Income Tax, It's Types And All About It.....

 Income Tax,a tax on the earnings of a person or corporation. Income taxes provide the largest single source of government revenues in most developed countries, including the United States and Canada. The revenues generated pay for a substantial part of government operations and services to the public.

In the United States, the federal government, most states, and a small number of local and municipal governments collect income taxes. In 2000 the U.S. federal government collected about $1 trillion in income taxes from individuals and about $200 billion in income taxes from corporations. Together these two sources accounted for about 60 percent of all federal revenues. State and local governments collect larger shares of their revenues from property taxes and sales taxes than from income taxes.

In Canada, the federal government, the provinces and territories, and a few local governments collect income taxes. In 2001 income taxes from individuals and corporations accounted for more than 56 percent of Canada’s federal revenues. Canadian provincial governments also collect the largest single portion of their revenue from income taxes.

Income taxes, and especially individual income taxes, are smaller sources of revenue in most developing countries, such as many nations of Africa, Asia, and Latin America. Some developing countries, however, generate a large portion of government revenues from corporate income taxes.

Governments levy income taxes on many kinds of earnings, including wages, interest on savings, and dividends from investments. People and corporations must report their income annually using tax forms, called returns. In the United States, the Internal Revenue Service (IRS), a division of the Department of the Treasury, administers the federal income tax.

The taxation of income has often created controversy. Many people oppose their government taking portions of their earnings to fund programs they may not support. Politicians and economists have also long debated how to design fair and simple income tax systems. Although they may agree in principle to tax income, they often disagree on what counts as income or on how much it should be taxed. See also Taxation; Public Finance.

II  TYPES OF INCOME TAX 

There are two types of income taxes in the United States and Canada: the individual income tax and the corporate income tax. The individual income tax, also called the personal income tax, is a tax on a person’s earnings. The corporate income tax is a tax on the profits of a corporation.

Economists classify three types of income tax systems: progressive, regressive, and proportional. In a progressive tax system, the tax rate (the proportion of earnings taken in taxes) is greater for higher incomes. With a regressive tax, people who earn less pay a larger part of their income in taxes than do people who earn more. For example, in a regressive tax system a person earning $10,000 per year might pay $1,000 in taxes, or 10 percent of income, whereas a person earning $100,000 per year might pay $8,000 in taxes, or 8 percent of income. Although the person earning more also pays more in taxes, the tax is actually a smaller portion of total income. In a proportional tax system, all people pay the same percentage of their earnings in taxes.

The United States, Canada, and many other countries have progressive federal income tax systems. These tax systems put greater demands on those who earn the most and proportionally fewer demands on those who earn the least. However, some economists believe that a series of tax cuts in the United States in 2001 and 2003 shifted the U.S. tax system toward one that favors wealthy investors by reducing taxes on income from investments by both businesses and individuals.

A  U.S. Individual Income Tax 

All people in the United States who earn income must pay taxes and file (send to the government) federal income tax returns. Income can come from many sources. Taxable earnings include wages and salaries from work, rents (fees for use of property), interest on savings, shareholder dividends from investments in businesses, and capital gains (profits made from the sale of financial assets). Many people also receive a large part of their income from other sources, such as government compensation programs, educational grants and scholarships, and legal settlements. Although the government taxes many kinds of income, it also excludes some kinds of income from taxation.

A1  Employment Earnings 

Earnings from work are the largest source of taxable income for most people. These earnings include salaries or wages, and in some jobs, tips, fees, or commissions. Self-employed individuals must also report their earnings as taxable income. Depending on how much people earn, a part of their retirement social security benefits may count as taxable income, as do most pensions and annuities. See also Retirement Plans.

In addition, many types of in-kind payments—compensation in the form of goods or services instead of cash—count as taxable income. For example, some businesses give employees fringe benefits, such as membership to a health club, many of which count as income. Employees who receive certain kinds of employer-provided stock options must also report them as income. 

The government does not tax some types of work-related compensation and benefits. These include the value of employer-provided health insurance or life insurance coverage up to a certain dollar amount.

A2  Interest Income 

Several kinds of interest count as income for tax purposes. Sources of interest income include most interest-bearing bank accounts, mutual funds, certificates of deposit, and federal government bonds. The tax code specifies several other forms of interest as nontaxable income. Interest received on bonds issued by state and local governments is not subject to federal tax. Under certain circumstances, individuals can also avoid paying taxes on the interest they earn from savings for retirement.

 In many [retirement] plans, deposits and interest earnings are exempt from taxation. 

