Test bank for McGraw-Hill’s Taxation of Individuals and Business Entities, 2016 Edition, 7th Edition

FALSE

TRUE

FALSE

FALSE

FALSE

A tax is a payment required by a government that is unrelated to any specific benefit or service received by the government.

FALSE

TRUE

FALSE

FALSE

TRUE

FALSE

Tax equals the tax base multiplied by the tax rate.

TRUE

FALSE

TRUE

FALSE

The marginal tax rate is particularly useful in tax planning because it represents the rate of taxation or savings that would apply to additional taxable income or additional tax deductions.

TRUE

TRUE

TRUE

FALSE

FALSE

TRUE

TRUE

FALSE

The most significant tax assessed by the U.S. government is the income tax.

FALSE

The 16^th amendment was ratified in February 1913.

TRUE

TRUE

FALSE

Excise taxes are levied on the quantity of products purchased.

FALSE

The estate tax is based on the fair value of wealth transfers upon death.

FALSE

A use tax is levied on goods owned, possessed, or consumed within a state that were not purchased within the state.

TRUE

FALSE

TRUE

FALSE

FALSE

TRUE

FALSE

FALSE

TRUE

I. A 1% special sales tax for funding local road construction.
II. A fee paid to the state for a license to practice as an attorney.
III. An income tax imposed by Philadelphia on persons working within the city limits.
IV. A special property assessment for installing a new water system in the taxpayer’s neighborhood.

A tax is a payment required by a government that is unrelated to any specific benefit or service received from the government.

Surcharges on alcohol and tobacco products are examples of “sin taxes”.

I. the tax base
II. the taxing agency
III. the tax rate
IV. the purpose of the tax

A proportional tax rate structure, also known as a flat tax, imposes a constant tax rate throughout the tax base.

$10,793.75 = 5,156.25 + .25(60,000 – 37,450)

17.99% = 10,793.75/60,000

16.61% = 10,793.75/(60,000 + 5,000)

See 2015 IRS rate schedule for single taxpayers.

See Exhibit 1-4 in text book.

See Exhibit 1-5 in text book.

See 2015 IRS tax schedule for single filers; 25%.

(21,071.25 – 12,043.75)/(100,000 – 65,000) = 25.79%

(24,325.75 – 15,925.75)/(110,000 – 80,000) = 28%

(8,293.75 – 15,925.75)/(50,000 – 80,000) = 25.44%

24,087.50/145,000 = 18.53%

24,087.50/(80,000 + 50,000 + 15,000) = 16.61%

$24,219.50 both separate – $24,087.50 jointly = $132.00.

119,996.25 + .396(750,000 – 413,200) = 253,369.05

The after-tax rate of return is the same as the pre-tax rate because the interest from municipal bonds is tax exempt.

The implicit tax equals the difference in pre-tax income earned from a similar (same risk) bond. In this case: (250,000 × .09) – (250,000 × .07) = $5,000

(250,000 × .09) × 0.28 = $6,300

Jackson’s marginal tax rate is 25%, so his after-tax rate of return on the Sundial, Inc. bonds would be 7.5%. Therefore, the city of Mitchell must pay 7.5% to make Jackson indifferent between the two bonds.

Implicit tax on City of Mitchell bonds: 10% – 7.8% = 2.2%, Explicit tax on Sundial, Inc. bonds: 10% × .25 = 2.5%.

Taxes are a part of everyday life and have a financial effect on many of the major personal decisions that individuals face (e.g., investment decisions, evaluating alternative job offers, saving for education expenses, gift or estate planning, etc.). Taxes play an equally important role in fundamental business decisions such as the following:

• What organizational form should a business use? Where should the business locate?
• How should business acquisitions be structured?
• How should employees be compensated? What is the appropriate mix of debt and equity for the business?
• Should the business rent or own equipment and property?
• How should the business distribute profits to its owners?

Savvy business decisions require consideration of all costs and benefits in order to evaluate the merits of a transaction. Although taxes do not necessarily dominate these decisions, they do represent large transaction costs that should be factored into the financial decision-making process.
Taxes also play a major part in the political process. U.S. presidential candidates often distinguish themselves from their opponents based upon their tax rhetoric. Indeed, the major political parties generally have very diverse views of the appropriate way to tax the public. Voters must have a basic understanding of taxes to evaluate the merits of alternative tax proposals.

a. $2.50 toll paid on the Florida Turnpike
b. $300 ticket for reckless driving
c. 1% local surcharge on hotel rooms to fund public roadways
d. 2% city surcharge on wages earned in the city of Philadelphia

a. Not a tax because receiving a specific benefit for amount paid.
b. Not a tax, penalties/fines are not taxes by definition.
c. A tax, required payment imposed by local government, tax not tied to specific benefit received by payor.
d. A tax, required payment imposed by local government, no specific benefit received by payor.

