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Solutions Manual for McGraw Hill's Taxation of Individuals and Business Entities, 2024 Edition, Spilker, 15th Edition

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SOLUTIONS
MANUAL

P E R F E C T • A C E

, Solutions Manual—Taxation of Individuals and Business Entities, by Spilker et al.

Chapter 1
An Introduction to Tax

SOLUTIONS MANUAL

Discussion Questions

(1) [LO 1] Jessica’s friend Zachary once stated that he couldn’t understand why
someone would take a tax course. Why is this a rather naïve view?

Taxes are a part of everyday life and have a financial effect on many of the major
personal decisions that individuals face (e.g., investment decisions, evaluating
alternative job offers, saving for education expenses, gift or estate planning, etc.).

(2) [LO 1] What are some aspects of business that require knowledge of taxation?
What are some aspects of personal finance that require knowledge of taxation?

Taxes play an important role in fundamental business decisions such as the
following:
 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
a transaction.

Common personal financial decisions that taxes influence include: choosing
investments, retirement planning, choosing to rent or buy a home, evaluating
alternative job offers, saving for education expenses, and doing gift or estate
planning.

(3) [LO 1] Describe some ways in which taxes affect the political process in the
United States.

U.S. presidential candidates often distinguish themselves from their opponents
based upon their tax rhetoric. Likewise, the major political parties generally have
very diverse views of the appropriate way to tax the public. Determining who is
taxed, what is taxed, and how much is taxed are difficult questions. Voters must
have a basic understanding of taxes to evaluate the merits of alternative tax

, Solutions Manual—Taxation of Individuals and Business Entities, by Spilker et al.

proposals offered by opposing political candidates and their political parties.

(4) [LO 2] Courtney recently received a speeding ticket on her way to the university.
Her fine 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
or penalty. Taxes differ from fines and penalties because taxes are not intended
to punish or prevent illegal behavior.

(5) [LO 2] Marlon and Latoya recently started building a house. They had to pay
$300 to the county government for a building permit. Is the $300 payment a tax?
Why or why not?

The building permit is not considered a tax because $300 payment is directly
linked to 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, the city of Birmingham recently
enacted a 1 percent surcharge on hotel rooms. Is this a tax? Why or why not?

The 1 percent surcharge is a tax. The 1 percent surcharge is an earmarked tax –
i.e., collected for a specific purpose. The surcharge is considered a tax because
the tax payments made by taxpayers do not directly relate to the specific benefit
received by the taxpayers.

(7) [LO 2] As noted in Example 1-2, tolls, parking meter fees, and annual licensing
fees are not considered taxes. Can you identify other fees that are similar?

There are several possible answers to this question. Some common examples
include entrance fees to national parks, tag fees paid to local/state government
for automobiles, boats, etc.

(8) [LO 2] If the general objective of our tax system is to raise revenue, why does the
income tax allow deductions for charitable contributions and retirement plan
contributions?

In addition to the general objective of raising revenue, Congress uses the federal
tax system to encourage certain behavior and discourage other behavior. The
charitable contribution deduction is intended to encourage taxpayers to support
the initiatives of charitable organizations, whereas deductions for retirement
contributions are intended to encourage retirement savings. Another objective of
the tax system is to redistribute wealth.

(9) [LO 2] One common argument for imposing so-called sin taxes is the social goal
of reducing demand for such products. Using cigarettes as an example, is there a

, Solutions Manual—Taxation of Individuals and Business Entities, by Spilker et al.

segment of the population that might be sensitive to price and for whom high
taxes might discourage purchases?

The most obvious segment sensitive to price may be teenagers and younger adults
that typically have less disposable income, although price sensitivity or elasticity
will vary by taxpayer.

(10) [LO 3] Dontae stated that he didn’t want to earn any more money because it
would “put him in a higher tax bracket.” What is wrong with Dontae’s
reasoning?

Although earning additional taxable income may increase Dontae’s marginal tax
rate (i.e., put him in a higher tax bracket), the additional income earned does not
affect the taxes that Dontae will pay on his existing income. Moving to a higher
tax bracket simply means that Dontae will pay a higher tax rate on the additional
income earned (not on the income that he already has).

(11) [LO 3] Describe the three different tax rates discussed in the chapter and how
taxpayers might use them.

