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.

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.

A.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.

A.2.

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.

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.

A.3.

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.

A.4.

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.

B.1.

Exemptions

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

B.2.

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.

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.

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.

C.

Effects of Inflation

Inflation, a general rise in prices over time, creates problems for income taxation because it affects people’s purchasing power—their ability to buy goods and services (see Inflation and Deflation). If people’s income and the general level of prices both increase at the same rate over time, then people’s real income—the amount their income will buy—remains the same. In other words, if your income doubled, but at the same time all prices doubled because of inflation, you would be no better or worse off. However, unless special actions are taken, under the existing progressive bracket rate schedule, the proportion of your income taken by taxes would increase.

Increases in income due to inflation can push people into higher tax brackets, a phenomenon known as bracket creep. In effect, inflation can increase people’s tax liability without any change in tax law.

To counteract bracket creep, the U.S. government has created a system known as tax indexing. In this system, the government ties the income ranges of the brackets to the rate of inflation. If prices double, then the level of income at which each bracket begins also doubles. The government has adjusted income tax brackets for inflation every year since 1985. It has also adjusted the standard deduction and the personal exemption levels over the same period.

Unfortunately, even indexed tax brackets cannot prevent inflation from negatively affecting taxpayers who invest in capital assets. Suppose, for instance, that an individual purchased some stock for $3,000, which then appreciated over four years to be worth twice as much, or $6,000. Suppose, also, that over those four years, all prices doubled because of inflation. The person could then sell the stock for $6,000 but have no increase in real income. The real value of the asset did not change. However, the individual would still have to pay taxes on the realized capital gain of $3,000.

To prevent this problem, the government could index the computation of capital gains to inflation, as it does the tax brackets. In other words, the law could allow taxpayers to adjust, on their tax forms, the purchase price of assets according to the amount of inflation that occurs between the time of purchase and the time of sale. In the above example, indexing the $3,000 purchase price to inflation, yielding a price of $6,000, would result in no real capital gain over four years and no capital gains taxes.

But this creates a new problem. If capital gains were indexed to inflation, it would be necessary to do so for all forms of capital income (such as interest), and this would create great complexity. Because of such difficulties, neither the U.S. nor the Canadian tax system has instituted indexing for capital gains.

D.

Taxable Unit and the Marriage Tax

Another problem in income taxation is how to fairly tax people who file as individuals and people who file as a family. Economists refer to any person or group of people who files a single income tax return as a taxable unit. In U.S. tax law, the taxable unit may vary. For instance, married people may choose to file separately as individuals or jointly as a couple. But in a progressive tax system, two people or two families with identical incomes can owe different amounts of taxes depending on whether their filing status is single, married filing separately, or married filing jointly.

Suppose that two people who earn about the same amount of money get married. Then their joint income (combined income) may put them in a higher tax bracket than either was in when single. This problem, a phenomenon known as the marriage tax, creates a tax penalty on marriage. Many people consider the marriage tax unfair and even a disincentive to marriage, something the government does not intend.

Perhaps the solution, then, would be for couples subject to the marriage tax to file as separate individuals, thus changing the choice of taxable unit. But in some circumstances, this leads to another problem. A couple in which both partners earn equal amounts often owes less in taxes than a couple in which one partner earns most of the income (and thus falls into a higher tax bracket), even though the total incomes of the two households are identical.

Both of these problems—the marriage tax and inequitable taxation of married couples filing separately—would disappear in a proportional income tax system. If one tax rate applied to all people, then all individuals with identical incomes, whether single or married, would pay the same total taxes. Couples with identical incomes would also always pay the same total taxes. But many people would not support doing away with the progressive tax rate structure in order to eliminate the marriage tax or the problem of the taxable unit. Again, conflicting objectives in tax design—in this case, the objectives of keeping a progressive tax and not penalizing or unfairly taxing families—lead to difficult choices. In 2001, the U.S. Congress attempted to address the problem by passing the Economic Growth and Tax Relief Reconciliation Act of 2001. The new law increased the basic standard deduction for a married couple filing a joint return to twice the basic standard deduction for an unmarried individual filing a single return. Although this reform reduced the marriage tax for some couples, it remained a serious issue for many others because it only affected households that take the standard deduction.  About 30 percent of tax returns do not use the standard deduction.  These taxpayers itemize their deductions, so the change in the marriage tax had no effect on them.

E.

Capital Gains Taxation

The difficulty of tracking capital gains and capital losses (losses from the sale of financial assets) creates one of the most significant problems for income tax collection. The government could earn a great amount of additional revenue if it could tax unrealized capital gains. But the value of an asset may be difficult to determine until the owner of that asset decides to sell it—that is, until the gain on the asset is realized.

