Income tax in USA

CONTENTS

INTRODUCTION

Income taxes in the United States are levied by the federal government and by state and local governments. The federal income tax, upon which this text focuses, is collected by the Internal Revenue Service (IRS), part of the Department of the Treasury. The rules for collecting income taxes are set in the Internal Revenue Code (IRC), Title 26 of the United States Code. The IRC is a statute written and regularly revised by Congress. Treasury Regulations are more detailed rules written by the IRS to effectuate the implementation of the IRC. Code provisions, which are statutory, always trump contrary regulatory provisions. Regulations can be of two types: legislative and interpretive. With legislative regulations, Congress says, for example, that depreciation will be an allowable expense "in accordance with regulations to be established by the IRS." It gives the IRS the power to make the rules. Interpretive regulations are those in which the IRS says how it will interpret and apply a given statute.

Disputes over tax rules are generally heard in the United States Tax Court before the tax is paid, or in a United States District Court or United States Court of Federal Claims after the tax is paid. Appeals from the Tax Court go to the United States Court of Appeals for the circuit in which the taxpayer resides, or was domiciled when the tax return in controversy was originally filed. From the Court of Appeals the taxpayer may file a writ of certiorari with the Supreme Court, which may or may not be granted. The IRS also periodically issues Revenue Rulings when taxpayers have questions about how to declare certain transactions. These rulings are only opinions, and are trumped by court rulings or contrary legislation. Revenue Rulings should not be confused with Private Letter Rulings. A Private Letter Ruling is a request by a specific taxpayer to the IRS to rule on the tax consequences of a specific transaction before the action is taken. A Private Letter Ruling is directed only towards the requesting taxpayer, and therefore can`t be relied upon by other taxpayers considering the exact action. Private Letter Rulings are released every Friday by the IRS.

1. Principal

The "tax net" refers to the types of payment that are taxed, which included personal earnings (wages), capital gains, and business income. The rates for different types of income may vary and some may not be taxed at all. Capital gains may be taxed when realized (e.g. when shares are sold) or when incurred (e.g. when shares appreciate in value). Business income may only be taxed if it is significant or based on the manner in which it is paid. Some types of income, such as interest on bank savings, may be considered as personal earnings (similar to wages) or as a realized property gain (similar to selling shares). In some tax systems, personal earnings may be strictly defined where labor, skill, or investment is required (e.g. wages); in others, they may be defined broadly to include windfalls (e.g. gambling wins).

Tax rates may be progressive, regressive, or proportional. A progressive tax applies progressively higher tax rates as earnings reach higher levels. For example, the first $10,000 in earnings may be taxed at 7%, the next $10,000 at 10%, and any more income at 30%. Alternatively, a proportional tax takes all earnings at the same rate. A regressive income tax may apply to income up to a certain amount, such as taxing only the first $90,000 earned. A tax system may use different taxation methods for different types of income.

Personal income tax is often collected on a pay-as-you-earn basis, with small corrections made soon after the end of the tax year. These corrections take one of two forms: payments to the government by taxpayers who did not pay enough during the tax year; and tax refunds from the government to those who overpaid. Income tax systems often have deductions available that lessen the total tax liability by reducing total taxable income. They may allow losses from one type of income to be counted against another. For example, a loss on the stock market may be deducted against taxes paid on wages. Other tax systems may isolate the loss, such that business losses can only be deducted against business tax by carrying forward the loss to later tax years.

The idea of a progressive tax has garnered support from macro economists and political scientists of many different ideologies - ranging from Adam Smith to Karl Marx, although there are differences of opinion about the optimal level of progressivity. Some economists trace the origin of modern progressive taxation to Adam Smith, who wrote in The Wealth of Nations:

The necessaries of life occasion the great expense of the poor. They find it difficult to get food, and the greater part of their little revenue is spent in getting it. The luxuries and vanities of life occasion the principal expense of the rich, and a magnificent house embellishes and sets off to the best advantage all the other luxuries and vanities which they possess. A tax upon house-rents, therefore, would in general fall heaviest upon the rich; and in this sort of inequality there would not, perhaps, be anything very unreasonable. It is not very unreasonable that the rich should contribute to the public expense, not only in proportion to their revenue, but something more than in that proportion.

