McGraw-Hill's Taxation of Individuals 2017, 8th Edition Solution Manual

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Solutions Manual–McGraw-Hill’s Taxation,by Spilker et al.Chapter 1An Introduction to TaxSOLUTIONS MANUALDiscussion Questions1.[LO 1]Jessica’sfriendZacharyonce stated that he couldn’t understand why someonewould take a tax course.Why is this a rather naïve view?Taxes are a partof everyday life and have a financial effect on many of the majorpersonal decisions that individuals face (e.g., investment decisions, evaluatingalternative job offers, saving for education expenses, gift or estate planning, etc.).2.[LO 1] What aresome aspects of business that require knowledge of taxation?Whatare some aspects of personal finance that require knowledge of taxation?Taxes play an important role in fundamental business decisions such as thefollowing:•What organizational form should a business use?•Where should the business locate?•How should business acquisitions be structured?•How should the business compensate employees?•What is the appropriate mix of debt and equity for the business?•Should the business rent or own its equipment and property?•How should the business distribute profits to its owners?One must consider all transaction costs (including taxes) to evaluate the merits of atransaction.Common personal financial decisions that taxes influence include: choosinginvestments, retirement planning, choosing to rent or buy a home, evaluatingalternative job offers, saving for education expenses, and doing gift or estateplanning.3.[LO 1] Describe some ways in which taxes affect the political process in the UnitedStates.U.S. presidential candidates often distinguish themselves from their opponents basedupon their tax rhetoric.Likewise, the major political parties generally have verydiverse views of the appropriate way to tax the public.Determining who is taxed,

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Solutions Manual–McGraw-Hill’s Taxation,by Spilker et al.what is taxed, and how much is taxed are difficult questions.Voters must have a basicunderstanding of taxes to evaluate the merits of alternative tax proposals offered byopposing political candidates and their political parties.4.[LO 2]Courtneyrecently received a speeding ticket on her way to the university.Herfine was $200.Is this considered a tax?Why or why not?The $200 speeding ticket is not considered a tax.Instead, it is considered a fine orpenalty.Taxes differ from fines and penalties because taxes are not intended topunish or prevent illegal behavior.5.[LO 2]Marlon and Latoyarecently started building a house.They had to pay $300 tothe county government for a building permit.Is the $300 payment a tax?Why or whynot?The building permit is not considered a tax because $300 payment is directly linkedto a benefit that they received (i.e., the ability to build a house).6.[LO 2]To help pay for the city’s new stadium, thecityof Birmingham recentlyenacted a 1percentsurcharge on hotel rooms.Is this a tax?Why or why not?The 1percentsurcharge is a tax.The 1percentsurcharge is an earmarked tax–i.e.,collected for a specific purpose.The surcharge is considered a tax because the taxpayments made by taxpayers do not directly relate to the specific benefit received bythe taxpayers.7.[LO 2] As noted inExample 1-2, tolls, parking meter fees, and annual licensing feesare not considered taxes.Can you identify other fees that are similar?There are several possible answers to this question.Some common examples includeentrance fees to national parks, tag fees paid to local/state government forautomobiles, boats, etc.8.[LO 2] If the general objective of our tax system is to raise revenue, why does theincome tax allow deductions for charitable contributions and retirement plancontributions?In addition to the general objective of raising revenue, Congress uses the federal taxsystem to encourage certain behavior and discourage other behavior.The charitablecontribution deduction is intended to encourage taxpayers to support the initiatives ofcharitable organizations,whereas deductions for retirement contributions areintended to encourage retirement savings.

