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Understanding Taxation

Updated on January 2, 2010

Tax is a compulsory levy by a government, primarily to obtain revenue. A government may also obtain revenue by borrowing, by selling property, by imposing fines and penalties for offenses, or by charging for government services. However, most government revenue comes from taxation.

Principles of Taxation

A tax may take its name from what is taxed. There are also categories of taxes. A tax category may take its name from the way certain taxes are levied, their effects, or the amounts fixed for the taxes.

  • Direct Taxes. If a person is taxed as an individual, he pays a head or poll tax. If the money he earns is taxed, he pays an income tax. If the wealth he possesses is taxed, he may pay a property tax; in the United States, the property tax is usually a tax on houses and land. A person may also pay a tax by purchasing a license to perform a certain service, such as run a beauty parlor or sell liquor, or engage in any other activity that the government wants to control, such as own a dog or go hunting. All of these taxes are classified as direct taxes, because they are paid directly to the government by the person taxed.
  • Indirect Taxes. Sometimes the person paying the tax may cause someone else to assume the cost of the tax. This is described as "shifting" the "incidence" of the tax. For example, if a tax is imposed on the sale of goods, the seller pays the sales tax to the government, but the cost of the sales tax is added as a separate item to the customer's bill. Sales taxes and other taxes that are shifted openly from the taxpayer to the consumer are called indirect taxes. The consumer may also pay indirectly taxes that are not shifted openly to him. For example, the property tax paid by a landlord is passed on to the tenant as part of his rent. Similarly, the property tax and the tax on corporate income paid by a manufacturer are included in the price he charges customers for manufactured goods.
  • Tax Base. The object of the tax - such as the individual in a poll tax, wealth in a property tax, the transaction in a sales tax - is called the "base" of the tax. The unit of measure used to decide the amount of tax is also called its base. The tax may be identical for each object, as it is in the poll tax or a license. Or the tax may vary according to the size or the value of the object that is taxed, as occurs with taxes on property, sales, or income.
  • Tax Rate. A tax that varies according to the size or value of the object that is taxed may be applied in three ways: proportionately, progressively, or regressively. A tax is "proportional" when it increases or decreases exactly in proportion to the size or value of the object that is taxed. This is the case when, for example, a house worth twice as much as another house is taxed twice as much. When the rate of taxation is higher for the larger or more valuable object, the tax is "progressive". This is the case when, for example, the tax on a personal income of $100,000 a year is $75,000 (a rate of 75 percent) and the tax on a personal income of $10,000 a year is $2,500 (25 percent). A "progressive" tax is supposed to favor people with low incomes, who can least afford to pay taxes. A "regressive" tax favors the rich. Sales taxes are regressive because, although levied proportionally, they consume a larger proportion of low incomes than of high incomes. This is because sales taxes are levied on consumer items, including such indispensables as clothing, soap, toilet paper, and food that are needed by everybody in about the same quantities. To subsist, people with low incomes must spend most of their incomes on such consumer items.

Purpose of Taxes

Although the main purpose of taxes is to raise revenue, governments can use them to achieve other objectives. Taxes can be a means by which a government redistributes the country's wealth. By levying a highly progressive income tax and then using the proceeds to finance social-welfare programs, the government, in effect, takes from the rich to help the poor and deprived. A government may decide, on the other hand, that it wants to strengthen its investing classes. It can vary its tax rates or exemptions so that the rich have more money left after paying taxes to invest in industry and economic expansion.

Taxes can be used as a fiscal tool to combat fluctuations in the business cycle. During a. recession, when investment lags and unemployment rises, tax rates can be lowered to encourage spending and to stimulate business activity. During an inflationary period, when prises rise too rapidly, a government may raise its tax rates in order to limit purchasing power and thus help stabilize prices.

Taxes can also be used to vary consumers' buying habits. By placing heavy taxes on imported goods, a government makes them more expensive to buy, inducing customers to buy domestic products.

Constitutional Powers

The right to levy a tax is derived from the power given to a government through its basic law. In the case of the United States, that law is the Constitution. It gives the legislative branch of the federal government the power to lay and collect taxes, provided these are uniform throughout the country (Article I, Section 8). It prohibits any export tax (Section 9). Before 1913 it also prohibited (in Section 9) any direct tax that was not a head tax (the same for each individual). This prohibition was removed by the 16th Amendment, which authorized the income tax.

