Income Tax

I

Introduction

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.

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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.

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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.

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1

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.

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