Tax

Tax consists of a rate and a base. Because income is the base for the income tax, a central question is: What constitutes income? Different theoretical concepts of income exist in economics, accounting, and taxation. The base of income to which the federal income tax rate structure applies is taxable income as constitutionally and statutorily defined. Thus, the concept of taxable income is grounded in theory and modified by political dynamics and administrative concerns.

From its modern introduction in 1913, the rate structure for the individual income tax has been progressive, meaning that tax rates graduate upward as the base of taxable income increases. Different tax rates apply to ranges of income, called brackets. Over time, the number of brackets and tax rates that apply to them have varied greatly. The tax rate applied to the last dollar of taxable income earned by a taxpayer is called the marginal tax rate. Total income tax as a percentage of total taxable income is the average tax rate, whereas total income tax as a percentage of total economic income is the effective tax rate.

Administration of Federal Income Tax

The Internal Revenue Service (IRS), which administers the income tax, is part of the U.S. Department of Treasury. Adapting to changes in technology to achieve the most efficient processing of information is a major challenge for the IRS. For many years the IRS was organized on a geographical basis, but in 1998 it was reorganized into four functional divisions differentiated by type of taxpayer.For corporate and individual taxpayers that report on a calendar-year basis, annual tax returns are due on or before March 15 and April 15, respectively, following the close of the calendar year. Providing that the tax due is paid, time extensions for filing returns may be obtained. Although the closing dates for the quarters differ, both individuals and corporations are subject to the payment of estimated tax in quarterly installments. Taxpayers who fail to file tax returns or fail to pay taxes are subject to monetary penalties, fines, and possibly prison sentences.

Extension of Income Tax to the State Level

Wisconsin was the first state to adopt an income tax—in 1911. Massachusetts and New York soon followed by adopting income taxes when faced with problems related to World War I. Most other states adopted the income tax as a response to revenue crises created by the Great Depression. At the state level, definitions of taxable income differ from the federal definition and differ among states. Exemptions, deductions, and rates of taxation vary among states. As of January 2000, Nevada, South Dakota, Washington, and Wyoming did not impose individual or corporate income taxes; Alaska, Florida, New Hampshire, and Texas did not impose an individual income tax; and Michigan did not impose a corporate income tax. Formulas are used to allocate the income of multistate corporations among the states in which they operate.

Since its establishment in 1913, the income tax has played the dominant role in providing the funds with which the federal government operates. An income tax is an extraction of some of the taxpayer's economic gain, usually on a periodic basis. The federal government, and almost every state government, imposes a tax on the income of individuals, corporations, estates, and trusts. A final tax reckoning—involving the reporting of income and payment of taxes due—is made at the end of each year. However, in order to ensure tax collections, Congress has created a pay-as-you-go requirement, through a combination of payroll with holdings and estimated tax prepayments during the year.

Income is generally defined as any permanent increment to wealth. It does not include loans or any other temporary increments. As a general rule, Congress considers any incremental wealth to be taxable income, unless specific statutory authority excludes it. These increments to wealth can take many forms, such as cash, property other than cash, and services that are ren dered to the taxpayer. While state governments set their own tax rules and rates, a majority of the states use the same definition of gross income as the federal government.

Unlike federal and state income taxes, wealth-transfer taxes are not significant revenue producers. Historically, the primary function of wealth-transfer taxes has been to hinder the accumulation of wealth by family units. Since 1976, the federal estate tax and the federal gift tax have been combined into one tax, known as the unified transfer tax. This unified system eliminates the distinction previously made between taxable lifetime transfers and transfers at death. Under this system, the value of a decedent's taxable estate is treated as his or her final gift.

Like federal income taxes, the tax rates on unified transfers are progressive. This means that an increasing percentage rate is applied to increasing increments of the tax base. Unlike the annual assessment of federal income taxes, the federal transfer tax is computed cumulatively on gifts made during a lifetime as well as on transfers at death. In addition, many states impose an inheritance tax on the right to receive property at death. Unlike an estate tax, which is imposed according to the value of property transferred at death, an inheritance tax is imposed on the recipient of property from an estate, although many wills provide that the estate should pay any inheritance taxes imposed on recipients of property.

In addition to income taxes and wealth transfer taxes, the federal government and most states impose some form of employment tax. The most common form of state employment tax is levied on wages, with the proceeds used to finance that state's unemployment compensation benefits program. In addition to its own unemployment tax, the federal government also imposes a Social Security tax on employers, employees, and self-employed individuals. The federal government uses proceeds from the Federal Insurance Contribution Act (FICA) tax to finance the payment of Social Security benefits as well as Medicare health insurance. If an employee will be eligible for Social Security and Medicare, the FICA tax is paid by both the employee and by his or her employer. Although subject to a different tax rate, self-employed individuals are required to pay FICA taxes on their net earnings from self-employment.

