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CHAPTER TWELVE

CHAPTER TWELVE. TAXES AND INFLATION. TAXES IN THE U.S. CORPORATE TAXES forms of business are taxed differently single proprietor and partnership income is taxed at personal income rates corporate income may be taxed twice once as it is earned using the corporate income rates

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CHAPTER TWELVE

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  1. CHAPTER TWELVE TAXES AND INFLATION

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

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

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

  5. CORPORATE TAX RATES • 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

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

  7. CORPORATE TAX RATES • CALCULATING AVERAGE TAX RATE • the average tax rate is equal to the An Example $17,150 / $85,000 = 20.18%

  8. PERSONAL INCOME TAXES • CALCULATING AFTER-TAX INCOME GROSS INCOME - ADJUSTMENTS ADJUSTED GROSS INCOME - DEDUCTIONS TAXABLE INCOME - TAXES AFTER-TAX INCOME

  9. PERSONAL INCOME TAXES • 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

  10. PERSONAL INCOME TAXES • 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

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

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

  13. PERSONAL INCOME TAXES • 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

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

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

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

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

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

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

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

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

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

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

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

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

  26. INFLATION IN THE U.S. • 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

  27. INFLATION IN THE U.S. • 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

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

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

  30. INFLATION IN THE U.S. • NOMINAL AND REAL RETURNS • FORMULA FOR CALCULATING REAL RETURNS where C0 = CPI at the beginning of period C1 = CPI at the end of the period NR = the time period’s nominal return RR =the real return for the period

  31. INFLATION IN THE U.S. • 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

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

  33. 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

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

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

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

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

  38. END OF CHAPTER 12

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