*** NOTE: Excerpted from the Academic American Encyclopedia (electronic) ***
TITLE(s): income tax The income tax is a levy based on the income of individuals, families, and corporations. The income tax is the largest source of tax revenue in advanced economies. In the United States over half of the federal government's tax revenue comes from income taxes, with the personal income tax accounting for about 45% and the corporate income tax for another 10% of the total tax revenue. Most individual states and some local governments also levy income taxes, but income taxes are less important than other sources of state tax revenue. An income tax was first instituted in Britain on a permanent basis in 1842. The United States did not use an income tax until 1861, as a temporary measure to help finance the Civil War; that tax was repealed in 1871. When Congress tried to reinstate the income tax, the Supreme Court, in POLLOCK V. FARMERS' LOAN AND TRUST CO. (1895), declared that it was unconstitutional. The 16TH AMENDMENT to the U.S. Constitution, ratified in 1913, consists of a single sentence that allows income taxation. The 1913 income tax exempted the first $3000 from taxation and taxed the remainder of income at graduated rates ranging from 1% for income up to $20000 to as high as 7% for income over $500000. This was sufficiently high relative to income at the time that less than 1% of the population was subject to the income tax then. The initial passage of the law established a progressive tax structure, which means that taxpayers are taxed at a higher percentage rate the higher their incomes are. A proportional tax would collect at the same percentage rate for all incomes, and a regressive tax collects a smaller percent of income for higher incomes. The tax structure in the United States has remained progressive since the tax was established, although specific rates have varied greatly. From an initial top rate of 7% in 1913, the top rate rose to 77% by 1918 to help finance world war I. The top rate fell to 25% from 1925 to 1928, but by 1936 had risen again to 78%. The highest top bracket was 94% in 1944 and 1945 to help finance World War II, and it remained above 90% in the early 1960s until it was reduced to 70% by the tax act of 1964. In 1981 the top rate was reduced to 50%, and it was reduced again by the Tax Reform Act of 1986. Effective in 1991 the top rate was 31%. One of the most significant events in the history of the U.S. income tax was the introduction of withholding during World War II. Prior to withholding, individuals were responsible for sending their tax payments to the government. Withholding, however, requires employers to deduct a part of an employee's pay and send it directly to the government to cover the employee's estimated income taxes. At the end of the year, the income earner computes the income tax due and either pays any additional amount or receives a refund from the government for payments in excess of the tax due. The withholding system makes it much easier for the government to collect taxes and makes evasion more difficult. THE PERSONAL INCOME TAX The amount of personal income tax due is computed in several steps. First, total income from all sources is added together. Certain types of income are not included in income for tax purposes; these are called exemptions. Examples include a personal exemption for the taxpayer and for individuals who are supported by the taxpayer's income, and for employee business expenses such as the cost of travel for a traveling salesperson. Total income minus exemptions equals adjusted gross income. Taxpayers then subtract deductions from adjusted gross income to compute taxable income. Items that can be deducted include home-mortgage interest payments and charitable contributions. In lieu of itemizing these deductions, taxpayers can choose to take a standard deduction; exemptions, therefore, can be more valuable to taxpayers than deductions because exemptions can be taken even if other deductions are not itemized. The tax due is computed from taxable income according to the tax rate schedule. An important concept in income taxation is the distinction between the average and marginal rates of taxation. The average rate is the fraction of income paid in taxes. The marginal rate is the fraction of any additional income that would have to be paid in taxes. The average and marginal rates are not the same because, first, some income is not taxed--due to exemptions, deductions, and credits; and, second, the progressive tax schedule taxes lower levels of income at a lower rate than higher levels of income.
