Introduction to Taxation: Individual Tax Fundamentals and Rate Structures

Defining a Tax and Its Key Components

• A tax is formally defined as a payment required by a government that is unrelated to any specific benefit or service received from the government.

• Key components that qualify a payment as a tax include:

  • The payment must be required (compulsory).

  • The payment is imposed by a government agency, whether at the federal, state, or local level.

  • The payment is not tied directly to a specific benefit received by the taxpayer from the government.

Determining What Qualifies as a Tax

To understand the definition, the following examples illustrate what does and does not constitute a tax:

• Payment for a driver’s license: This is not a tax because it is a fee for a specific service or privilege.

• Payment for a government-required house appraisal: This is not a tax because the payment is for a service (the appraisal) and is typically not paid to a government agency for general revenue.

• Payment for hotel use of $1\%$ of the bill to pay for city projects: This is a tax because the payment is required by a government and is not tied to a specific benefit received by the hotel guest.

• Payment for rental car use of $3\%$ of the bill to pay for roads: This is a tax because it is a government-imposed command for revenue to fund public infrastructure (roads), unrelated to a specific service provided to the individual beyond what the general public receives.

Basic Tax Calculations and Measurement Principles

• To calculate a tax, a taxpayer must identify two primary variables:

  • Tax Rate: The level of taxes imposed on the tax base, usually expressed as a percentage.

  • Tax Base: Defines what is actually taxed and is usually expressed in monetary terms (e.g., taxable income, purchase price).

• The general formula for calculating tax is: $\text{Tax} = \text{Tax Base} \times \text{Tax Rate}$

Different Ways to Measure Tax Rates

Tax analysts and taxpayers use three separate measures to evaluate the tax burden:

• Marginal Tax Rate: The tax rate that applies to the next additional increment of a taxpayer’s taxable income. This is crucial for decision-making regarding earned income or investments.

• Average Tax Rate: Represents the taxpayer’s average level of taxation on each dollar of taxable income. It is calculated as: $\text{Average Tax Rate} = \frac{\text{Total Tax}}{\text{Taxable Income}}$

• Effective Tax Rate: Represents the taxpayer’s average rate of taxation on each dollar of total income, encompassing both taxable and nontaxable income. It is calculated as: $\text{Effective Tax Rate} = \frac{\text{Total Tax}}{\text{Total Income (Taxable + Nontaxable)}}$

2020 Married Filing Jointly Tax Brackets

The following table outlines the 2020 tax rates for the "Married Filing Jointly" status (as well as Single status for comparison):

• $10\%$ Rate:

  • Single: Up to $\$9,875$

  • Married Filing Jointly: Up to $\$19,750$

• $12\%$ Rate:

  • Single: $\$9,876$ to $\$40,125$

  • Married Filing Jointly: $\$19,751$ to $\$80,250$

• $22\%$ Rate:

  • Single: $\$40,126$ to $\$85,525$

  • Married Filing Jointly: $\$80,251$ to $\$171,050$

• $24\%$ Rate:

  • Single: $\$85,526$ to $\$163,300$

  • Married Filing Jointly: $\$171,051$ to $\$326,600$

• $32\%$ Rate:

  • Single: $\$163,301$ to $\$207,350$

  • Married Filing Jointly: $\$326,601$ to $\$414,700$

• $35\%$ Rate:

  • Single: $\$207,351$ to $\$518,400$

  • Married Filing Jointly: $\$414,701$ to $\$622,050$

• $37\%$ Rate:

  • Single: Over $\$518,400$

  • Married Filing Jointly: Over $\$622,050$

Case Study: Tax Rate Calculation for Bill and Mercedes

Scenario: Bill and Mercedes have $\$160,000$ of taxable income and an additional $\$10,000$ of nontaxable income.

Initial Calculation (Taxable Income = $\$160,000$):

• Tax Due = $\$26,780$, computed using the progressive brackets:

  • \19,750 \times 10\% = \$1,975$

  • (\$80,250 - \19,750) \times 12\% = \$60,500 \times 12\% = \$7,260$

  • (\$160,000 - \80,250) \times 22\% = \$79,750 \times 22\% = \$17,545$

  • Total: $\$1,975 + \$7,260 + \$17,545 = \$26,780$

• Average Tax Rate: $16.74\% \quad (\$26,780 / \$160,000)$

• Effective Tax Rate: $15.75\% \quad (\$26,780 / \$170,000)$

• Marginal Tax Rate: $22\%$ (at the $\$160,000$ income level).

