CHAPTER TWELVE
TAXES AND INFLATION
TAXES IN THE U.S.
CORPORATE TAXES•forms of business are taxed
differentlysingle proprietor and partnership income
is taxed at personal income ratescorporate 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
MARGINAL TAX RATES•are the most important for the
corporation and represent the tax on additional income earned
CORPORATE TAX RATES
MARGINAL TAX RATES•are the rates on the next dollar
earned
CORPORATE TAX RATES
MARGINAL TAX RATES: An ExampleSuppose a corporation earns $85,000It pays
.15 on first $50,000 = $7,500
.25 on next $25,000 = $6,250
.34 on next $10,000 = $3,400Total tax on$85,000 = $17,150
CORPORATE TAX RATES
CALCULATING AVERAGE TAX RATE•the average tax rate =
TOTAL TAX PAID TOTAL TAXABLE INCOME
CORPORATE TAX RATES
CALCULATING AVERAGE TAX RATE•the average tax rate is equal to theAn Example
$17,150 / $85,000 = 20.18%
PERSONAL INCOME TAXES CALCULATING AFTER-TAX INCOME
GROSS INCOME- ADJUSTMENTSADJUSTED GROSS INCOME- DEDUCTIONSTAXABLE INCOME- TAXESAFTER-TAX INCOME
PERSONAL INCOME TAXES EXAMPLE: A MARRIED COUPLE
ARE EVALUATING AN INVESTMENTAssume: No Bracket “Creep”Taxable Income = $80,000Marginal Tax rate = .28Possible Investment Income:
Tax (.28 x $3,000) = $840
PERSONAL INCOME TAXES EXAMPLE: A MARRIED COUPLE
ARE EVALUATING AN INVESTMENTAssume: Bracket “Creep”Possible Investment Income: $20,000Tax .28 x 16,900 = $4,732
.31 x 3,100 = $ 96120,000 = $5,693
PERSONAL INCOME TAXES TAX-EXEMPT BONDS
•DEFINITION: securities whose income is not subject to federal income taxes
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
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
TAX TREATMENT FOR CAPITAL GAINS AND LOSSES CATEGORIES OF GAIN
•depend on holding periods and tax treatmentHOLDING PERIOD TAX
TREATMENT
TAX TREATMENT FOR CAPITAL GAINS AND LOSSES CATEGORIES OF GAIN
•depend on holding periods and tax treatmentHOLDING PERIOD TAX
TREATMENT
•Less than one year ordinary income
TAX TREATMENT FOR CAPITAL GAINS AND LOSSES CATEGORIES OF GAIN
•depend on holding periods and tax treatmentHOLDING PERIOD TAX
TREATMENT
•Less than one year ordinary income
• 12 to 18 months max rate = 28%
TAX TREATMENT FOR CAPITAL GAINS AND LOSSES CATEGORIES OF GAIN
•depend on holding periods and tax treatmentHOLDING PERIOD TAX TREATMENT
•Less than one year ordinary income
• 12 to 18 months max rate = 28%
• more than 18 months 20%*
TAX TREATMENT FOR CAPITAL GAINS AND LOSSES CATEGORIES OF GAIN
•depend on holding periods and tax treatmentHOLDING 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%
TAX TREATMENT FOR CAPITAL GAINS AND LOSSES CATEGORIES OF GAIN
•depend on holding periods and tax treatmentHOLDING 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%**
TAX TREATMENT FOR CAPITAL GAINS AND LOSSES CATEGORIES OF GAIN
•depend on holding periods and tax treatmentHOLDING 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%
TAX TREATMENT FOR CAPITAL GAINS AND LOSSES CATEGORIES OF GAIN
•depend on holding periods and tax treatmentHOLDING 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%**
INFLATION IN THE U.S.
INFLATION•DEFINITION: the percentage change
in a specific cost-of-living index at various points in time.
INFLATION IN THE U.S.
INFLATION•cost-of-living index
the “overall” price level computed for a “basket of goods”
INFLATION IN THE U.S.
PRICE INDICES•measure changes in prices relative to
a fixed period in time usually called the base period
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
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
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
INFLATION IN THE U.S.
NOMINAL AND REAL RETURNS•price change may impact an asset’s
nominal return
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
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
10
1
C
NRCRR
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 periodNR= the nominal returnRR= the real return
INFLATION IN THE U.S.
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 returnE(NR) = the expected nominal
returnE(CCL)= the expected inflation rate
STOCK RETURNS AND INFLATION OVER LONG PERIODS OF TIME
•common stocks generated large, positive real returns
STOCK RETURNS AND INFLATION OVER LONG PERIODS OF TIME
•T-bills produced much lower, positive real returns
STOCK RETURNS AND INFLATION OVER SHORT PERIODS OF TIME
•stock returns are not positively related to either actual or expected rates of inflation
STOCK RETURNS AND INFLATION OVER SHORT PERIODS OF TIME
•stock returns are positively related to both actual and expected rates of inflation
END OF CHAPTER 12