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Solutions Manual–McGraw-Hill’s Taxation,by Spilker et al.9.[LO 2]Onecommonargument forimposing so-calledsin taxes is the social goal ofreducingdemand for such products.Using cigarettes as an example, is there asegment of the population that might be sensitive to price and for whom high taxesmight discourage purchases?The most obvious segment sensitive to price may be teenagers and younger adults,although price sensitivity will vary by taxpayer.10.[LO 3]Dontaestated that he didn’t want to earn any more money because it would“put him in a higher tax bracket.”What is wrong withDontae’sreasoning?Although earning additional taxable income may increaseDontae’smarginal tax rate(i.e., put him in a higher tax bracket), the additional income earned does not affectthe taxes thatDontaewill pay on his existing income.Moving to a higher tax bracketsimply means thatDontaewill pay a higher tax rate on the additional income earned(not income that he already has).11.[LO 3] Describe the three different tax rates discussed in the chapter and howtaxpayers might use them.The marginal tax rateis the tax rate that applies to the taxpayer’s additional taxableincome or deductions that the taxpayer is evaluating in a decision.Specifically,Marginal Tax Rate =TaxTaxableIncome=)()(IncomeOldTaxableIncomeNewTaxablexOldTotalTaxNewTotalTa−−The marginal tax rate is particularly useful in tax planning because it represents therate of taxation or savings that would apply to additional taxable income or taxdeductions.Theaverage tax raterepresents the taxpayer’s average level of taxation on eachdollar of taxable income.Specifically,Average Tax Rate =omeTaxableIncTotalTaxTheaverage tax rate is often used in budgeting tax expense as a portion of income(i.e., what percent of taxable income earned is paid in tax).Theeffective tax raterepresents the taxpayer’s average rate of taxation on eachdollar of total income (i.e., taxableandnontaxable income).Specifically,

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Solutions Manual–McGraw-Hill’s Taxation,by Spilker et al.Effective Tax Rate =eTotalIncomTotalTaxRelative to the average tax rate, the effective tax rate provides a better depiction of ataxpayer’s tax burden because it depicts the taxpayer’s total tax paid as a ratio of thesum of both taxable and nontaxable income earned.12.[LO 3] Which is a more appropriate tax rate to use to compare taxpayers’ tax burdens–the average or the effective tax rate?Why?Relative to the average tax rate, the effective tax rate provides a better depiction of ataxpayer’s tax burden because it depicts the taxpayer’s total tax paid as a ratio of thesum of both taxable and nontaxable income earned.13.[LO 3] Describe the differences between a proportional, progressive, and regressivetax rate structure.A proportional (flat) tax rate structure imposes a constant tax rate throughout the taxbase.In other words, as the tax base increases, the taxes paid increases, but themarginal tax rate remains constant.Because the marginal tax rate is constant acrossall levels of the tax base, the average tax rate remains constant across the tax baseand always equals the marginal tax rate.Common examples of proportional taxesinclude sales taxes and excise taxes (i.e., taxes based on quantity such as gallons ofgas purchased).A progressive tax rate structure imposes an increasing marginal tax rate as the taxbase increases.In other words, as the tax base increases, both the marginal tax rateand the taxes paid increase.Common examples of progressive tax rate structuresinclude federal andmoststate income taxes and federal estate and gift taxes.A regressive tax rate structure imposes a decreasing marginal tax rate as the tax baseincreases.In other words, as the tax base increases, the taxes paid increases, but themarginal tax rate decreases.Regressive tax rate structures are not common.In theUnited States, the Social Security taxand the federal employment taxemployaregressive tax rate structure.However, there are other regressive taxes when the taxis viewed in terms of effective tax rates.For example, a sales tax by definition is aproportional tax–i.e., as taxable purchases increase, the sales tax rate (i.e., themarginal tax rate) remains constant.Nonetheless, when you consider that theproportion of one’s total income spent on taxable purchases likely decreases as totalincome increases, the sales tax may be considered a regressive tax.14.[LO 3]Arnold and Lillyhave recently had a heated discussion about whether a salestax is a proportional tax or a regressive tax.Lillyargues that a sales tax is regressive.

