment taxes, which fund temporary unemployment benefits for individuals terminated from their jobs without cause. The tax base for the unemployment taxes is wages or salary.

What is the distinguishing feature of an excise tax?

Excise taxes differ from other taxes in that the tax base on excise taxes is typically based on the quantity of an item or service purchased. The federal government imposes a number of excise taxes on goods such as alcohol, diesel fuel, gasoline, tobacco products and services such as telephone services. In addition, states also often impose excise taxes on these same items.

What is the difference between horizontal and vertical equity? How do tax preferences affect people's view of horizontal equity?

Horizontal equity means that two taxpayers in similar situations pay the same tax. Vertical equity is achieved when taxpayers with greater ability to pay tax, pay more tax relative to taxpayers with a lesser ability to pay tax. One can view vertical equity in terms of tax dollars paid or in terms of tax rates.

Hugh has the choice between investing in a City of Heflin bond at 6 percent or a Surething bond at 9 percent. Assuming that both bonds have the same nontax characteristics and that Hugh has a 40 percent marginal tax rate, in which bond should he invest?

Hugh's after tax rate of return on the tax-exempt City of Heflin bond is 6 percent. The Surething bond pays taxable interest of 9 percent. Hugh's after tax rate of return on the Surething bond is 5.4 percent (i.e., 9% interest income - (9% x 40%) tax = 5.4%). Hugh should invest in the City of Heflin bond.

If Chuck earns an additional $40,000 of taxable income, what is his marginal tax rate on this income? What is his marginal rate if, instead, he had $40,000 of additional deductions?

If Chuck earns an additional $40,000 of taxable income, his marginal tax rate on the income is 23.63 percent. If Chuck instead had $40,000 of additional tax deductions, his marginal tax rate on the deductions would be 21.08 percent.

what will happen to the government's tax revenues if Song chooses to spend more time pursuing her other passions besides work in response to the tax rate change and earns only $75,000 in taxable income? What is the term that describes this type of reaction to a tax rate increase? What types of taxpayers are likely to respond in this manner?

If Song only earns $75,000 of taxable income, she would pay only $18,750 of tax under the new tax structure (i.e., $75,000 x .25). Thus, the government's tax revenues would decrease by $1,250 (i.e., $18,750 - $20,000). This is an example of the substitution effect, which may be descriptive for taxpayers with more disposable income.

When we calculate average and effective tax rates, do we consider implicit taxes? What effect does this have on taxpayers' perception of equity?

Implicit taxes are very difficult to quantify and thus, are generally not considered when calculating average and effective tax rates. Since implicit taxes are ignored in these calculations, taxpayers may conclude that groups of taxpayers investing in tax advantaged assets (subject to implicit tax) do not pay their fair share of tax as represented by a low effective tax rate.

If the general objective of our tax system is to raise revenue, why does the income tax allow deductions for charitable contributions and retirement plan contributions?

In addition to the general objective of raising revenue, Congress uses the federal tax system to encourage certain behavior and discourage other behavior. The charitable contribution deduction is intended to encourage taxpayers to support the initiatives of charitable organizations, whereas deductions for retirement contributions are intended to encourage retirement savings.

Kobe strongly dislikes SUVs and is appalled that so many are on the road. He proposes to eliminate the federal income tax and replace it with a $50,000 annual tax per SUV. Based on the number of SUVs currently owned in the United States, he estimates the tax will generate exactly the amount of tax revenue currently collected from the income tax. What is wrong with Kobe's proposal? What type of forecasting is Kobe likely using?

Kobe's forecast is based on static forecasting (i.e., he is ignoring how taxpayers may alter their activities in response to the tax law change). Given that taxpayers are likely to substitute purchases of other vehicles for SUVs (i.e., the substitution effect), Kobe's proposal is likely to result in a large discrepancy in projected and actual tax revenues.

Excise taxes (state and local)

States typically impose excise taxes on items subject to federal excise tax.

Jessica's friend Zachary once stated that he couldn't understand why someone would take a tax course. Why is this a rather naïve view?

Taxes are a part of everyday life and have a financial effect on many of the major personal decisions that individuals face (e.g., investment decisions, evaluating alternative job offers, saving for education expenses, gift or estate planning, etc.).

What are some aspects of business that require knowledge of taxation?

Taxes play an important role in fundamental business decisions such as the following: • What organizational form should a business use? • Where should the business locate? • How should business acquisitions be structured? • How should the business compensate employees? • What is the appropriate mix of debt and equity for the business? • Should the business rent or own its equipment and property? • How should the business distribute profits to its owners? One must consider all transaction costs (including taxes) to evaluate the merits of a transaction.

