CH1

Chapter 1: An Introduction to Tax

Learning Objectives

  • Demonstrate how taxes influence:

    • Basic business decisions

    • Investment decisions

    • Personal decisions

    • Political decisions

  • Discuss what constitutes a tax and the general objectives of taxation.

  • Describe different tax rate structures and how to calculate a tax.

  • Identify various federal, state, and local taxes.

  • Apply criteria to evaluate alternative tax systems.

Importance of Taxes

Businesses

  • Key questions related to taxes that businesses consider:

    • What organizational form should a business adopt?

    • Location decisions for the business?

    • Structure of business acquisitions?

    • Compensation structures for employees?

    • Debt vs. equity finance considerations?

    • Rent or own equipment and property?

    • Distribution of profits to owners?

Politicians

  • Distinction through tax rhetoric among politicians.

  • Voter awareness of tax implications to evaluate proposals.

Individuals

  • Homeownership and tax deductions for mortgage interest and real estate taxes.

  • Retirement planning and tax-advantaged saving methods.

What Qualifies as a Tax?

  • Definition: A tax is a mandatory payment required by government without any specific benefit received.

  • Key Components of a Tax:

    • Payment is mandatory.

    • Payment imposed by government (federal, state, local).

    • Not directly tied to services or benefits received by the taxpayer.

Examples of Taxes vs. Non-Taxes

  • Driver’s License Payment - Not a tax

  • Required House Appraisal Payment - Not a tax

  • Hotel Charge for City Projects - A tax

  • Rental Car Charge for Roads - A tax

How to Calculate a Tax

  • Calculation Formula:

    • Tax = Tax Base × Tax Rate

  • Tax Rate: The percentage applied to the tax base.

  • Tax Base: The monetary value subject to tax.

Measuring Tax Rates

  • Three ways to measure:

    • Marginal Tax Rate: Rate applied to the next increment of taxable income.

    • Average Tax Rate: Average taxation level on each dollar of taxable income.

    • Effective Tax Rate: Average tax rate on total income (taxable and nontaxable).

Example of Tax Calculation

  • For Bill and Mercedes:

    • Tax Due: $25,306 calculated using the tax brackets.

    • Average tax rate: 15.82%

    • Effective tax rate: 14.89%

    • Marginal tax rate on additional $80,000 of income: 22.97%.

Tax Rate Structures

  • Proportional Tax Rate (Flat Tax): Constant rate across all income levels.

  • Progressive Tax Rate: Increasing rate as income increases.

  • Regressive Tax Rate: Decreasing rate as income increases.

Types of Taxes

Federal Taxes

  • Types of federal taxes:

    • Income taxes

    • Employment and unemployment taxes

    • Excise taxes

    • Transfer taxes

State and Local Taxes

  • Types of state and local taxes:

    • Income taxes

    • Sales and use taxes

    • Property taxes

    • Excise taxes

    • Implicit Taxes: Indirect taxes from tax advantages.

Evaluating Alternative Tax Systems

  • Criteria to Evaluate:

    • Sufficiency: Ensure tax system generates required revenue.

    • Equity: Fair distribution of tax burden.

    • Certainty: Clarity on tax obligations.

    • Convenience: Ease of tax payment.

    • Economy: Minimize compliance and administrative costs.

Sufficiency in Revenue Forecasting

  • Two types of revenue forecasting:

    • Static Forecasting: Current state ignores taxpayer response.

    • Dynamic Forecasting: Predicts taxpayer responses to law changes.

Tax Equity Principles

  • Horizontal Equity: Similar taxpayers pay similar taxes.

  • Vertical Equity: Higher ability to pay results in higher tax burden.