People do commonly assess the value of certain types of unrealized assets, such as land and housing, in order to obtain loans or insurance. However, the expense and difficulty of such assessments makes them impractical for tracking capital gains and losses. Thus, unrealized capital gains go untaxed, even though all capital gains increase one’s potential to consume.

Because only realized capital gains are taxed, individuals who are thinking about exchanging assets face a dilemma. Whenever people sell current assets in order to obtain money to buy other assets, they must pay capital gains taxes. Thus, people are discouraged from buying new assets. This phenomenon is called the lock-in effect because the tax system tends to lock investors into their current investments.

Many economists see the lock-in effect as unhealthy for the economy. The effect would essentially disappear if the government stopped taxing capital gains. But this would create another problem. People would begin using capital assets as tax shelters, converting other forms of income in order to escape taxation and significantly reducing the government’s revenues.

Another problem in capital gains taxation concerns fairness to people with different levels of income. The U.S. government taxes realized capital gains at lower rates than it does other sources of income. Favorable rates for realized capital gains give what many people consider an unfair advantage to people who have higher incomes and can afford to invest in such assets.

In 2003, following passage of new tax cuts, the maximum tax rate on capital gains was 15 percent. By contrast, the government taxed other forms of income, such as wages, at a maximum rate of 35 percent. The Canadian government also extends favorable tax treatment to realized capital gains.

VI.

History of Income Taxation

A.

Early Development

Income taxation has existed in various forms for thousands of years. In all civilized societies, a central administration has collected portions of people’s productive output to use as a reserve in hard times, to provide for the needy, and to increase the wealth and power of rulers. Until the modern era, rulers and their administrators would commonly take portions of people’s crops, with no consideration of the costs of farm work.

The resources that rulers obtained through taxation allowed them to undertake such activities as building monuments and waging battles. Thus, taxes supported all early civilizations—first in the Middle East, and then around the world.

For example, in one of the earliest known civilizations, the 6,000-year-old society of Lagash, Sumer, in present-day Iraq, taxation supported massive warfare. During a time of peace, a new king established freedom by ending all tax collection. Lagash soon fell to outside invaders. The Old Testament of the Bible also contains rules requiring farmers to turn over a tithe (one-tenth) of their crops to their kings. Some portion of these taxes served as a safety net for those in need. Once the food was collected, it was to be made available to “the stranger, and the fatherless, and the widow” so that they could “eat and be satisfied” (see Deuteronomy 14:28-29).

B.

The First Income Taxes

Early systems of public finance often taxed a variety of goods and activities, including property, trade, and sometimes wealth. Administrators in England attempted to collect the first true income tax, a tax on wages, in 1404, but the public quickly demanded its repeal, and all tax records were burned.

Modern forms of income taxation date to a British income tax levied in 1799. This tax raised revenues for the Napoleonic Wars against France, which Britain and a coalition of other European nations won in 1815. By popular demand, the British repealed a second income tax in 1816. All of these tax records were also burned.

In 1842 Britain introduced another income tax that was less burdensome. This tax survived, and within a few decades, income taxes provided significant revenues to the British government. By the end of the 19th century, Germany, the Netherlands, Sweden, Switzerland, Canada, and several other countries had enacted income taxes.

C.

Early U.S. Income Taxation

The Constitution of the United States, drafted in 1787, prohibited a direct tax on citizens. But the Supreme Court of the United States supported the government’s enactment of the country’s first income tax in 1862, during the Civil War (1861-1865).

The government of the North was not able to finance the war using traditional revenue sources such as tariffs (taxes on imports and exports), and the government imposed the income tax as an emergency measure. This tax, which the government renewed in 1864, had a progressive rate structure, taking higher percentages from higher incomes. After the war, the revenue needs of the U.S. government declined dramatically. After a series of reductions in tax rates, the government repealed the income tax in 1872.

By the late 19th century, however, businesspeople and citizens began to express dissatisfaction with the existing federal system of public finance. At that time, the government relied heavily on three sources for its revenues: tariffs, excise taxes (taxes on specific items, such as alcohol), and property taxes. Many people complained that these taxes, particularly tariffs, hurt farmers and other workers, and drove up prices, which affected the poor. Many believed that a progressive income tax was a fairer mechanism for raising taxes because it would put more of the tax burden on wealthier citizens.

The United States Congress passed an income tax law in 1894 that imposed a 2 percent tax on all income over $4000. In 1895 the Supreme Court ruled the new income tax inequitable and unconstitutional. The ruling asserted that a legal tax on U.S. citizens had to bring in revenues in proportion to each state’s total population, a requirement the 1894 tax did not meet.

D.

Creation of the Modern U.S. Income Tax

In 1913 the states ratified the 16th Amendment to the Constitution, which authorized Congress to tax the incomes of citizens. In late 1913 Congress instituted a restricted tax on personal income, with a maximum rate of 7 percent. This new income tax treated capital gains as regular income and taxed them at the same rates. A 1918 tax act allowed the first full deductions for capital losses. Another tax act in 1921 instituted favorable tax rates on capital gains for the first time, a practice that continued in various ways for many decades.