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Solutions Manual–McGraw-Hill’s Taxation,by Spilker et al.Arnoldcounters that the sales tax is a flat tax.Who is correct?Arnold and Lillyare both correct.A sales tax by definition is a proportional tax–i.e.,as taxable purchases increase, the sales tax rate (i.e., the marginal tax rate) remainsconstant.For this reason,Arnoldis correct.Nonetheless, when you consider that theproportion of one’s total income spent on taxable purchases likely decreases as totalincome increases, the sales tax may be considered a regressive tax.For this reason,Lillyis correct.15.[LO 4] Which is the largest tax collected by the U.S. government?What types oftaxpayers are subject to this tax?The federal income tax is the largest tax collected by the U.S. government.Currently,federal income taxes are levied on individuals, corporations, estates, and trusts.16.[LO 4] What is the tax base for the Social Security and Medicare taxes for anemployeeoremployer?What is the tax base for Social Security and Medicare taxesfor a self-employed individual?Is the self-employment tax in addition to or in lieu offederal income tax?Employee wages is the tax base for the Social Security and Medicare taxes.Netearnings from self-employment is the tax base for the self-employment tax.The self-employment tax is in addition to the federal income tax.17.[LO 4] What are unemployment taxes?Employers are required to pay federal and state unemployment taxes, which fundtemporary unemployment benefits for individuals terminated from their jobs withoutcause.The tax base for the unemployment taxes is wages or salary.18.[LO 4] What is the distinguishing feature of an excise tax?Excise taxes differ from other taxes in that the tax base on excise taxes is typicallybased on the quantity of an item or service purchased.The federal governmentimposes a number of excise taxes on goods such as alcohol, diesel fuel, gasoline,tobacco products and services such as telephone services.In addition, states alsooften impose excise taxes on these same items.19.[LO 4] What are some of the taxes that currently are unique to state and localgovernments?What are some of the taxes that the federal, state, and localgovernments each utilize?The sales, use, and property (personal, real, intangible) taxes are unique to state and

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Solutions Manual–McGraw-Hill’s Taxation,by Spilker et al.local governments.Taxes that are common among the federal, state, and localgovernments include income taxes, excise taxes, and estate and gift taxes.20.[LO 4] The state of Georgia recently increased its tax on a pack of cigarettes by$2.00.What type of tax is this?Why might Georgia choose this type of tax?The cigarette tax is both considered an excise tax (i.e., a tax based on quantitypurchased) and a “sin” tax (i.e., a tax on goods that are deemed to be sociallyundesirable).Georgia may choose this type of tax to discourage smoking and becausesin taxes are often viewed as acceptable ways of increasing tax revenues.21.[LO 4] What is the difference between a sales tax and a use tax?The tax base for sales taxes is retail sales of goods (and some services).The tax basefor the use tax is the retail price of goodsowned, possessed or consumed within astate that were not purchased within the state (e.g., goods purchased over theinternet).22.[LO 4] What is anad valoremtax?Name an example of this type of tax.An ad valorem tax is a tax based on the fair market value of property.Real andpersonal property taxes are examples of ad valorem taxes.23.[LO 4] What are the differences between an explicit and an implicit tax?Anexplicit tax is a tax that is directly imposed by a government unit and easilyquantified.Implicit taxes arethe reduced rates ofpretaxreturn that a tax-favoredasset produces (e.g., the lowerpretaxrate of return earned by tax exempt municipalbonds).Although implicit taxes are real and equally important in understanding ourtax system, they are difficult to quantify.24.[LO 4]Whenwecalculate average and effective tax rates,do we considerimplicittaxes?What effect does this have on taxpayers’ perception of equity?Implicit taxes are very difficult to quantify and thus, are generally not consideredwhen calculating average and effective tax rates.Since implicit taxes are ignored inthese calculations, taxpayers may conclude that groups of taxpayers investing in taxadvantaged assets (subject to implicit tax) do not pay their fair share of tax asrepresented by a low effective tax rate.25.[LO 4]Benjaminrecently bought a truck in Alabama for his business in Georgia.What different types of federal and state taxes may affect this transaction?

