Lecture Notes
Chapter 1: Introduction to Tax
ACCT 5400 – Fall 2018 - Demeré
1.
What is a tax? (pp. 1-4 through 1-5)
➢ A tax is a payment that is:
• ___Required__ (i.e., not voluntary)
• Imposed by a _______government agency________(federal, state, or local)
• Not tied ____directly____ to the benefit received by the taxpayer
➢ What is the purpose of taxes?
• Primary → Raise ____revenue___ to fund government operations
• Secondary → ___Encourage___ socially beneficial behavior and
__discourage__ socially destructive behavior
➢ ____Sin Tax_____: Tax imposed on the purchase of goods that are considered
socially less desirable (Examples: surcharge on alcohol/tobacco; ACA sharedresponsibility payment) Discourage
➢ ___Earmarked tax_____: Tax assessed for a specific purpose (Example: education)
✓ Let’s practice! Example 1: Are the following taxes?
• 1& special sales tax to pay for construction on Lumpkin Street: Yes. Required.
No direct benefit. (sales money to road benefit which some doesn’t use).
• Postage paid to mail a package: No. direct benefit.
• Property taxes on a home: Yes. Required. By government. Indirect benefit.
(Benefit go somewhere else).
• Speeding ticket: No. Punishment is a direct benefit.
• Cigarette taxes: Yes. Required by government. No direct benefit. Sin tax.
2.
Types of explicit taxes (pp. 1-11 through 1-15)
➢ What are the different types of federal taxes?
• __Income taxes__ – Taxes in which the tax base is income. A schedule.
❖ Most significant tax assessed by U.S. government
• Employment Taxes
❖ Old Age, Survivors, and Disability Insurance (OASDI)
1
▪
Commonly known as _Social Security_
▪
_12.4%______ of first __$135,200_____ of wages. 1
Wages over $134,200 will not be taxed
Page 1
o 6.2% paid by employee; 6.2% paid by employer
o Self-employed taxpayers→ Have to pay both the employee and
employer share of OASDI
❖ Medical Health Insurance (MHI)
▪
Commonly known as _Medicare____
▪
___2.9%___ of wages
o ____1.45%___ paid by employee; _1.45%___ paid by employer
o Self-employed taxpayers → Have to pay both the employee
and employer share of MHI
• Unemployment Taxes
❖ Federal: Employer pays __6.0%__ of first __$7,000__ of wages.
❖ A federal credit (capped at 5.4%) is available for employers required to
pay state unemployment taxes.
• Excise Taxes: Sin tax
❖ Levied on particular products (e.g., gasoline, cigarettes, alcohol).
❖ Based on ____quantity____, not _value (sales tax)_(gallons of gasoline,
packs of cigarettes, etc)
❖ Consumers often bear the burden of these taxes through higher prices
• __Transfer taxes_______ – Taxes on the transfer of wealth from one taxpayer
to another.
❖ ___Estate tax____: Assessed based on the fair market value of wealth
transfer upon death
❖ ____Gift tax_______: Assessed based on the fair market value of wealth
transfer by gift
❖ Only ___large___ transfers subject to transfer taxes because of: (1) the
annual gift exclusion ($15K/donee/year) and (2) the unified tax credit
($11.2M/person)
Pay the year amount minus the 15k/year
Pay the total amount minus the 11.2M/person
➢ What are the different types of state and local taxes?
• Income taxes – Taxes in which the tax base is income
❖ Largely conform to _federal_ taxable income calculations with limited
number of modifications
❖ State tax rates much _lower_ than federal income tax rates
• _____Sales Taxes________ (#1 source of state revenue)
Page 2
❖ Flat tax rate (varies by state)
❖ Based on the ____Selling price____ of the product or service
▪
GA state and local sales tax generally = _7-9%_(4% state; rest local)
▪
Not imposed on everything, depends on state & local government
o GA sales tax rate on groceries → local taxes only
❖ Retailers responsible for collecting and remitting the tax
• ____Use Taxes________
❖ Flat tax rate (varies by state)
❖ Based on the retail price of goods owned, possessed or consumed within
a state that were __not purchased within the state___
❖ Purpose is to discourage sales tax avoidance
• Property taxes (#1 source of locality revenue)
❖ _Ad valorem_ taxes on both real and personal property (tax base is the
fair market value of the property) Based on value in Latin.
