Taxes

The Federal Tax System

The United States is a federal republic with autonomous state and local governments with taxes imposed at each level.

Learning Objectives

Describe the various levels of the tax structure in the United States

Key Takeaways

Key Points

  • Taxes are imposed on net income of individuals and corporations by federal, most state, and some local governments. Federal tax rates vary from 10% to 35% of taxable income. State and local tax rates vary widely by jurisdiction, from 0% to 12.696% and many are graduated.
  • Payroll taxes are imposed by the federal and all state governments. These include Social Security and Medicare taxes imposed on both employers and employees, at a combined rate of 15.3% (13.3% for 2011).
  • Property taxes are imposed by most local governments and many special purpose authorities based on the fair market value of property. Sales taxes are imposed on the price at retail sale of many goods and some services by most states and some localities.

Key Terms

  • autonomous: Self-governing. Governing independently.
  • tariff: a system of government-imposed duties levied on imported or exported goods; a list of such duties, or the duties themselves

The Federal Tax System

The United States is a federal republic with autonomous state and local governments. Taxes are imposed at each of these levels. These include taxes on income, payroll, property, sales, imports, estates and gifts, as well as various fees. The taxes collected in 2010 by federal, state and municipal governments amounted to 24.8% of the GDP.

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U.S. Tax Revenues: U.S. Tax Revenues as a Percentage of GDP

Taxes are imposed on net income of individuals and corporations by the federal, most state, and some local governments. Citizens and residents are taxed on worldwide income and allowed a credit for foreign taxes. Income subject to tax is determined under tax rules, not accounting principles, and includes almost all income. Most business expenses reduce taxable income, though limits apply to a few expenses. Individuals are permitted to reduce taxable income by personal allowances and certain non-business expenses that can include home mortgage interest, state and local taxes, charitable contributions, medical, and certain other expenses incurred above certain percentages of income. State rules for determining taxable income often differ from federal rules. Federal tax rates vary from 10% to 35% of taxable income. State and local tax rates vary widely by jurisdiction, from 0% to 12.696% and many are graduated. State taxes are generally treated as a deductible expense for federal tax computation. Certain alternative taxes may apply. The United States is the only country in the world that taxes its nonresident citizens on worldwide income or estate, in the same manner and rates as residents.

Payroll taxes are imposed by the federal and all state governments. These include Social Security and Medicare taxes imposed on both employers and employees, at a combined rate of 15.3% (13.3% for 2011). Social Security tax applies only to the first $106,800 of wages in 2009 through 2011. Employers also must withhold income taxes on wages. An unemployment tax and certain other levies apply.

Property taxes are imposed by most local governments and many special purpose authorities based on the fair market value of property. School and other authorities are often separately governed, and impose separate taxes. Property tax is generally imposed only on realty, though some jurisdictions tax some forms of business property. Property tax rules and rates vary widely.

Sales taxes are imposed on the retail price of many goods and some services by most states and some localities. Sales tax rates vary widely among jurisdictions, from 0% to 16%, and may vary within a jurisdiction based on the particular goods or services taxed. Sales tax is collected by the seller at the time of sale, or remitted as use tax by buyers of taxable items who did not pay sales tax.

The United States imposes tariffs or customs duties on the import of many types of goods from many jurisdictions. This tax must be paid before the goods can be legally imported. Rates of duty vary from 0% to more than 20%, based on the particular goods and country of origin.

Estate and gift taxes are imposed by the federal and some state governments on property passed by inheritance or donation. Similar to federal income taxes, federal estate and gift taxes are imposed on worldwide property of citizens and residents and allow a credit for foreign taxes.

Federal Income Tax Rates

Federal income tax is levied on the income of individuals or businesses, which is the total income minus allowable deductions.

Learning Objectives

Summarize the key moments in the development of a national income tax

Key Takeaways

Key Points

  • In order to help pay for its war effort in the American Civil War, the federal government imposed its first personal income tax on August 5, 1861 as part of the Revenue Act of 1861.
  • In 1913, the Sixteenth Amendment to the Constitution made the income tax a permanent fixture in the U.S. tax system.
  • Taxpayers generally must self assess income tax by filing tax returns. Advance payments of tax are required in the form of withholding tax or estimated tax payments.
  • The 2012 marginal tax rates for a single person is 10 percent for $0–8,700, 15 percent for $8,701–35,350, 25 percent for $35,351–85,650, 28 percent for $85,651–178,650, 33 percent for $178,651–388,350 and 35 percent for $388,351 and up.
  • In the United States, payroll taxes are assessed by the federal government, all fifty states, the District of Columbia, and numerous cities.
  • The United States social insurance system is funded by a tax similar to an income tax.

