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PERSONAL TAX

Table A.6 shows the U.S. rates of personal tax. Notice that as income increases the tax rate also increases. Notice also that the top personal tax rate is higher than the top corporaterate.

The tax rates presented in Table A.6 are marginal tax rates. The marginal tax rate is the tax that the individual pays on each extra dollar of income. For example, as a single taxpayer, you would pay 15 cents of tax on each extra dollar you earn when your income is below $25,750, but once income exceeds $25,750, you would pay 28 cents of tax on each dollar of income up to an income of $62,450. For example, if your total income is $40,000, your tax bill is 15 percent of the first $25,750 of income and 28 percent of the remaining $14,250:

Tax = (.15 $25,750) + (.28 $14,250) = $7,852.50

The average tax rate is simply the total tax bill divided by total income. In this example it is $7,852.50/$40,000 = .196 = 19.6 percent. Notice that the average rate is below the marginal rate. This is because of the lower rate on the first $25,750.

Financial managers need to worry about personal tax rates because the dividends and interest payments that companies make to individuals are both subject to tax at the rates shown in Table A.6. If these payments are heavily taxed, individuals will be more reluctant to buy the company`s shares or bonds. Remember that each dollar of income that the company earns is taxed at the corporate tax rate. If the company then pays a dividend out of this after-tax income, the shareholder also pays personal income tax on the dividend. Thus income that is paid out as dividends is taxed twice, once in the hands of the firm and once in the hands of the shareholder. Suppose instead that the company earns a dollar which is then paid out as interest. This dollar escapes corporate tax, but an individual who receives the interest must pay personal tax.

Capital gains are also taxed, but only when the capital gains are realized. For example, suppose that you bought Bio-technics stock when it was selling for 10 cents a share. Its market price is now $1 a share. As long as you hold onto your stock, there is no tax to pay on your gain. But if you sell, the 90 cents of capital gain is taxed. The marginal tax rate on capital gains for most shareholders is 20 percent.

The tax rates in Table A.6 apply to individuals. But financial institutions are major investors in shares and bonds. These institutions often have special rates of tax. For example, pension funds, which hold huge numbers of shares, are not taxed on either dividend income or capital gains.

MARGINAL TAX RATE

Additional taxes owed per dollar of additional income.

AVERAGE TAX RATE

Total taxes owed divided by total income.