The income tax is the largest source of Money
TITLE(s): income tax
The income tax is a levy based on the income of individuals, families, and
The income tax is the largest source of tax revenue in advanced
economies. In the United States over half of the federal government's tax
revenue comes from income taxes, with the personal income tax accounting for
about 45% and the corporate income tax for another 10% of the total tax
revenue. Most individual states and some local governments also levy income
taxes, but income taxes are less important than other sources of state tax
An income tax was first instituted in Britain on a permanent basis in
1842. The United States did not use an income tax until 1861, as a temporary
measure to help finance the Civil War; that tax was repealed in 1871. When
Congress tried to reinstate the income tax, the Supreme Court, in POLLOCK V.
FARMERS' LOAN AND TRUST CO. (1895), declared that it was unconstitutional.
The 16TH AMENDMENT to the U.S. Constitution, ratified in 1913, consists of
a single sentence that allows income taxation. The 1913 income tax exempted
the first $3,000 from taxation and taxed the remainder of income at graduated
rates ranging from 1% for income up to $20,000 to as high as 7% for income
over $500,000. This was sufficiently high relative to income at the time
that less than 1% of the population was subject to the income tax then.
The initial passage of the law established a progressive tax structure,
which means that taxpayers are taxed at a higher percentage rate the higher
their incomes are. A proportional tax would collect at the same percentage
rate for all incomes, and a regressive tax collects a smaller percent of
income for higher incomes. The tax structure in the United States has
remained progressive since the tax was established, although specific rates
have varied greatly.
From an initial top rate of 7% in 1913, the top rate rose to 77% by 1918
to help finance World War I. The top rate fell to 25% from 1925 to 1928, but
by 1936 had risen again to 78%. The highest top bracket was 94% in 1944 and
1945 to help finance World War II, and it remained above 90% in the early
1960s until it was reduced to 70% by the tax act of 1964. In 1981 the top
rate was reduced to 50%, and it was reduced again by the Tax Reform Act of
1986. Effective in 1991 the top rate was 31%.
One of the most significant events in the history of the U.S. income tax
was the introduction of withholding during World War II. Prior to
withholding, individuals were responsible for sending their tax payments to
the government. Withholding, however, requires employers to deduct a part of
an employee's pay and send it directly to the government to cover the
employee's estimated income taxes. At the end of the year, the income
earner computes the income tax due and either pays any additional amount or
receives a refund from the government for payments in excess of the tax due.
The withholding system makes it much easier for the government to collect
taxes and makes evasion more difficult.
THE PERSONAL INCOME TAX
The amount of personal income tax due is computed in several steps.
First, total income from all sources is added together. Certain types of
income are not included in income for tax purposes; these are called
exemptions. Examples include a personal exemption for the taxpayer and for
individuals who are supported by the taxpayer's income, and for employee
business expenses such as the cost of travel for a traveling salesperson.
Total income minus exemptions equals adjusted gross income.
Taxpayers then subtract deductions from adjusted gross income to compute
taxable income. Items that can be deducted include home-mortgage interest
payments and charitable contributions. In lieu of itemizing these deductions,
taxpayers can choose to take a standard deduction; exemptions, therefore,
can be more valuable to taxpayers than deductions because exemptions can be
taken even if other deductions are not itemized.
The tax due is computed from taxable income according to the tax rate
schedule. An important concept in income taxation is the distinction between
the average and marginal rates of taxation. The average rate is the fraction
of income paid in taxes. The marginal rate is the fraction of any additional
income that would have to be paid in taxes. The average and marginal rates
are not the same because, first, some income is not taxed--due to
exemptions, deductions, and credits; and, second, the progressive tax
schedule taxes lower levels of income at a lower rate than higher levels of
The Tax Reform Act of 1986 simplified the tax structure and reduced the
total number of tax brackets to four. Lowest-income taxpayers had an income
tax rate of 15%, and as income rose, the marginal tax rate rose to 28%, then
to 33%, and then back down to 28%. For the first time in the history of the
income tax, the taxpayers with the highest incomes were not in the highest
tax bracket. In 1991 the two top brackets were combined and the tax rate
for that bracket was set at 31 percent. This reduced the number of tax
brackets to three, with marginal tax rates of 15, 28, and 31%.
