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There is a five-step procedure for analyzing the tax impacts on the investment:

1 Determine the investment’s tax classification.

2 Determine the investor’s tax status (i.e., form of business organization).

3 Estimate the investor’s marginal tax rate.

4 Forecast the taxable income resulting from operations and from the disposition (sale) of the investment

5 Using the investor’s marginal tax rate and the taxable income figures, compute the estimated taxes.

Once the tax consequences of the investment have been determined, they may be added to (in the case of a tax savings) or deducted from (in the case of a tax due) the before-tax cash flows (BTCFs) from operations and sale to derive the after tax cash flows (ATCFs) and after-tax equity reversion (ATER), respectively. To illustrate, we return to our apartment building example.

The ATCFs are of greatest interest to the investor because they are the actual net cash amounts the investor expects to receive after paying all expenses, including taxes.

These and other problems have contributed to the “welfare mess” and have led to frequent calls to scrap the whole system. Reformers seek a simple structure that would get income into the hands of the poor without destroying the incentive to work. The solution suggested most frequently by economists is the so-called negative income tax (NIT).

A particular NIT plan is defined by picking two numbers: a minimum income level below which no family is allowed to fall (the “guarantee”), and a rate at which benefits are “taxed away” as income rises. The table considers a plan with a $6000 guaranteed income (for a family of four) and a 50 percent tax rate. Thus, a family with no earnings (top row) would receive a $6000 payment (a “negative tax”) from the government. A family earning $2000 (second row) would have the basic benefit reduced by 50 percent of its earnings. Thus, since half its earnings is $1000, it would receive $5000 from the government plus the $2000 earned income for a total income of $7000.

Notice in Table 37-4 that, with a 50 percent tax rate, the increase in total income as earnings rise is always half of the increase in earnings. Thus, there is always some incentive to work. Notice also that there is a level of income at which benefits cease-$12,000 in this example. This “break-even” level of income is not a third number that policymakers can select in the way they select the guarantee and the tax rate. Rather, it is dictated by the other two choices. In our example, $6000 is the maximum possible benefit, and benefits are reduced by 50 cents for each $1 of earnings. Hence benefits will be reduced to zero when 50 percent of earnings is equal to $6000-which occurs when earnings are $12,000. The general relation is:

Guarantee = Tax rate x Break-even level.

The fact that the break-even level is completely determined by the guarantee and the tax rate creates a vexing problem. To make a real dent in the poverty problem, the guarantee will have to come fairly close to the poverty line. But then, any moderate tax rate will push the break-even level way above the poverty line. This means that families who are not considered “poor” (though they are certainly not rich) will also receive benefits. For example, a low tax rate of 333 percent means that some benefits are paid to families whose income is as high as three times the guarantee level.

But if we raise the tax rate to bring the guarantee and the break-even level closer together, the incentive to work shrinks, and with it the principal rationale for the NIT in the first place. So the NIT is no magic cure-all. Difficult choices must still be made.

Using cash flows as a basis for decision making. Two basic decision-making tools: traditional valuation methods and rules of thumb and ratios. Since traditional valuation methods and most ratios do not explicitly use after-tax figures in their analysis, here we cover only one commonly used rule of thumb along with new techniques called discounted cash flow models.

Rule of Thumb: The After-Tax Rate (ATR)

Operationally,
ATR = ATCF equity investment

For instance, the expected ATCF for our apartment building example was $1,860 for the first year, and the equity investment is the $140,000 price plus the acquisition costs ($1,500) and the financing costs ($2,240) less the $112,000 mortgage, or $31,740; the ATR then would be 5.86 percent. As a basis for decision making, the ATR is subject to the same limitations as the EDR.

There is a five-step procedure for analyzing the tax impacts on the investment:

1 Determine the investment’s tax classification.
2 Determine the investor’s tax status (i.e., form of business organization).
3 Estimate the investor’s marginal tax rate.
4 Forecast the taxable income resulting from operations and from the disposition (sale) of the investment
5 Using the investor’s marginal tax rate and the taxable income figures, compute the estimated taxes.

The tax on individual incomes traces its origins to the Sixteenth Amendment to the Constitution in 1913, but it was inconsequential until the beginning of World War II. Then the tax was raised substantially to finance the war, and it has been the major source of federal revenue ever since. The personal income tax has been at the top of the news since 1980. President Reagan made phased reductions in personal tax rates the cornerstone of his economic policy; the tax code was thoroughly rewritten in 1986; and President Bush has pledged not to increase taxes.