Key Terms

  • net: The amount remaining after expenses are deducted; profit.

Federal income tax is levied on the income of individuals or businesses. When the tax is levied on the income of companies, it is often called a corporate tax, corporate income tax or profit tax. Individual income taxes often tax the total income of the individual, while corporate income taxes often tax net income. Taxable income is total income less allowable deductions.

Income is broadly defined. Most business expenses are deductible. Individuals may also deduct a personal allowance and certain personal expenses. These include home mortgage interest, state taxes, contributions to charity, and some other items. Some of these deductions are subject to limits. Capital gains are taxable, and capital losses reduce taxable income only to the extent of gains. Individuals currently pay a lower rate of tax on capital gains and certain corporate dividends.

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U.S. Income Taxes out of Total Taxes: This graph shows the revenue the U.S. government has made purely from income tax, in relation to all taxes.

In order to help pay for the American Civil War, the federal government imposed its first personal income tax on August 5, 1861 as part of the Revenue Act of 1861. The tax rate was 3 percent of all incomes over $800 ($20,693 in 2011 dollars). This tax was repealed and replaced by another income tax in 1862.

In 1894, Democrats in Congress passed the Wilson-Gorman tariff, which imposed the first peacetime income tax. The rate was 2 percent on income over $4,000 ($107,446.15 in 2011 dollars). This meant fewer than 10 percent of households would pay the tax. The purpose of Wilson-Gorman tariff was to make up for revenue that would be lost by other tariff reductions.

In 1895 the Supreme Court, in Pollock v. Farmers’ Loan & Trust Co., ruled that a tax based on receipts from the use of property was unconstitutional. The Court held that taxes on rents from real estate, interest income from personal property, and other income from personal property were treated as direct taxes on property, and had to be apportioned. Since apportionment of income taxes was impractical, this decision effectively prohibited a federal tax on income from property.

In 1913, the Sixteenth Amendment to the Constitution made the income tax a permanent fixture in the U.S. tax system. The United States Supreme Court, in Stanton v. Baltic Mining Co., ruled that the amendment conferred no new power of taxation. They ruled that it simply prevented the courts from taking the power of income taxation from Congress. In fiscal year 1918, annual internal revenue collections for the first time passed the billion-dollar mark, rising to 5.4 billion by 1920. With the advent of World War II, employment increased, as did tax collections—to 7.3 billion. The withholding tax on wages was introduced in 1943 and was instrumental in increasing the number of taxpayers to $60 million and tax collections to $43 billion by 1945.

Taxpayers generally must self-assess income tax by filing tax returns. Advance payments of tax are required in the form of withholding tax or estimated tax payments. Taxes are determined separately by each jurisdiction imposing tax. Due dates and other administrative procedures vary by jurisdiction. April 15 is the due date for individual returns for federal and many state and local returns. Tax, as determined by the taxpayer, may be adjusted by the taxing jurisdiction.

Social Security Tax

The United States social insurance system is funded by a tax similar to an income tax. Social Security tax of 6.2% is imposed on wages paid to employees. The tax is imposed on both the employer and the employee. For 2011 and 2012, the employee tax has been reduced by 6.2% to 4.2%. The maximum amount of wages subject to the tax for 2009, 2010, and 2011 was/is $106,800. This amount is indexed for inflation. A companion Medicare Tax of 1.45% of wages is imposed on employers and employees, with no limitation. A self-employment tax in like amounts (totaling 15.3%, 13.3% for 2011 and 2012) is imposed on self-employed persons.

Payroll Tax

Payroll taxes generally fall into two categories: deductions from an employee’s wages and taxes paid by the employer based on the employee’s wages. In the United States, payroll taxes are assessed by the federal government, all fifty states, the District of Columbia, and numerous cities. These taxes are imposed on employers and employees and on various compensation bases and are collected and paid to the taxing jurisdiction by the employers. Most jurisdictions imposing payroll taxes require reporting quarterly and annually in most cases, and electronic reporting is generally required for all but small employers.

Tax Loopholes and Lowered Taxes

Tax evasion is the term for efforts by individuals, corporations, trusts and other entities to evade taxes by illegal means.