In addition to the general objective of raising revenue, Congress uses the federal tax system to encourage certain behavior and discourage other behavior. The charitable contribution deduction is intended to encourage taxpayers to support the initiatives of charitable organizations (social objective) whereas deductions for retirement contributions are intended to encourage retirement savings (social objective). Taxes are also often used to encourage investment and stimulate the economy. Likewise, taxes are also used to discourage certain less desirable taxpayer behavior. For example, “sin taxes” impose relatively high surcharges on alcohol and tobacco products to discourage their use.

The marginal tax rate is the tax rate that applies to the taxpayer’s additional taxable income or deductions that the taxpayer is evaluating in a decision. Specifically,

The marginal tax rate is particularly useful in tax planning because it represents the rate of taxation or savings that would apply to additional taxable income or tax deductions.

The average tax rate represents the taxpayer’s average level of taxation on each dollar of taxable income. Specifically,

The average tax rate is often used in budgeting tax expense as a portion of income (i.e., what percent of taxable income earned is paid in tax).

The effective tax rate represents the taxpayer’s average rate of taxation on each dollar of total income (i.e., taxable and nontaxable income). Specifically,

Relative to the average tax rate, the effective tax rate provides a better depiction of a taxpayer’s tax burden because it depicts the taxpayer’s total tax paid as a ratio of the sum of both taxable and nontaxable income earned.

A proportional (flat) tax rate structure imposes a constant tax rate throughout the tax base. Common examples of proportional taxes include sales taxes and excise taxes (i.e., taxes based on quantity such as gallons of gas purchased).
A progressive tax rate structure imposes an increasing marginal tax rate as the tax base increases. Common examples of progressive tax rate structures include federal and state income taxes and federal estate and gift taxes.
A regressive tax rate structure imposes a decreasing marginal tax rate as the tax base increases. Regressive tax rate structures are not common. In the United States, the Social Security tax and federal and state unemployment taxes employ a regressive tax rate structure. However, there are other regressive taxes when the tax is viewed in terms of effective tax rates. For example, a sales tax by definition is a proportional tax – i.e., as taxable purchases increase, the sales tax rate (i.e., the marginal tax rate) remains constant. Nonetheless, when you consider that the proportion of one’s total income spent on taxable purchases likely decreases as total income increases, the sales tax may be considered a regressive tax.
One can view vertical equity in terms of tax dollars paid or in terms of tax rates. Proponents of proportional tax rate structures are more likely to argue that vertical equity is achieved when taxpayers with a greater ability to pay tax simply pay more in tax dollars. Thus, from this view, a proportional tax rate achieves vertical equity.
Proponents of a progressive tax system are more likely to argue that taxpayers with a greater ability to pay should be subject to a higher tax rate. This view is based upon the argument that the relative burden of a flat tax rate decreases as a taxpayer’s income increases. Thus, vertical equity is achieved only when taxpayers with a greater ability to pay are subject to a higher tax rate.
Regressive tax rate structures are generally considered not to satisfy vertical equity (unless one is a strong advocate of the belief that those with a greater ability to pay do so simply by paying more tax dollars, albeit at a lower tax rate).

Employment taxes consist of the Old Age, Survivors, and Disability Insurance (OASDI) tax, commonly called Social Security tax, and the Medical Health Insurance (MHI) tax known as the Medicare tax. The Social Security tax pays the monthly retirement, survivor, and disability benefits for qualifying individuals, whereas the Medicare tax pays for medical insurance for individuals who are elderly or disabled. The tax base for the Social Security and Medicare taxes is wages or salary, and the rates are 12.4% (10.4% in 2012) and 2.9%, respectively. Employers and employees split this tax equally. Thus, Bart will have to pay the employer’s portion of these taxes for his employees.
As a self-employed individual, Bart must pay also the self-employment tax, which is basically the same as the employer’s and employee’s share of the Social Security and Medicare taxes. The tax rates for these taxes are 12.4% and 2.9%, respectively, and the tax base is net self-employment income. The self-employment tax is in addition to any federal income tax owed by the individual.
In addition to the Social Security and Medicare taxes, employers are also required to pay federal and state unemployment taxes, which fund temporary unemployment benefits for individuals terminated from their jobs without cause. The tax base for the unemployment taxes is also wages or salary.

