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.