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Solutions Manual–McGraw-Hill’s Taxation,by Spilker et al.Benjaminwill have to pay state sales tax in Alabama for thetruckpurchased.Assuming thevehiclewill be registered in Georgia,Benjaminwill have to pay use taxon the purchase at a rate representing any difference in the Alabama sales tax rateand the Georgia use tax rate.Benjaminwill also have to pay personal property taxannually on thetruck.Finally, since thevehicleis used inBenjamin’sbusiness, hewill be able to depreciate thetruckfor federal income tax purposes.26.[LO 5]Kobestrongly dislikes SUVs and is appalled that so many are on the road.Heproposes to eliminate the federal income tax and replace it with a $50,000 annual taxper SUV.Based on the number of SUVs currently owned in the UnitedStates, heestimates the tax will generate exactly the amount of tax revenue currently collectedfrom the income tax.What is wrong withKobe’sproposal?What type of forecastingisKobelikely using?Kobe’sforecast is based on static forecasting (i.e., he is ignoring how taxpayers mayalter their activities in response to the tax law change).Given that taxpayers arelikely to substitute purchases of other vehicles for SUVs (i.e., the substitution effect),Kobe’sproposal is likely to result in a large discrepancy in projected and actual taxrevenues.27.[LO 5] What is the difference between the income and substitution effects?For whichtypes of taxpayers is the income effect more likely descriptive?For which types oftaxpayers is the substitution effect more likely descriptive?Theincome effectpredicts that when taxpayers are taxed more (e.g., tax rateincreases from 25 to 28 percent), they will work harder to generate the same after-taxdollars.Thesubstitution effectpredicts that when taxpayers are taxed more, they willsubstitute nontaxable activities (e.g., leisure activities) for taxable activities becausethe marginal value of taxable activities has decreased.The income effect is likely tobe more descriptive for taxpayers with insufficient income to meet their necessities,etc. for their desired standard ofliving.The substitution effect is likely to be moredescriptive for taxpayers with sufficient income to meet their necessities and tosustain their desired standard of living.28.[LO 5] What is the difference between horizontal and vertical equity?How do taxpreferences affect people’s view of horizontal equity?Horizontal equity means that two taxpayers in similar situations pay the same tax.Vertical equity is achieved when taxpayers with greater ability to pay tax, pay moretax relative to taxpayers with a lesser ability to pay tax.One can view vertical equityin terms of tax dollars paid or in terms of tax rates.Proponents of a flat income tax orsales tax (i.e., proportional tax rate structures) are more likely to argue that verticalequity is achieved when taxpayers with a greater ability to pay tax, pay more in tax