The Tax Reform Act of 1986 simplified the tax structure and reduced the total number of tax brackets to four. Lowest-income taxpayers had an income tax rate of 15%, and as income rose, the marginal tax rate rose to 28%, then to 33%, and then back down to 28%. For the first time in the history of the income tax, the taxpayers with the highest incomes were not in the highest tax bracket. In 1991 the two top brackets were combined and the tax rate for that bracket was set at 31 percent. This reduced the number of tax brackets to three, with marginal tax rates of 15, 28, and 31%. The complexities of the tax code are the result of the attempt to achieve a number of goals in its design. The first goal is fairness, and, with the income tax, fairness is generally interpreted to mean that taxpayers should be taxed in proportion to their ability to pay. In trying to implement the ability-to-pay principle, the tax code taxes single taxpayers more than married taxpayers with nonworking spouses, but taxes married couples who both work more than if they both were single. Families with children also pay less in an attempt to tax the same amount for those with equal abilities to pay. The progressive nature of the tax code implements the ability-to-pay principle by suggesting that those with more income have a more-than-proportional ability to pay. How progressive the tax code should be, however, is a matter of debate. A second goal of the tax code is efficiency, which means collecting a given amount of tax revenue at the least cost. The efficiency of the tax is affected by the costs of collection, such as the cost of filling out forms, having the government monitor payments, and so on. Efficiency is also influenced by the incentives that an income tax introduces against earning taxable income. Higher tax rates provide an incentive for taxpayers to work less to do their own work rather than hire someone else who will have to pay income tax, and to cheat by not reporting income. These incentives can be minimized by keeping tax rates low, so the goal of efficiency conflicts with the equity goal of progressive taxation. Historically, the tax code has also been used to further other goals by providing tax incentives. Home-mortgage interest can be deducted from taxable income, creating an incentive for home ownership. Charitable contributions can be deducted, providing an incentive for charitable giving. The use of the tax system to provide these kinds of incentives is controversial, and the Tax Reform Act of 1986 eliminated many incentives of this type.
THE CORPORATE INCOME TAX In 1960 the corporate income tax comprised 23.2% of federal tax revenues, but had fallen to 12.5 percent of federal tax revenues by 1980, due to the effects of tax reform undertaken in the 1960s and 1970s. The decline resulted from corporations being able to shelter more income from taxation through credits, exemptions, and deductions. Because of the 1981 tax reform, corporate income tax collections made up only 6.2% of federal tax revenues in 1983, in large part because the 1981 tax act allowed more favorable treatment of depreciation. The Tax Reform Act of 1986 contained measures to increase the contribution of corporate income taxes to total federal taxes, and by 1989 corporate income tax collections made up more than 11% of federal tax revenue. Taxable income for corporations is computed by subtracting allowable expenses from income, but from 1960 to the mid-1980s a greater range of expenses was being allowed. An investment tax credit allowed the reduction of tax payments by 10% of investment expenditures, and firms were permitted to write off large depreciation expenses to lower their taxes. The Tax Reform Act of 1986 reduced corporate income tax rates, but corporations must pay taxes on more of their income, since less can be deducted. As a result, corporate income tax collections as a share of total federal taxes have increased by more than 80 percent. One controversy regarding corporate tax rates is who actually ends up paying the tax. Corporations may raise their prices to cover the corporate income taxes they pay, which would mean that the tax is actually paid by the corporation's customers rather than by the corporation itself. If the corporation did not raise its prices to cover the tax, then the tax would lower corporate profits, so that the stockholders of the corporation would end up paying the tax. Since insurance companies and pension plans own large blocks of stock, the corporate income tax may fall heavily on those industries and their customers. Economists agree that the tax is ultimately paid from all of these groups, but there is no agreement on who pays how much. Another controversy regarding the corporate income tax is the issue of double taxation. A tax on corporate income taxes the stockholder several times because corporations pay income tax on the money they pay out as dividends and then the recipient of the dividend must pay personal income tax on the dividend. Furthermore, stock is bought with after-tax income, then, when the stockholder is paid a dividend from the corporation or sells the stock at a profit, the income earned is taxed again. Some people argue that corporate income should not be taxed in order to avoid double taxation, while others argue that those who earn corporate income can best afford to pay taxes. The question is closely related to the issue of who ultimately pays the corporate income tax, since corporations really only collect taxes that are paid by individual stockholders and customers. TAX POLICY AND TAX REFORM Originally, the income tax was seen solely as a method of raising revenue, but since World War II it has been used as a tool for furthering other goals as well. In 1964 a tax cut designed by Presidents Kennedy and Johnson was enacted to help the sagging economy. The logic was that a tax cut would give consumers more money to spend, which would stimulate business activity. This was the first time that income tax reform was undertaken primarily to try to fine-tune the economy.
