Income tax

Income tax

Income tax is a tax on the earnings of individuals and corporations. Nearly all nations levy income taxes to pay for their government programs. Such taxes may be levied by the federal government, state or provincial governments, and even some local governments.

The United Kingdom was the first country to collect a general income tax. The government enacted the tax in 1799 as a temporary measure to help pay the costs of the Napoleonic Wars. Many countries enacted income taxes from time to time during the 1800's to help meet unusual expenses, such as wars. The income tax came into wide permanent use during the early 1900's.

In countries where most people work for wages or salaries-including Canada, the United Kingdom, and the United States-the individual income tax raises more money for the government than any other source of revenue. In countries where most people are self-employed in agriculture or service industries, such as India and Malaysia, individual income taxes provide a much smaller part of the government's revenue.

Many people have questioned the fairness of the income tax, its effect on economic activities, and how complicated it has become in many countries. Some people have even called for its elimination. But the income tax will likely remain an important part of most countries' tax systems.

Types of income taxes
The two major kinds of income taxes are individual income taxes and corporate income taxes. Individual income taxes, also called personal income taxes, are levied on the income of individuals. Corporate income taxes are applied to the earnings of corporations.

An income tax may be either progressive or proportional. Under a progressive income tax, the more taxable income a person earns, the higher percentage of taxes he or she owes. Taxable income is the amount left over after certain items have been subtracted from total earnings. For example, a person with a taxable income of $10,000 may pay a tax of 20 percent of that income, or $2,000. But a person whose taxable income is $20,000 may pay a tax of 25 percent of that income, or $5,000.

Under a proportional income tax, people pay the same percentage of tax for all levels of taxable income. For example, under a proportional tax rate of 20 percent, a person whose taxable income is $10,000 must pay a tax of 20 percent of that income, or $2,000. A person with a taxable income of $20,000 must also pay a tax of 20 percent of his or her income, or $4,000.

 

Defining taxable income.

To levy an income tax, a government must define taxable income. Taxpayers are allowed to subtract certain expenses in figuring their taxable income. These expenses are referred to as deductions in the United States and as allowances in the United Kingdom and other countries that use British English. In many countries, for example, charitable contributions, a percentage of medical expenses, and contributions to private pension funds or certain kinds of savings plans may be deducted. Some countries, including Germany, Japan, and the United States, allow certain taxpayers to deduct state and local taxes.

Nearly all countries permit taxpayers to deduct from taxable income expenses necessary to the earning of income. But it is often difficult to determine what constitutes a necessary expense. For example, the cost of a business trip may be a necessary expense and, therefore, a legal deduction. But should a taxpayer be allowed to deduct the cost of a luxurious hotel room if less expensive lodgings were available?

Some political leaders have proposed eliminating most or all deductions and other adjustments of taxable income. When such a tax plan also has a proportional rate structure, it is often called a flat tax. Some people believe that adopting a flat tax would eliminate many unfair deductions and simplify tax returns. Opponents of the flat tax say that it would cause the middle class to pay too much, and the rich to pay too little. See FLAT TAX.

In some countries, serious problems arise over the taxation of capital gains. Capital gains are the profits earned from the sale of stocks, real estate, or other income-producing property. Some people believe low capital gains rates strengthen the economy by encouraging investment. Others believe low rates provide a loophole for wealthy taxpayers. See CAPITAL GAINS TAX.

 

Effects of inflation. The tax systems of most countries are designed to be progressive-that is, to tax large incomes at a higher rate than small incomes. Many people are concerned about the influence of inflation on progressive income taxes. This concern arises because an increase in people's income during a period of inflation does not necessarily mean an increase in their wealth. For example, if prices generally rise 10 percent and a worker receives a 10 percent raise, the worker can buy only as much as he or she could buy before the inflation occurred. But under a progressive income tax, such a raise may cause the worker's income to be taxed at a higher rate even though the worker's buying power has remained the same. This is known as bracket creep, because inflation pushes people into higher tax brackets.

To solve this problem, governments in some countries adjust their tax rate schedules based on changes in prices for certain items. This is known as indexing the tax system for inflation. This method of adjustment helps keep inflation from causing people to pay more in taxes.

Inflation can also cause an income tax system to make mistakes in measuring the real return (profit) someone has earned on an investment. For example, consider what happens if an individual buys a share of stock for $100, holds it for one year, and sells it for $110. Under the income tax system of many countries, including that of the United States, selling the stock would mean that the individual owes tax on the $10 increase in the stock's value. If prices rose by 10 percent during the year, however, the stock price has merely kept up with inflation. In other words, it is not worth more when it is sold than when it was purchased. In this case, the tax system overestimates how much the individual profited.

The same problem arises with interest payments and receipts, because part of the interest earned is only keeping up with inflation. Eliminating bracket creep does not address this problem, and fixing it would require much more complex adjustments.

History of U.S. income taxes
Some states levied an individual income tax before 1850. The federal government first collected an income tax in 1863. Congress had passed individual income tax laws in 1861 and 1862 because the Union government needed revenue to pay the cost of the American Civil War (1861-1865). The tax ended in 1872. Congress passed another income tax law, in 1894, but the Supreme Court of the United States declared it to be unconstitutional. The court based this decision on a statement in the Constitution that any tax levied directly on individuals must be levied in proportion to a state's population. That is, a higher total tax had to be collected from a state with many people than from one with fewer people.

In 1909, Congress passed a law providing for a kind of corporate income tax. The Supreme Court declared the law constitutional. To avoid future adverse court decisions, backers of an individual tax worked to amend the Constitution. In February 1913, the 16th Amendment removed the requirement that an income tax be levied in proportion to state population. The Underwood Tariff Act of 1913 included an income tax section.

Since 1913, the income tax laws have changed many times, and income tax rates have increased greatly. For example, withholding of employee income taxes began in 1943. Simplified returns and standard deductions came into use in 1944. In 1948, new provisions allowed exemptions for blindness and old age, and split-income joint returns for married couples. The Tax Reform Act of 1969 was a major revision of the income tax laws. It eliminated some situations in which corporations and individuals could legally avoid paying income taxes.

The Tax Reform Act of 1986 was probably the most important change in income tax legislation since the 1940's. The act sharply reduced the number and level of tax rates. It also greatly increased the tax base by restricting deductions, credits, and exclusions. The act established two basic rates of 15 and 28 percent for the individual income tax. These rates replaced 14 rates ranging from 11 to 50 percent. The act also increased the size of personal exemptions for individuals, spouses, and dependents.

During the 1990's, changes in tax laws introduced many new deductions, credits, and exclusions; and the tax rates increased. In 1990, Congress established a third individual income tax rate of 31 percent, which applied to people with the largest incomes. In 1993, Congress added individual income tax rates of 36 and 39.6 percent. It also raised the rate for some corporations. The Taxpayer Relief Act of 1997 added new credits for dependent children and for college tuition.

In 2001, Congress significantly reduced individual income tax rates. It also added a sixth individual rate of 10 percent and increased several deductions and credits.