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.