The individual states of the United States also may levy taxes within their borders, except that they may not tax federal property. Subdivisions of a state, such as cities, counties, towns, or boroughs, may levy taxes only to the extent and in the manner permitted by the state legislature.

In Canada, in general, the right to levy direct taxes was originally given to the provincial legislatures, and the right to levy indirect taxes which provide greater revenues, was left to the Parliament. Later, Parliament restored to the provinces the right to impose some indirect taxes.

Practical Limitations

For various reasons, governments do not always tax to the full limit of their authority. For instance, if a city or county tried to impose a personal income tax with high rates on large incomes, most of its wealthier residents would move to neighboring communities. Even states have found that high income taxes will cause a significant number of their well-to-do residents to leave the state.

Large corporations, too, can often arrange their property holdings and business activities so as to operate in communities, states, or countries with light taxes ("tax shelters").

Moreover, the administration of some taxes, such as personal and corporate income taxes, is too complicated for most local governments. Therefore when they levy income taxes they often just copy federal requirements. States find it more practical to raise revenues from consumption taxes, such as the general sales tax and the excise tax, which is levied on the sale of a specific item. Property taxes, which are most easily collected by local governments, provide the bulk of local tax revenues.

Personal Income Tax

A personal income tax is a tax levied on the yearly income of individuals. It is a direct tax, and it is difficult to shift its incidence. It is by far the most important source of revenue in the United States, providing almost half of the federal government's tax income and more than one-third of the total tax income. Few other countries depend so heavily on the income tax for revenue, and some, such as Italy and France, obtain only 13 percent to 17 percent of their tax revenues in this way.

Taxable Income

Not all funds or items of value received by an individual in the course of a year are subject to taxation as income. In the United States, for example, a gift or inheritance is not taxed as income. Unemployment and social security benefits are not taxable, nor are insurance benefits received from accident, health, casualty, and life insurance policies. If the taxpayer is a farmer or a businessman, he subtracts all of his business expenses from his gross receipts to arrive at his net income. One of these expenses is depreciation, an allowance for wear and tear in his business property through use and time. On the other hand, wages, salaries, rents, tips, alimony, commissions, royalties, dividends, most interest payments, and some pensions all constitute income subject to taxes.

The U.S. government allows a number of deductions and exemptions from funds that are considered income. Many of these exemptions are intended to equalize individuals' capacity to pay taxes. To help large families, each individual subject to the tax receives a $750 personal exemption for himself and each of his dependents. A taxpayer over 65, or one who is blind, is entitled to a larger exemption. Deductions may include medical expenses, contributions to charity, interest on home mortgages, and certain taxes paid to state and local governments. The balance left after all exemptions and deductions are made is the individual's taxable income.

The rate imposed on taxable income is progressive. In the United States, for a married couple, it starts at 14 percent on the first $1,000 of taxable income and rises, through 25 steps or brackets, to 70 percent on the excess over $200,000. The rate levied on married couples filing a joint return is lower than that levied on single individuals. Taxpayers whose income fluctuates widely from year to year, such as athletes, authors, or actors, may average their income over a five-year period.

Pay-As-You-Go

The federal and some state governments administer income taxes on a pay-as-you-go, or withholding, basis. Employers withhold from each employee's earnings and send to the Treasury an amount that, on an annual basis, closely approximates the tax that must be paid on his salary or wages for the year.

People with income exceeding $200 from business, interest, dividends, pensions, and other such sources must estimate each coming year's income and its tax in advance. They then make four payments on their estimated tax during the year. At the end of the year they must calculate their exact tax, which is often a very complex affair, and make the necessary adjustments.

Capital Gains and Losses

Capital gains are profits earned by selling properties for more than their original price. In order to qualify for treatment as capital gains, these properties must have been held at least six months. Although capital gains must be reported with other sources of income, they are usually taxed at a lower rate than that imposed on other income. Capital losses may be offset either against capital gains or against $1,000 of ordinary income.

Payroll Taxes

In many countries the payments made by individuals to government social insurance programs do not constitute a tax. In the United States, however, such payments are legally considered taxes. The federal government levies three. Two of these, one paid by employees and one by employers, are earmarked for the social security trust fund. A third is imposed on employers as an inducement to the states to set up unemployment insurance systems financed by their own payroll taxes. All the states now have such systems and taxes.