Income taxes are used in most countries around the world, but are not without criticism. Frank Chodorov wrote "... you come up with the fact that it gives the government a prior lien on all the property produced by its subjects." The government "unashamedly proclaims the doctrine of collectivized wealth. ... That which it does not take is a concession."^[5] Some have argued that the economic effects of an income tax system penalize work, discourage saving and investing, and hinder the competitiveness of business and economic growth. Income taxes are also not border-adjustable; meaning the tax component embedded into products via taxes imposed on companies cannot be removed when exported to a foreign country (see Effect of taxes and subsidies on price). Alternate tax systems such as a national sales tax or value added tax remove the tax component when goods are exported and apply the tax component on imports.

2. Types

Personal

A personal or individual income tax is levied as a percentage of a person's wages and salaries, with some deductions permitted, along with the net income or loss from businesses and investments. It is typically collected on a pay-as-you-earn basis, with corrections at the end of the year for over payments and under payments. Income tax systems typically offer exemptions, deductions, or credits which lessen the total tax liability; these are frequently a method of rewarding income-use-patterns encouraged by the government (home ownership, supporting children, charitable contributions). Tax structures may allow losses from one type of income to be counted against another. For example, a loss from businesses and investments might offset wages before calculating the taxes due.

Corporate

Corporate tax or company tax refers to a tax imposed on entities that are taxed at the entity level. Such taxes may include income taxes, capital gains taxes, or other taxes. The tax systems of most countries impose an income tax on certain types of entities (company or corporation). Many systems additionally tax owners or members of those entities on dividends or other distributions from the entity to the members. The tax is generally calculated on net taxable income, which is generally the financial statement income with modifications which are defined in great detail. The rate of tax varies by jurisdiction and is frequently progressive.

Payroll

A payroll tax generally refers to two kinds of taxes: employee and employer payroll taxes. Employee payroll taxes are taxes which employers are required to withhold from employees' pay, also known as withholding, pay-as-you-earn (PAYE) or pay-as-you-go (PAYG) tax. These withholdings contribute to the payment of an employee's personal income tax obligation; if the payments exceed this obligation, the employee may be eligible for a tax refund or carry forward to future periods.

Employer payroll taxes are paid from the employer's own funds, either as a fixed charge per employee or as a percentage of each employee's pay. Payroll taxes often cover government social insurance programs, such as social security, health care, unemployment, and disability. These payments do not count toward the income taxes of employees and employers, but are normally deductible by the employer as a business expense.

Inheritance

The inheritance tax, estate tax and death duty are the names given to various taxes which arise on the death of an individual. In international tax law, there is a distinction between an estate tax and an inheritance tax: the former taxes the personal representatives of the deceased, while the latter taxes the beneficiaries of the estate. However, this distinction is not universally recognized. For example, the "inheritance tax" in the UK is a tax on personal representatives, and is therefore, strictly speaking, an excise tax.

Capital gains tax

A capital gains tax is levied on profits from the sale of capital assets (e.g., real estate, machinery, stocks, bonds, art, commodities). In many cases, the amount of a capital gain is treated as ordinary income and subject to the marginal rate of income tax, so the distinction becomes unimportant. Typically, trading in assets or commodities is recognized as a business venture, thus the profits are considered ordinary income rather than capital gains. Partly to compensate for changes in the value of money over time, some systems index for inflation before applying a tax rate, others have lower tax rates for longer-term capital gains.

3. History

The concept of taxing income is a modern innovation and presupposes several things: a money economy, reasonably accurate accounts, a common understanding of receipts, expenses and profits, and an orderly society with reliable records. For most of the history of civilization, these preconditions did not exist, and taxes were based on other factors. Taxes on wealth, social position, and ownership of the means of production (typically land and slaves) were all common. Practices such as tithing, or an offering of first fruits, existed from ancient times, and can be regarded as a precursor of the income tax, but they lacked precision and certainly were not based on a concept of net increase.