Tax-deferred retirement options include individual retirement accounts (IRAs), special accounts into which limited amounts of money can be deposited to finance retirement; 401(k) plans, which deduct funds from employee paychecks; and Keogh plans, available to the self-employed. In these plans, deposits and interest earnings are exempt from taxation until they are withdrawn. A new type of IRA, known as a Roth IRA, offers tax-free withdrawal. Although contributions are taxed, the interest earned on contributions is exempt from taxation.

A3  Dividend Income and Capital Gains 

When people invest in companies by buying shares of stock, they may receive yearly dividends (returns on company profits), which count as income. Profits from the sale of financial assets—including securities, derivatives, or personal property—count as capital gains. For example, if a person buys $1,000 worth of stock at the beginning of the year and sells the stock after it increases in value to $1,200, the person achieves a capital gain of $200. When a person sells an asset that has gained value, the capital gain is said to be realized, and the gain counts as taxable income. The government does not tax unrealized capital gains—gains on assets that have increased in value but that have not been sold.

A4  Other Income 

Many people also earn income from a variety of sources other than employment or investment. The government taxes many of these other forms of income, including payments from government unemployment insurance programs; alimony payments received by divorced spouses; fees earned from renting out real estate (such as land, office space, and housing); royalties earned from sales of patented or copyrighted items, such as inventions and books; winnings from gambling and prizes; and court awards in lawsuits. The tax code exempts from taxation such sources of income as welfare benefits for the poor, the elderly, and people with disabilities; veterans’ benefits for those who served in the military; workers’ compensation benefits for people who are injured on the job; proceeds from life insurance policies; and certain scholarships or grants toward schooling.

B  U.S. Corporate Income Tax 

Corporations, legally defined economic alliances of two or more people, pay taxes in much the same way as individual people. Just as individuals report their incomes, corporations must report gross profits, the year’s total sales minus the costs of production. For example, the gross profit of an automobile manufacturer equals the value of its car sales minus the cost of making cars. Corporations also have to pay tax on interest income, dividend income, capital gains, rents, and royalties.

To figure taxable income, corporations subtract a number of expenses from gross profits. These expenses include the costs of compensation to corporate officers, salaries and wages to workers, repair and maintenance of facilities, charitable contributions, advertising, and employee benefit programs. In general, the IRS requires corporations to record as much detail as possible about their finances.

Many economists note that the corporate income tax leads to so-called double taxation of corporate profits. Profits are first taxed as corporate income. But some after-tax profits become shareholder dividends, which are then taxed again as personal income. Double taxation of dividends discourages businesses from organizing as corporations. Some smaller businesses, however, may form what are known as S corporations, in which all income and expenses accrue to the shareholders themselves, who then pay the necessary taxes. Also, some economists argue that because corporate tax laws are full of loopholes, many large, profitable corporations pay little or no taxes and are not harmed by so-called double taxation.

Other economists believe that corporations have no independent ability to bear a tax, and that therefore only shareholders should be taxed on corporate income. One proposal for corporate income tax reform, known as corporate tax integration, would end double taxation and decrease the complexity of tax collection. Corporate integration would treat corporate and individual taxes more like one system than two independent systems. The corporation income tax as a separate system would cease to exist.

In one approach to corporate integration, the government would attribute all corporate earnings to shareholders, who would then pay taxes on dividends. In another approach, called dividend relief, shareholders could reduce their income tax liability by the amount of taxes on dividend distributions paid by corporations. A number of countries, including Canada, have at least some measure of dividend relief. In 2003 tax-cut legislation in the United States reduced taxes on dividends and capital gains. Dividend earnings were previously taxed as ordinary income and so could be taxed as high as 38.6 percent in 2002. The maximum tax rate for dividends under the 2003 tax cut was 15 percent. The tax rate on capital gains was lowered from 20 percent in 2002 to 15 percent in 2003. However, so-called sunset provisions revoked these tax reductions after 2004.

III  COMPUTING THE INDIVIDUAL INCOME TAX 

In the United States, Canada, and many other countries, people must calculate and report to the government their income and tax liability, (amount owed in taxes). Individuals and families in the United States generally determine their federal income tax liability in four major steps. (1) They first calculate their adjusted gross income, which equals total income minus losses and certain nontaxable income. (2) They take allowable exemptions and deductions from adjusted gross income to arrive at a figure of taxable income. (3) They consult a tax table (table that shows how much tax is owed for different amounts of income earned) or a rate schedule (list of tax rates for different levels of income) to find their preliminary tax liability based on taxable income. (4) They subtract taxes paid during the year and any allowable tax credits to arrive at the amount they must pay the government.

