Introduction
Income as Tax Base, Tax Terms and Computation
**Code Sections: 61, 262(a)
§Taxation
o Definition: The process by which the government collects revenues from the private sector to the public realm (private resources for public use)
§ Tax is meant to be grounded in notions of fairness (in the ability to pay—to some extent)
§ Tax system is designed to encourage people, through lower tax incentives, to spend their money on things deemed socially desirable (charity, education, retirement savings)
· **Allowing deductions is a way of govt. spending (i.e. govt. foregoes revenue they would have otherwise collected)
o **Computation: Tax Base (taxable income) x Tax Rate = Tax Debt
§Vocabulary:
o Income: competing definitions:
o
§ Haig-Simons Definition: “personal income may be defined as the algebraic sum of (1) the market value of rights exercised in consumption and (2) the change in the value of the store of property rights between the beginning and the end of the period in question.”
§ Economic Change: change in your economic power from the beginning to the end of a taxable period can be measured by :
· (1) how much you spend on consumption (personal purposes)
· (2) PLUS the change in net worth (how much you have available for savings and future consumption)
§ Accounting Definition: Receipts (MINUS) cost of producing those receipts
o Gross Income: things that come in; economic value, to the taxpayer.
§ Not only cash, can also be the value of property you get as a bonus (ex. car or services)
· §1.61-1(a)(2): “gross income includes wages, not only those received in cash, but property goods and services as well”
§ §61 Gross Income: “Gross income means all income from whatever source derived, including (but not limited to) the following items . . .”
§ 1040: gross income is listed on lines 7-21
o Adjusted Gross Income: permissible subtractions of “business related expenses (above the line)” from the gross income computation
§ AGI is the floor from which we calculate certain itemized deductions (i.e. medical expenses, unreimbursed business expenses, and casualty losses)
o Exclusions: amounts that come in, enjoyed by the person, but are Congressionally excluded from gross income (don’t have to count them)
§ Exclusion Provisions: §102 (gifts), §103 (interest on state/local bonds), §104 (comp. for injury/sickness), §106 (employer provided health insurance), §119 (meal lodging furnished for convenience of employer), §132 (certain fringe benefits)
o Deductions: allow you to subtract certain expenses or payments that you have already made (outlay)—(subject to tax rate)
§ Above the line: deductions are listed on 1040 lines 23-35 (all are listed in Section 62)
· Better for taxpayers who do not itemize, because they get the benefit of BOTH above the line deductions AND the standardized deduction
§ Itemized Deductions: Below the line deductions (compared to the standard deduction—pick the larger of the two)
· people at a higher marginal rate save more with deductions
§ Standard Deduction: **used more often by less wealthy people (often higher than itemized deductions would be)—**also reduces audit burden
o Personal Exemptions: An amount that is deductible (subtracted) for each of the “people who are supported” by the income
o Credit: dollar for dollar deduction of the tax (not subject to tax rate)—better than even above the line deductions
§Computation:
Compute Gross Income (Income – exclusions)
(-)§62 deductions
Adjusted Gross Income
(-) the greater of the itemized deductions or the standard deduction
(-) personal exemptions
Taxable Income
(*) tax Rate under §1or rate tables
Tax Liability
(-) credits
(-) taxes previously paid
Amount Owed or Refunded
Tax Rates (Introduction to Capital Gains and Losses)
**Code Sections: 1(a-e), (h); 1221(a) and 1222(1)-(8)
§Progressive Tax System
o Horizontal Equity: Tries to equally tax people who have the same increase in economic power (whether through cash or property)
o Vertical equity: how do we tax people who earn more income in contrast with those who earn less
§ The progressive rate structure was adopted as a kind of vertical equity—we want to tax those who earn more at a higher rate of tax than those who earn less
o The progressive income tax rises as income rises: taxes a greater proportion of income (higher percentage of income is paid as well as higher raw dollar value)
o Progressive Rate structure Pro v. Con:
§ Pro: People making more money don’t “feel” the tax as much (marginal utility of the dollar is less at the top
· goes to notions of fairness—redistribution of wealth to ease growing disparities of wealth
§ Con: may discourage increasing net wealth (if tax rate gets too high, people may actively try NOT to earn/invest that next dollar)
§Effective Rate vs. Marginal Rate
o Marginal Rate: the tax rate applied to the last dollar you earned
§ **income is taxed at a series of rates
o Effective Rate: the percentage of your income that you actually pay in tax—lower than the marginal rate because it is an average of the constantly rising series of marginal tax rates
§ FORMULA: Effective Rate = (Tax liability) / (Taxable Income)
o EXAMPLES (Using 2007 Rate Schedule):
§ (1) Single Taxpayer w/ 20,000 Taxable income
· Tax liability:782.50 + 15% of amount over 7,825 = 2,608.75
· Marginal Rate: 15%
· Effective Rate: 2,608.75 / 20,000 = 13%
§ (2) 2 Taxpayers, earning 150,000 each, get married
· **MARRIAGE PENALTY RULE: When 2 taxpayers marry, who earn about equal amounts, the amount of tax paid is greater than if each were paying taxe
est the money now and have it earn interest, thus offsetting the eventual tax which will be paid in the future
§ ALSO, deferring is beneficial in cases when you don’t necessarily have the cash to pay the tax now (this is why realization events are important)
· Example: T gets stock valued at 300 as compensation—if she were taxed upon receipt of the stock, she may not have the cash on hand to pay (since she has not sold the stock for cash)
o T can leave the stock alone and only pay tax when she does sell (that way she has money in pocket to pay the tax with)
§ Valuation Issues: Deferral is a good mechanism when the property in question cannot easily be valued before there is a realization event—better to wait until a clear value can be discerned before taxing that value
· **GENERALLY the value of an asset is the Fair Market Value (if it can be determined)
o Possible Disadvantage: Deferring tax may push someone into a higher marginal rate situation once the realization event occurs—sometimes it could be advantageous to “split” the tax (some now and some later) to avoid this problem
§ Example: T gets 100 shares of stock worth 3 a share. She sells stock after 2 years for 9 a share
· Deferring tax until she sells would give her 900 in income in that year—However, if she is taxed upon receipt she will include 300 initially and then 600 when she sells (this could be “better” for her marginal rate (if possible to do)
§Present Value
o Bottom Line: How much would I have in ___ years vs. the present value of that same amount
§ Generally it is better to take money now and defer payment as long as possible
o Two ways to compute:
§ How much do I need to invest today at ___ % to have $ ___ in ___ years?
· Table on p.42 gives the discount factor to compute present value
o Example: discount factor from table is .558 (for ten years) * $10,000 = Present value is 5,580 at 6%
§ that means if taxpayer owed 10,000, but was able to defer for 10 years, he could invest 5,580 today at 6% and would have 10,000 in 10 years
§ What is the present value of 100 dollars if I invest it at ___ % for ___ year?
· Example: $100 invested at 6% for 1 year. X+6%X = 100
o 1.06X = 100
o X (present value) = 93.34 (93.34 today will be equal to 100 in one year)