China

In the year 10 AD, Emperor Wang Mang of the Xin Dynasty instituted an unprecedented tax—the income tax—at the rate of 10 percent of profits, for professionals and skilled labor. (Previously, all taxes were either head tax or property tax.) He was overthrown 13 years later in 23 AD and earlier laissez-faire policies were restored during the Later Han.

United Kingdom

One of the first recorded taxes on income was the Saladin tithe introduced by Henry II in 1188 to raise money for the Third Crusade. The tithe demanded that each layperson in England be taxed a tenth of their personal income and moveable property. However, the inception date of the modern income tax is typically accepted as 1799.

Income tax was announced in Britain by William Pitt the Younger in his budget of December 1798 and introduced in 1799, to pay for weapons and equipment in preparation for the Napoleonic wars. Pitt's new graduated income tax began at a levy of 2d in the pound (0.8333%) on annual incomes over £60 and increased up to a maximum of 2s in the pound (10%) on incomes of over £200 (£170,542 in 2007). Pitt hoped that the new income tax would raise £10 million (£8,527,100,000 in 2007), but actual receipts for 1799 to talled just over £6 million.

The tax was repealed in 1816 and opponents of the tax, who thought it should only be used to finance wars, wanted all records of the tax destroyed along with its repeal. Records were publicly burned by the Chancellor of the Exchequer but copies were retained in the basement of the tax court.^[14]

4. Around the world

Systems of taxation on personal income  

No income tax on individuals  

Territorial  

Residential  

Citizenship-based

Income taxes are used in most countries around the world. The tax systems vary greatly and can be progressive, proportional, or regressive, depending on the type of tax. Comparison of tax rates around the world is a difficult and somewhat subjective enterprise. Tax laws in most countries are extremely complex, and tax burden falls differently on different groups in each country and sub-national unit. Of course, services provided by governments in return for taxation also vary, making comparisons all the more difficult.

Countries that tax income generally use one of two systems: territorial or residential. In the territorial system, only local income – income from a source inside the country – is taxed. In the residential system, residents of the country are taxed on their worldwide (local and foreign) income, while nonresidents are taxed only on their local income. In addition, a very small number of countries, notably the United States, also tax their nonresident citizens on worldwide income.

Countries with a residential system of taxation usually allow deductions or credits for the tax that residents already pay to other countries on their foreign income. Many countries also sign tax treaties with each other to eliminate or reduce double taxation.

Countries do not necessarily use the same system of taxation for individuals and corporations. For example, France uses a residential system for individuals but a territorial system for corporations, while Singapore does the opposite, and Brunei taxes corporate but not personal income.

5. Basics

A tax is imposed on net taxable income in the United States by the federal, most state, and some local governments. Income tax is imposed on individuals, corporations, estates, and trusts. The definition of net taxable income for most sub-federal jurisdictions mostly follows the federal definition.

The rate of tax at the federal level is graduated; that is, the tax rates of higher amounts of income are higher than on lower amounts. The lower rate on lower income was phased out at higher incomes prior to 2010. Some states and localities impose an income tax at a graduated rate, and some at a flat rate on all taxable income. federal tax rates in 2009 varied from 10% to 35%.

From 2003 through 2011, individuals were eligible for a reduced rate of federal income tax on capital gains and qualifying dividends. The tax rate and some deductions are different for individuals depending on filing status. Married individuals may compute tax as a couple or separately. Single individuals may be eligible for reduced tax rates if they are head of a household in which they live with a dependent.

Taxable income: is defined in a comprehensive manner in the Internal Revenue Code and regulations issued by the Department of Treasury and the Internal Revenue Service. Taxable income is gross income as adjusted minus tax deductions. Most states and localities follow this definition at least in part, though some make adjustments to determine income taxed in that jurisdiction. Taxable income for a company or business may not be the same as its book income.

Gross income: includes all income earned or received from whatever source. This includes salaries and wages, tips, pensions, fees earned for services, price of goods sold, other business income, gains on sale of other property, rents received, interest and dividends received, alimony received, proceeds from selling crops, and many other types of income. Some income, however, is exempt from income tax. This includes interest on municipal bonds.

