Income Tax

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.

IV

Collection and Filing of Income Taxes

In the United States, the IRS relies on taxpayers to comply with the law and voluntarily calculate and pay their taxes. In 2002 the IRS handled about 131 million federal personal income tax returns and almost 6 million corporate income tax returns. The agency also monitors tax evasion, instances in which people or corporations illegally avoid paying some or all of their required income taxes. The IRS may audit (check for accuracy and compliance in payment) anyone they suspect of tax evasion by requesting complete records of all earnings and expenses.

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Most employers automatically withhold (deduct) a portion of their employees’ wages and send them to the IRS once or twice a month. Thus, income tax withholdings actually earn interest for the federal government throughout the year. Employees must fill out a form W-4 for their employers, on which they claim allowances (reductions in taxes withheld) or increase withholding, depending on what they expect to owe.

People and corporations who have major sources of income from which taxes are not automatically withheld generally pay estimated taxes at intervals throughout the year. People who are self-employed, for instance, often pay estimated taxes. Most people who pay estimated taxes send them to the IRS four times a year.

The U.S. tax filing deadline, the date by which returns such as the 1040 form must be sent to the IRS, falls on April 15 every year. Most people compute and file their taxes themselves, working at home using forms received in the mail from the IRS or obtained from government institutions or public libraries. People with relatively complex finances may pay professional tax preparers to calculate and file their returns. In the 1990s the IRS began accepting returns filed electronically. People can file by phone or by using a computer connected to the Internet and one of several types of tax preparation software that contain copies of official tax forms.

Most people and corporations aim to have their withholdings and estimated taxes match what they will owe each year at filing time, so that no taxes will be due. The IRS assesses a monetary penalty on people who pay too little in taxes throughout the year and have a large tax bill at filing time. People who overpay get refund checks from the government.

V

Problems in Income Taxation

Many specific problems affect the U.S. income tax system. These problems include (1) deciding what income to tax, (2) the management of tax loopholes and shelters, (3) the effects of inflation, (4) inequities in the taxation of people who pay under different filing statuses, and (5) the taxation of capital gains. Income tax systems in other countries share some of the same problems and have different problems of their own. These problems, along with the overall complexity of tax laws, have prompted citizens and politicians in many countries to regularly call for income tax reform. Most governments periodically review and amend their tax laws, often in response to the concerns of particular industries or groups of people.

A

Defining Income

To collect income taxes, governments have to specify what counts as income and what kinds of income they will tax. The most widely accepted definition of income was developed by American economists Robert M. Haig and Henry C. Simons in the 1920s and 1930s. According to this definition, income is the money value of the net (overall) increase over a period of time in a person’s potential to consume. Consumption, in economics, refers broadly to the purchase or acquisition of goods and services of any kind. The increase in potential to consume equals actual consumption plus saving.

Many economists consider the Haig-Simons definition of income the ideal on which to base income taxes. However, this definition identifies many more sources of income than the U.S. government, or any government, actually taxes.

An income tax system designed to collect all forms of income would face a number of practical problems. For example, a parent who stays at home taking care of a child is producing valuable services for the family. In principle, these services have value as income, but what is their precise money value in terms of their potential to increase consumption? Is it the same as the cost of a professional child-care service, and if so, at what wage? Because the government cannot make these determinations, it does not count the value of some types of work as income.

According to the Haig-Simons definition, the measurement of income should take into account the expenses of earning, such as business expenses. Indeed, the tax code allows people and corporations to subtract the costs of doing business. But the differences between earning expenses and consumption may sometimes be unclear. For example, if someone buys a computer for working at home but also uses the computer to play video games, how much of the computer should count as an expense of earning income and how much as consumption?

B

Loopholes and Shelters

People and corporations may find legal ways to avoid paying some taxes. Tax rules that allow taxpayers to do this are commonly called tax loopholes and tax shelters.

Tax loopholes develop when tax laws create ways for taxpayers to legally avoid paying taxes on some earnings. The U.S. tax code contains many loopholes. Why? Some people may see loopholes where others see desirable tax exemptions that will benefit society. For example, some people characterize the exclusion of interest earned on state and local bonds from taxation as a loophole, arguing that it should be taxed like any other form of income. Others believe that this exemption serves a useful social goal by making it less expensive for state and local governments to borrow money for such projects as building schools and repairing roads.

Tax shelters shield certain kinds of income from some or all taxation. People can move income from a place that is subject to standard taxation, such as a personal savings account, into a sheltered place, such as a low-tax or tax-free investment. A very simple type of shelter involves transferring capital income (dividends and interest) from someone who has a high marginal tax rate to someone who has a low marginal tax rate.

For example, parents can save on their tax payments by making investments in the names of dependent children 14 years or older. Children generally have little or no income of their own, and therefore have low marginal tax rates. Thus, if parents invest money in a child’s name, the income from at least part of that investment is taxed at the lowest marginal rate. Taxing everyone at the same marginal tax rate would eliminate this kind of shelter, but it would also eliminate progressivity from the tax system, which many people would regard as undesirable.

Governments may have political motivations for creating certain tax shelters. For instance, the U.S. government offers what it calls a depletion allowance to oil and natural gas companies to stimulate exploration of new sources of fossil fuels. The government could also stimulate this exploration by giving money directly to the companies. The allowance is more politically attractive because, among other things, it disguises what is essentially a subsidy to oil and gas companies. Otherwise, the government would have to put the subsidy into a budget proposal, where the public could more easily scrutinize or reject it. To work, these kinds of shelters must clearly target their intended users.

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