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Solutions Manual–McGraw-Hill’s Taxation,by Spilker et al.dollars.Proponents of a progressive tax system are more likely to argue thattaxpayers with a greater ability to pay should be subject to a higher tax rate.Governmental units provide tax preferences for a variety of reasons–e.g., encourageinvestment, social objectives, etc.Whether one views these tax preferences asappropriate or not, greatly influences whether one considers a tax system to be fair ingeneral and specifically, horizontally equitable.Specifically, if one views a taxpreference as being inappropriate, this would adversely affect one’s view ofhorizontal equity.29.[LO 3,LO 5]Montelargues that a flat income tax rate system is vertically equitable.Oprahargues that a progressive tax rate structure is vertically equitable.How do theirarguments differ?Who is correct?Vertical equity is achieved when taxpayers with greater ability to pay tax, pay moretax relative to taxpayers with a lesser ability to pay tax.One can view vertical equityin terms of tax dollars paid or in terms of tax rates.Proponents of a flat income tax orsales tax (i.e., proportional tax rate structures) are more likely to argue that verticalequity is achieved when taxpayers with a greater ability to pay tax, pay more in taxdollars.Proponents of a progressive tax system are more likely to argue thattaxpayers with a greater ability to pay should be subject to a higher tax rate.Thisview is based upon the argument that the relative burden of a flat tax rate decreasesas a taxpayer’s income (e.g., disposable income) increases.Which is the correctanswer?There is no correct answer.Nonetheless, many feel very strongly regardingone view or the other.30.[LO 3,LO 5] Discuss why evaluating vertical equity simply based on tax ratestructure may be less than optimal.Although tax rate structures can be used, in part, to assess vertical equity, focusingon the tax rate structure solely ignores the role that the tax base plays in determiningvertical equity.Indeed, focusing on the tax rate structure in evaluating a tax system isappropriate only if the tax base chosen (e.g., taxable income, purchases, propertyowned, etc.) accurately portrays a taxpayer’s ability to pay.This can be a ratherstrong assumption.Consider the sales tax.Although taxable purchases typicallyincrease as taxpayers’ total incomes increase, total incomes typically increase at amuch faster rate than taxable purchases.Thus, the gap between taxable purchasesand total income widens as total income increases.The end result is that the effectivetax rates for those with a greater ability to pay are lower than those taxpayers with alesser ability to pay.Regressive tax rate structures are generally considered not tosatisfy vertical equity (unless one is a strong advocate of the belief that those with agreater ability to pay simply should be paying a higher tax, albeit at a lower rate).Insum, evaluating vertical equity in terms of effective tax rates may be much more

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Solutions Manual–McGraw-Hill’s Taxation,by Spilker et al.informative than simply an evaluation of tax rate structures.31.[LO 4,LO 5] Compare the federal income tax to sales taxes using the “certainty”criterion.Certaintymeans that taxpayers should be able to determine when to pay the tax,where to pay the tax, andhow to determine the tax.It is relatively easy to determinewhen and where to pay the federal income tax and sales taxes.For example,individual federal income tax returns and the remaining balance of taxes owed mustbe filed with the Internal Revenue Service each year on or before April 15th(or thefirst business day following April 15th).Likewise, sales taxes are paid to retailerswhen items are purchased, and property taxes are typically paid annually to localgovernments.The ease of “how to determine the tax,” however, varies by tax system.Sales taxes are determined with relative ease–i.e., they are based on the value oftaxable purchases.In contrast, income taxes are often criticized as being complex.What are taxable/nontaxable forms of income?What are deductible/nondeductibleexpenses?When should income or expense be reported?For many taxpayers (e.g.,wage earners with few investments), the answers to these questions arestraightforward.For other taxpayers (e.g., business owners, individuals with a lot ofinvestments), the answers to these questions are nontrivial.Constant tax law changesenacted by Congress also add to the difficulty in determining the proper amount ofincome tax to pay.These changes can make it difficult to determine a taxpayer’scurrent tax liability much less plan for the future.32.[LO 5] Many years ago a famous member of Congress proposed eliminating federalincome tax withholding.What criterion for evaluating tax systems did this proposalviolate?What would likely have been the result of eliminating withholding?Eliminating withholding would violate the convenience criterion–i.e., a tax systemshould be designed to facilitate the collection of tax revenues without undue hardshipon the taxpayer or the government (i.e., a tax system should make collection as easyas possible).Eliminating withholding would most likely have slowed collection oftaxes and increased taxpayer aggressiveness (or tax evasion).Prior researchsuggests that taxpayers are more likely to take more aggressive tax positions whenthey owe additional taxes when filing their return.33.[LO 5] “The federal income tax scores very high on the economy criterion becausethe current IRS budget is relatively low compared to the costs of a typical collectionagency.”Explain why this statement may be considered wrong.This statement ignores the economy criterion from the taxpayer’s perspective.Theincome tax is often criticized for the compliance costs imposed on the taxpayer.Indeed, for certain taxpayers, record-keeping costs, accountant fees, attorney fees,

