Chapter 1: Introduction to Taxation

1-2 The Structure of Tax Systems
Most taxes have two components: a tax rate and a tax base (such as income, wages, value, or sales price). Tax liability is computed by multiplying these two components.

1-2a Tax Rates

Tax rates can be progressive, proportional, or regressive. A tax rate is progressive if the rate increases as the tax base increases. The Federal income tax imposed on individuals is a progressive tax as indicated by the Tax Rate Schedules you can find inside the front cover of this text. Currently, the tax rates increase from 10 percent to 37 percent as taxable income (the tax base) increases. A tax is proportional if the rate of tax is constant, regardless of the size of the tax base. State retail sales taxes are proportional. Finally, regressive tax rates decrease as the tax base increases. Federal employment taxes , such as FICA and FUTA, can be termed regressive.

For tax compliance and planning purposes, a taxpayer’s statutory, marginal, and average tax rates are determined and used. The statutory tax rate is the tax rate (or rates) specified in the law. For example,
Code § 11 provides that the income tax rate for corporations is 21 percent. The marginal tax rate is the tax rate applicable to the next dollar of income (if describing an income tax effect). This rate is relevant to let a taxpayer know the tax effect of, for example, earning a $1,000 bonus from one’s employer.
The average tax rate is equal to the tax liability divided by taxable income. This rate can be useful in comparing taxpayers or a taxpayer’s changed tax picture from one year to another. The effective tax rate is equal to taxes paid (often the tax liability) divided by the taxpayer’s ability to pay (some income measure, like adjusted gross income or disposable income). This rate is often used by policy makers to measure the progressivity of a tax system. For financial reporting purposes, effective tax rate generally refers to total tax expense as a percentage of pretax book income (see text Section 3-3c).

1.2b Tax Bases

Most taxes are levied on one of four kinds of tax bases.

-Transactions [including sales or purchases of goods and services and transfers of

wealth (e.g., by gift or at death)].

-Property or wealth (including ownership of specific kinds of property).

-Privileges and rights (including the ability to do business as a corporation, the right

to work in a certain profession, and the ability to move goods between countries).

-Income on a gross or net-of-expenses basis.

1-3 Types of Taxes

In many countries, transaction taxes are more important than income taxes. We willdiscuss three types of transaction taxes: sales and certain excise taxes , employment taxes, and taxes on the transfer of wealth (as gifts and at death).

1-3a Taxes on the Production and Sale of Goods
Excise taxes and general sales taxes differ by the breadth of their bases. An excise tax base is limited to a specific kind of good or service, but a general sales tax is broad-based (e.g., it might be levied on all retail sales).

Federal Excise Taxes

Currently, trucks, trailers, tires, liquor, tobacco, firearms, certain sporting equipment, medical devices, and air travel all are subject to Federal excise taxes. Excise taxes extend beyond sales transactions. They also are levied on privileges and rights, as discussed below. The bases used for Federal excise taxes are as diverse as the goods that are taxed. Fuels are taxed by the gallon, vaccines by the dose, air travel by the price paid for the ticket, water travel by the passenger, coal by the ton extracted or by the sales price, insurance by the premiums paid, and the gas guzzler tax by the mileage rating on the auto-
mobile produced. Some of these taxes are levied on producers, some on resellers, and some on consumers. In almost every circumstance, the tax rate structure is proportional. With the exception of Federal excise taxes on alcohol, tobacco, and firearms, Federal excise taxes are due at least quarterly, when the Federal excise tax return (Form 720) is filed.

State Excise Taxes
Many states levy excise taxes on the same items taxed by the Federal government. For example, most states have excise taxes on gasoline, liquor, and tobacco.

Local Excise Taxes
Over the last few years, two types of excise taxes imposed at the local level have become increasingly popular. These are the hotel occupancy tax and the rental car “surcharge.” Because they tax the visitor who cannot vote.

General Sales Tax
The broad-based general sales tax is a major source of revenue for most state and local governments. It is used in all but five states (Alaska, Delaware, Montana, New Hampshire, and Oregon).

Use Taxes 

One obvious approach to avoiding state and local sales taxes is to purchase goods in a state that has little or no sales tax and then transport the goods back to one’s home state. Another alternative is to purchase goods from an out-of-state internet-based vendor (e.g., an Amazon affiliate) that then ships the goods directly to the purchaser. Use taxes exist to prevent this tax reduction ploy. The use tax is a transaction tax imposed at the same rate as the sales tax on the use, consumption, or storage of tangible property. Every state that imposes a general sales tax levied on the consumer also applies a use tax.

Value Added Tax 

The value added tax (VAT) is a variation of a sales tax and is levied at each stage of production on the value added by the producer. A VAT is used by almost all countries around the world; the United States is one of the few countries that does not use a VAT.
The most commonly used form of VAT is the credit invoice VAT. In its basic form, sellers charge a VAT on everything they sell, and all buyers pay the VAT. Business buyers, though, get the VAT they pay refunded (or credited) against the VAT they collect and have to remit to the government. As a result, the final consumer pays the VAT, but it is assessed and collected throughout the production and distribution of the goods or services (in contrast, the sales tax is paid by the final consumer only).