With only a few exceptions, state and local units of government in the United States also use the income tax and wealth transfer taxes as a source of revenue. In addition, these taxing jurisdictions have customarily relied on two other tax sources that generally escape taxation by the federal government:

1. The annual assessment of property tax has traditionally been the backbone of the local revenue system. It is a tax on the value of property — usually only real property, such as land and buildings — owned within a jurisdiction by nonexempt individuals or organizations.
2. In addition, most states and many local units of government impose sales taxes. This is a tax on the gross receipts from the retail sale of tangible personal property—such as automobiles and clothing— and certain services. Each taxing authority determines its own tax rate as well as the services and articles to be taxed. The seller collects the tax at the time of the sale, and then periodically remits the revenue to the appropriate taxing authority.

Kinds of Taxes

The two basic kinds of taxes are excise taxes and property taxes.

Excise Tax

An excise tax is directly imposed by the law-making body of a government on merchandise, products, or certain types of transactions, including carrying on a profession or business, obtaining a license, or transferring property. It is a fixed and absolute charge that does not depend upon the taxpayer's financial status or the value that the taxed property has to the taxpayer.

An estate tax is a tax that is placed on, and paid by, the estate of a decedent prior to the distribution of the property among the heirs in exchange for the privilege of transferring the property. Individuals who inherit property may be required to pay an inheritance tax on the value of the particular property received. Gift taxes are incurred by an individual who gives another a valuable gift.

Another type of excise tax is a sales tax, which is placed on certain goods and services. Precisely what goods and services are taxed is determined by the individual state legislatures. In some instances, a sales tax placed upon expensive items that are considered luxuries is known as a luxury tax.

A corporate tax is an excise tax imposed upon the privilege of conducting business in the corporate capacity, which provides certain advantages to individuals, such as limited liability. It is measured by the income of the corporation involved.

Other common examples of excise taxes are those imposed upon the processing of meat, tobacco, cheese, and sugar.

Property Tax

A property tax takes the taxpayer's wealth into account, as represented by the taxpayer's income or the property he or she owns. Income tax for example, is a property tax that is assessed and levied upon the taxpayer's income; property taxes are imposed mainly on real property.

Direct and Indirect Taxes

Taxes are also classified as direct and indirect. A direct tax is one that is assessed upon the property, business, or income of the individual who is to pay the tax. Conversely indirect taxes are taxes that are levied upon commodities before they reach the consumer who ultimately pay the taxes as part of the market price of the commodity. A common example of an indirect tax is a value-added tax, which is paid on the value added to the product at each stage of production, distribution, and sales.

Federal Tax

The Constitution and laws passed by Congress have given the U.S. government authorization to collect various taxes. For example, duties are taxes imposed upon imports and can be either ad valorem (a percentage of the value of the property) or specific (a fixed amount). An impost is another name for an import tax. Congress may not, however, tax exports.

The Sixteenth Amendment to the Constitution gives Congress the power to impose a federal income tax. Congress has also enacted laws that allow the federal government to tax estates remaining after people die and gifts made while people are alive

State Tax

States possess the inherent power to levy both property and excise taxes. The Tenth Amendment to the Constitution, which reserves to the states powers that have neither been granted to the United States nor proscribed to the states by the Constitution, implicitly acknowledges this fundamental right. A state may raise funds by taxation in aid of its own welfare, provided the tax does not constitute unjust discrimination among those who are to share the tax burden. Property taxes, for example, may properly be imposed on landowners within the jurisdiction. In addition, the state may levy income, gift, estate, and inheritance taxes upon its residents.

Equality

Equality is a fundamental principle of taxation. The taxing power of the legislature must always be exercised in such a way that the burdens imposed by taxation are laid as equally as possible on all classes. The progressive tax, which imposes a higher rate of taxation upon individuals with large incomes than on those with small incomes, is an attempt to achieve this objective.

Equality in taxation is achieved when no higher rate in proportion to value is imposed on one individual or his or her property than on other people or property in similar circumstances. Equality does not mandate that the benefits that arise from taxation should be enjoyed by all the people in equal degree or that each individual should share in each particular benefit. For example, the fact that a husband and wife have no children or choose to send their children to private school does not signify that they are permitted to stop paying their share of school tax.

Uniformity

The principle of uniformity of taxation bears a close relation to the concept of equality because similar items are taxed equally only if the mode of assessment is the same or uniform.

A tax that is levied upon property must be in proportion or according to its value, ordinarily determined as its fair cash or fair market value. This requirement protects equality and uniformity of taxation by preventing arbitrary or inconsistent methods of determining how much tax is due. This requirement applies only to property taxes, not to excise taxes.