The marginal tax rate is the tax rate that applies to the taxpayer’s additional
taxable income or deductions that the taxpayer is evaluating in a decision.
Specifically,

Δ Tax (NewTotalTax  OldTotalT ax )
M argin al Tax Rate  
Δ TaxableIncome (N ewTaxab l eIn co me  OldTaxableIncom e )

The marginal tax rate is particularly useful in tax planning because it represents
the rate of taxation or savings that would apply to additional taxable income or
tax deductions.

The average tax rate represents the taxpayer’s average level of taxation on each
dollar of taxable income. Specifically,

TotalTax
Average Tax Rate =
TaxableIncome

The average 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).

The effective tax rate represents the taxpayer’s average rate of taxation on each
dollar of total income (i.e., taxable and nontaxable income). Specifically,

, Solutions Manual—Taxation of Individuals and Business Entities, by Spilker et al.

Total Tax
Effective Tax Rate =
Total Income

The effective tax rate provides a depiction of a taxpayer’s tax burden because it
depicts the taxpayer’s total tax paid as a ratio of the sum 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 a taxpayer’s tax burden because it depicts the taxpayer’s total tax paid as a
ratio of the sum of both taxable and nontaxable income earned.

(13) [LO 3] Describe the differences between a proportional, progressive, and
regressive tax rate structure.

A proportional (flat) tax rate structure imposes a constant tax rate throughout the
tax base. In other words, as the tax base increases, the taxes paid increases, but
the marginal tax rate remains constant. Because the marginal tax rate is constant
across all levels of the tax base, the average tax rate remains constant across the
tax base and always equals the marginal tax rate. Common examples of
proportional taxes include sales taxes and excise taxes (i.e., taxes based on
quantity such as gallons of gas purchased).

A progressive tax rate structure imposes an increasing marginal tax rate as the
tax base increases. In other words, as the tax base increases, both the marginal
tax rate and the taxes paid increase. Common examples of progressive tax rate
structures include federal and most state income taxes and federal estate and gift
taxes.

A regressive tax rate structure imposes a decreasing marginal tax rate as the tax
base increases. In other words, as the tax base increases, the taxes paid
increases, but the marginal tax rate decreases. Regressive tax rate structures are
not common. In the United States, the Social Security tax and the federal
employment tax employ a regressive tax rate structure. However, there are other
regressive taxes when the tax is viewed in terms of effective tax rates. For
example, 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) remains constant.
Nonetheless, when you consider that the proportion of your total income spent on
taxable purchases likely decreases as your total income increases, you can see the
sale tax as a regressive tax.

(14) [LO 3] Arnold and Lilly recently had a discussion about whether a sales tax is a
proportional tax or a regressive tax. Arnold argued that a sales tax is regressive.
Lilly countered that the sales tax is a flat tax. Who was correct?

, Solutions Manual—Taxation of Individuals and Business Entities, by Spilker et al.

Arnold and Lilly were 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)
remains constant. For this reason, Arnold was correct. Nonetheless, when you
consider that the proportion of one’s total income spent on taxable purchases
likely decreases as total income increases, the sales tax may be considered a
regressive tax. A good example of this is food. Although higher-income taxpayers
may pay more for food than lower-income taxpayers, higher-income taxpayers
spend a smaller percentage of their income on food—this is why many states
exempt food from the sales tax base—because of its regressive nature. For this
reason, Lilly was correct.

(15) [LO 4] Which is the largest tax collected by the U.S. government? What types
of taxpayers 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 an
employee or employer? What is the tax base for Social Security and Medicare
taxes for a self-employed individual? Is the self-employment tax in addition to or
in lieu of federal income tax?

Employee wages is the tax base for the Social Security and Medicare taxes. Net
earnings from self-employment is the tax base for the self-employment tax. The
self-employment tax is in addition to the federal income tax. The same is true for
employment taxes—they are 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 fund
temporary unemployment benefits for individuals terminated from their jobs
without cause. 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 typically
based on the quantity of an item or service purchased. The federal government
imposes a number of excise taxes on goods such as alcohol, diesel fuel, gasoline,
tobacco products and services such as telephone services. In addition, states also
often impose excise taxes on these same items.

, Solutions Manual—Taxation of Individuals and Business Entities, by Spilker et al.