Capital gains: and qualified dividends may be taxed as part of taxable income. However, the tax is limited to a lower tax rate. Capital gains include gains on selling stocks and bonds, real estate, and other capital assets. The gain is the excess of the proceeds over the adjusted basis (cost less depreciation deductions allowed) of the property. This limit on tax also applies to dividends from U.S. corporations and many foreign corporations. There are limits on how much net capital loss may reduce other taxable income.

Tax credits: All taxpayers are allowed a tax credit for foreign taxes and for a percentage of certain types of business expenses. Individuals are also allowed credits related to education expenses, retirement savings, child care expenses, and a credit for each child. Each of the credits is subject to specific rules and limitations. Some credits are treated as refundable payments.

Alternative Minimum Tax: All taxpayers are also subject to the Alternative Minimum Tax if their income exceeds certain exclusion amounts. This tax applies only if it exceeds regular income tax, and is reduced by some credits.

Tax returns: Individuals must file income tax returns in each year their income exceeds the standard deduction plus one personal exemption, or if any tax is due. Other taxpayers must file income tax returns each year. These returns may be filed electronically. Generally, an individual's tax return covers the calendar year. Corporations may elect a different tax year. Most states and localities follow the federal tax year, and require separate returns.

Tax payment: Taxpayers must pay income tax due without waiting for an assessment. Many taxpayers are subject to withholding taxes when they receive income. To the extent withholding taxes do not cover all taxes due, all taxpayers must make estimated tax payments.

Tax penalties: Failing to make payments on time, or failing to file returns, can result in substantial penalties. Certain intentional failures may result in jail time.

Tax returns may be examined and adjusted by tax authorities. Taxpayers have rights to appeal any change to tax, and these rights vary by jurisdiction. Taxpayers may also go to court to contest tax changes. Tax authorities may not make changes after a certain period of time (generally 3 years).

Federal income tax rates

Marginal tax rates

 Marginal tax rates for 2012

Marginal tax rates for 2013

An individual's marginal income tax bracket depends upon his or her income and tax-filing classification. As of 2013, there are seven tax brackets for ordinary income (ranging from 10% to 39.6%) and four classifications: single, married filing jointly (or qualified widow or widower), married filing separately, and head of household.

An individual pays tax at a given bracket only for each dollar within that bracket's range. For example, a single taxpayer who earned $10,000 in 2012 would be taxed 10% of each dollar earned from the first dollar to the 8,700th dollar (10% × $8,700 = $870.00), then 15% of each dollar earned from the 8,701st dollar to the 10,000th dollar (15% × $1,300 = $195.00), for a total of $1,065. Notice this amount ($1,065) is lower than if the individual had been taxed at 15% on the full $10,000 (for a tax of $1,500). This is because the individual's marginal rate (the percentage tax on the last dollar earned, here 15%) is effected only on the portion of income exceeding that taxed at a lower bracket (here exceeding the first $8,700 of income taxed at 10%).

This ensures that every rise in a person's pre-tax salary results in an increase of their after-tax salary. Otherwise, a person earning a pre-tax 2012 salary of $8,700 would a enjoy a greater after-tax salary ($8,700 - $870 = $7,830) before a raise of his pre-tax salary to $9,200 ($9,200 - $1,380 = $7,820). However, it does occur for some wage earners that their marginal tax rate goes down once they have reached the taxable limit for the FICA or social security tax which in 2012 was paid at a rate of 4.2% on earned incomes up to $110,100, after which point the wage earners marginal tax rate decreases by 4.2% until the next income tax bracket is reached.

6. Effective income tax rates

While the top marginal tax rate on ordinary income is 35 percent, average rates that a household in the upper income bracket pays is less. Much of the earnings of those in the top income bracket come from capital gains, interest and dividends, which are taxed at a maximum of 15 percent. Also because only income up to $106,800 is subject to payroll taxes of 15.3%, which are paid by the employer and employee, individuals in the upper income bracket pay on average an effective rate not much different than that of other income brackets. The effective tax rate paid by an individual in the upper income bracket is highly dependent on the ratio of income they earn from capital gains, interest and dividends. The table below shows the average effective income tax rates for different income groups for 2007.