Most U.S. taxpayers use IRS Form 1040 to compute their tax liability. People with simpler finances can use a modified version of the 1040 form that requires fewer calculations. People with complex finances use additional forms to make calculations on income, deductions, or credits that are not included on the main 1040 form.

A  Adjusted Gross Income 

To compute adjusted gross income, U.S. taxpayers first calculate their total income. Income includes wages or personal business profits, dividends, interest, capital gains, rents, royalties, and unemployment benefits. Some people may report negative figures for these categories, such as capital losses or personal business losses. Not all income is taxable, and the government may tax only a portion of some types of income. For example, interest income from conventional bank accounts is taxable, but interest from municipal bonds is not. Income from individual retirement accounts, retirement pensions, and social security benefits may also include taxable and nontaxable amounts. Self-employed individuals may subtract their business expenses. 

Americans are allowed to subtract certain amounts from their total income to arrive at a figure for adjusted gross income. These subtractions can include expenses from moving for business purposes, contributions to IRAs or 401(k)s, the cost of insurance for the self-employed, and alimony payments. Self-employed people may subtract from their income half the amount of a tax the government requires them to pay to cover the costs of future retirement benefits—a tax that is paid separately from income taxes.

B  Taxable Income 

Adjusted gross income minus a variety of allowed subtractions equals an amount known as preliminary taxable income. The government includes these subtractions, known as exemptions and deductions, for a variety of reasons. Some are present to try to make taxes fair to people with various extra monetary burdens, some are supposed to encourage certain types of behavior, and some are responses to political influences. Exemptions and deductions can make taxable income substantially lower than adjusted gross income.

B1  Exemptions 

Any taxpayer may make a subtraction known as a personal exemption. An exemption is allowed for each member of the family. 

B2  Deductions 
Other types of subtractions from adjusted gross income are known as deductions. United States taxpayers either take a fixed-amount standard deduction or they itemize deductions (list all allowable deductions individually), whichever results in a larger deduction. 

The U.S. government allows deductions for a variety of expenses. Individuals can deduct medical expenses greater than a certain percentage of adjusted gross income. This deduction is allowed because the government assumes that very large medical expenses are beyond people's control and represent an unusual burden on their incomes. People may also deduct the cost of state and local income taxes and property taxes. The government believes that such taxes also are beyond people’s control and decrease their ability to pay federal taxes. Others view these deductions as inappropriate because state and local taxes represent payments for the goods and services provided by state and local governments.

United States homeowners benefit from another major deduction. They can deduct interest paid on mortgages, which are loans generally used to purchase a house. The rationale for this deduction is that interest from savings counts as income, so interest on expenses should be subtracted from income. But the law does not extend that logic to some other kinds of interest. For instance, taxpayers cannot deduct interest that they pay on credit card charges and automobile loans. Critics of the homeowners’ deduction say that it is unfair because it reduces income taxes for homeowners but not for renters or for purchasers of other items, such as cars.

Individuals can also deduct the value of money and in-kind contributions made to certain charitable, religious, and educational institutions. This deduction serves as government encouragement to give to charity, and evidence suggests it successfully stimulates giving.

C  Preliminary Tax Liability 

The U.S. federal income tax table shows the amount of tax due—the preliminary tax liability—for various levels of taxable income. There are four different rate schedules: (1) for married people who file together (known as a joint return); (2) for married people who file separately; (3) for single people; and (4) for single heads of household who have dependent family members.

Taxable income is divided into ranges called tax brackets, each with its own tax rate. The rate that applies to a specific bracket is known as its marginal tax rate. Income up to the top of the first bracket is taxed at that bracket’s marginal rate. The next higher rate applies to all income within the next bracket. 

D  Final Tax Liability 

To figure final tax liability, people subtract tax credits from preliminary tax liability. A tax credit reduces tax liability, as opposed to deductions or exemptions, which reduce taxable income. In order to determine the amount they must send to the government, people subtract taxes they have already paid, such as taxes withheld by employers or banks, from final tax liability.

An important example of a tax credit is the earned income tax credit, which subsidizes the earnings of poor individuals and families. Other types of credits include those for the costs of childcare and care for the elderly, for the costs of adopting a child, and for taxes paid in foreign countries during the tax year.

Many people end up owing the government some money when they file. They must send a check to the government with their tax forms. However, people who either had too much money withheld over the year in taxes or have earned income tax credits in excess of their preliminary tax liability receive payment back from the government. This payment is known as a tax refund. The U.S. Department of the Treasury issues checks to those who qualify for a refund.