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 pro-
duced by the asset. Cash flows from an asset consist of
income plus depreciation,
and usable income means income
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) before you file your personal or business tax returns.
Currently (2005), federal income tax rates for individuals go up to 35 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 indi-
vidual 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 38 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 continue to debate 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 appendix, tax
rates and other factors will almost certainly be different from those we provide. Still, if
you understand this appendix, 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 spe-
cialists 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.
Individual Income Taxes