Income tax

An income tax is a tax levied on the income of individuals or businesses (corporations or other legal entities). Various income tax systems exist, with varying degrees of tax incidence. Income taxation can be progressive, proportional, or regressive. When the tax is levied on the income of companies, it is often called a corporate tax, corporate income tax, or profit tax. Individual income taxes often tax the total income of the individual (with some deductions permitted), while corporate income taxes often tax net income (the difference between gross receipts, expenses, and additional write-offs). Various systems define income differently, and often allow notional reductions of income (such as a reduction based on number of children supported).

Principles of taxes

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).

A progressive tax applies higher tax rates as earnings reach higher levels.

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." 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.

Types

Personal

A personal or individual income tax is levied on the total income of the individual (with some deductions permitted). It 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, for taxpayers who have not paid enough during the tax year; and tax refunds from the government for those who have overpaid. Income tax systems will 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.

Corporate

Main article: Corporate tax

Corporate tax refers to a direct tax levied on the profits made by companies or associations and often includes capital gains of a company. Earnings are generally considered gross revenue minus expenses. Corporate expenses related to capital expenditures are usually deducted in full (for example, trucks are fully deductible in the Canadian tax system, while a corporate sports car is only partly deductible) over their useful lives by using percentage rates based on the class of asset they belong to.

Accounting principles and tax rules about recognition of expenses and revenue will vary at times, giving rise to book-tax differences. If the book-tax difference is carried over more than a year, it is referred to as a deferred tax. Future assets and liabilities created by a deferred tax are reported on the balance sheet.

See also: Excess profits tax, Windfall profits tax

Payroll

Main article: Payroll tax

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 carryforward 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

Main article: Inheritance tax

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

Main article: Capital gains tax

A capital gains tax is the tax levied on profits from the sale of capital assets. In many cases, the amount of a capital gain is treated as income and subject to the marginal rate of income tax.

In an inflationary environment, capital gains may be, to some extent, illusory. If prices in general have doubled over five years, then selling an asset for twice the price it was purchased at five years earlier represents no gain at all. Partly to compensate for such changes in the value of money over time, some jurisdictions, such as the United States, give a favorable capital gains tax rate based on the length of holding. European jurisdictions have a similar rate reduction to nil on certain property transactions that qualify for the participation exemption. In Canada, 20–50% of the gain is taxable income. In India, Short Term Capital Gains Tax (arising before one year) is 10% [15 % from F.Y 2008-09 as per Finance Act 2008] flat rate of the gains and Long Term Capital Gains Tax is nil for stocks and mutual fund units held one year or more, provided the sale of shares involved payment of the Securities Transaction Tax, and 20% for any other assets held three years or more.

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 firstfruits, 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

Punch cartoon (1907); illustrates the unpopularity amongst Punch readers of a proposed 1907 income tax by the Labour Party in the United Kingdom.

Main article: Taxation in the United Kingdom § History

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 totaled 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.

United States

Main article: Income tax in the United States

In order to help pay for its war effort in the American Civil War, the US federal government imposed its first personal income tax, on August 5, 1861, as part of the Revenue Act of 1861 (3% of all incomes over US $800) ($27,129 in 2023 dollars). This tax was repealed and replaced by another income tax in 1862.

In 1894, Democrats in Congress passed the Wilson-Gorman tariff, which imposed the first peacetime income tax. The rate was 2% on income over $4000 ($140,861.54 in 2023 dollars), which meant fewer than 10% of households would pay any. The purpose of the income tax was to make up for revenue that would be lost by tariff reductions. Also, the Panic of 1893 is said to have something to do with the passage of Wilson-Gorman.

In 1895 the United States Supreme Court, in its ruling in Pollock v. Farmers' Loan & Trust Co., held a tax based on receipts from the use of property to be unconstitutional. The Court held that taxes on rents from real estate, on interest income from personal property and other income from personal property (which includes dividend income) were treated as direct taxes on property, and therefore had to be apportioned. Since apportionment of income taxes is impractical, this had the effect of prohibiting a federal tax on income from property. However, the Court affirmed that the Constitution did not deny Congress the power to impose a tax on real and personal property, and it affirmed that such would be a direct tax. Due to the political difficulties of taxing individual wages without taxing income from property, a federal income tax was impractical from the time of the Pollock decision until the time of ratification of the 16th Amendment in 1913.

In 1913, the Sixteenth Amendment to the United States Constitution made the income tax a permanent fixture in the U.S. tax system. The United States Supreme Court in its ruling Stanton v. Baltic Mining Co. stated that the amendment conferred no new power of taxation but simply prevented the courts from taking the power of income taxation possessed by Congress from the beginning out of the category of indirect taxation to which it inherently belongs. In fiscal year 1918, annual internal revenue collections for the first time passed the billion-dollar mark, rising to $5.4 billion by 1920. With the advent of World War II, employment increased, as did tax collections—to $7.3 billion. The withholding tax on wages was introduced in 1943 and was instrumental in increasing the number of taxpayers to 60 million and tax collections to $43 billion by 1945.

Around the world

Main articles: Tax rates around the world and International taxation

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.

Systems of taxation on personal income

  No income tax on individuals

  Territorial

  Residential

  Citizenship-based

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.

Transparency/public disclosure

Public disclosure of personal income tax filings occurs in Finland and Norway.

See also

• Income tax in Australia
• Income tax in Canada
• Income tax in India
• Income tax in the Netherlands
• Income tax in Singapore
• Income tax in Tanzania
• Income tax in the United States
• Lifetime income tax
• Local income tax
• Negative income tax
• Papal income tax
• Wealth tax

External links

• Tax Policy Analysis, OECD Tax Database
• History of the Income Tax in the United States — Infoplease.com