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Solutions Manual–McGraw-Hill’s Taxation,by Spilker et al.etc. can be quite substantial.Advocates of alternative tax systems often challenge theincome tax on this criterion.Problems34.[LO 3]Chuck, a single taxpayer, earns $75,000 in taxable income and $10,000 ininterest from an investment in City of Heflinbonds.Using the U.S. tax rate schedule,how much federal tax will he owe?What is his average tax rate?What is his effectivetax rate?What is his current marginal tax rate?Chuckwill owe $14,521.25in federal income tax this year computed as follows:$14,521.25 = $5,183.75+ 25%($75,000−$37,650).Chuck’saverage tax rate is19.36.Average Tax Rate =omeTaxableIncTotalTax=000,75$25.521,14$=19.36%Chuck’seffective tax rate is 17.08percent.Effective tax rate =eTotalIncomTotalTax=)000,10$000,75($25.521,14$+= 17.08%Chuckis currently in the 25percenttax rate bracket.His marginal tax rate onincreases in incomeup to $16,150and deductionsfrom income up to $37,350is 25percent.35.[LO 3] Using the facts in the previous problem, ifChuckearns an additional $40,000of taxable income, what is his marginal tax rate on this income?What is his marginalrateif, instead,hehad $40,000 of additional deductions?IfChuckearns an additional $40,000 of taxable income, his marginal tax rate on theincome is 26.79percent.Marginal Tax Rate =TaxTaxableIncome=)000,75$000,115($)25.521,14$75.236,25($−−= 26.79%IfChuckinstead had $40,000 of additional tax deductions, his marginal tax rateonthe deductions would be 24.34percent.

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Solutions Manual–McGraw-Hill’s Taxation,by Spilker et al.Marginal Tax Rate =TaxTaxableIncome=)000,75$000,35($)25.521,14$25.786,4($−−= 24.34%36.[LO 3] In reviewing the tax rate schedule for a single taxpayer,Chucknotes that thetax on $75,000 is $5,183.75plus 25percentof the taxable income over $37,650.What does the $5,183.75represent?The $5,183.75represents the income tax on $37,650–i.e., $927.50+ 15% ($37,650–$9,275).37.[LO 3]Campbell, a single taxpayer, earns $400,000 in taxable income and $2,000 ininterest from an investment inStateof New York bonds.Using the U.S. tax rateschedule, how much federal tax will she owe?What is her average tax rate?What isher effective tax rate?What is her current marginal tax rate?Campbellwill owe $115,529.25in federal income tax this year computed as follows:$115,529.25= $46,278.75+ 33%×($400,000 −$190,150).Campbell’s average tax rate is28.88percent.Average Tax Rate =omeTaxableIncTotalTax=000,400$25.529,115$=28.88Campbell’s effective tax rate is28.74percent.Effective tax rate =eTotalIncomTotalTax=)000,2$000,400($25.529,115$+= 28.74Campbellis currently in the 33percenttax rate bracket. Her marginal tax rate ondeductions up to $209,850 will be33percent. However, hermarginal tax rate on thenext $13,350 ofincomewill be 33%,and income earned over $413,350will be35percent.Income earned in excess of $415,050 will be taxed at 39.6%.38.[LO 3] Using the facts in the previous problem, ifCampbellearns an additional$15,000 of taxable income, what is her marginal tax rate on this income?What is hermarginal rate if, instead, she had $15,000 of additional deductions?IfCampbellearns an additional $15,000 of taxable income, hermarginal tax rate onthe income is 33.22percent.