In its basic structure, this original income tax resembled the modern U.S. income tax system. The first income tax included exemptions and deductions from total income in order to compute taxable income. It also applied a graduated scale of marginal tax rates to determine tax liability. However, there were critical differences. For example, the bracket rates ranged from 1 to 7 percent, compared with the range of 10 to 38.6 percent in 2002. Further, the personal exemption was very large relative to the incomes that prevailed at the time. As a consequence, very few people even filed income tax returns.

Until World War II (1939-1945), the income tax did not contribute much to U.S. federal government revenue. As late as 1942, individual income taxes made up only 2 to 3 percent of the country’s gross domestic product (GDP), or total national income. During the war, however, the government raised income tax rates and cut personal exemptions.

In 1943 the U.S. government began to withhold taxes for certain social programs, such as Social Security, from people’s pay, which made tax collection much easier. By 1945 bracket rates ranged from 23 to 94 percent, and the income tax accounted for close to 9 percent of GDP. After the war, the top tax rate fell substantially, but since then individual income taxes have generally accounted for 8 to 10 percent of GDP.

E.

Recent Reforms

By the end of the 1970s, many citizens and politicians began to call for income tax reform. They wanted lower tax burdens. They also complained about the complexity of income tax laws, which made it almost impossible for some people to file their own taxes without the help of a professional tax preparer.

Popular demand for less and simpler income taxation prompted Congress under President Ronald Reagan to pass the Tax Reform Act of 1986. Reagan believed that lower taxes would stimulate work, saving, and investment, a theory known as supply-side economics.

The 1986 act introduced many significant changes to long-standing tax laws. It reintroduced the practice of treating capital gains as ordinary income, without preferential rates. The act also eliminated previously established deductions, including those for sales taxes paid and for interest paid on student and consumer loans. In addition, it raised the personal exemption and standard deduction so that fewer families would need to itemize deductions—which requires extensive record keeping—or need to file at all if they had low incomes. These changes, along with an increase in taxes on corporate income, enabled legislators to lower marginal tax rates. The top rate fell from 50 percent to 28 percent.

However, parts of the reform did not last into the 1990s. The high costs of government operations, combined with cuts in income taxes, produced a growing federal budget deficit. In 1990 Congress under President George H. W. Bush passed a deficit-reduction bill that cut government spending and included income tax increases. The deficit continued to grow, however, for the next two years.

In 1993 Congress under President Bill Clinton passed another deficit-reduction plan with more spending cuts and tax increases. Among other provisions, the 1993 Omnibus Budget Reconciliation Act added two new top income tax brackets of 36 and 39.6 percent for higher income individuals and families, and raised taxes on many Social Security benefits. It reinstituted favorable tax rates on many realized capital gains, making capital assets such as corporate stocks more attractive as tax shelters. The act also added new tax-deferred retirement savings plans and gave new credits to the poor.

The budget deficit actually decreased after 1993 to fairly low levels, in part because of higher than expected tax revenues from capital income. Encouraged by these changes, in 1997 Congress under President Clinton passed the Taxpayers’ Relief Act.

Among the two largest reductions in the 1997 act were new credits for families with children and for people with certain expenses for college or other types of higher education. The act also established new reductions on the taxation of many capital gains. The 1997 act, however, introduced substantial new complexity into the income tax system.

In 2001, under the administration of President George W. Bush, Congress sought to lower taxes still more with passage of the Economic Growth and Tax Relief Reconciliation Act. The act reduced the lowest tax bracket to 10 percent immediately and the top tax bracket to 35 percent by the year 2006, addressed the marriage tax penalty by doubling the standard deduction for married couples filing jointly, raised exemptions for estate and gift taxes, and offered tax savings for adoption, childcare, education, and retirement. The act contained a sunset provision, however, that in effect repealed the law in 2011. See also Estate Tax, Gift Tax.

Another round of tax cuts in 2003, the third largest cuts in U.S. history, immediately reduced the top tax bracket to 35 percent, increased the amount of tax credit per child for certain income levels, and lowered the tax rate on capital gains and dividends. The tax rate on capital gains went from 20 percent to 15 percent, while the rate on dividends, which were previously counted as ordinary income and could be taxed as high as 38.6 percent, was fixed at a maximum of 15 percent. The 2003 cuts became controversial, however, because they substantially increased budget deficits and because many critics, especially congressional Democrats, said the cuts favored the wealthy. The legislation narrowly passed Congress. To win passage, the Bush administration had to agree to new sunset provisions so that most of the tax-cut provisions would expire after either 2003 or 2004.