The Federal Income Tax System

A web site explaining federal tax law is http://www. taxsites.com. From this home page one can visit other sites that provide summaries of recent tax legislation or current information on corporate and individual tax rates. The official government site is http:// www.irs.gov.

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 inflation rate, 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 and on the Web) before you file your personal or business tax returns.

Currently (early 2002), 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, Congress and the administration are debating the merits of different changes in the tax laws. 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. Thus, by the time you read this chapter, 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 really enough, though, 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.

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