Chapter 1: An Introduction to Tax

Who cares about taxes?

Businesses, politicians, and individuals

Primary Tax Considerations for Businesses

• Organizational Form

• Location

• Structure of acquisitions

• Debt/Equity Mixes

• Renting vs. Owning Assets

• Distribution of Profits

Republican Tax Ideology

• Government should tax only to raise money for its essential functions.

• Tax relief stimulates economy by keeping money in business’ hands to grow and hire more employees.

Democratic Tax Ideology

• Raise certain taxes to provide money for government spending, which in turn generates business.

Primary Tax Considerations for Individuals

• Purchasing a home

• Retirement

Definition of a Tax

A payment by a government agency that is unrelated to any specific benefit or service received from the government agency

Purpose of a Tax

To fund the operations of government

What are the key components of a tax?

• Payment is required

• Payment is imposed by a government agency

• Payment is not tied directly to benefit received by the taxpayer

Is a payment for a drivers license a tax?

No

Is a government required payment for a house appraisal a tax?

No

Is a payment for a hotel where 1% of the bill goes towards city projects considered a tax?

Yes

Tax Rate

Level of taxes imposed on the tax base and is usually expressed as percentage

Tax Base

Defines what is actually taxed and is usually expressed in monetary terms

Formula for Tax

Tax Base x Tax Rate

Proportional Tax Rate

Imposes a constant tax rate throughout the tax base

Progressive Tax Rate

Imposes an increasing marginal tax rate as the tax base increases

Regressive Tax Rate

Imposes a decreasing marginal tax rate as the tax base increases

Income, employment/unemployment, excise, and transfer taxes are all considered what type of tax?

Federal Tax

Sales and use, property, income, and excise taxes are all considered what type of tax?

State and Local Tax

What type of tax(es) represented more than 60% of all tax revenues collected in the United States in 2024?

Income Tax

What type of tax(es) was the second largest group of taxes imposed by the U.S. government (33%)?

Employment and Unemployment Taxes

Examples of Employment Taxes

OASDI (Social Security Tax) and MHI (Medicare Tax)

True or False: Unemployment taxes fund temporary unemployment benefits for individuals terminated from their jobs without cause

True

What type of tax(es) was the third largest group of taxes imposed by the U.S. government?

Excise Tax

Excise Taxes

• Levied on retail sale of particular products

• Levied on the quantity of products sold — not monetary value

Transfer Taxes — Estate and Gift Taxes

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

What was the annual gift exclusion threshold for 2024 and 2025?

$18,000; $19,000

What was the exclusion threshold for 2024 and 2025?

$13,610,000; $13,990,000

What is the maximum tax rate for transfer taxes (estate and gift)

40%

What is the tax base for a sales tax?

The retail sales of goods and some services

What is the tax base for a use tax?

The retail price of goods owned, possessed or consumed within a state that were not purchased within the state

Property taxes are considered ad valorem taxes, meaning that…

The tax base for each is the fair market value of the property

What do real property taxes consist of?

Taxes on land and structures permanently attached to land

What do personal property taxes include?

Taxes on all other types of property, both tangible and intangible

True or False: Most state taxable income calculations largely conform to the federal taxable income calculations, with a limited number of modifications

True

True or False: States typically do not impose excise taxes on items subject to federal excise tax

False

Marginal Tax Rate

The tax rate that applies to the next additional increment of a taxpayer’s taxable income

Average Tax Rate

The taxpayer’s average level of taxation on each dollar of taxable income

Effective Tax Rate

The taxpayer’s average rate of taxation on each dollar of total income (meaning both taxable and non-taxable)

“Current marginal tax rate” is also known as…

The tax rate in the current tax bracket

Which type of tax rate calculation is useful in tax planning?

Marginal Tax Rate

Formula for Marginal Tax Rate

(New Total Tax - Old Total Tax)/(New Taxable Income - Old Taxable Income) OR Change in Tax/Change in Taxable Income

Which type of tax rate calculation is used in budgeting tax expense as a portion of income

Average Tax Rate

Which type of tax rate calculation is useful in comparing the relative (true economic) tax burden of taxpayers?

Effective Tax Rate

Formula for Average Tax Rate

Total Tax/Taxable Income

Formula for Effective Tax Rate

Total Tax/Total Income

Explicit Tax

Taxes directly imposed by a government and are easily quantified

Implicit Tax

Indirect Taxes

True or False: Implicit taxes are paid directly to the government

False

What is the result of a tax advantage the government grants to certain transactions to satisfy social, economic, and other objectives

An implicit tax

True or False: An implicit tax can be known as the reduced before tax-return that a tax-favored asset produces because of its tax advantaged status

True

True or False: Implicit taxes are often difficult to quantify but important to understand in evaluating the relative tax burdens of tax-advantaged investments

True

Sufficiency

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

Equity

Evaluates how the tax burden should be distributed across taxpayers

Certainty

Taxpayers should be able to determine when to pay the tax, where to pay the tax, and how to determine the tax

Convenience

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

Economy

Compliance and administration costs associated with the tax system should be minimized

Static Revenue Forecasting

Ignores how taxpayers might alter their activities in response to a tax law change and bases projected tax revenues on the existing state of transactions

Dynamic Revenue Forecasting

Tries to predict possible responses by taxpayers to new laws

Income Effect

As tax rates go up, people will work harder to maintain the 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

What makes a tax system fair or equitable?

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