(19) [LO 4] What are some of the taxes that currently are unique to state and local
governments? What are some of the taxes that the federal, state, and local
governments each utilize?

The sales, use, and property (personal, real, intangible) taxes are unique to state
and local governments. Taxes that are common among the federal, state, and
local governments 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. 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 quantity
purchased) and a “sin” tax (i.e., a tax on goods that are deemed to be socially
undesirable). Georgia may choose this type of tax to discourage smoking and
because sin 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
base for the use tax is the retail price of goods owned, possessed or consumed
within a state that were not purchased within the state (e.g., goods purchased
over the internet). The prevalence of the use tax has significantly declined since
economic nexus for sales taxes was found to be constitutional (see State and
Local Taxes chapter for a discussion).

(22) [LO 4] What is an ad valorem tax? Name an example of this type of tax.

An ad valorem tax is a tax based on the fair market value of property. Real and
personal property taxes are examples of ad valorem taxes.

(23) [LO 4] What are the differences between an explicit and an implicit tax?

An explicit tax is a tax that is directly imposed by a government unit and easily
quantified. Implicit taxes are the reduced rates of pretax return that a tax-favored
asset produces (e.g., the lower pretax rate of return earned by tax exempt
municipal bonds). Although implicit taxes are real and equally important in
understanding our tax system, they are difficult to quantify.

(24) [LO 4] When we calculate average and effective tax rates, do we consider
implicit taxes? What effect does this have on taxpayers’ perception of equity?

Implicit taxes are very difficult to quantify and thus, are generally not considered
when calculating average and effective tax rates. Since implicit taxes are ignored
in these calculations, taxpayers may conclude that groups of taxpayers investing

, Solutions Manual—Taxation of Individuals and Business Entities, by Spilker et al.

in tax advantaged assets (subject to implicit tax) do not pay their fair share of tax
as represented by a low effective tax rate.

(25) [LO 4] Benjamin recently bought a truck in Alabama for his business in
Georgia. What different types of federal and state taxes may affect this
transaction?

Benjamin will have to pay state sales tax in Alabama for the truck purchased.
However, some states only charge sales tax when the purchased vehicle is
registered. Assuming Alabama sales tax was charged, when the vehicle is
registered in Georgia, Benjamin will have to pay use tax on the purchase at a rate
representing any difference in the Alabama sales tax rate and the Georgia use tax
rate. Benjamin will also have to pay personal property tax annually on the truck.
Finally, since the vehicle is used in Benjamin’s business, he will be able to
depreciate the truck for federal income tax purposes.

(26) [LO 5] Kobe strongly dislikes SUVs and is appalled that so many are on the
road. He proposes to eliminate the federal income tax and replace it with a
$50,000 annual tax per SUV. Based on the number of SUVs currently owned in
the United States, he estimates the tax will generate exactly the amount of tax
revenue currently collected from the income tax. What is wrong with Kobe’s
proposal? What type of forecasting is Kobe likely using?

Kobe’s forecast is based on static forecasting (i.e., he is ignoring how taxpayers
may alter their activities in response to the tax law change). Given that taxpayers
are likely to substitute purchases of other vehicles for SUVs (i.e., the substitution
effect), Kobe’s proposal is likely to result in a large discrepancy in projected and
actual tax revenues since taxpayers will likely purchase fewer SUVs that are
subject to the tax.

(27) [LO 5] What is the difference between the income and substitution effects? For
which types of taxpayers is the income effect more likely descriptive? For which
types of taxpayers is the substitution effect more likely descriptive?

The income effect predicts that when taxpayers are taxed more (e.g., tax rate
increases from 22 to 24 percent), they will work harder to generate the same
after-tax dollars. The substitution effect predicts that when taxpayers are taxed
more, they will substitute nontaxable activities (e.g., leisure activities) for taxable
activities because the marginal value of taxable activities has decreased. The
income effect is likely to be more descriptive for taxpayers with insufficient
income to meet their necessities, etc. for their desired standard of living. The
substitution effect is likely to be more descriptive for taxpayers with sufficient
income to meet their necessities and to sustain their desired standard of living.

, Solutions Manual—Taxation of Individuals and Business Entities, by Spilker et al.

(28) [LO 5] What is the difference between horizontal and vertical equity? How do
tax preferences 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
more tax relative to taxpayers with a lesser ability to pay tax. One can view
vertical equity in terms of tax dollars paid or in terms of tax rates.