1-3b Employment Taxes

Both Federal and state governments tax the salaries and wages paid to employees. On the Federal side, employment taxes represent a major source of funds. For example, the FICA tax accounts for more than one-third of revenues in the Federal budget, second only to the income tax in its contribution.

The Federal government imposes two kinds of employment tax. The Federal Insurance Contributions Act (FICA) imposes a tax on self-employed individuals, employees, and employers. The proceeds of the tax are used to finance Social Security and Medicare benefits. The Federal Unemployment Tax Act (FUTA) imposes a tax on employers only. The FUTA tax provides funds to state unemployment benefit programs. Most state employment taxes are similar to the FUTA tax, with proceeds used to finance state unemployment benefit payments

FICA Taxes 

The FICA tax has two components: old age, survivors, and disability insurance payments (commonly referred to as Social Security) and Medicare health insurance payments. The Social Security tax rate is 6.2 percent for the employee and 6.2 percent for the employer, and the Medicare tax rate is 1.45 percent for both the employer and the employee. The maximum base for the Social Security tax is $142,800 for 2021. There is no ceiling on the base amount for the Medicare tax. 

Payments usually are made through weekly or monthly electronic payments or deposits to a Federal depository. Employers also file Form 941, Employer’s Quarterly Federal Tax Return, by the end of the first month following each quarter of the calendar year.

FICA tax is not assessed on all wages paid. For example, wages paid to children under the age of 18 who are employed in a parent’s trade or business are exempt from the tax.

An additional 0.9 percent Medicare tax is imposed on earned income (including self-employment income) above $200,000 (single filers) or $250,000 (married filing jointly). Unlike the Social Security tax of 6.2 percent and the regular Medicare portion of 1.45 percent, an employer does not match the employees’ 0.9 percent additional Medicare tax.

 

Self-Employment Tax 

Self-employed individuals also pay into the FICA system in the form of a selfemployment (SE) tax (determined on Schedule SE, filed with Form 1040, U.S. Individual Income Tax Return). Self-employed individuals are required to pay both the employer and the employee portion of the FICA taxes. The 2021 SE tax rate is 15.3 percent on self employment income up to $142,800 and 2.9 percent on all additional self-employment income. Self-employed individuals deduct half of the SE tax—the amount normally deductible by an employer as a business expense. Self-employment income is discussed in more detail in text Section 11-4b

Unemployment Taxes 

For 2021, FUTA applies at a rate of 6.0 percent on the first $7,000 of covered wages paid during the year to each employee. The Federal government allows a credit for unemployment tax paid (or allowed under a merit rating system)3 to the state. The credit cannot exceed 5.4 percent of the covered wages. As a result, the amount required to be paid to the U.S. Treasury could be as low as 0.6 percent (6.0% 2 5.4%) of an employee’s wages. FUTA and state unemployment taxes differ from FICA in that the tax is imposed only on the employer.

1-3c Taxes at Death

The transfer of property upon the death of the owner may be a taxable event. If the tax is imposed on the transferor at death, it is called an estate tax . If the law taxes the recipient of the property, it is termed an inheritance tax.

The Federal government imposes an estate tax. Only a few state governments levy their own additional inheritance taxes, estate taxes, or both. In a typical year, about 2.8 million U.S. individuals die. At the same time, only about 5,400 estates file a Federal estate tax return showing a taxable estate.

The Federal Estate Tax

Determination of the estate tax base begins with the gross estate, which includes property the decedent owned at the time of death. It also includes property interests, such as life insurance proceeds paid to the estate or to a beneficiary other than the estate if the deceased-insured had any ownership rights in the policy. Most property included in the gross estate is valued at fair market value as of the date of death. Deductions from the gross estate in arriving at the taxable estate include funeral and administration expenses, certain taxes, debts of the decedent, and transfers to charitable organizations. A marital deduction is available for amounts passing to a surviving spouse (a widow or widower). Once the taxable estate has been determined and certain taxable gifts have been added to it, one must determine a tentative tax liability. The tentative liability is reduced by a variety of credits to arrive at the amount due. In 2021, $11.7 million of a U.S. decedent’s estate effectively is excluded from the
estate tax, with a maximum 40 percent tax rate on any excess. Spouses can share a
$23.4 million estate tax exclusion. These amounts are indexed annually for inflation.4

State Taxes at Death

States usually levy an inheritance tax, an estate tax, or both. The two forms of tax differ according to whether the liability is imposed on the heirs or on the estate. Typically, an inheritance tax divides the heirs into classes based on their relationship to the decedent. The more closely related the heir, the lower the rates imposed and the greater the exemption allowed. Some states allow a zero rate of tax on amounts passing to a surviving spouse.

1-3d Gift Tax