Chapter 1 An Introduction to Taxation HISTORY OF TAXATION IN THE UNITED STATES Incremental basis when a change in the tax law is deemed necessary by Congress the entire law isn t changed but specific provisions of the tax law are added changed or deleted on an incremental basis o Federal income tax is referred to as quiltwork of tax laws TYPES OF TAX RATE STRUCURES THE STRUCTURE OF INDIVIDUAL INCOME TAX RATES Virtually all tax structures are comprised of 2 basic pars o tax base the amount to which the tax rate is applied to determine the tax due For example an individual s tax base for the federal income tax is taxable income TI as defined and determined by the income tax law Generally the fair market value of property subject to the tax o tax rate the percentage rate applied to the tax base Tax rates may be progressive proportional or regressive Progressive rate structure the rate of tax increases as the tax base increases o o Ex federal income tax Proportional tax rate flat tax the rate of tax is the same for all taxpayers regardless of the level of their tax base Generally used for real estate taxes state and local sales taxes personal property taxes customs duties and excise taxes o Regressive tax decreases with an increase in the tax base ex income Not consistent with the fairness of the income tax Ex Social Security FICA tax is regressive MARGINAL AVERAGE AND EFFECTIVE TAX RATES FOR TAX PAYERS A taxpayer s marginal tax rate is the tax applied to an incremental amount of TI that s added to the tax base o The MTR concept is useful for planning because it measures the tax effect of a proposed transaction While the MTR measures the tax rate applicable to the next 1 of income or deduction for a taxpayer there are 2 other tax rates that are used primarily by tax policy makers average and effective tax rate o Average tax rate computed by dividing the total tax liability by the amount of TI This represents the average rate of tax for each dollar of taxable income For ex a single taxpayer with TI of 400 000 in 2012 would incur a total tax liability of 116 761 The taxpayer s MTR is 35 but his average tax rate is 29 2 116 761 400 000 o Effective tax rate the total tax liability divided by total economic income Total economic income includes all types of economic income that the taxpayer has for the year Much broader than TI and includes most types of excludible income such as tax exempt bond interest and generally permits business deductions but not personal type deductions Not statutorily defined and experts may disagree on a price calculation The basic purpose of calculating the effective tax rate is to provide a broad measure of taxpayers ability to pay taxes The effective tax rate is mainly used by tax policy makers to determine the fairness of the income tax system CRITERIA FOR A TAX STRUCTURE Establishing criteria for a good tax structure was first attempted in 1776 by economist Adam Smith 4 cannons of taxation equity certainty convenience and economy o Many have added a 5th canon simplicity EQUITY An obvious criteria that the tax be equitable or fair to taxpayers o However equity fairness is elusive because of the subjectivity of the concept What one person may think is fair may be different to another In other words fairness is relative in nature and is difficult to measure 2 aspects of equity o Horizontal equity the notion that similarly situated taxpayers should be treated equally Thus 2 taxpayers with income of 50 000 should both pay the same amount of tax o Vertical equity provides that the incidence of taxation should be borne by those who have the ability to pay the tax based on income or wealth The progressive rate structure is founded on the vertical equity premise CERTAINTY A certain tax 1 ensures a stable source of government operating revenues and 2 provides taxpayers with some degree of certainty concerning the amount of their annual tax liability A tax that is simple to understand and administer provides certainty for taxpayers The uncertainty in the tax law causes frequent disputes between taxpayers and the IRS has resulted in extensive litigation The federal income tax system has made some attempts to provide certainty for tax payers o For example the IRS issues advance rulings to taxpayers which provides some assurance concerning the tax consequences of a proposed transaction for the taxpayer who requires the ruling The taxpayer may rely on the ruling if the transaction is completed in accordance with the terms of the ruling requires CONVENIENCE A tax law should be easily assessed collected and administered Taxpayers shouldn t be overly burdened with the maintenance of records and compliance considerations preparation of their tax returns payment of their taxes and so on Sales tax is convenient o Consumers don t need to complete a tax return or keep detailed records ECONOMY An economical tax structure should require only minimal compliance and administration costs The IRS collection costs less than 5 of revenues are minimal relative to the total collections of revenues from the federal income tax Complying with tax laws is expensive for businesses and individuals in the US SIMPLICITY Not undue complexity Taxpayers should be able to understand and comply with any tax system within reasonable boundaries o The sales tax is an example of a tax system that s relatively simple although the sales tax as it applies to businesses can become fairly complex OBJECTIVES OF THE FEDERAL INCOME TAX LAW The primary objective of the federal income tax law is to raise revenues for government operations ECONOMIC OBJECTIVES The federal income tax law is used as a fiscal policy tool to stimulate private investment reduce unemployment and mitigate the effects of inflation on the economy Many items in the tax law are adjusted for inflation by using the consumer price index CPI including the tax brackets personal and dependency exemptions and standard deduction amounts o These inflation adjustments provide relief for individual tax payers who would otherwise be subject to increased taxes due to the effects of inflation ENCOURAGEMENT OF CERTAIN ACTIVITIES AND INDUSTRIES The federal income tax law also attempts to stimulate and encourage certain activities specialized industries and small businesses SOCIAL OBJECTIVES The tax law attempts to encourage or discourage certain socially desirable or undesirable activities For example o o o Special tax favored pension and profit sharing