1. Read and summarize chapter 5 of your financial management text book in at least 400 words.

* Research what the 2022 tax rate is for someone that is in $50,000 tax bracket. What is it?

*In regards to tax law, what is the definition of “capital gains?”

*Thinking about the all of the money people made on stock trading apps like “Robinhood” or “We Bull,” do you think those who made large profits realized the implications that of capital gains would have on them? Explain.

2. Research billionaire Warren Buffet saying that his receptionist pays more taxes than he does.

*What did he mean by that?

*Why do you think she pays more than he does? 

In assessing a companys current and future cash flows, the financial analyst requires information concerning a companys tax obligations. Unfortunately, the companys tax return is not publicly available, requiring the analyst to understand the basics of corporate taxation and to work with information disclosed in the financial statements.

The tax laws are changed almost constantly and are likely being changed as you read this chapter. Hence, no purpose would be served by covering all the details of present tax laws; they might be outdated as soon as you learn them. Instead, we discuss some of the principles behind the tax laws and in doing so provide an opportunity for you to learn some terminology, do some basic taxation calculations, and see how taxes affect a companys cash flows. We use the rates in the 2001 tax laws for demonstration purposes.

Following are the main kinds of taxes:

• Income taxes are taxes specifically levied on the basis of income.
• Employment taxes are also based on income, but specifically on wage and salary income. In the United States, employment taxes are paid by the employee and the employer, and they are designated spe- cifically for social insurance programs (i.e., retirement and unem-
  ployment).
• Excise taxes are taxes on certain commodities, such as alcoholic
  beverages, tobacco products, telephone service, and gasoline. Excise taxes provide an easy way of raising revenue, and they can be imposed to discourage the use of specific products, such as tobacco.
• Import and export taxes (or tariffs) are taxes based on trade with other countries and are imposed to achieve specific economic goals in world trade.

CHAPTER 5Taxation

107

108 FOUNDATIONS

In this chapter, we focus on income taxes and, specifically, U.S. fed- eral corporate income taxes. However, any of the other types of taxes may have a strong influence on the cash flows of industries or firms. For example, excise taxes and import and export taxes will influence the demand for a firms products and therefore the firms cash flows.

THE U.S. TAX LAW

In the United States, the federal tax law is the product of all three branches of federal government. Congress passes the tax legislation that comprises the Internal Revenue Code (IRC). The Internal Revenue Ser- vice (IRS), a part of the Treasury Department, interprets these laws, adds the details, and implements them. The IRS does this by providing and processing tax forms, collecting tax payments, explaining the law in its regulations, and even providing decisions regarding the law (called rulings) in some situations. The courts are also called on to interpret the law through specific court cases, and there is now a well-developed case law related to the IRC. Together the Internal Revenue Code, IRS regula- tions, IRS rulings, and the case law make up federal tax law.

In forecasting future cash flows, the financial analyst needs to be aware that tax rates change frequently. The financial analyst cannot simply assume that the tax rate in existence today will be the same in five or ten years. Moreover, in comparing the after-tax performance of a firm over time, changes in tax rates must be considered.

U.S. FEDERAL TAX RATES

Exhibit 5.1 shows the 2001 U.S. federal income tax rate schedules for cor- porations. We can look at the schedule for a corporation to see how the income tax is computed. Each line of the schedule represents a layer of tax- able income, sometimes called a tax bracket; the lower limit of each bracket is called its base. So the first line, for example, represents the tax- able income layer with base $0 and maximum taxable income of $50,000.

Each line of the schedule also tells us the dollar amount of the tax on the base and the rate at which income above the base is taxed in that bracket. Suppose a corporation has taxable income of $12 million. Using the tax rate schedule, we see that the tax is 15% on the first $50,000, 25% on the next $25,000, 34% on the next $25,000, 39% on the next $235,000, 34% on the next $9,665,000, and 35% on the last $2,000,000,