The Federal Income Tax System

The value of any financial asset (including stocks, bonds, and mortgages) as well as most real assets such as plants or even entire firms depends on the stream of cash flows produced by the asset. Cash flows from an asset consist of usable income plus depreciation and usable income means income after taxes.

Our tax laws can be changed by congress and in recent years changes have occurred frequently. Indeed a major change has occurred on average, every three to four years since 1913, when our federal income tax system began. Further, certain parts of our tax system are tied to the rate of inflation, so changes occur automatically each year, depending on the rate of inflation during the previous year. Therefore, although this section will give you a good background on the basic nature of our tax system, you should consult current rate schedules and other data published by the internal Revenue Service (available in U.S. post offices) before you file your personal or business tax returns.

Currently (1997), federal income tax rates for individuals go up to 39.6 percent, and when social security, Medicare and state and city income taxes are included, the marginal tax rate on an individual’s income can easily exceed 50 percent. Business income is also taxed heavily. The income from partnerships and proprietorships is reported by the individual owners as personal income and consequently, is taxed at federal-plus-state rates going up to 50 percent or more. Corporate profits are subject to federal income tax rates of up to 39 percent, plus state income taxes. Furthermore, corporations pay taxes and then distribute after-tax income to their stockholders as dividends, which are also taxed. So, corporate income is really subject to double taxation. Because of the magnitude of the tax bite, taxes play a critical role in many financial decisions.

As this text is being written, a Republican Congress and a Democratic administration are debating the merits of different changes in the tax laws. To stimulate investment depreciation schedules may be liberalized and capital gains may be taxed at a lower rate. Even in the unlikely event that no explicit changes are made in the tax laws, changes will still occur because certain aspects of the tax calculation are tied to the inflation rate. Tax rates and other factors will almost certainly be different from those we provide. Still, if you understand this section you will understand the basics of our tax system, and you will know how to operate under the revised tax code.

Taxes are so complicated that university law schools offer master’s degrees in taxation to lawyers, many of whom are also CPAs. In a field complicated enough to warrant such detailed study, only the highlights can be covered in a book such as this. This is rally enough, because business managers and investors should and do rely on tax specialists rather than trusting their own limited knowledge. Still it is important to know the basic elements of the tax system as a starting point for discussions with tax experts.

Individual Income Taxes

Individuals pay taxes on wages and salaries, on investment income (dividends, interest, and profits from the sale of securities,) and on the profits of proprietorships and partnerships. Our tax rates are progressive that is the higher one’s income, the larger the percentage paid in taxes. Table 2-5 gives the tax rates for single individuals and married couples filing joint returns under the rate schedules that were in effect in April 1997.

1. Taxable income is defined as gross income less a set of exemptions and deductions which are spelled out in the instructions to the tax forms individuals must file. When filing a tax return in 1997 for the tax year 1996, each taxpayer received an exemption of $2.550 for each dependent, including the taxpayer, which reduces taxable income. However, this exemption is indexed to rise with inflation and the exemption is phased out (taken away) for high-income taxpayers. Also, certain expenses including mortgage interest paid, state and local income taxes paid and charitable contributions, can be deducted and thus be used to reduce taxable income, but again, high-income taxpayers lose most of these deductions.

2. The marginal tax rate is defined as the tax rate on the last unit of income. Marginal rates begin at 15 percent and rise to 39.6 percent. Note, though that when consideration is given to the phase-out of exemptions and deductions to Social Security and Medicare taxes, and to state taxes, the marginal tax rate can actually exceed 50 percent.

3. One can calculate average tax rates from the data in Table 2.5. For example, if Jill Smith, a single individual, had taxable income of $35,000. her tax bill would be $3.600 + ($35,000-$24,000) (0.28) = $3,600+$3,080=$6,680. Her average tax rate would be $6.680/$35,000=19.1% versus a marginal rate of 28 percent. If Jill received a raise of $1,000, bringing her income to $36,000. she would have to pay $280 of it as taxes, so her after-tax raise would be $720. In addition, her Social Security and Medicare taxes would increase by $76,50. Which would cut her net raise to $643,50.

4. As indicated in the notes to the table, the tax code indexes tax brackets to inflation to avoid the bracket creep that occurred several years ago and that in reality raised tax rates substantially.

Taxes on Dividend and Interest Income. Dividend and interest income received by individuals from corporate securities is added to other income and thus is taxed at rates going up to about 50 percent.