Governmental units provide tax preferences for a variety of reasons – e.g.,
encourage investment, social objectives, etc. For example, a deduction for
mortgage interest paid which encourages home ownership. Whether one views
these tax preferences as appropriate or not, greatly influences whether one
considers a tax system to be fair in general and specifically, horizontally
equitable. Specifically, if one views a tax preference as being inappropriate, this
would adversely affect one’s view of horizontal equity.

(29) [LO 3, LO 5] Montel argues that a flat income tax rate system is vertically
equitable. Oprah argues that a progressive tax rate structure is vertically equitable.
How do their arguments differ? Who is correct?

Vertical equity is achieved when taxpayers with greater ability to pay tax, pay
more tax relative to taxpayers with a lesser ability to pay tax. One can view
vertical equity in terms of tax dollars paid or in terms of tax rates. Proponents of
a flat income tax or sales tax (i.e., proportional tax rate structures) are more
likely to argue that vertical equity is achieved when taxpayers with a greater
ability to pay tax, pay more in tax dollars. Proponents of a progressive tax
system are more likely to argue that taxpayers with a greater ability to pay should
be subject to a higher tax rate. This view is based upon the argument that the
relative burden of a flat tax rate decreases as a taxpayer’s income (e.g.,
disposable income) increases. Which is the correct answer? There is no correct
answer. Nonetheless, many feel very strongly regarding one view or the other.

(30) [LO 3, LO 5] Discuss why evaluating vertical equity simply based on tax rate
structure may be less than optimal.

Although tax rate structures can be used, in part, to assess vertical equity,
focusing on the tax rate structure solely ignores the role that the tax base plays in
determining vertical equity. Indeed, focusing on the tax rate structure in
evaluating a tax system is appropriate only if the tax base chosen (e.g., taxable
income, purchases, property owned, etc.) accurately portrays a taxpayer’s ability
to pay. This can be a rather strong assumption. Consider the sales tax. Although
taxable purchases typically increase as taxpayers’ total incomes increase, total
incomes typically increase at a much faster rate than taxable purchases. Thus, the
gap between taxable purchases and total income widens as total income

, Solutions Manual—Taxation of Individuals and Business Entities, by Spilker et al.

increases. The end result is that the effective tax rates for those with a greater
ability to pay are lower than those taxpayers with a lesser ability to pay.
Regressive tax rate structures are generally considered not to satisfy vertical
equity (unless one is a strong advocate of the belief that those with a greater
ability to pay simply should be paying a higher tax, albeit at a lower rate). In
sum, evaluating vertical equity in terms of effective tax rates may be much more
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.

Certainty means that taxpayers should be able to determine when to pay the tax,
where to pay the tax, and how to determine the tax. It is relatively easy to
determine when 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 must be filed with the Internal Revenue Service each year on or before
April 15th (or the first business day following April 15th if the 15th falls on a
weekend). Likewise, sales taxes are paid to retailers when items are purchased,
and property taxes are typically paid annually to local governments. 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 of taxable
purchases. In contrast, income taxes are often criticized as being complex. What
are taxable/nontaxable forms of income? What are deductible/nondeductible
expenses? When should income or expense be reported? For many taxpayers
(e.g., wage earners with few investments), the answers to these questions are
straightforward. For other taxpayers (e.g., business owners, individuals with a lot
of investments), the answers to these questions are nontrivial. Constant tax law
changes enacted by Congress also add to the difficulty in determining the proper
amount of income tax to pay. These changes can make it difficult to determine a
taxpayer’s current tax liability much less plan for the future.

(32) [LO 5] Many years ago a famous member of Congress proposed eliminating
federal income tax withholding. What criterion for evaluating tax systems did this
proposal violate? What would likely have been the result of eliminating
withholding?

Eliminating withholding would violate the convenience criterion – i.e., a tax
system should be designed to facilitate the collection of tax revenues without
undue hardship on the taxpayer or the government (i.e., a tax system should make
collection as easy as possible). Eliminating withholding would most likely have
slowed collection of taxes and increased taxpayer aggressiveness (or tax
evasion). Prior research suggests that taxpayers are more likely to take more
aggressive tax positions when they owe additional taxes when filing their return.

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