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An Introduction to Tax

Chapter 1: An Introduction to Tax

Learning Objectives:

  • Demonstrate how taxes influence basic business, investment, personal, and political decisions.
  • Discuss what constitutes a tax and the general objectives of taxes.
  • Describe the difference tax rate structures and calculate a tax.
  • Identify the various federal, state, and local taxes.
  • Apply appropriate criteria to evaluate alternative tax systems.

How Cares About Taxes and Why?

  • tax deductions for home mortgage interest and real estate taxes can reduce after-tax costs of owning a home relative to renting
  • tax-advantage methods of saving for retirement can increase after-tax value of retirement nest egg
  • personal financial decisions that taxes influence include: choosing investment, evaluating alternative job offers, saving for education expenses, doing gift or estate planning
  • taxes represent large transaction costs that businesses should factor into financial decision-making process
  • taxes play major part in political process – major political parties have very diverse views of appropriate way to tax public
  • taxes affect many aspects of personal, business, and political decisions

What Qualifies as a Tax?

  • tax: a payment required by a government that is unrelated to any specific benefit or service received from the government
  • general purpose of tax is to fund operations of government (raise revenue)
  • differ from fines and penalties in that taxes are not intended to punish or prevent illegal behavior
  • government encourages behaviors like charitable contributions, retirement savings, and research and development
  • sin taxes: taxes imposed on the purchase of goods (e.g. alcohol, tobacco products) that are considered socially less desirable
  • key components of definition of tax are:
    • payment is required (not voluntary)
    • payment is imposed by a government agency (federal, state, or local)
    • payment is not tied directly to the benefit received by taxpayer
  • taxpayers benefit from national defense, judicial system, law enforcement, public schools – taxes paid are not directly related to any specific benefit received by taxpayer
  • earmarked tax: tax that is assessed for a specific purpose (e.g. education)
  • payment made by taxpayer doesn’t directly relate to specific behavior received by taxpayer

How to Calculate a Tax

  • Tax = Tax Base x Tax Rate
  • tax base: item that is being taxed (e.g. purchase price of a good, taxable income, real estate values, personal property values, etc.)
  • tax rate: level of taxes imposed on the tax base, usually expressed as a percentage
  • different portions of a tax base may be taxed at different rates
  • flat tax: tax in which a single tax rate is applied throughout the tax base
  • graduated taxes: taxes in which the tax base is divided into a series of monetary amounts, or brackets, where each successive bracket is taxed at a different (gradually higher or gradually lower) percentage rate
  • brackets: a subset (portion) of the tax base subject to a specific tax rate - common to graduated taxes

Different Ways to Measure Tax Rates

  • marginal tax rate: tax rate that applied to the next additional increment of a taxpayer’s taxable income (or deductions)
  • Marginal Tax Rate = ΔTax / ΔTaxable Income = (New total tax – old total tax) / (New taxable income – old taxable income)
  • “old” refers to current tax and “new” refers to revised tax after incorporating additional income (or deductions) in question
  • graduated income tax systems – additional income (deductions) can push a taxpayer into a higher (lower) tax bracket, thus changing marginal tax rate
  • useful in tax planning because it represent rate of taxation or savings that would apply to additional taxable income (or tax deductions)
  • average tax rate: taxpayers average level of taxation on each dollar of taxable income
  • Average Tax Rate = Total Tax / Taxable income
  • used in budgeting tax expense as a portion of income
  • effective tax rate: taxpayer’s average rate of taxation on each dollar of total income (economic income) including taxable and nontaxable income
  • Effective Tax Rate = Total Tax / Total Income
  • provides better depiction of taxpayer’s tax burden because it depicts taxpayer’s total tax paid as ratio of sum of both taxable and nontaxable income earned

Tax Rate Structures

  • three basic tax rate structures used to determine a tax: proportional, progressive, and regressive

Proportional Tax Rate Structure

  • proportional tax rate structure: flat tax; imposes a constant tax rate throughout the tax base
  • as taxpayer’s tax base increases, taxpayer’s taxes increase proportionally
  • rate stays same throughout all levels of tax base, marginal tax rate remains constant and equals the average tax rate
  • example is sales tax
  • Proportional Tax = Tax Base x Tax Rate

Progressive Tax Rate Structure

  • progressive tax rate structure: imposes an increasing marginal tax rate as the tax base increases
  • as tax base increases, both marginal tax rate and taxes paid increases
  • examples are federal an state income taxes
  • will always be less than or equal to the marginal tax rate