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Solutions Manual–McGraw-Hill’s Taxation,by Spilker et al.Marginal Tax Rate =TaxTaxableIncome=)000,400$000,415($)25.529,115$95.512,120($−−= 33.22%IfCampbellinstead had $15,000 of additional tax deductions, hermarginal tax rateon the deductions would be 33.00percent.Marginal Tax Rate =TaxTaxableIncome=)000,400$000,385($)25.529,115$25.579,110($−−=33.00%39.[LO 3]JorgeandAnita, married taxpayers, earn $150,000 in taxable income and$40,000 in interest from an investment inCityof Heflin bonds.Using the U.S. taxrate schedule for married filing jointly, how much federal tax will they owe?What istheir average tax rate?What is their effective tax rate?What is their current marginaltax rate?JorgeandAnitawill owe $29,042.50in federal income tax this year computed asfollows:$29,042.50 = $10,367.50+ 25%($150,000−$75,300).JorgeandAnita’saverage tax rate is 19.36percent.Average Tax Rate =omeTaxableIncTotalTax=000,150$50.042,29$= 19.36%JorgeandAnita’seffective tax rate is 15.29percent.Effective tax rate =eTotalIncomTotalTax=)000,40$000,150($50.042,29$+= 15.29%JorgeandAnitaare currently in the 25percenttax rate bracket.Theirmarginal taxrate on increasesofincomeup to $1,900and deductionsup to $74,700is 25percent.40.[LO 3]Using the facts in the previous problem, if Jorge and Anita earn anadditional$100,000 of taxable income, what is their marginal tax rate on this income?What istheir marginal rate if, instead, they reported an additional $100,000 in deductions?IfJorgeandAnitaearn an additional $100,000 of taxable income, their marginal taxrate on the income is28.87percent.

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Solutions Manual–McGraw-Hill’s Taxation,by Spilker et al.Marginal Tax Rate =TaxTaxableIncome=)000,150$000,250($)50.042,29$913,57($−−=28.87%IfJorgeandAnitainstead had $100,000 of additional tax deductions, their marginaltax rate on the deductions would be 22.47percent.Marginal Tax Rate =omeTaxableIncTax=)000,150$000,50($)50.042,29$50.572,6($−−= 22.47%41.[LO 3]In reviewing the tax rate schedule for married filing jointly,JorgeandAnitanote that the tax on $155,000 is $29,517.50plus 28percentof the taxable incomeover $151,900.What does the $29,517.50represent?The $29,517.50represents the income tax on $151,900–i.e., $10,367.50+25%($151,900–75,300).42.[LO 3]Scotand Vidia, married taxpayers, earn $240,000 in taxable income and$5,000 in interest from an investment inCityof Tampa bonds.Using the U.S. tax rateschedule for married filingjointly, how much federal tax will they owe?What is theiraverage tax rate?What is their effective tax rate?What is their current marginal taxrate?Scot and Vidia will owe $54,613in federal income tax this year computed as follows:$54,613 = $51,791.50+ 33%($240,000−$231,450).Scot and Vidia’s average tax rate is 22.76percent.Average Tax Rate =omeTaxableIncTotalTax=000,240$613,54$=22.76%Scot and Vidia’s effective tax rate is 22.29percent.Effective tax rate =eTotalIncomTotalTax=)000,5$000,240($613,54$+= 22.29%Scot and Vidia are currently in the 33percenttax rate bracket.Their marginal taxrate on increases in incomeup to $173,350and deductionsup to $8,550is 33percent.