Courtney recently received a speeding ticket on her way to the university. Her fine was $200. Is this considered a tax? Why or why not?

The $200 speeding ticket is not considered a tax. Instead, it is considered a fine or penalty. Taxes differ from fines and penalties because taxes are not intended to punish or prevent illegal behavior.

To help pay for the city's new stadium, the city of Birmingham recently enacted a 1 percent surcharge on hotel rooms. Is this a tax? Why or why not?

The 1 percent surcharge is a tax. The 1 percent surcharge is an earmarked tax - i.e., collected for a specific purpose. The surcharge is considered a tax because the tax payments made by taxpayers do not directly relate to the specific benefit received by the taxpayers.

Average Tax Rate

The average tax rate represents the taxpayer's average level of taxation on each dollar of taxable income. The average tax rate is often used in budgeting tax expense as a portion of income (i.e., what percent of taxable income earned is paid in tax). =TotalTax --------- TaxableIncome

Marlon and Latoya recently started building a house. They had to pay $300 to the county government for a building permit. Is the $300 payment a tax? Why or why not?

The building permit is not considered a tax because $300 payment is directly linked to a benefit that they received (i.e., the ability to build a house).

The state of Georgia recently increased its tax on a pack of cigarettes by $2.00. What type of tax is this? Why might Georgia choose this type of tax?

The cigarette tax is both considered an excise tax (i.e., a tax based on quantity purchased) and a "sin" tax (i.e., a tax on goods that are deemed to be socially undesirable). Georgia may choose this type of tax to discourage smoking and because sin taxes are often viewed as acceptable ways of increasing tax revenues.

Effective Tax Rate

The effective tax rate represents the taxpayer's average rate of taxation on each dollar of total income (i.e., taxable and nontaxable income). The effective tax rate provides a depiction of a taxpayer's tax burden because it depicts the taxpayer's total tax paid as a ratio of the sum of both taxable and nontaxable income earned. =total tax ----------- total income

Which is the largest tax collected by the U.S. government? What types of taxpayers are subject to this tax?

The federal income tax is the largest tax collected by the U.S. government. Currently, federal income taxes are levied on individuals, corporations, estates, and trusts.

What is the difference between the income and substitution effects? For which types of taxpayers is the income effect more likely descriptive? For which types of taxpayers is the substitution effect more likely descriptive?

The income effect predicts that when taxpayers are taxed more (e.g., tax rate increases from 25 to 28 percent), they will work harder to generate the same after-tax dollars. The income effect is likely to be more descriptive for taxpayers with insufficient income to meet their necessities, etc. for their desired standard of living. The substitution effect predicts that when taxpayers are taxed more, they will substitute nontaxable activities (e.g., leisure activities) for taxable activities because the marginal value of taxable activities has decreased. The substitution effect is likely to be more descriptive for taxpayers with sufficient income to meet their necessities and to sustain their desired standard of living.

Marginal Tax Rate (MTR)

The marginal tax rate is particularly useful in tax planning because it represents the rate of taxation or savings that would apply to additional taxable income or tax deductions. = (NewTotaltax- OldTotaltax) -------------------------------- (NewTaxableIncome - OldTaxableIncome)

One common argument for imposing so-called sin taxes is the social goal of reducing demand for such products. Using cigarettes as an example, is there a segment of the population that might be sensitive to price and for whom high taxes might discourage purchases?

The most obvious segment sensitive to price may be teenagers and younger adults, although price sensitivity will vary by taxpayer.

What are some of the taxes that currently are unique to state and local governments? What are some of the taxes that the federal, state, and local governments each utilize?

The sales, use, and property (personal, real, intangible) taxes are unique to state and local governments. Taxes that are common among the federal, state, and local governments include income taxes, excise taxes, and estate and gift taxes.

What is the difference between a sales tax and a use tax?

The tax base for sales taxes is retail sales of goods (and some services). The tax base for the use tax is the retail price of goods owned, possessed or consumed within a state that were not purchased within the state (e.g., goods purchased over the internet).

(1) Consider the following tax rate structure. Is it horizontally equitable? Why or why not? Is it vertically equitable? Why or why not? Taxpayer Salary Total Tax Rajiv 10,000 600 LaMarcus 20,000 600 Dory 10,000 600

The tax rate schedule is horizontally equitable because those taxpayers in the same situation (Rajiv and Dory) pay the same tax ($600). The tax is not vertically equitable because the taxpayer with a greater ability to pay (LaMarcus) does not pay more tax, nor does he pay a higher tax rate.