Corporate Income Tax

Corporate incomes are taxed by fewer countries in the world than are individual incomes. However, in both the United States and Canada, the corporate income tax has been the government's second most important revenue producer. Unlike a tax on personal income, a tax on corporate income is indirect and its incidence is shifted in more than one way. A certain amount of the tax burden is undoubtedly passed along to consumers in the form of higher prices. Some is shifted to the corporation's stockholders in the form of lower dividends. Many corporate taxes are not set on a truly graduated scale. At the present time only two rates apply to corporate income in the United States.

Calculating Corporate Taxes

To determine its tax bill, a U.S. corporation subtracts from its gross income all expenses incurred in obtaining that income. These expenses include not only the cost of producing the product, but selling and operating expenses such as salaries, advertising, rent, and interest payments made to the holders of its bonds. Entertainment expenses are deductible as long as the corporation can prove they were for legitimate business purposes. A corporation is also allowed to deduct a certain amount for the depreciation, or loss of value, of its capital equipment. To encourage firms to modernize and expand their facilities, the U.S. government allows corporations to write off the full cost of equipment before it has actually worn out.

After deductions the corporation pays a 22-percent tax on the balance left as taxable income and a surtax of 26 percent on all taxable income exceeding $25,000. Canada's corporate tax is similar, except that the rate is slightly lower.

Depletion Allowances

In the United States and Canada special depletion allowances are given to investors in industries such as oil, iron ore, and timber production. Because they deplete the supply of resources they exploit and must spend money to develop new supplies, they are allowed to deduct from taxable income a fixed percentage of their gross income every year. In the United States the highest depletion allowance is awarded to oil and gas producers. The lowest depletion allowance is awarded to producers of brick and clay, gravel, sand, shells, and peat.

Property Tax

Although the property tax has become less important in many countries, it is still the most important source of revenue for local governments in both the United States and Canada. It is considered a direct tax, and its most common form in both countries is as a general tax on the assessed value of taxable property. As the most productive local tax, it is traditionally applied to public education.

At one time, local governments in the United States considered real estate and personal property equally taxable. However, any attempt to tax personal property, defined as possessions that can be moved, presents obvious problems. For instance, a tax assessor cannot force his way into homes to discover what kind of television set, washing machine, or jewelry a family the income tax during the 19th century, in the United States an act of 1894 reestablishing a U.S. income tax was declared unconstitutional. Congress was not empowered to levy the income tax until the 16th Amendment was ratified in 1913.

The costs of World War I led to the levying of additional taxes, such as those on excess profits and estates. The first federal gift tax was imposed in 1924. By the time World War II began, the federal government was levying the lion's share of U.S. taxes. By far the most important single tax was the personal income tax, which was made pay-as-you-go in 1943. Other federal governments, such as Canada's, followed a similar course.

Tax Issues

In socialist countries most of the expenses of government are met from charges on the economic enterprises it owns and operates. Elsewhere, however, private enterprise and individuals must be taxed for the necessary revenues.

The levying and collection of taxes present many problems. First, there is the question of what to tax. Some countries tax the wealth rather than the income of individuals. This is not the practice of the federal governments of the United States and Canada. Then, there is the question of how to collect the tax. In the United States, the tax on an individual's earned income is withheld at the source, making income tax collection very effective. But in many countries, especially where taxes on individual incomes are not withheld from the paychecks, it is difficult to enforce the payment of income taxes, and there is widespread tax evasion. Another question focuses on who should bear the tax burden. In the United States, there have been repeated efforts to "broaden the base" of taxation. One way to broaden the base is to make the tax rates more "progressive", by levying taxes more according to capacity to pay. Another way is to eliminate, or close, tax loopholes. A "tax loophole" is an exception in the tax law that gives benefits regarded as unjustified to a few taxpayers. An example is the full deduction of foreign tax payments allowed U.S. oil producers.

The allotment of tax revenues also presents many problems. Some taxes were adopted to meet one specific need but may later be needed for another. For example, in the United States, "highway taxes", including the excise tax on gasoline and certain licenses, were intended to pay for building new highways and maintaining existing highways. But because of the need for improved mass transit facilities, some of these funds have to be diverted to new uses. Certain payroll taxes were assigned to a trust fund for present and future social security payments. However, later these payments were at times made partly from general funds, and the earmarking of the trust fund was discontinued.

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