Many taxpayers have little or no tax to pay when the annual April 15th day of reckoning comes around, because income taxes are withheld from payrolls by employers and forwarded to the U.S. Treasury. In fact, many taxpayers are, “overwithheld” during the year and receive a refund check from Uncle Sam. Nevertheless, most taxpayers dread the arrival of their Form 1040 because of its legendary complexity.

The personal income tax is progressive. Average tax rates do indeed rise as income rises, but that progrcssivity nearly disappears at very high income levels. In a departure from past practice, the Tax Reform Act of 1986 made the income tax almost proportional beyond some point-about $200,000 for a family of four. However, few families have such high incomes; so most live under a progressive tax structure.

Two features are notable. First, they display a curious pattern-rising to a peak of 33 percent and then dropping back to 28 percent. This happens because Congress placed a special tax surcharge on incomes within certain ranges-for a family of four, between about $90,000 and about $200,000. Second, marginal income tax rates in the United States are now quite low, especially for high-income familiesfar lower than they used to be and much below those prevailing in other advanced countries.

The payroll tax may be thought of as an excise tax on the employment of labor. The U.S. payroll tax comes in two parts: half is levied on the employees (payroll deductions) and half on employers. A fundamental point, which people who have never studied economics often fail to grasp is that:

The incidence of a payroll tax is the same whether it is levied on employers or on employees.

A simple numerical example will illustrate why this is so. Consider an employee earning $100 a day with a 16 percent payroll tax that is shared equally between the employer and the employee, as under our present law. How much does it cost the firm to hire this worker? It costs $100 in wages paid to the worker plus $8 in taxes paid to the government, for a total of $108 a day. How much does the worker receive? He gets S100 in wages paid by the employer less $8 deducted and sent to the government, or $92 a day. The difference between wages paid and wages received is $108 - S92 = $16, the amount of the tax. . Now suppose Congress tries to “shift” the burden of the tax entirely onto firms by raising the employer’s tax to $16 while lowering the employee’s tax to zero. At first, the daily wage is fixed at $100, so firms’ total labor costs (including tax) rise to $116 per day and workers’ net income rises to $100 per day. Congress seems to have achieved its goal.

But the achievement is fleeting, for this is not an equilibrium situation. With the daily cost of labor at S116 for firms, the quantity of labor demanded will be less than when labor cost only $108 per day. Similarly, with take-home pay up to $100 for workers, the quantity of labor supplied will be more than when the after-tax wage was only $92. There will therefore be a surplus of labor on the market (an excess of quantity supplied over quantity demanded), and this surplus will put downward pressure on wages.

How far will wages have to fall? It is easy to see that an after-tax wage of $92 will restore equilibrium. If daily take-home pay is $92, labor will cost firms $108 per day, just as it did before the tax change. So they will demand the same quantity as they did when the payroll tax was shared. Similarly, workers will receive the same $92 net wage as they did previously; so quantity supplied will be the same as it was before the tax change. Thus, in the end, the market will completely frustrate the intent of Congress.

The payroll tax is an excellent example of a case in which Congress, misled by the flypaper theory of incidence, thinks it is “taxing firms” when it raises the employer’s share and “taxing workers” when it raises the employee’s share. In truth, who is really paying depends on the incidence of the tax. But no lasting difference results from a change in the employee’s and the employer’s shares.

Who, then, really bears the burden of the payroll tax? Like any excise tax, the incidence of the payroll tax depends on the elasticities of the supply and demand schedules. In the case of labor supply, there is a large body of empirical evidence pointing to the conclusion that the quantity of labor supplied is not very responsive to price for most population groups. The supply curve is almost vertical. The result is that workers as a group are able to shift little of the burden of the payroll tax.

But employers can shift it in most cases. Firms view their share of the payroll tax as an additional cost of using labor. So when payroll taxes go up, firms try to substitute cheaper factors of production (capital) for labor wherever they can. This reduces the quantity of labor demanded, lowering the wage received by workers. And this is how market forces shift part of the tax burden from firms to workers.

To the extent that the supply curve of labor has some positive slope, the quantity of labor supplied will fall when the wage goes down, and in this way workers can shift some of the burden back onto firms. But the firms, in turn, can shift that burden onto consumers by raising their prices. Prices in competitive markets generally rise when costs (like labor costs) increase. It is doubtful, therefore, that firms bear much of the burden of the payroll tax. Here, the flypaper theory of incidence could not be further from the truth. Even though the tax is collected by the firm, it is really borne by workers and consumers.

