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.