Regressive Tax Rate Structure

  • regressive tax rate structure: imposes a decreasing marginal tax rate as tax base increases
  • as tax base increases, taxes paid increases, but marginal tax rate decreases
  • not common
  • examples are Social Security tax and federal and state unemployment taxes
  • sales tax is regressive tax when looking at effective tax rates (capture the incidence of taxation, which relates to ultimate economic burden of tax)

Types of Taxes

Federal Taxes

  • federal government imposes taxes to fund federal programs (national defense, Social Security, interstate highway system, education, Medicare)
  • major taxes include income taxes, employment taxes, estate and gift taxes, excise taxes
  • absent from list is sales tax (common for state and local governments) and a value-added tax (sales tax – referred to as VAT)
  • value-added tax: imposed on the producers of goods and services based on the value added to the goods and services at each stage of production; common in Europe

Income Tax

  • income tax: a tax in which the tax base is income; imposed by the federal government
  • most significant tax assessed by US government
  • represents 50.4% of all tax revenue collected
  • Congress enacted first US personal income tax in 1861 to help fund Civil War
  • levied on individuals (max rate of 35%), corporations (max rate of 39%), estates (max rate of 35%) and trusts (max rate of 35%)

Employment and Unemployment Taxes

  • employment taxes: taxes consisting of Old Age, Survivors, and Disability Insurance (OASDI) tax (Social Security) and Medical Heath Insurance (MHI) tax (Medicare)
  • Social Security tax: pays monthly retirement, survivor, and disability benefits for qualifying individuals
  • Medicare tax: pays for medical insurance for individuals who are elderly or disabled
  • tax base is wages or salary
  • employers and employees split taxes equally
  • self-employment tax: Social Security and Medicare taxes paid by self-employed on a taxpayer’s net earnings from self-employment; terms “self-employment tax” and “FICA tax” are synonymous
  • unemployment taxes: tax that pays for temporary unemployed individuals terminated from their jobs without cause
  • tax base is wages or salary

Excise Taxes

  • excise taxes: taxes levied on the retail sale of particular products
  • tax base depends on quantity purchased, rather than monetary amount
  • imposes on goods such as alcohol, diesel fuel, gasoline, tobacco products and on services such as telephone use, air transportation, tanning beds
  • states impose excise taxes on same things
  • many consumers aren’t aware that businesses build these taxes into prices consumers pay – consumers bear incidence of taxes because of higher price

Transfer Taxes

  • transfer taxes: taxes on the transfer of wealth from one taxpayer to another
  • estate tax: tax on fiduciary legal entity that comes into existence upon a person’s death and is empowered by the probate court to gather and transfer the decendent’s real and personal property
  • gift tax: tax on transfer of property where no consideration (or inadequate consideration) is paid for the property
  • based on fair market values of wealth transfers upon death or by gifts
  • traditionally been high compared to income taxes rates and can be burdensome without proper planning
  • only large transfers are subject to

State and Local Taxes

  • state tax: tax imposed by one of the 50 US states
  • local tax: taxes imposed by local governments (cities, counties, school districts)
  • largest state and local revenues are generated by state sales tax and local property taxes

Income Taxes

  • impose income taxes on individuals and corporations who either reside in or earn income within the state
  • calculations of taxable income vary state by state
  • most state taxable income calculations largely conform to the federal taxable income calculations, with a limited number of modifications

Sales and Use Taxes

  • sales tax: tax imposed on retail sales of goods (plus certain services); retailers are responsible for collecting and remitting the tax
  • typically is collected at point of sale
  • use tax: tax imposed on the retail price of goods owned, possessed, or consumed within a state that were not purchased within the state
  • discourage taxpayers from buying goods out of state in order to avoid or minimize sales tax in their home state
  • removes competitive disadvantage a retailer may incur from operating in a state with high sales tax
  • poor compliance, as it’s difficult for states to tax other out-of-state purchases

Property Taxes

  • real property taxes: tax on fair market value of land and structures permanently attached to land
  • personal property taxes: tax on fair market value of all types of tangible and intangible property, except real property
  • ad valorem taxes: tax based on the value of property
  • tangible personal property – automobiles, boats, private planes, business inventory, equipment, furniture
  • intangible personal property – stocks, bonds, intellectual property
  • real property taxes are easier to administer because is not moveable and purchases are registered with the state
  • personal property is mobile (easier to hide) and may be more difficult to value


Excise Taxes

  • based on quantity of item or service purchased
  • imposed on items subject to federal excise tax
  • often include sale of alcohol, diesel fuel, gasoline, tobacco products, telephone services