President Kennedy also instituted the investment tax credit to encourage investment, and throughout the 1960s and 1970s many other tax benefits were added to the tax system. Among them were oil depletion allowances that made oil exploration more profitable, an energy tax credit that provided an incentive for energy-efficient investment, and tax exemptions under certain conditions for retirement savings and health insurance. Each change, taken by itself, had an individual rationale, but the cumulative effect of such reforms was to reduce the amount of income subject to taxation, which required higher average rates to raise the same amount of revenue. Throughout the 1960s and 1970s inflation had the effect of continually pushing taxpayers into higher income tax brackets, which provided additional revenue to compensate for the increase in tax benefits. Inflation provided enough additional revenue that rate reductions to partially offset the effects of inflation were also common. The 1981 tax reform act contained a provision to automatically index tax brackets to offset inflation, making this type of tax reform unnecessary. The Tax Reform Act of 1986 was the most comprehensive change in the structure of the U.S. income tax since it was enacted. The cumulative effect of many small tax reforms over the preceding several decades was to increase the number of deductions, credits, and exemptions, which resulted in less income being subject to taxation. The 1986 reform was designed to lower tax rates while collecting about the same amount of revenue, by eliminating most tax preferences and thus increasing the amount of income that could be taxed. Reduced tax rates also have the advantages of increasing the incentive to earn income, while lowering the incentive for taxpayers to look for tax shelters to avoid taxation. One measure of the success of the 1986 tax reform is that only minor changes were made to the income tax structure in the five years following that reform. Randall G. Holcombe
Bibliography: Bradford, D. F., Untangling the Income Tax (1986); Davies, David G., United States Taxes and Tax Policy (1986); Hall, Robert E., and Rabushka, Alvin, The Flat Tax (1985); Holcombe, Randall G., Public Sector Economics (1988); Peacock, Alan, and Forte, Frances, eds., The Political Economy of Taxation (1981); (1985); Strassels, Paul N., The 1986 Tax Reform Act (1987).
TITLE(s): Treasury, U.S. Department of the The U.S. Department of the Treasury is the department of the executive branch of government that oversees the nation's finances. The department was created in 1789, and its first secretary was Alexander Hamilton. The secretary of the treasury is the second-ranking officer (after the secretary of state) in the president's cabinet. The secretary is the president's chief advisor on fiscal affairs and is responsible for managing the public debt. The law requires the secretary to report each year to the Congress on the government's fiscal operations and its financial condition. The secretary is also involved in financial dealings with other nations. The secretary has special staffs dealing with such matters as defense lending, debt analysis, financial analysis, international finance, international tax affairs, and law-enforcement coordination. The Treasury Department's operating bureaus include the COMPTROLLER OF THE CURRENCY, who supervises national banks; the United States Customs Service, which collects taxes on goods brought into the country from abroad; the Bureau of Engraving and Printing, which produces currency, bonds, Federal Reserve notes, and postage stamps; the Bureau of Government Financial Operations, which is responsible for the government's cash management program and central accounting and reporting system; the Bureau of the Public Debt; the INTERNAL REVENUE SERVICE, which collects taxes; the United States Mint, which manufactures coinage; the Bureau of Alcohol, Tobacco and Firearms, which enforces federal laws on production, use and distribution; and the SECRET SERVICE, which protects top U.S. officials and presidential candidates and enforces laws against counterfeiting.
