Tax Exam 1

tax

compulsory payment to support the cost of government

taxpayer

any person or organization required by law to pay tax (individuals and corporations)

incidence

ultimate economic burden of a tax (not always on the person or organization who pays the tax)

jurisdiction

right of a government to tax

tax formula

tax = rate x base

flat rate

single rate applies to entire tax base

graduated rate

multiple rates apply to portions of the tax base

base

an item, occurrence, transaction, or activity on which a tax is levied

revenue

total tax collected by the government

how to increase tax revenue

increasing either the rate or base

two ways to characterize taxes

frequency with which tax occurs, or activity-based tax

examples of taxes taxed by frequency

sales tax, excise tax, estate tax, gift tax

examples of activity-based tax

income tax

can taxes be linked to specific government expenditures?

yes! social security, medicare, excise taxes

real property tax

tax assessors derive the value of realty and inform owners of that value

abatements on real property tax

lower taxes to entice new businesses to start

what gets a personal property tax

on household tangibles, business tangibles, intangibles

What do state taxes often exclude

necessities such as food and drugs

excise tax

imposed on retail sale of specific goods and services to encourage or discourage the use of certain products

History of Federal Income Tax

before 1861—> tariffs, excise, property taxes

first income tax was used to pay for the Civil War

16th Amendment made income tax constitutional

What are the federal employment taxes?

social security and medicare

What are the federal unemployment taxes?

excise and transfer taxes

Value-Added Tax

foreign taxes similar to US income tax

a sales tax on the incremental value added by a business at each stage of the production process

Jurisdictional Competition

increasing the tax rate or expanding the definition of the taxable can cause taxpayers to flee the tax jurisdiction

What are the current trends in increasing the tax base?

annexation to expand city property, sales tax expansion, lotteries, and casino gambling

Physical presence test

Supreme Court overruled the physical presence test in 2018, allowing states to require online sellers to collect sales tax based on the residence of the purchaser

What is the statutory authority of federal tax law?

the IRC — internal revenue code

Who are the administrative authorities of the federal tax law?

treasury regulations, IRS revenue rulings, revenue procedures

Who are the judicial authority of the federal tax law?

trail courts — tax court, district court, court of federal claims

appellate courts

supreme courts

Why do both business managers and their tax advisors share a keen interest in tax policy?

they know that complex tac rules have underlying policy rationale that if they understand, the rules are easier to interpret and apply and anticipate developments that might affect their firm’s long-term strategies

4 standards of a good tax

sufficient to raise necessary government revenues

convenient to administer and pay

efficient in economic terms

fair to taxpayers required to pay

A tax is sufficient if

it generates enough funds to pay for the public goods and services provided by the government and allows a government to balance its budget

What is the consequence of an insufficient tax system?

government also generates revenue shortfall from other sources

What other sources can the government generate revenue from?

non-tax revenues like fees, fines, and other sources

borrowing by selling debt obligations in the capital markets

revenue from goods or services sold by government owned entities

leasing or selling of government owned assets or property rights

Is the US federal tax system sufficient?

No — operated at a deficit for every fiscal year since 1970 expect for 1998-2001

How can governments increase tax revenues?

increase the rate of an existing tax, exploit a new tax base, or enlarge an existing tax base

Why is it hard to determine the effect of such changes?

hard to predict human nature

Statistic Forecast

assumes base stays the same

Dynamic Forecast

estimate change in base due to change in rate

Substitution Effect

taxpayers change their behavior in reaction to increased tax rates

as tax increases, base decreases

as tax decreases, base increases

What do taxpayers substitute between in the substitution effect?

labor and leisure

Income effect

if tax increases, base increases

if tax decreases, base decreases

What do most taxpayers work to maintain?

the same after-tax income

What kind of taxpayers is the income effect and substitution effect most powerful for?

income effect: lower-income taxpayers

substation effect: higher-income taxpayers

A tax is convenient if…

the tax is easy to administer, easy to understand and offers few opportunities for noncompliance

the tax is easy to pay, easy to compute, and requires minimal time to comply

Is the federal income tax system convenient for the taxpayer?

No. taxpayers spend billions of hours and dollars to comply with federal tax laws

A tax is efficient if (classical standard of efficiency)

it is neutral in effect on the market so that it doesn’t distort the market, create suboptimal allocation of goods and service, or modify taxpayer behavior

A tax is efficient if (Keynesian / modern standards)

it is an effective fiscal policy for regulating the economy. Governments should use taxes to move the economy in the desired direction

What standard of efficiency does the US government advocate?

the Keynesian standard

A tax is fair if

taxpayers have the ability to pay the tax

tax enhances horizontal equity and vertical equity

Horizontal equity

achieved when persons with the same ability to pay owe the same tax

What does horizontal equity concern?

rational and impartial measure of the taxbase, including the significant variables that affect economic circumstances like marital status, number of dependents, health, etc

Why are tax preferences implemented?