The student is considering explicit taxes and ignoring implicit taxes. An explicit tax is a tax that is directly imposed by a government unit and easily quantified. Implicit taxes are the reduced rates of pre-tax return that a tax-favored asset produces (e.g., the lower pre-tax rate of return earned by tax exempt municipal bonds). Although implicit taxes are real and equally important in understanding our tax system, they are difficult to quantify.
Because implicit taxes are difficult to quantify, they are not generally considered when calculating average and effective tax rates (i.e., when assessing relative tax burdens). Since implicit taxes are ignored in these calculations, taxpayers may conclude that groups of taxpayers investing in tax advantaged assets (subject to implicit tax) do not pay their fair share of tax as represented by a low effective tax rate.

A sales tax by definition is a proportional tax – i.e., as taxable purchases increase, the sales tax rate (i.e., the marginal tax rate) remains constant. For this reason, Milton is correct. Nonetheless, when you consider that the proportion of one’s total income spent on taxable purchases likely decreases as total income increases, the sales tax may be considered a regressive tax. For this reason, Rocco is correct.
Vertical equity is achieved when taxpayers with greater ability to pay tax pay more tax relative to taxpayers with a lesser ability to pay tax. One can view vertical equity in terms of tax dollars paid or in terms of tax rates. Proponents of a sales tax (e.g., Milton) are more likely to argue that vertical equity is achieved when taxpayers with a greater ability to pay tax pay more in tax dollars. Opponents of a national sales tax (e.g., Rocco) are more likely to argue that taxpayers with a greater ability to pay should be subject to a higher tax rate. This view is based upon the argument that the relative burden of a sales tax decreases as a taxpayer’s income (e.g., disposable income) increases.

Certainty means that taxpayers should be able to determine when to pay the tax, where to pay the tax, and how to determine the tax. It is relatively easy to determine when and where to pay the federal income tax. For example, individual federal income tax returns and the remaining balance of taxes owed must be filed with the Internal Revenue Service each year on or before April 15^th (or the first business day following April 15^th). Thus, from this perspective, the federal income tax scores high.
However, the federal income tax is often criticized as being complex. What are taxable/nontaxable forms of income? What are deductible/nondeductible expenses? When should income or expense be reported? For many taxpayers (e.g., wage earners with few investments), the answers to these questions are straightforward. For other taxpayers (e.g., business owners, individuals with a lot of investments), the answers to these questions are nontrivial. Constant tax law changes enacted by Congress also add to the difficulty in determining the proper amount of income tax to pay. These changes can make it difficult to determine a taxpayer’s current tax liability much less plan for the future. From this perspective of “certainty”, the federal income tax system does not fare so well.
Economy requires that a good tax system should minimize the compliance and administration costs associated with the tax system. Economy can be viewed from both the taxpayers’ and government’s perspectives. From the government’s perspective, the federal tax system fares well with respect to economy. For example, the current IRS budget represents approximately ½ of a percent of every tax dollar collected. Compared to the typical costs of a collection agency, this is quite a low percentage cost.
From the taxpayer’s perspective of economy, the federal income tax does not fare so well. The income tax is often criticized for the compliance costs imposed on the taxpayer. Indeed, for certain taxpayers, record-keeping costs, accountant fees, attorney fees, etc. can be quite substantial.

Jonah will owe $35,071.25 in federal income tax this year computed as follows:
$35,071.25 = $18,481.25 + (28% × ($150,000 – $90,750)).

Jonah’s average tax rate is 23.38%.

Jonah’s effective tax rate is 21.92%.

Jonah is currently in the 28% tax rate bracket. His marginal tax rate on small increases in income and deductions is 28%.

If Jonah earns an additional $40,000 of taxable income, his marginal tax rate on the income is 28.09%.

Heather will owe $9,322.50 in federal income tax this year computed as follows:
$9,322.50 = $6,872.50 + (25% × ($60,000 – $50,200)).

Heather’s average tax rate is 15.54%.

Heather’s effective tax rate is 14.34%.

Heather is currently in the 25% tax rate bracket. Her marginal tax rate on small increases in income and deductions is 25%.

If Heather has an additional $20,000 of tax deductions, her marginal tax rate on the deductions is 19.90%.

Fred and Wilma will owe $16,587.50 in federal income tax this year computed as follows:
$16,587.50 = $10,312.50 + (25% × ($100,000 – $74,900)).

Fred and Wilma’s average tax rate is 16.59%.

Fred and Wilma’s effective tax rate is 13.82%.

Fred and Wilma are currently in the 25% tax rate bracket. Their marginal tax rate on small increases in income and deductions is 25%.