Implicit Taxes

  • explicit taxes: taxes directly imposed by a government and are easily quantified
  • implicit taxes: indirect taxes, not paid directly to the government, that result from a tax advantage the government grants to certain transactions to satisfy social, economic, or other objectives
  • reduced before-tax return that a tax-favored asset produces because of its tax-advantaged status
  • tax-favored – when income asset produces is either excluded from tax base or subject to a lower tax rate or if asset generates some other tax benefit such as large tax deductions
  • tax benefits (all other things equal) result in higher after-tax profits from investing in tax-advantaged assets
  • tax benefits associated with tax-favored asset increase demand for asset – increased demand drives up price of asset, which reduces its before-tax return (definition of implicit tax)
  • municipal bond interest income is not subject to federal income taxation
  • difficult to quantify, but are important to understand in evaluating the relative tax burdens of tax-advantaged investments

Evaluating Alternative Tax Systems

  • lawmakers engage in continuous debate over basic questions of whom to tax, what to tax, and how much to tax

Sufficiency

  • sufficiency: assessing the aggregate size of the tax revenues that must be generated and ensuring that the tax system provides these revenues
  • accurately estimating government expenditures and revenues is daunting and imprecise process
  • impossible to predict the unknown

Static vs. Dynamic Forecasting

  • static forecasting: ignores how taxpayers may alter their activities in response to a proposed tax law change and bases projected tax revenues on the existing state of transactions
  • may result in large discrepancies in projected versus actual tax revenues if taxpayers change their behavior
  • dynamic forecasting: attempts to account for possible taxpayer responses to a proposed tax law change
  • only a good as assumptions underlying the forecasts and doesn’t guarantee accurate results
  • static forecasting can lead to tax consequence opposite the desired outcome

Income vs. Substitution Effects

  • income effect: predicts that when taxpayers are taxed more (ex. tax rate increases from 25 to 28 percent), they will work harder to generate the same after-tax dollars
  • substitution effect: predicts that when taxpayers are taxed more, rather than work more, they will substitute nontaxable activities like leisure pursuits for taxable ones because the marginal value of taxable activities has decreased
  • some factors are more likely to correlate with the substitution effect (having higher disposable income)
  • if tax system fails to generate sufficient revenues, the government must seek other sources to pay for governmental expenditures – most common source is issuance of debt instruments such as Treasury bonds
  • debt issuances require both interest and principal payments, which require federal government to identify more sources of revenue to service the debt issued or cut governmental spending
  • government may default on debt obligations – costs of this option are devastating
  • best option is for government to match revenues with expenses – not spend more than it collects

Equity

  • equity: tax system is considered fair or equitable if tax is based on taxpayer’s ability to pay; taxpayers with a greater ability to pay tax, pay more tax
  • fairness is inherently subject to personal interpretation and informed minds often disagree about what is fair
  • no “one-size-fits-all” definition of fairness

Horizontal vs. Vertical Equity

  • horizontal equity: two taxpayers in similar situations pay the same tax
  • not entirely horizontally equitable
  • two taxpayers with same income may not pay same taxes if one income was earned by salary and the other by tax-exempt interest income, dividend income, and capital gains income (subject to lower tax rate)
  • two taxpayers with same dollar amount of purchases may not pay same taxes if one buys higher proportion of goods (subject to a lower tax rate)
  • two taxpayers with real estate may not pay same taxes if one owns farmland (subject to lower tax rate)
  • two taxpayers with estates may not pay same taxes if one bequeaths more of property to charity or spouse because transfers aren’t subject to estate tax
  • failures of horizontal equity are due to tax preferences
  • vertical equity: achieved when taxpayers with greater ability to pay tax, pay more tax than taxpayers with less ability to pay (dollars paid or terms of tax rates)
  • focusing on tax rate structure in evaluating tax system is appropriate only if tax base chosen accurately portrays taxpayer’s ability to pay
  • effective tax rates for those with greater ability to pay are lower than those taxpayers with lesser ability to pay, making tax regressive
  • regressive tax rate structures are generally considered not to satisfy vertical equity

Certainty

  • certainty: taxpayers should be able to determine when to pay the tax, where to pay the tax, and how to determine the tax
  • tax returns must be filed with IRS on or before April 15
  • sales taxes are based on value of taxable purchases
  • property taxes are based on assessed property values
  • excise taxes are based on number of taxable units purchased
  • determining when and where to pay each of taxes is relatively easy
  • calculated for taxpayer and often charged regular intervals or at point of purchase – don’t require tax return
  • income taxes are often criticized as being too complex

Convenience

  • convenience: tax system should be designed to facilitate the collection of tax revenues without undue hardship on the taxpayer or the government
  • various tax systems meet this criterion by tying the collection of tax as closely as possible to transaction that generates it

Economy

  • economy: a good tax system should minimize the compliance and administration costs associated with the tax system
  • can view from both taxpayers’ and government’s perspectives