7. Taxable income

Income tax is imposed as a tax rate times taxable income, less applicable tax credits. Taxable income is gross income less allowable tax deductions. Taxable income as determined for federal tax purposes may be modified for state tax purposes.

Gross income

The Internal Revenue Code states that "gross income means all income from whatever source derived," and gives specific examples. Gross income is not limited to cash received. "It includes income realized in any form, whether money, property, or services." Gross income includes wages and tips, fees for performing services, gain from sale of inventory or other property, interest, dividends, rents, royalties, pensions, alimony, and many other types of income.^[14] Items must be included in income when received or accrued. The amount included is the amount the taxpayer is entitled to receive. Gains on property are the gross proceeds less amounts returned,cost of goods sold, or tax basis of property sold.

Certain types of income are subject to tax exemption. Among the more common types of exempt income are interest on municipal bonds, a portion of Social Security benefits, life insurance proceeds, gifts or inheritances, and the value of many employee benefits.

Gross income is reduced by adjustments and tax deductions. Among the more common adjustments are reductions for alimony paid and IRA and certain other retirement plan contributions. Adjusted gross income is used in calculations relating to various deductions, credits, phase outs, and penalties.

Business deductions

Deductions are permitted for most business expenses of entities and individuals. There are limits on some types of these deductions. The deduction for depreciation expense must be computed under MACRS rules. Deductions for meals and entertainment are limited to 50% of the amount incurred.

Certain deductions must be capitalized or deferred. These include:

• Cost of goods sold, including costs required to be capitalized under tax rules that differ from financial accounting rules,
• Personal, living, and family expenses,
• Items producing future benefits,
• Political contributions,
• Expenses not properly documented under tax rules, and
• Other items.

Business losses may reduce nonbusiness income for individuals and corporations. However, losses from passive activities may reduce only income from other passive activities. Passive activities include most rental activities (except for real estate professionals) and business activities in which the taxpayer does not materially participate. In addition, losses may not, in most cases, be deducted in excess of the taxpayer's amount at risk (generally tax basis in the entity plus share of debt).

Overall net operating losses (business deductions in excess of gross income) may be deducted in other years by carryover or carryback of the loss.

Personal deductions

Individuals are allowed a special deduction called a personal exemption for dependents. This is a fixed amount allowed each taxpayer, plus an additional fixed amount for each child or other dependents the taxpayer supports. The amount of this deduction for 2009 and 2010 is $3,650. The amount is indexed annually for inflation. The amount of exemption is phased out at higher incomes through 2009; the phase out expired for 2010.

Citizens and individuals who have U.S. tax residence may deduct a flat amount as a standard deduction. Alternatively, they may claim an itemized deduction for actual amounts incurred for specific categories of nonbusiness expenses. Home owners may deduct the amount of interest and property taxes paid on their principal and second homes. Local and state income taxes are deductible, or the individual may elect to deduct state and localsales tax. Contributions to charitable organizations are deductible by individuals and corporations, but the deduction is limited to 50% and 10% of gross income respectively. Medical expenses in excess of 7.5% of adjusted gross income are deductible, as are uninsured casualty losses. Other income producing expenses in excess of 2% of adjusted gross income are also deductible. For years before 2010, the allowance of itemized deductions was phased out at higher incomes. The phase out expired for 2010.

CONCLUSION

Contrary to what the wealthy have taught us to believe, a strongly progressive income tax does not take away from the economy or diminish incentive for honest work and creativity. The strongly progressive tax rates have been in effect for approximately 70 of the last 100 years and have served the public well. It has enhanced our freedoms and allowed the lower classes to advance rapidly. It funded important government programs and services which serve us all. 

The claims to the contrary by the right wing have now proven themselves wrong across the board and are substantially responsible for the economic mess we are in today. The strongly progressive income tax coupled with the electoral reforms proposed by the Fundamental Reform Network can entirely change the way our government and economy work to the betterment of us all.