Bibliography: Adams, S., The United States Treasury System (1979); Gaines, Tilford C., Techniques of Treasury Debt Management (1962); Gurney, Gene and Clare, The United States Treasury: A Pictorial History (1977); Taus, Esther R., Central Banking Functions of the United States Treasury, 1789-1941 (1943; repr. 1966); Walston, M., The Department of the Treasury (1989).
TITLE(s): Internal Revenue Service The U.S. government's tax collecting agency, the Internal Revenue Service, was created in 1862. However, it did not assume its present shape until the federal power to tax incomes was sanctioned by the 16TH AMENDMENT (1913) and revenues increased enormously after World War II. The IRS, a division of the Department of the Treasury, administers all of the internal revenue laws except those relating to alcohol, tobacco, firearms, and explosives; its most important assignments are to collect personal and corporate INCOME TAXES, SOCIAL SECURITY taxes, and excise, estate, and gift taxes. The IRS seeks to obtain voluntary compliance with the tax laws as far as possible. To this end it stresses communication with taxpayers by providing assistance and information for those who need it. Most of the approximately 118000 employees of the IRS work in field offices throughout the country. There are 7 regions, each headed by a regional commissioner, and 64 districts administered by district directors. Tax returns are processed in separate tax service centers. The national office in Washington, D.C., develops policies and supervises the field organization. By the early 1980s the IRS was confronting increasing tax evasion and taxpayer resistance, fueled by perceptions that the tax laws were unfair and administered unfairly. The IRS must interpret the tax laws through the regulations it issues, although the IRS is not responsible for writing the laws themselves. Despite a massive overhaul of the tax system in 1986, the IRS's interpretations are regularly challenged in cases brought to the U.S. TAX COURT; and, in adjudication, IRS tax assessments are sometimes rejected. It is, however, often possible for businesses and individuals to negotiate settlements directly with the IRS. Another source of taxpayer unhappiness is the complexity of many of the tax forms. They are often so cumbersome and difficult to understand that ordinary taxpayers may require the services of an accountant merely to file a tax return. In its efforts to discover tax evaders, the IRS has invested in computerized systems that allow it to gather information from many different sources and match it with data in its own files, in order to root out, for example, individuals whose life-styles indicate larger incomes than their tax returns list. Thus, the IRS can collect information from the 50 states on automobile and boat registration, professional licenses issued, and business activities that require state permits. It has also attempted to buy computerized lists from private marketing organizations. Such activities have raised questions relating to the issue of invasion of privacy. IRS information has been used by other state and government agencies. In most cases--the enforcement of child-support laws, for example, or the attempt to find those who have defaulted on student loans--the disclosure of information has been authorized by Congress.
Bibliography: Burnham, David: A Law unto Itself: Power, Politics, and the IRS (1990); Saltzman, Michael, IRS Practice and Procedures (1981); Shafiroff, I., Internal Revenue Service Practice and Procedure Deskbook, 2d ed. (1989).
TITLE(s): Tax Court, U.S. The United States Tax Court is a court of the federal government that hears cases brought by taxpayers who challenge decisions of the Internal Revenue Service (IRS) dealing with overpayment or underpayment of taxes. In many instances the decisions of the U.S. Tax Court can be appealed to the U.S. Court of Appeals and ultimately to the Supreme Court. When taxpayers exercise an option to agree to the use of simplified court procedures in disputes involving $10000 or less, however, the cases tried under these procedures cannot be appealed to a higher court. The U.S. Tax Court also decides disputes over the rights of taxpayers to see documents and other materials that are related to their cases and that are contained in IRS files. The court is composed of 19 judges appointed for life and 17 special trial judges appointed by the chief judge who serve at the pleasure of the court. It is augmented by retired judges when the case load is heavy. The court's offices are in Washington, D.C., but it maintains a field office in Los Angeles and holds trial sessions throughout the United States.
Bibliography: Taylor, M. W., and Simonson, K. J., Tax Court Practice, 7th ed. (1990).