Evaluating Tax Systems – The Trade-off

  • much of debate regarding alternative tax systems reduces choice between simplicity and fairness
  • taxes that are simpler and easier to administer are typically viewed as less fair
  • taxes that are viewed as more fair are more complex to administer
  • understanding of evaluative criteria should be helpful to anyone trying to reconcile trade-offs among alternative tax proposals

Conclusion

  • taxes are part of life
  • influence decisions about personal finance, investment, business, and politics

Summary

  • Demonstrate how taxes influence basic business, investment, personal, and political decisions.
    1. Taxes are significant costs that influence many basic business, investment, and personal decisions.
      1. Business decisions: what organization form to take; where to locate; how to compensate employees; appropriate debt mix’ owning vs. renting equipment and property; how to distribute profits, and so forth.
      2. Investment decisions: alternative methods for saving for education or retirement, and so forth.
  • Personal finance decisions: evaluating job offers; gift or estate planning; owning vs. renting home, and so forth.
  1. Taxes also play a major part in the political process. Major parties typically have very diverse views on whom, what, and how much to tax.
  • Discuss what constitutes a tax and the general objectives of taxes.
  1. The general purpose of taxes is to fund the government. Unlike fines or penalties, taxes are not meant to punish or prevent illegal behavior; but “sin taxes” (on alcohol, tobacco, tanning beds, etc.) are meant to discourage some behaviors.
  2. The three criteria necessary to be a tax are that the payment is (1) required (it is not voluntary), (2) imposed by a government (federal, state, or local), and (3) not tied directly to the benefit received by the taxpayer.
  • Describe the difference tax rate structures and calculate a tax.
  1. Tax = Tax Rate x Tax Base, where the tax base is what is taxed and the tax rate is the level of taxes imposed on the base. Different portions of a tax base may be taxed at different rates.
  2. There are three different tax rates that are useful in contrasting the different tax rate structures, tax planning, and/or assessing the tax burden of a taxpayer: the marginal, average, and effective tax rates.
  • The marginal tax rate is the tax that applies to the next increment of income or deduction. The average tax rate represents a taxpayer’s average level of taxation on each dollar of taxable income.  The effective tax rate represents the taxpayer’s average rate of taxation on each dollar of total income (taxable and nontaxable income).
  1. The three basic tax rate structures are proportional, progressive, and regressive.
  2. A proportional tax rate structure imposes a constant tax rate throughout the tax base. As a taxpayer’s tax base increases, the taxpayer’s taxes increase proportionally.  The marginal tax rate remains constant and always equals the average tax rate. A common example is a sales tax.
  3. A progressive tax rate imposes an increasing marginal tax rate as the tax base increases. As a taxpayer’s tax base increases, both the marginal tax rate and the taxes paid increases.  A common example is the US federal income tax.
  • A regressive tax rate imposes a decreasing marginal tax rate as the tax base increases. As a taxpayer’s tax base increases, the marginal tax rate decreases while the total taxes paid increases.
  • Identify the various federal, state, and local taxes.
  1. Federal taxes include the income tax, employment taxes (Social Security and Medicare taxes), unemployment taxes, excise taxes (levied on quantity purchased), and transfer taxes (estate and gift taxes).
  2. State and local taxes include the income tax (levied by most states), sales tax (levied on retail sales of goods and some services), use tax (levied on the retail price of goods owned or consumed within a state that were purchased out of state), property taxes (levied on fair market value of real and personal property), and excise taxes.
  • Implicit taxes are indirect taxes that result from a tax advantage the government grants to certain transactions to satisfy social, economic, or other objectives. They are defined as the reduced before-tax return that a tax-favored asset produces because of its tax-advantaged status.
  • Apply appropriate criteria to evaluate alternative tax systems.
  1. Sufficiency involves assessing the aggregate size of the tax revenues that must be generated and ensuring that the tax system provides these revenues. Static forecasting ignores how taxpayers may alter their activities in response to a proposed tax law change and bases projected tax revenues on the existing state of transactions.  Dynamic forecasting attempts to account for possible taxpayer responses to a proposed tax law change.
  2. Equity considers how the tax burden should be distributed across taxpayers. Generally, a tax system is considered fair or equitable if the tax is based on the taxpayer’s ability to pay – that is, taxpayers with a greater ability to pay tax, pay more tax.  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.
  • Certainty means taxpayers should be able to determine when, where, and how much tax to pay.
  1. Convenience means a tax system should be designed to facilitate the collection of tax revenues without undue hardship on the taxpayer or the government.
  2. Economy means a tax system should minimize its compliance and administration costs.
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