❖ __Real___ property: Land and structures permanently attached to the
land (Example: House property taxes)
❖ __Personal__ property: All other types of property, both tangible and
intangible (Example: Automobile registration taxes)
3.
Computing a tax (pp.1-5 and 1-8 through 1-11)
➢ What is the general tax formula?
• __tax___ = ___tax base____ x ____tax rate____
❖ The tax base is:
▪
What is actually taxed and is usually expressed in _monetary__
terms (Examples: taxable income, purchase amounts, property
values, etc.)
❖ The tax rate:
▪
Is defined by law and determines the level of taxes imposed on the
tax base and generally expressed as a _percentage___.
▪
Can __vary__ with the size of the tax base depending on the tax
rate structure (tax brackets vs. a flat tax)
✓ Let’s practice! Example 2: Tyrion, a single taxpayer, earns $95,000 in taxable income
from his job and $10,000 in interest from an investment in City of Athens bonds.
Using the U.S. tax rate schedule, how much federal tax will he owe?
Interest is EXEMPTED.
Tax base= $95,000
$14,089.50+24%(95,000-82,500)
Page 3
=17,089.50
➢ What are the different tax rate structures?
Proportional
• ____________________
tax rate structure
❖ Tax rate: Constant throughout the tax base
❖ Example: Sales tax or flat tax
Progressive
• ____________________
tax rate structure
❖ Tax rate: Increases as the tax base increases
❖ Example: Income tax
Regressive
• ____________________
tax rate structure
❖ Tax rate: Decreases as the tax base increases
❖ Example: Social security taxes
4.
3 ways to measure tax rates (pp. 1-5 through 1-8)
➢ Marginal tax rate (MTR):
next additional increment
• Definition → Tax rate that applies to the ________________________________
of a taxpayer’s taxable income (or deductions)
• MTR Formula →
(new total tax-old total tax)
———————————————————
(new taxable income -old taxable income)
Δtax
—————
Δtaxable income
• When is the MTR most useful?
❖ Useful in tax planning
➢ Average tax rate (ATR):
• Definition → Measures a taxpayer’s average level of taxation on each dollar
of taxable income
• ATR Formula →
(total tax)
——————
(taxable income)
• When is ATR most useful?
❖ Useful in budgeting tax expense
➢ Effective tax rate (ETR):
• Definition → The taxpayers’ average rate of taxation on each dollar of total
(taxable and nontaxable) income
• ETR Formula →
(Total tax)
———————
(Total Income)
• When is the ETR most useful?
Page 4
❖ Useful in comparing the relative tax burdens of taxpayers
✓ Let’s practice! Example 3: Tyrion, a single taxpayer, earns $95,000 in taxable income
from his job and $10,000 in interest from an investment in City of Athens bonds.
What is his marginal tax rate? What is his average tax rate? What is his effective tax
rate?
MTR: 24% (from the rate schedule)
$14,089.5+($95,000-$82,500)*0.24=$17,089.5
ATR: $17,089.5/$95,000=17.99%
ETR: $17,089.5/($95,00+$10,000)=16.28%
5.
Implicit taxes (pp. 1-16 through 1-17)
➢ The federal and state and local taxes listed above are explicit taxes (i.e., they are
taxes you pay directly). What are implicit taxes?
indirect
• In general, implicit taxes are _______________________
taxes (i.e., not paid
directly to the government) that result from a tax advantage the government
grants to certain transactions to satisfy social, economic, or other objectives
before-tax return
• Implicit taxes = the reduced ________________________
that a tax-favored
asset produces because of its tax-advantaged status
❖ Examples of “tax-advantaged” transactions/assets: Home ownership
(b/c of mortgage interest deduction); Municipal bonds (b/c exempt
from federal taxation)
✓ Let’s practice! Example 4: Cersei invests $50,000 in a city of Athens bond that pays
5% interest. Alternatively, Cersei could have invested the $50,000 in a bond recently
issued by Jittery Joe's, Inc. that pays 8% interest with similar non-tax characteristics
as the city of Athens bond (e.g., similar risk). Assume that Cersei's marginal tax rate
is 25%. How much explicit tax does Cersei pay on the city of Athens bond? How
much explicit tax would she have paid on the Jittery Joe's, Inc. bond? What is her
after-tax rate of return for the city of Athens bond? For the Jittery Joe's, Inc. bond?