In a representative democracy such as ours, we can change this in one election if a popular revolt makes it totally clear that any incumbent or candidate for office will not receive the majority of votes cast in this fall’s elections unless they are dedicated to fundamentally change the way our government and economy works taking away the stranglehold of the rich. We have to make the message clear: We know how the game is played and we won’t stand for it any longer. Fear tactics will no longer work on us. Join us or be voted out of office. Serve the public as you are elected to do, or you’re out. Taking huge corporate campaign contributions will automatically result in our not voting for you regardless of other promises you make or how good they sound. Our votes can’t be bought. We are energized by this injustice and we are all pledged to personally vote and to turn out the votes of the 98% of us who will benefit through these changes.

Totally eliminating the ability of the ultra-rich to buy our government and economy is what we expect of our representative. This is what we demand of our representatives. Nothing less will do.  It only takes about 10% of the uncommitted independent vote plus a good turn out by the Democratic base to make that happen. This is nothing compared to the approximate 5% of the voters who identify with the extreme right. The odds are strongly on our side. And what will energize that kind of surge in support? Nothing short of a plan to eliminate the corrupting influence of big money in our governmental decisions through electoral reforms and reinstating the strongly progressive income tax once and for all.  This is the change we believed Obama had promised us, but it appears he succumbed to business as normal inside the belt way. Obama’s Audacity of Hope brought out the Democratic base, the independent voter and hoards of new voters especially among the young and minorities. The pundits are already forecasting the continued decline in popularity of Democrats in Congress and the President, and a resurgence of the right wing in this fall’s election. The only way that can happen is for them to successfully blame the gridlock they caused on the Democrats. But it is not nearly enough to insure the retention of power by the Democrats. Not at all. Not as long as they too are bought. We have to change the way our government is run or live with the mess we have. 

We need not let that happen. We must not let that happen. The Fundamental Reform Network has a positive and achievable vision, a plan to make it happen and the means though which we can make this effort possible. “Against a great evil, a small effort does not result in a small result. It produces no result at all.” The choice is our. Will you join with us to make this happen?

REFERENCES

1. JCX-49-11, Joint Committee on Taxation, September 22, 2011, pp 48, 50.
2. See below for additional reading. The U.S. Internal Revenue Service offers many free publications which are available online, including one for individuals and one for corporations, in both .pdf and web formats. An incomplete index is available by topic. Many states offer similar publications.
3. "Effective Income Tax Rates". The New York Times. 2012-01-17.
4. Campbell, Andrea (September/October 2012). "America the Undertaxed, U.S. Fiscal Policy in Perspective".Foreign Affairs. Retrieved 1 October 2012. 
5. US Constitution.net
6. Steward Machine Co. v. Davis, 301 U.S. 548 (1937), 581-582
7. Joseph A. Hill, "The Civil War Income Tax," Quarterly Journal of Economics Vol. 8, No. 4 (Jul., 1894), pp. 416-452 in JSTOR; appendix in JSTOR 
8. "U.S. Federal Individual Income Tax Rates History, 1913-2011". Tax Foundation. 9 September 2011.
9. "Distribution of the Income Tax". The Independent. Jul 20, 1914. Retrieved August 23, 2012. 
10. Tax History Project, under year 1920.
11. History of Federal Individual Income Bottom and Top Bracket Rates. Retrieved 2010-02-04.
12. Logan, D. S. (2011, October 24). Summary of latest federal individual income tax data. Tax Foundation. Retrieved from http://www.taxfoundation.org/
13. Outline of major tax law provisions in 2013 under multiple scenarios. (2012, April 12). Tax Foundation. Retrieved from http://www.taxfoundation.org/
14. U.S. Federal Individual Marginal Income Tax Rates History, 1913-2009, The Tax Foundation.
15. How Progressive is the U.S. Federal Tax System?, Journal of Economic Perspectives, Winter, 2007, by T. Piketty and E. Saez, p. 23-24.
16. U.S. Federal Individual Income Tax Rates History, 1913-2011 (Nominal and Inflation-Adjusted Brackets)Tax Foundation. Accessed: 10 November 2011.