CH01

Chapter 1: Introduction to Tax

Who Cares about Taxes?

• Businesses:

  • Organizational form decisions

  • Location choices

  • Structuring of business acquisitions

  • Employee compensation strategies

  • Mix of debt and equity

  • Distribution of profits to owners

• Politicians:

  • Tax rhetoric differentiates political parties

  • Voter knowledge needed for evaluating tax proposals

• Individuals:

  • Home Ownership:

    • Tax deductions available for mortgage interest and real estate taxes can lower costs.

  • Retirement Savings:

    • Understanding tax-advantaged savings can enhance retirement value.

What Qualifies as a Tax?

• A tax is defined as a compulsory payment to a government unrelated to specific services received.

• Key Components of a Tax:

  • Required payment

  • Imposed by a government agency (federal, state, local)

  • Not directly tied to benefits received by the taxpayer

Tax Classification Questions

• Examples of Potential Taxes:

  • Payment for driver's license

  • Payment for required house appraisal

  • Hotel payment for city project funding (1% of bill)

  • Rental car payment for road funding (3% of bill)

How to Calculate a Tax

• Calculating tax requires knowledge of:

  • Tax Rate: The percentage of the tax imposed on the tax base.

  • Tax Base: The monetary value that is actually taxed.

  • Formula:

    • Tax = Tax Base × Tax Rate

Ways to Measure Tax Rates

• Marginal Tax Rate:

  • Applies to the next increment of taxable income.

• Average Tax Rate:

  • Average taxation level per dollar of taxable income.

• Effective Tax Rate:

  • Average tax rate on each dollar of total income (taxable + nontaxable).

Tax Rates Example

• Scenario: Bill and Mercedes with $160,000 taxable income and $10,000 nontaxable income.

  • Tax Due Calculation:

    • $26,780 using 2020 married filing jointly rates

  • Average Tax Rate:

    • 16.74%

  • Effective Tax Rate:

    • 15.75%

  • Marginal Tax Rate on $80,000 additional income:

    • 23.72%

Tax Rate Structures

• Proportional Tax Rate (Flat Tax):

  • Constant tax rate applied across the tax base.

• Progressive Tax Rate:

  • Increases marginal tax rate with larger tax base.

• Regressive Tax Rate:

  • Decreases marginal tax rate as tax base increases.

Types of Taxes

• Federal Taxes:

  • Income taxes, Employment and unemployment taxes, Excise taxes, Transfer taxes

• State and Local Taxes:

  • Income taxes, Sales and use taxes, Property taxes, Excise taxes

• Implicit Taxes:

  • Indirect taxes derived from government grants on specific transactions.

Evaluating Alternative Tax Systems

• Sufficiency:

  • Assessment of tax revenue generation

• Equity:

  • Distribution fairness of tax burdens

• Certainty:

  • Clarity on tax payment timing and calculations

• Convenience:

  • Ease of tax compliance

• Economy:

  • Minimizing compliance costs

Sufficiency Considerations

• Static Forecasting:

  • Ignores taxpayer response to tax changes

• Dynamic Forecasting:

  • Anticipates taxpayer adjustments to tax laws (Income Effect and Substitution Effect)

Equity Considerations

• Horizontal Equity:

  • Similar taxpayers pay similar taxes

• Vertical Equity:

  • Taxpayers with greater abilities pay more relative to their capacity

Questions?