The payroll tax may be thought of as an excise tax on the employment of labor. The U.S. payroll tax comes in two parts: half is levied on the employees (payroll deductions) and half on employers. A fundamental point, which people who have never studied economics often fail to grasp is that:

The incidence of a payroll tax is the same whether it is levied on employers or on employees.

A simple numerical example will illustrate why this is so. Consider an employee earning $100 a day with a 16 percent payroll tax that is shared equally between the employer and the employee, as under our present law. How much does it cost the firm to hire this worker? It costs $100 in wages paid to the worker plus $8 in taxes paid to the government, for a total of $108 a day. How much does the worker receive? He gets S100 in wages paid by the employer less $8 deducted and sent to the government, or $92 a day. The difference between wages paid and wages received is $108 - S92 = $16, the amount of the tax. . Now suppose Congress tries to “shift” the burden of the tax entirely onto firms by raising the employer’s tax to $16 while lowering the employee’s tax to zero. At first, the daily wage is fixed at $100, so firms’ total labor costs (including tax) rise to $116 per day and workers’ net income rises to $100 per day. Congress seems to have achieved its goal.

But the achievement is fleeting, for this is not an equilibrium situation. With the daily cost of labor at S116 for firms, the quantity of labor demanded will be less than when labor cost only $108 per day. Similarly, with take-home pay up to $100 for workers, the quantity of labor supplied will be more than when the after-tax wage was only $92. There will therefore be a surplus of labor on the market (an excess of quantity supplied over quantity demanded), and this surplus will put downward pressure on wages.

How far will wages have to fall? It is easy to see that an after-tax wage of $92 will restore equilibrium. If daily take-home pay is $92, labor will cost firms $108 per day, just as it did before the tax change. So they will demand the same quantity as they did when the payroll tax was shared. Similarly, workers will receive the same $92 net wage as they did previously; so quantity supplied will be the same as it was before the tax change. Thus, in the end, the market will completely frustrate the intent of Congress.

The payroll tax is an excellent example of a case in which Congress, misled by the flypaper theory of incidence, thinks it is “taxing firms” when it raises the employer’s share and “taxing workers” when it raises the employee’s share. In truth, who is really paying depends on the incidence of the tax. But no lasting difference results from a change in the employee’s and the employer’s shares.

Who, then, really bears the burden of the payroll tax? Like any excise tax, the incidence of the payroll tax depends on the elasticities of the supply and demand schedules. In the case of labor supply, there is a large body of empirical evidence pointing to the conclusion that the quantity of labor supplied is not very responsive to price for most population groups. The supply curve is almost vertical, like that shown in Figure 33-8. The result is that workers as a group are able to shift little of the burden of the payroll tax.

But employers can shift it in most cases. Firms view their share of the payroll tax as an additional cost of using labor. So when payroll taxes go up, firms try to substitute cheaper factors of production (capital) for labor wherever they can. This reduces the quantity of labor demanded, lowering the wage received by workers. And this is how market forces shift part of the tax burden from firms to workers.

To the extent that the supply curve of labor has some positive slope, the quantity of labor supplied will fall when the wage goes down, and in this way workers can shift some of the burden back onto firms. But the firms, in turn, can shift that burden onto consumers by raising their prices. Prices in competitive markets generally rise when costs (like labor costs) increase. It is doubtful, therefore, that firms bear much of the burden of the payroll tax. Here, the flypaper theory of incidence could not be further from the truth. Even though the tax is collected by the firm, it is really borne by workers and consumers.

One risk-minimization guideline is the loan-to-value ratio. This ratio protects the lender by assuring the lender that the borrower has sufficient equity invested in the property to properly maintain the property and to make mortgage payments on time. The ratio also protects the lender by ensuring an ample margin between the property value and the loan amount, in case of foreclosure on the property. Maximum loan-to-value ratios vary according to the type of property and state and federal requirements. Higher ratios can be granted with private mortgage insurance (to be discussed later) or government loan insurance (FHA, VA). In general, the average loan-to-value ratios range from 65 to 80 percent. The loan-to-value ratio of an income property loan usually ranges from 65 to 75 percent, and that of a residential loan from 75 to 95 percent. The loan-to-value ratio of FHA and VA loans ranges from 97 to 100 percent.