If Fred and Wilma earn an additional $40,000 of taxable income, their marginal tax rate on the income is 25.00%.

Nick would owe $30,664.50 and Jessica would owe $71,957.95 computed as follows:
Nick: $30,644.50 = $25,788.75 + (33% × ($130,000 – $115,225)).
Jessica: $71,957.95 = $64,998.25 + (39.6% × ($250,000 – $232,425)).

Nick’s average tax rate is 23.59%.

Jessica’s average tax rate is 28.78%.

Nick is in the 33% tax rate bracket, and Jessica is in the 39.6% tax rate bracket. Thus, their marginal tax rates are 33% and 39.6%, respectively, on small increases in income and deductions.

If Nick and Jessica filed jointly, they would owe $100,929 in tax.
$100,929 = $51,577.50 + (33% × ($380,000 – $230,450)).
Thus, filing jointly would save them $1,693.45 (($30,664.50 + $71,957.95) – $100,929).

Since the city of Las Vegas bond is a tax exempt bond, Ariel’s after tax rate of return on the bond is equal to its pre-tax rate of return (5%). Ariel pays no explicit tax on the interest earned from the city of Las Vegas bond. The Jittery Joe’s bond would pay $4,000 of interest (i.e., 8% × $50,000). Since Ariel’s marginal tax rate is 25%, she would have paid $1,000 of explicit tax (i.e., 25% × $4,000) on the interest earned from the Jittery Joe’s, Inc. bond and her after-tax rate of return is 6% ($4,000 interest – $1,000 tax)/$50,000 investment. Ariel earns $2,500 of interest on the city of Las Vegas bond (i.e., 5% × $50,000). A similar priced taxable bond (i.e., the Jittery Joe’s, Inc. bond) would pay $4,000 of taxable interest (i.e., 8% × $50,000). Ariel pays $1,500 of implicit tax on the city of Las Vegas bond (i.e., the difference between the pre-tax interest earned from a similar taxable bond ($4,000) and the pre-tax interest earned from the city of Las Vegas bond ($2,500)). Ariel should choose the Jittery Joe’s, Inc. bond because it earns a higher after-tax rate of return ((($4,000 interest – $1,000 tax)/$50,000 investment) = 6%) than the city of Las Vegas bond (5%).

Nelson’s after tax rate of return on the tax exempt city of Fruithurst bond is 4%. The J.B. Ribs, Inc. bond pays taxable interest of 6.5%. Nelson’s after tax rate of return on the J.B. Ribs, Inc. bond is 3.9% (i.e., 6.5% interest income – (6.5% × 40%) tax = 3.9%). Nelson should invest in the city of Fruithurst bond.

To be indifferent between investing in the two bonds, the J.B. Ribs, Inc. bond should provide Nelson the same after-tax rate of return as the city of Fruithurst bond (4%). To solve for the required pre-tax rate of return we can use the following formula: After-tax return = Pre-tax return × (1 – Marginal Tax Rate).

J.B. Ribs, Inc. needs to offer a 6.67% interest rate to generate a 4% after-tax return and make Nelson indifferent between investing in the two bonds

4% = Pre-tax return × (1 – 40%);
Pre-tax return = 4%/(1 – 40%) = 6.67%

Namratha’s after tax rate of return on the tax exempt city of Watkinsville bond is 4.5%. The Moe’s, Inc. bond pays taxable interest of 7%. Namratha’s after tax rate of return on the Moe’s, Inc. bond is 5.25% (i.e., 7% interest income – (7% × 25%) tax = 5.25%). Namratha should invest in the Moe’s, Inc. bond.

To be indifferent between investing in the two bonds, the Moe’s, Inc. bond should provide Namratha the same after-tax rate of return as the city of Watkinsville bond (4.5%). To solve for the required pre-tax rate of return we can use the following formula: After-tax return = Pre-tax return × (1 – Marginal Tax Rate).

Moe’s, Inc. needs to offer a 6% interest rate to generate a 4.5% after-tax return and make Namratha indifferent between investing in the two bonds

4.5% = Pre-tax return × (1 – 25%);
Pre-tax return = 4.5%/(1 – 25%) = 6%

Mort’s average tax rate is 20%.

A 20% average tax rate on Lizzy’s $80,000 taxable income would result in $16,000 of tax (i.e., 20% × $80,000 = $16,000). Thus, Lizzy must pay more than $16,000 tax for the tax structure to be progressive with respect to average tax rates.

Mort’s effective tax rate is 16%.

