CHAPTER TWELVE TAXES AND INFLATION TAXES IN THE

CHAPTER TWELVE TAXES AND INFLATION

TAXES IN THE U. S. n CORPORATE TAXES • forms of business are taxed differently 3 single proprietor and partnership income is taxed at personal income rates 3 corporate income may be taxed twice – – once as it is earned using the corporate income rates again as dividend income using the personal rates

CORPORATE TAX RATES n MARGINAL TAX RATES • are the most important for the corporation and represent the tax on additional income earned

CORPORATE TAX RATES n MARGINAL TAX RATES • are the rates on the next dollar earned

CORPORATE TAX RATES n MARGINAL TAX RATES: An Example Suppose a corporation earns $85, 000 It pays. 15 on first $50, 000 = $7, 500. 25 on next $25, 000 = $6, 250. 34 on next $10, 000 = $3, 400 Total tax on$85, 000 = $17, 150

CORPORATE TAX RATES n CALCULATING AVERAGE TAX RATE • the average tax rate = TOTAL TAX PAID TOTAL TAXABLE INCOME

CORPORATE TAX RATES n CALCULATING AVERAGE TAX RATE • the average tax rate is equal to the An Example $17, 150 / $85, 000 = 20. 18%

PERSONAL INCOME TAXES n CALCULATING AFTER-TAX INCOME GROSS INCOME - ADJUSTMENTS ADJUSTED GROSS INCOME - DEDUCTIONS TAXABLE INCOME - TAXES AFTER-TAX INCOME

PERSONAL INCOME TAXES n EXAMPLE: A MARRIED COUPLE ARE EVALUATING AN INVESTMENT Assume: No Bracket “Creep” Taxable Income = $80, 000 Marginal Tax rate =. 28 Possible Investment Income: Tax (. 28 x $3, 000) = $840

PERSONAL INCOME TAXES n EXAMPLE: A MARRIED COUPLE ARE EVALUATING AN INVESTMENT Assume: Bracket “Creep” Possible Investment Income: $20, 000 Tax. 28 x 16, 900 = $4, 732. 31 x 3, 100 = $ 961 20, 000 = $5, 693

PERSONAL INCOME TAXES n TAX-EXEMPT BONDS • DEFINITION: securities whose income is not subject to federal income taxes

PERSONAL INCOME TAXES n TAX-EXEMPT BONDS • most income from bonds issued by states, municipalities, and their agencies need not be included in taxable income for federal returns

PERSONAL INCOME TAXES n TAX-EXEMPT BONDS • to calculate fully-taxable-equivalent yield of a tax-exempt bond use the formula yield = __i__ 1 - t where t = the investor’s marginal tax rate i = the tax-exempt yield

TAX TREATMENT FOR CAPITAL GAINS AND LOSSES n CATEGORIES OF GAIN • depend on holding periods and tax treatment HOLDING PERIOD TAX TREATMENT

TAX TREATMENT FOR CAPITAL GAINS AND LOSSES n CATEGORIES OF GAIN • depend on holding periods and tax treatment HOLDING PERIOD • Less than one year TAX TREATMENT ordinary income

TAX TREATMENT FOR CAPITAL GAINS AND LOSSES n CATEGORIES OF GAIN • depend on holding periods and tax treatment HOLDING PERIOD • Less than one year • 12 to 18 months TAX TREATMENT ordinary income max rate = 28%

TAX TREATMENT FOR CAPITAL GAINS AND LOSSES n CATEGORIES OF GAIN • depend on holding periods and tax treatment HOLDING PERIOD • Less than one year • 12 to 18 months • more than 18 months TAX TREATMENT ordinary income max rate = 28% 20%*

TAX TREATMENT FOR CAPITAL GAINS AND LOSSES n CATEGORIES OF GAIN • depend on holding periods and tax treatment HOLDING PERIOD • Less than one year • 12 to 18 months • more than 18 months TAX TREATMENT ordinary income max rate = 28% 20%* * unless taxpayer is in the 15% tax bracket in which case the rate = 10%

TAX TREATMENT FOR CAPITAL GAINS AND LOSSES n CATEGORIES OF GAIN • depend on holding periods and tax treatment HOLDING PERIOD • Less than one year • 12 to 18 months • more than 18 months • five years or more TAX TREATMENT ordinary income max rate = 28% 20%* 18%**

TAX TREATMENT FOR CAPITAL GAINS AND LOSSES n CATEGORIES OF GAIN • depend on holding periods and tax treatment HOLDING PERIOD • five years or more TAX TREATMENT 18%** **Exception: If taxpayer is in 15% tax bracket, the asset must have been sold in the year 2001 or later, then rate = 8%

TAX TREATMENT FOR CAPITAL GAINS AND LOSSES n CATEGORIES OF GAIN • depend on holding periods and tax treatment HOLDING PERIOD • Less than one year • 12 to 18 months • more than 18 months • five years or more TAX TREATMENT ordinary income max rate = 28% 20%* 18%**

INFLATION IN THE U. S. n INFLATION • DEFINITION: the percentage change in a specific cost-of-living index at various points in time.

INFLATION IN THE U. S. n INFLATION • cost-of-living index 3 the “overall” price level computed for a “basket of goods”

INFLATION IN THE U. S. n PRICE INDICES • measure changes in prices relative to a fixed period in time usually called the base period

INFLATION IN THE U. S. n PRICE INDICES • the Consumer Price Index (CPI) is calculated by the U. S. Bureau of Labor Statistics in the Department of Labor

INFLATION IN THE U. S. n PRICE INDICES • the Consumer Price Index (CPI) is calculated by the U. S. Bureau of Labor Statistics in the Department of Labor • the Bureau uses a “market basket” of over 2000 U. S. consumer goods and services

INFLATION IN THE U. S. n NOMINAL AND REAL RETURNS • Fisher Model of Real Returns stated that real returns are important to investors • they represented how much purchasing power has changed

INFLATION IN THE U. S. n NOMINAL AND REAL RETURNS • price change may impact an asset’s nominal return

INFLATION IN THE U. S. n NOMINAL AND REAL RETURNS • adjustments to the nominal return are needed to remove the effects on purchasing power of inflation or deflation

INFLATION IN THE U. S. n NOMINAL AND REAL RETURNS • FORMULA FOR CALCULATING REAL RETURNS where C 0 = CPI at the beginning of period C 1 = CPI at the end of the period NR = the time period’s nominal return RR =the real return for the period

INFLATION IN THE U. S. n NOMINAL AND REAL RETURNS • a quick calculation of the real return NR - IR = RR where IR = the rate of inflation for the period NR= the nominal return RR= the real return

INFLATION IN THE U. S. n THE EFFECT OF INVESTOR EXPECTATIONS • investors’ attitudes toward inflation show they are concerned with real returns

INFLATION IN THE U. S. • THE EFFECT OF INVESTOREXPECTATIONS Looking to the future E(RR) = E(NR) - E(CCL) where E(RR) = the expected real return E(NR) = the expected nominal return E(CCL)= the expected inflation rate

STOCK RETURNS AND INFLATION n OVER LONG PERIODS OF TIME • common stocks generated large, positive real returns

STOCK RETURNS AND INFLATION n OVER LONG PERIODS OF TIME • T-bills produced much lower, positive real returns

STOCK RETURNS AND INFLATION n OVER SHORT PERIODS OF TIME • stock returns are not positively related to either actual or expected rates of inflation

STOCK RETURNS AND INFLATION n OVER SHORT PERIODS OF TIME • stock returns are positively related to both actual and expected rates of inflation

END OF CHAPTER 12