to achieve economic and social benefits even if they are not consistent with enhancing horizontal equity

Vertical Equity

achieved if persons with greater ability to pay owe more tax than persons with lesser ability to pay

What is vertical equity concerned with?

a fair rate structure

What should the rate structure look like?

its not whether the rich should pay more tax than the poor, but how much more they should pay

Regressive rate structure

rate decreases as base increases

Proportionate rate structure

single rate applied to taxable income

average and marginal rates are the same

Progressive rate structure

rate increases as base increases

marginal rate increases as taxable income increases

average rate is less than the marginal rate

Average tax rate

total tax paid divided by taxable income

Marginal tax rate

rate applied to the next dollar of taxable income

What is distributive justice as a tax policy objective?

the current distribution of wealth across american households is often criticized as unjust and individuals are increasingly likely to underreport their income

present value

when cash flows from a transaction occur at different times, quantification of net cash flow should take into account the time value of money

time value of money

a dollar received today is worth more than a dollar to be received in a future period

What is the role of net present value in decision making?

managers want to make decisions that maximize the value of the firm by maximizing positive cash flow or minimizing negative cash flow

Present Value

value of a dollar today

Discount Rate

rate of interest on invested funds for deferral period

Net Present Value

the sum of present values of cash inflows and outflows from a transaction

as the discount rate “r” increases, how does present value change?

present value decreases (inversely related)

how is the discount rate “r” related to risk?

the riskier the project, the higher the r

positively correlated

should you always use the same discount rate “r” to evaluate different planning schemes?

only if the different schemes have equal risk

Present value of $1 formula

PV($1) = 1 / (1+r) n

where r = interest rate and n = number of periods

Present Value of an Annuity Due

the value today of a series of constant dollar payments available at the beginning of each period of a specific number of consecutive and even periods

Present Value of an Ordinary Annuity

the value today of a series of constant dollar payments available at the end of each period for a specific number of consecutive and even periods

PVOA formula

Pa = (1/r) - 1/ (r(1+r)^n)

when is the tax cost a cash outflow

if a transaction results in an increase in any tax for any period

when is the tax cost a cash inflow

if a transaction results in a decrease in any tax for any period

what is the after-tax cash inflow if the cash inflow is nontaxable?

after-tax cash inflow = before-tax cash inflow

what is the after-tax cash inflow if the cash inflow is taxable?

after-tax cash inflow = before-tax cash inflow x (1-t)

where t = marginal tax rate

what is the after-tax cash outflow if the cash outflow is nondeductible?

after-tax cash outflow = before-tax cash outflow

what is the after-tax cash outflow if the cash outflow is deductible?

after-tax cash outflow = before-tax cash outflow x (1-t)

does the after-tax cost of a deductible expense increase or decrease as the taxpayer's marginal income tax rate increases?

decreases

5 Steps of Taxes and Cash Flows

Step 1: determine before-tax cash inflows and outflows

Step 2: determine taxable income and deductions

Step 3: compute tax cost of income and tax savings from deductions

Step 4: compute net after-tax cash inflows or outflows

Step 5: compute PV of individual cash flows and NPV of net cash flows

What are some tax-related uncertainties that add complexity to the tax planning process?

audit risk, tax law uncertainty, and marginal rate uncertainty

Audit Risk

the IRS can challenge a taxpayer’s treatment and application of a tax law to transactions through an audit, leading to the taxpayer might having to owe additional tax and penalties and litigation costs

How can managers reduce audit risk?

engaging a tax professional or requesting a private letter ruling from the IRS

Tax Law Uncertainty

tax law may change during the time period of the NPV computation

Marginal Rate Uncertainty

the taxpayer may not be able to accurately forecast their future situation as the actual marginal tax rate for future years could vary from the projected rate

How can firms change tax consequences?

changing legal or financial structures

however, it might not be the best course of action if it adversely affects other non-tax factors

The extent to which managers can control tax consequences of transactions depends on what?

the nature of the market in which the transaction occurs: private market, public market, or fictional market between related parties

private market

both parties can customize the transaction to minimize the aggregate tax cost ; tax savings can be shared between the parties

examples of private markets

executive and employer

merger target and acquirer

public market

parties do not engage in direct negotiation; tax planning is one sided

example of a public market

investing b purchasing shares of a publicly traded company

fictional market between related parties

if related parties are not dealing at arm’s length, no true market exists and any transaction between them may not reflect economic reality; IRS may disallow favorable tax treatment

step transaction

O’Brien sells house to me and then I sell the house to his son

(O’Brien avoiding selling house directly to his son)

tax avoidance

consists of legitimate means of reducing taxes

tax evasion

consists of illegal means of reducing taxes

What kind of offense is tax evasion?

a felony — punishable by severe monetary fines and imprisonment

What are the four variables that tax consequences depend on?

1. Entity Variable

2. Time Period Variable

3. Jurisdiction Variable

4. Character Variable