A 16% effective tax rate on Lizzy’s $110,000 total income would result in $17,600 of tax (i.e., 16% × $110,000 = $17,600). Thus, Lizzy must pay more than $17,600 tax for the tax structure to be progressive with respect to effective tax rates.

Diego’s average tax rate is 5%.

A 5% average tax rate on Dora’s $50,000 taxable income would result in $2,500 of tax (i.e., 5% × $50,000 = $2,500). Thus, Dora must pay more than $2,500 tax for the tax structure to be progressive with respect to average tax rates.

Diego’s effective tax rate is 3.75%.

A 3.75% effective tax rate on Dora’s $55,000 total income would result in $2,062.50 of tax (i.e., 3.75% × $55,000 = $2,062.50). Thus, Dora must pay more than $2,062.50 tax for the tax structure to be progressive with respect to effective tax rates.

Under the current income tax, Junior has $60,000 of income after tax. If the income effect is descriptive and Congress increases tax rates so that Junior’s average tax rate is 30%, Junior will need to earn $85,714.29 to continue to have $60,000 of income after tax.
After-tax income = Pre-tax income (1 – tax rate)
$60,000 = Pre-tax income (1 – .30)
Pre-tax income = $60,000/.70
Pre-tax income = $85,714.29
Junior will pay $25,714.29 in tax ($85,714.29 × .30). Accordingly, if the income effect is descriptive, the tax base and the tax collected will increase.
If Junior only earns $60,000 of taxable income, he would pay $18,000 of tax under the new tax structure (i.e., $60,000 × .30). Thus, the government’s tax revenues would decrease by $2,000 (i.e., $18,000 – $20,000). This is an example of the substitution effect, which may be descriptive for taxpayers with more disposable income who can afford to earn less and maintain a style of living.

Horizontal equity means that two taxpayers in similar situations pay the same tax. Thus, to make the tax structure horizontally equitable, Carrie should pay $1,500 in tax.

Fantasia’s average tax rate is 7.5%.

To be vertically equitable with respect to tax rates, Simon should pay a tax rate higher than 7.5%. A 7.5% tax rate on Simon’s $30,000 taxable income would result in $2,250 of tax (i.e., 7.5% × $30,000 = $2,250). Thus, Simon must pay more than $2,250 tax for the tax structure to be vertically equitable (i.e., to generate a tax rate more than 7.5%). This would result in a progressive tax rate structure.

The tax rate schedule is horizontally equitable because those taxpayers in the same situation (Lucy and Ethel) pay the same tax ($4,500). The tax is not vertically equitable because the taxpayers with a greater ability to pay (Lucy and Ethel) do not pay more tax, nor do they pay a higher tax rate than Ricky.

We cannot evaluate whether the tax rate structure is horizontally equitable because we are unable to determine if taxpayers in similar situations pay the same tax (i.e., the problem does not give data for two taxpayers with the same income). The tax rate structure would be considered vertically equitable because taxpayers with higher income pay more tax and at a higher rate. Specifically, Moe’s, Larry’s, and Curly’s average tax rates are 7.5%, 20%, and 25%, respectively.

Taxes will affect several aspects of Jed’s decision. Jed should consider differences in Georgia and Tennessee for (1) business taxes (e.g., corporate taxes), (2) individual income taxes, (3) excise taxes on beer, (4) real estate taxes (business and personal), (5) estate taxes (e.g., for wealth transfers from his parents), and (6) sales taxes.
Some nontax factors to be considered would include relative competition from other distributors, differences in beer consumption across states, factors that might influence long-term growth in the business, differences in costs associated with operating the business (licenses, relative wages, utilities, etc.), quality of life factors such as the quality of education, crime, recreational opportunities, etc.

Based on the information above, the average taxpayer pays $14,000 of tax (i.e., $80,000 × 17.5%), leaving $66,000 of income after tax. A 20 percent increase in revenues would mean that the average taxpayer pays $16,800 in tax ($14,000 × 1.20). With this new tax amount, we can solve for the tax rate that would generate this tax amount.
After-tax income = Pre-tax income × (1 – tax rate)
After-tax income = Pre-tax income – (Pre-tax income × tax rate)
After-tax income = Pre-tax income – Tax
Substituting information from the problem results in:
$66,000 = Pre-tax income – $16,800
Pre-tax income = $82,800
We can use the above formula to solve for the new tax rate.
After-tax income = Pre-tax income × (1 – tax rate)
$66,000 = $82,800 × (1 – tax rate)
Tax rate = $16,800/$82,800 = 20.29%
This is an example of dynamic forecasting.