Learning Objectives

Describe the legal and illegal ways individuals and corporations avoid paying some or all taxes owed

Key Takeaways

Key Points

  • The ” term tax mitigation ” has also been used in the tax regulations of some jurisdictions to distinguish tax avoidance foreseen by the legislators from tax avoidance, which exploits loopholes in the law.
  • The United States Supreme Court has stated that “The legal right of an individual to decrease the amount of what would otherwise be his taxes or altogether avoid them, by means which the law permits, cannot be doubted”.
  • Tax evasion is the general term for efforts by individuals, corporations, trusts, and other entities to evade taxes by illegal means. Both tax avoidance and evasion can be viewed as forms of tax noncompliance, as they describe a range of activities that are unfavorable to a state’s tax system.
  • The Internal Revenue Service has identified small business and sole proprietorship employees as the largest contributors to the tax gap between what Americans owe in federal taxes and what the federal government receives.
  • When tips, side-jobs, cash receipts, and barter income is not reported, it is illegal cheating because no tax are paid by individuals. Similarly, those who are self-employed or run small businesses may not declare income and evade the payment of taxes.

Key Terms

  • mitigation: relief; alleviation
  • loophole: A method of escape, especially an ambiguity or exception in a rule that can be exploited in order to avoid its effect.
  • evasion: The act of eluding or avoiding, particularly the pressure of an argument, accusation, charge, or interrogation; artful means of eluding.

Tax Avoidance

Tax avoidance is the legal utilization of the tax regime to one’s own advantage, to reduce the amount of tax that is payable by means that are within the law. The term tax mitigation’s original use was by tax advisors as an alternative to the pejorative term tax avoidance. The term has also been used in the tax regulations of some jurisdictions to distinguish tax avoidance foreseen by the legislators from tax avoidance which exploits loopholes in the law. The United States Supreme Court has stated that “The legal right of an individual to decrease the amount of what would otherwise be his taxes or altogether avoid them, by means which the law permits, cannot be doubted. ”

Tax Evasion

Tax evasion is the general term for efforts by individuals, corporations, trusts and other entities to evade taxes by illegal means. Both tax avoidance and evasion can be viewed as forms of tax noncompliance, as they describe a range of activities that are unfavorable to a state’s tax system. Tax evasion is an activity commonly associated with the underground economy, and one measure of the extent of tax evasion is the amount of unreported income, namely the difference between the amount of income that should legally be reported to the tax authorities and the actual amount reported, which is also sometimes referred to as the “tax gap. ”

Taxes are imposed in the United States at each of these levels. These include taxes on income, payroll, property, sales, imports, estates, and gifts, as well as various fees. In 2010, taxes collected by federal, state and municipal governments amounted to 24.8% of GDP. Under the federal law of the United States of America, tax evasion or tax fraud is the purposeful illegal attempt of a taxpayer to evade payment of a tax imposed by the federal government. Conviction of tax evasion may result in fines and imprisonment.

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U.S. Income Taxes out of Total Taxes: This graph shows the revenue the U.S. government has made purely from income tax, in relation to all taxes.

The Internal Revenue Service has identified small business and sole proprietorship employees as the largest contributors to the tax gap between what Americans owe in federal taxes and what the federal government receives. Rather than W-2 wage earners and corporations, small business and sole proprietorship employees contribute to the tax gap, because there are few ways for the government to know about skimming or non-reporting of income without mounting more significant investigations. When tips, side-jobs, cash receipts, and barter income is not reported it is illegal cheating, because no tax is paid by individuals. Similarly, those who are self-employed or run small businesses may not declare income and evade the payment of taxes.

Examples of Tax Evasion

An IRS report indicates that, in 2009, 1,470 individuals earning more than $1,000,000 annually faced a net tax liability of zero or less. Also, in 1998 alone, a total of 94 corporations faced a net liability of less than half the full 35% corporate tax rate and the corporations Lyondell Chemical, Texaco, Chevron, CSX, Tosco, PepsiCo, Owens & Minor, Pfizer, JP Morgan Saks, Goodyear, Ryder, Enron, Colgate-Palmolive, Worldcom, Eaton, Weyerhaeuser, General Motors, El Paso Energy, Westpoint Stevens, MedPartners, Phillips Petroleum, McKesson, and Northrup Grumman all had net negative tax liabilities. Additionally, this phenomenon was widely documented regarding General Electric in early 2011. A Government Accountability Office study found that, from 1998 to 2005, 55% of United States companies paid no federal income taxes during at least one year in a seven-year period it studied. A review in 2011 by Citizens for Tax Justice and the Institute on Taxation and Economic Policy of companies in the Fortune 500 profitable every year from 2008 through 2010 stated these companies paid an average tax rate of 18.5%, and that 30 of these companies actually had a negative income tax due.

In the United States, the IRS estimate of the 2001 tax gap was $345 billion. For 2006, the tax gap is estimated to be $450 billion. A more recent study estimates the 2008 tax gap in the range of $450–$500 billion, and unreported income to be approximately $2 trillion. Thus, 18-19 percent of total reportable income is not properly reported to the IRS.