As noted in Example 1-2, tolls, parking meter fees, and annual licensing fees are not considered taxes. Can you identify other fees that are similar?

There are several possible answers to this question. Some common examples include entrance fees to national parks, tag fees paid to local/state government for automobiles, boats, etc.

Describe some ways in which taxes affect the political process in the United States.

U.S. presidential candidates often distinguish themselves from their opponents based upon their tax rhetoric. Likewise, the major political parties generally have very diverse views of the appropriate way to tax the public. Determining who is taxed, what is taxed, and how much is taxed are difficult questions. Voters must have a basic understanding of taxes to evaluate the merits of alternative tax proposals offered by opposing political candidates and their political parties.

Taxpayer Salary Total Tax Marilyn 10,000 600 Kobe 20,000 3,000 Alfonso 30,000 6,000

We cannot evaluate whether the tax rate structure is horizontally equitable because we are unable to determine if taxpayers in similar situations pay the same tax (i.e., the problem does not give data for two taxpayers with the same income). The tax rate structure would be considered vertically equitable because taxpayers with higher income pay more tax and at a higher rate. Specifically, Marilyn's, Kobe's, and Alfonso's average tax rates are 6 percent, 15 percent, and 20 percent, respectively.

Melinda invests $200,000 in a City of Heflin bond that pays 6 percent interest. Alternatively, Melinda could have invested the $200,000 in a bond recently issued by Surething Inc. that pays 8 percent interest with similar risk and other nontax characteristics to the City of Heflin bond. Assume Melinda's marginal tax rate is 25 percent.

a. What is her after-tax rate of return for the City of Heflin bond? Since the City of Heflin bond is a tax-exempt bond, Melinda's after tax rate of return on the bond is equal to its pretax rate of return (6 percent). b. How much explicit tax does Melinda pay on the City of Heflin bond? Since the City of Heflin bond is a tax-exempt bond, Melinda pays no explicit tax on the interest earned from the City of Heflin bond. c. How much implicit tax does she pay on the City of Heflin bond? Melinda earns $12,000 of interest on the City of Heflin bond (i.e., 6% x $200,000). A similar priced taxable bond (i.e., the Surething Inc. bond) would pay $16,000 of taxable interest (i.e., 8% x $200,000). Melinda pays $4,000 of implicit tax on the City of Heflin bond (i.e., the difference between the pretax interest earned from a similar taxable bond ($16,000) and the pretax interest earned from the City of Heflin bond ($12,000)). d. How much explicit tax would she have paid on the Surething Inc. bond? Since Melinda's marginal tax rate is 25 percent, she would have paid $4,000 of explicit tax (i.e., 25% x $16,000) on the interest earned from the Surething, Inc. bond. e. What is her after-tax rate of return on the Surething Inc. bond? Her after-tax income from the Surething Inc. bond would be $12,000 ($16,000 interest income - $4,000 tax). Thus, her after-tax return from the Surething Inc. bond would be 6 percent (after-tax income of $12,000 divided by her $200,000 investment).

Equity:

how the tax burden should be distributed across taxpayers. In general terms, a tax system is considered fair or equitable if the tax is based on the taxpayer's ability to pay. Horizontal Equity: two taxpayers in similar situations pay the same tax. Vertical Equity: taxpayers with greater ability to pay tax, pay more tax relative to taxpayers with a lesser ability to pay tax.

Proportional (flat) tax rate structure

imposes a constant tax rate throughout the tax base. In other words, as the tax base increases, the taxes paid increases, but the marginal tax rate remains constant. Because the marginal tax rate is constant across all levels of the tax base, the average tax rate remains constant across the tax base and always equals the marginal tax rate. Common examples of proportional taxes include sales taxes and excise taxes (i.e., taxes based on quantity such as gallons of gas purchased).

Regressive tax rate structure

imposes a decreasing marginal tax rate as the tax base increases. In other words, as the tax base increases, the taxes paid increases, but the marginal tax rate decreases. Regressive tax rate structures are not common. In the United States, the Social Security tax and the federal employment tax employ a regressive tax rate structure.

Sufficiency:

involves assessing the aggregate size of the tax revenues that must be generated and making sure that the tax system provides these revenues.

Certainty:

means that taxpayers should be able to determine when to pay the tax, where to pay the tax, and how to determine the tax.

Convenience:

tax system should be designed to be collected without undue hardship to the taxpayer.

Which is a more appropriate tax rate to use to compare taxpayers' tax burdens - the average or the effective tax rate? Why?

the effective tax rate provides a better depiction of a taxpayer's tax burden because it depicts the taxpayer's total tax paid as a ratio of the sum of both taxable and nontaxable income earned.