Scenario Adjustment (Additional $\$80,000$ of Taxable Income):

• Total Taxable Income: $\$160,000 + \$80,000 = \$240,000$

• Total Income: $\$240,000 + \$10,000 = \$250,000$

• Tax Due = $\$45,759$, computed as:

  • \19,750 \times 10\% = \$1,975$

  • \60,500 \times 12\% = \$7,260$

  • \90,800 \times 22\% = \$19,976$ (This fills the $22\%$ bracket ending at $\$171,050$ and exceeds into the next bracket)

  • \68,950 \times 24\% = \$16,548$

  • Total: $\$45,759$

• Average tax rate: $19.07\% \quad (\$45,759 / \$240,000)$

• Effective tax rate: $18.30\% \quad (\$45,759 / \$250,000)$

• Marginal tax rate: $24\%$

• Marginal tax rate on the additional $\$80,000$ itself:

  • First part of the $\$80,000$ within the $22\%$ bracket: $\$171,050 - \$160,000 = \$11,050$

  • \11,050 \times 22\% = \$2,431$

  • Remaining part of the $\$80,000$ in the $24\%$ bracket: $\$80,000 - \$11,050 = \$68,950$

  • \68,950 \times 24\% = \$16,548$

  • Total tax on new income: $\$2,431 + \$16,548 = \$18,979$

  • Incremental Marginal Rate: $\$18,979 / \$80,000 = 23.72\%$

Tax Rate Structures

• Proportional Tax Rate (Flat Tax): Imposes a constant tax rate throughout the tax base. As the tax base increases, the tax rate remains the same.

• Progressive Tax Rate: Imposes an increasing marginal tax rate as the tax base increases. As the taxpayer earns more, the rate on the last dollar earned increases (e.g., Federal High Income Tax).

• Regressive Tax Rate: Imposes a decreasing marginal tax rate as the tax base increases. This occurs when the relative burden of the tax decreases as the base grows (e.g., Social Security taxes which have a cap).

Types of Taxes: Federal, State, and Local

Federal Taxes

• Income Taxes: The primary source of federal revenue. Approximately $56.5\%$ of all tax revenues in the United States come from income taxes (Individuals contribute $47.3\%$, Corporations contribute $9.2\%$). These are levied on individuals, corporations, estates, and trusts.

• Employment and Unemployment Taxes: The second-largest group of federal taxes.

  • Employment taxes include OASDI (Old-Age, Survivors, and Disability Insurance, commonly known as Social Security tax) and MHI tax (Medicare Health Insurance tax).

  • Unemployment taxes fund temporary unemployment benefits for individuals terminated from their jobs without cause.

• Excise Taxes: The third-largest group of federal taxes. These are levied on the quantity of products sold (e.g., gallons of gasoline, packs of cigarettes).

• Transfer Taxes: Levied on the fair market values of wealth transfers. This includes Estate and Gift taxes, which are triggered upon death or the giving of a gift.

State and Local Taxes

• Sales and Use Taxes:

  • Sales Tax: The tax base is the retail sales of goods and some services.

  • Use Tax: The tax base is the retail price of goods owned, possessed, or consumed within a state that were not purchased within that state (intended to discourage out-of-state shopping to avoid sales tax).

• Property Taxes: These are ad valorem taxes, meaning the tax base for each is the fair market value of the property.

  • Real property taxes: Taxes on land and structures permanently attached to land.

  • Personal property taxes: Taxes on all other types of property, including both tangible (e.g., cars, machinery) and intangible property.

• Income Taxes: Most states calculate taxable income by largely conforming to federal taxable income calculations, though they apply a limited number of modifications.

• Excise Taxes: States typically impose excise taxes on the same types of items subject to federal excise taxes.

• Implicit Taxes: These are hidden taxes (often in the form of lower before-tax rates of return) that taxpayers pay on tax-favored assets (e.g., municipal bonds).

Evaluating Alternative Tax Systems

Effective tax systems are typically evaluated based on five criteria:

1. Sufficiency: Assessing the aggregate size of the tax revenues that must be generated and ensuring the system provides these required revenues.

2. Equity: Determining how the tax burden should be distributed across taxpayers fairly.

3. Certainty: Taxpayers should be able to determine when to pay, where to pay, and how to determine the amount due.

4. Convenience: The system should be designed for collection without undue hardship to the taxpayer.

5. Economy: The system should minimize the compliance and administration costs associated with it.

Revenue Forecasting and Taxpayer Responses

Sufficiency is measured through revenue forecasting, which falls into two categories:

• Static Forecasting: Ignores how taxpayers might alter their activities in response to a tax law change. It bases projected revenues on the existing state of transactions.

• Dynamic Forecasting: Attempts to predict possible responses by taxpayers to new tax laws. Two primary effects are considered:

  • Income Effect: Predicts that as tax rates go up, people will work harder to maintain the same level of after-tax income.

  • Substitution Effect: Predicts that as tax rates go up, people will substitute taxable activities with nontaxable ones (like leisure) because the marginal value of working has decreased.

Concepts of Equity

A tax system is generally considered fair or equitable if based on the taxpayer’s "ability to pay."

• Horizontal Equity: Occurs when two taxpayers in similar economic situations pay the same amount of tax.

• Vertical Equity: Occurs when taxpayers with a greater ability to pay (higher income or wealth) pay more tax relative to taxpayers with a lesser ability to pay.This is often achieved through progressive tax structures.