Chapter 1. Federal Income Taxation— An Overview Instructor PowerPoint Slides This file contains illustrative problems that will be used in the lecture to illustrate important concepts and procedures. Updated August 30, 2016 Howard Godfrey, Ph.D., CPA Professor of Accounting ©Howard Godfrey-2016

It is very important to be able to relate this formula to the tax return. Students: identify the Form 1040 line numbers for each line on this slide.

Continue identifying line numbers on Form 1040.

Note that an employee having a salary of $100,000 and business expenses of $2,000, will get no deduction. The employee would rather have the employer pay a salary of $98,000 and reimburse the $2,000 of expenses.

Definition of a Tax An enforced, involuntary contribution Required and determined by law Providing revenue for public and governmental purposes For which no specific benefits or services are received If I pay my water and sewer bill, is that a tax? If I pay tax on the purchase of a shirt, is that a tax?

Purpose of a Tax Revenue Penalty Social changes Economic changes Equity The economic stimulus package changed the law and provided for major first year write-off of the cost of machinery, equipment, etc. What area is applicable? We provide a child care credit so that both spouses can work outside the home and improve the financial stability of the family. Which of the above purposes applies here?

Vertical Equity. Look at the basic computations page for Susan and Sam. Susan had twice as much taxable income as Sam. Did Susan pay twice as much tax as Sam? How would a flat tax (everybody pays same tax rate) change the tax liabilities of Susan and Sam? Does the Susan-Sam example illustrate a progressive tax system?

Tax Rates for Income Tax Marginal Tax Rate – rate of tax on the next dollar of taxable income Average Tax Rate – rate equal to the total tax divided by tax base. Effective Tax Rate – rate equal to the total tax divided by economic income (taxable & nontaxable income). Look at the basic computations page for Susan and Sam.

Progressive Tax Rate System Tax rates increase as income increases In 1913 rates ranged from 1% to 7% To finance World War I, top rate was increased to 77% In 1985, 15 tax brackets from 11% to 50% 2003 Tax Act reduced top rate from 38.6% to 35% (rates now 10%, 15%, 25%, 28%, 33%, and 35%). 2012 Tax Act kept rates at 10%, 15%, 25%, 28%, 33%, and 35%, but added 39.6% rate.

What do you think?-1 Two persons are in the 35% marginal tax bracket because of equal salaries. A earns bonus of $20,000 taxed at a 35% rate. B has $20,000 of capital gains taxed at 15 percent. A pays an additional $7,000 in tax. B pays only $3,000 in tax on the additional $20,000 of income. Do we see horizontal equity, which dictates that equal incomes should be taxed equally.

What do you think?-2 A wealthy person invests in municipal bonds, and earned tax-exempt interest of $100,000. Her neighbor, who is not wealthy, earns a salary of $100,000. The working person may pay taxes at rates up to 25 to 30 percent. Is this equitable? Both taxpayers have the same inflow of income, but one is able to avoid tax because of his or her wealth and ability to invest in tax-sheltered investments.

What do you think?-3 The individual investing in a municipal bond may accept a market rate of interest of 4%, passing up a market rate of interest of 6% on corporate bonds which pay interest that is taxable. If the individual earned $100,000 on 4% bonds, she could have earned $150,000 if she had chosen 6% corporate bonds. You could say that she has paid a tax, by loaning money to a local government at a low interest rate, accepting less interest.