How much implicit tax does she pay on the city of Athens bond? Which bond should
she choose?
Return:
Tax on Athens tax-free bond=0
After tax Rate of Return= 5%
Rate on Return: income (after tax)
—————————
Initial money
Jittery Joe’s income: $50,000 *8%=$4,000
JJ explicit tax= $4,000*25%=$1,000
After tax income= $3,000
JJ RoR(after tax)=(4k-1k)/$50,000=6%
JJ Return (pre-tax)=4,000
Athens Return 5%*$50,000=$2,500
Page 5
Implicit tax paid= 1,500 OR (8-5)%*50,000=1,500
JJ=3,000
Athens=2,500
JJ ROR=6%
Athens= 5%
JJ is better at ROR and Return.
✓ Let’s practice! Example 5: How would your answer change if we instead assume that
Cersei's marginal tax rate is 40%? Which bond should she choose?
6.
Criteria to evaluate tax systems (pp. 1-17 through 1-23):
➢ Criterion 1: Sufficiency
• Question criterion addresses:
❖ Does the tax system raise enough tax _____________________ to cover
government ____________________?
• In practice, assessing this criterion is difficult due to:
❖ Unforeseen events (e.g., financial crisis, Hurricane Katrina, wars, etc.) and
❖ Unforeseen taxpayer responses (e.g., if the city increases gasoline excise
taxes, taxpayer may take the bus and the city ends up raising less money
via gasoline taxes)
• Ignore income vs. substitution effects in the textbook
➢ Criterion 2: Equity
• Questions criterion addresses:
❖ Are tax burdens distributed __________________ across taxpayers?
❖ Is the tax system based on a taxpayer’s ________________________?
• Two types of equity:
❖ ____________________ equity
▪
Do two taxpayers in similar situations pay the same tax?
❖ ____________________ equity
▪
Do taxpayers with greater ability to pay actually pay more tax
relative to taxpayers with a lesser ability to pay?
Page 6
▪
Note: Vertical equity can be thought of in terms of tax dollars paid
or in terms of tax rates
❖ General rule for evaluating two types of equity:
▪
To evaluate horizontal equity → Evaluate tax liability of taxpayers
in the ____________________ economic situation
▪
To evaluate vertical equity → Evaluate the tax liability of taxpayers
in ____________________ economic situations
✓ Let’s practice! Example 5: Assessing equity. Are the following scenarios
horizontally equitable? Vertically equitable?
Scenario A:
Taxpayer
A
B
Tax
1,000
1,000
Economic Income
10,000
10,000
Effective tax rate
Economic Income
10,000
10,000
20,000
20,000
Effective tax rate
Economic Income
10,000
10,000
20,000
20,000
Effective tax rate
10%
10%
10%
10%
Is this tax system horizontally equitable?
Is this tax system vertically equitable?
Scenario B:
Taxpayer
A
B
C
D
Tax
1,000
1,000
1,000
1,000
Is this tax system horizontally equitable?
Is this tax system vertically equitable?
Scenario C:
Taxpayer
A
B
C
D
Tax
1,000
1,000
2,000
2,000
Is this tax system horizontally equitable?
Is this tax system vertically equitable?
Page 7
➢ Criterion 3: Certainty
• Questions criterion addresses:
❖ Are taxpayers able to determine:
▪
___________________ to pay?
o Taxpayers have specific filing deadlines (Chapter 2)
▪
___________________ to pay?
o Instructions say where to send payment (for us that’s Atlanta
IRS office)
▪
___________________ to determine the amount?
o Easy for most taxpayers; not as easy for businesses and highwealth individuals
➢ Criterion 4: Convenience
• Question criterion addresses:
❖ Are taxes collected without _____________________________ on the
taxpayer or the government?
▪
Yes, we have a pay-as-you-go system where taxpayers pay via: (i)
Withholdings; (ii) Quarterly payments; or (iii) both.
➢ Criterion 5: Economy
• Questions criterion addresses:
❖ Are taxes collected at a low cost to the ______________________?
▪ IRS only costs 0.5% of total taxes collected
❖ Are taxes collected at a low cost to the ______________________?
▪ Can be more costly to taxpayers (especially businesses and wealthy
taxpayers)
Page 8