Engineering Economic Analysis

Problems 387

The first step in computing individual income taxes is to tabulate gross income. Any

~djustments-for example, allowabletaxpayer contributionsto a retirement fund-are sub-

tracted to yield adjusted gross income. Personal exemptionsand either itemized deductions

or the standard deduction are subtracted to find taxable income. This is used, together with

a tax rate table, to compute the income tax liability for the year.

For corporations,taxable income equals gross incomeminusall ordinary and necessary

expenditures (except capital expenditures) and depreciation and depletion charges. The.

income tax computation (whether for an individual or a corporation) is relatively simple,

with rates ranging from 10 to 39.6%. The proper rate to use in an economic analysis is the

incremental tax rate applicable to the increment of taxable income being considered.

Most individuals and corporations pay state income taxes in addition to federal in-

come taxes. Since state income taxes are an allowable deduction in computing federal

taxable income, it follows that the taxable income for the federal computation is lower than

the state taxable income..

Combined state and federal incremental tax rate

=L\Statetaxrate + (L\Federaltax rate)(1-L\State tax rate)

To introduce the effect of income taxes into an economic analysis, the startingpoint is a

before-tax cash flow.Then the depreciation schedule is deducted from appropriate parts of

the before-tax cash flowto obtain taxable income. Income taxes are obtained by multiplying

taxable income by the proper tax rate. Before-tax cash flow less income taxes equals the

after-tax cash flow.

Current tax law has decreased long-term capital gains on most nondepreciated assets

for individuals to 20% when held for more than 1 year and provided an exclusion on the

gain of the principal residence held for more than 2 years.

When dealing with nondepreciable assets, there is a nominal relationship between

before-tax and after-tax rate of return. It is

After-tax rate of return=(1- L\Tax rate)(Before-tax rate of return)

There is no simple relationship between before-tax and after-tax rate of return in the more

usual case of investmentsinvolving depreciable assets.

PROBLEMS

_These can be solved by hand, but most will be solved

~ much more easily with a spreadsheet.

12-1 An unmarried taxpayer with no dependents expects
an adjusted gross income of $48,000 in a given year.
His nonbusiness deductions are expected to be $3400.
(a) What will his federal income tax be?
(b) He is considering an additional activity expected
to increase his adjusted gross income. If this in-
crease should be $16,000 and there should be no
change in nonbusiness deductions or exemptions,

what will be the increase in his federal income

tax?

12-2 John Adams has a $50,000 adjusted gross income

from Apple Corp. and allowable itemized deductions

of $5000. Mary Eve has a $45,000 adjusted gross in~

come and $2000 of allowable itemized deductions.

Compute the total tax they would pay as unmar-

ried individuals. Then compute their tax as a married

couple filing a joint return. (Answers:$7618.50 +

6336 = $13,954.50; $15,562.50)

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