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