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
Individual Tax Model-1.
Gross income- Less Excl.
Less:
Deductions for adjusted gross income
Equals: Adjusted Gross Income (AGI)
Less:
Deductions from AGI (greater of
itemized or standard deduction)
Less:
Exemptions (personal & dependency)
Equals: Taxable income (loss)
Individual Tax Model-2
Taxable income
Times: Tax rates
Equals: Gross income tax liability
Plus:
Additions to tax
Less:
Tax credits or prepayments
Equals: Tax owed or refund due
General Tax Formula ($000)
Gross Income - Form 1040-Pg 1
Deductions For A.G.I.
Adjusted Gross Income (AGI)
Exemptions
(6)
Regular Itemized Ded.
(15)
Misc. Itemized Ded.
(5)
Less 2% of AGI
2
Deductible Amount
(3)
Total Deductions From AGI
Taxable Income
$110
(10)
100
(24)
$76
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
Purpose of a Tax
• Revenue
• Penalty
• Social changes
• Economic changes
• Equity
Adam Smith's Standards for a Good Tax
Equity
Tax should be based on the
taxpayer’s ability to pay.
Horizontal Equity: Two
similarly situated taxpayers
are taxed the same.
Certainty
Taxpayer should know when
and how a tax is to be paid.
Taxpayer should be able to
determine amount of tax.
Convenience
Tax should be levied when
taxpayer has funds to pay
Vertical Equity: Differently Economy
situated taxpayers are
taxed differently but fairly.
Costs of complying with
tax law should be minimal.
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).
Connect HW-#2
Base
$37,650
Top layer
$37,350
Totals
$75,000
Rate
25%
Total
$5,183.75
$9,337.50
$14,521
Rate
Base
Top layer
Totals
$91,150
$23,850
$115,000
Increase in tax
Increase in income
Marginal rate
Total
$18,558.75
28% $6,678.00
$25,237
$10,716
$40,000
26.79%
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 is Regressive-5 Person A Person B
Salary
$30,000 $300,000
Amount spent on
taxable purchases $20,000 $100,000
Sales Tax Rate
10%
10%
Sales Tax Paid
Percentage of income
for Sales Tax
Is this a regressive tax?
What is Regressive-5
A
B
Salary
$30,000 $300,000
Amount spent on
taxable purchases
$20,000 $100,000
Sales Tax Rate
10%
10%
Sales Tax Paid
$2,000 $10,000
Percentage of
income for Sales Tax 6.667% 3.333%
Is this a regressive tax?
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.
Laura Bush, age 48. No dependents.
Salary
Dividend income
Income from rents
Subtotal
She also has this information:
Contribution to IRA
Expenses relating to rents
Cost of stock publications
Charitable contributions
Employee expenses
Subtotal
Adjusted Gross Income (AGI)
Facts
Return
$38,000
$2,000
$16,000
$2,000
$9,000
$1,000
$1,500
$1,000
Laura Bush, age 48. No dependents.
Salary
Dividend income
Income from rents
Subtotal
She also has this information:
Contribution to IRA
Expenses relating to rents
Cost of stock publications
Charitable contributions
Employee expenses
Subtotal
Adjusted Gross Income
Facts
Return
$38,000 $38,000
$2,000
$2,000
$16,000 $16,000
$56,000
$2,000
$9,000
$1,000
$1,500
$1,000
$2,000
$9,000
$11,000
$45,000