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Solutions Manual–McGraw-Hill’s Taxation,by Spilker et al.43.[LO3] Using the facts in the previous problem, if Scot and Vidia earn an additional$70,000 of taxable income, what is their marginal tax rate on this income?Howwould your answer differ if they, instead, had $70,000 of additional deductions?If Scot and Vidia earn an additional $70,000 of taxable income, their marginaltaxrate on the income is 33 percent.Marginal Tax Rate =TaxTaxableIncome=)000,240$000,310($)613,54$713,77($−−= 33%If Scot and Vidia instead had $70,000 of additional tax deductions, their marginal taxrate on the deductions would be28.61percent.Marginal Tax Rate =TaxTaxableIncome=)000,240$000,170($)613,54$50.585,34($−−=28.61%44.[LO 3,LO 4]Melindainvests $200,000 in aCityof Heflin bond that pays 6percentinterest.Alternatively,Melindacould have invested the $200,000 in a bond recentlyissued by Surething, Inc. that pays 8percentinterest with similarrisk and othernontaxcharacteristicstotheCityof Heflin bond.AssumeMelinda’smarginal tax rateis 25percent.a.What is her after-tax rate of return for theCityof Heflin bond?Since theCityof Heflin bond is a tax exempt bond,Melinda’safter tax rate ofreturn on the bond is equal to itspretaxrate of return (6percent).b.How much explicit tax doesMelindapay on theCityof Heflin bond?Since theCityof Heflin bond is a tax exempt bond,Melindapays no explicit taxon the interest earned from theCityof Heflin bond.c.How much implicit tax does she pay on theCityof Heflin bond?Melindaearns $12,000 of interest on theCityof Heflin bond (i.e., 6%×$200,000).A similar priced taxable bond (i.e., the Surething, Inc. bond) wouldpay $16,000of taxable interest (i.e., 8% ×$200,000).Melindapays $4,000 ofimplicit tax on theCityof Heflin bond (i.e., the difference between thepretaxinterest earned from a similar taxable bond ($16,000) and thepretaxinterestearned from theCityof Heflin bond ($12,000)).d.How much explicit tax would she have paid on the Surething, Inc. bond?SinceMelinda’smarginal tax rate is 25percent, she would have paid $4,000 of

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Solutions Manual–McGraw-Hill’s Taxation,by Spilker et al.explicit tax (i.e., 25% ×$16,000) on the interest earned from the Surething, Inc.bond.e.What is her after-tax rate of return on the Surething, Inc. bond?Her after-tax incomefrom the Surething, Inc. bond would be$12,000 ($16,000interest income −$4,000 tax).Thus, her after-tax returnfrom the Surething, Inc.bond would be6percent(after-tax income of $12,000 divided by her $200,000investment).45.[LO 3,LO 4]{Planning}Hughhas the choice between investing in aCityof Heflinbond at 6percentor a Surething bond at 9percent.Assuming that both bonds havethe samenontaxcharacteristics and thatHughhas a 40percentmarginal tax rate, inwhich bond should he invest?Hugh’safter tax rate of return on the tax exemptCityof Heflin bond is 6percent.TheSurething bond pays taxable interest of 9percent.Hugh’s after tax rate of return onthe Surething bond is 5.4percent(i.e., 9% interest income–(9% ×40%) tax = 5.4%).Hughshould invest in theCityof Heflin bond.46.[LO 3,LO 4]{Planning}Using the facts in the previous problem, what interest ratedoes Surething, Inc. need to offer to makeHughindifferent between investing in thetwo bonds?To be indifferent between investing in the two bonds, the Surething, Inc. bond shouldprovideHughthe same after-tax rate of return as theCityof Heflin bond (6percent).To solve for the requiredpretaxrate of return we can use the following formula:After-tax return =Pretaxreturn ×(1–Marginal Tax Rate).Surething, Inc. needs to offer a 10percentinterest rate to generate a 6percentafter-tax return and makeHughindifferent between investing in the two bonds–i.e.,6% =Pretaxreturn×(1–40%);Pretaxreturn = 6% / (1–40%) = 10%47.[LO 3,LO 4]{Planning}Fergiehas the choice between investing in aStateof NewYork bond at 5percentand a Surething bond at 8percent.Assuming that both bondshave the samenontaxcharacteristics and thatFergiehas a 30percentmarginal taxrate, in which bond should she invest?Fergie’safter tax rate of return on the tax exemptStateof New York bond is 5percent.The Surething bond pays taxable interest of 8percent.Fergie’s after tax rateofreturn on the Surething bond is 5.6percent(i.e., 8% interest income–(8%×30%)

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