The complexities of the tax code are the result of the attempt to achieve
a number of goals in its design. The first goal is fairness, and, with the
income tax, fairness is generally interpreted to mean that taxpayers should
be taxed in proportion to their ability to pay. In trying to implement the
ability-to-pay principle, the tax code taxes single taxpayers more than
married taxpayers with nonworking spouses, but taxes married couples who
both work more than if they both were single. Families with children also
pay less in an attempt to tax the same amount for those with equal abilities
to pay. The progressive nature of the tax code implements the ability-to-pay
principle by suggesting that those with more income have a
more-than-proportional ability to pay. How progressive the tax code should
be, however, is a matter of debate.
A second goal of the tax code is efficiency, which means collecting a
given amount of tax revenue at the least cost. The efficiency of the tax is
affected by the costs of collection, such as the cost of filling out forms,
having the government monitor payments, and so on. Efficiency is also
influenced by the incentives that an income tax introduces against earning
taxable income. Higher tax rates provide an incentive for taxpayers to work
less to do their own work rather than hire someone else who will have to pay
income tax, and to cheat by not reporting income. These incentives can be
minimized by keeping tax rates low, so the goal of efficiency conflicts with
the equity goal of progressive taxation.
Historically, the tax code has also been used to further other goals by
providing tax incentives. Home-mortgage interest can be deducted from
taxable income, creating an incentive for home ownership. Charitable
contributions can be deducted, providing an incentive for charitable giving.
The use of the tax system to provide these kinds of incentives is
controversial, and the Tax Reform Act of 1986 eliminated many incentives of
THE CORPORATE INCOME TAX
In 1960 the corporate income tax comprised 23.2% of federal tax revenues,
but had fallen to 12.5 percent of federal tax revenues by 1980, due to the
effects of tax reform undertaken in the 1960s and 1970s. The decline
resulted from corporations being able to shelter more income from taxation
through credits, exemptions, and deductions. Because of the 1981 tax reform,
corporate income tax collections made up only 6.2% of federal tax revenues
in 1983, in large part because the 1981 tax act allowed more favorable
treatment of depreciation. The Tax Reform Act of 1986 contained measures to
increase the contribution of corporate income taxes to total federal taxes,
and by 1989 corporate income tax collections made up more than 11% of federal
Taxable income for corporations is computed by subtracting allowable
expenses from income, but from 1960 to the mid-1980s a greater range of
expenses was being allowed. An investment tax credit allowed the reduction
of tax payments by 10% of investment expenditures, and firms were permitted
to write off large depreciation expenses to lower their taxes. The Tax
Reform Act of 1986 reduced corporate income tax rates, but corporations must
pay taxes on more of their income, since less can be deducted. As a result,
corporate income tax collections as a share of total federal taxes have
increased by more than 80 percent.
One controversy regarding corporate tax rates is who actually ends up
paying the tax. Corporations may raise their prices to cover the corporate
income taxes they pay, which would mean that the tax is actually paid by the
corporation's customers rather than by the corporation itself. If the
corporation did not raise its prices to cover the tax, then the tax would
lower corporate profits, so that the stockholders of the corporation would
end up paying the tax. Since insurance companies and pension plans own large
blocks of stock, the corporate income tax may fall heavily on those
industries and their customers. Economists agree that the tax is ultimately
paid from all of these groups, but there is no agreement on who pays how
Another controversy regarding the corporate income tax is the issue of
double taxation. A tax on corporate income taxes the stockholder several
times because corporations pay income tax on the money they pay out as
dividends and then the recipient of the dividend must pay personal income tax
on the dividend. Furthermore, stock is bought with after-tax income, then,
when the stockholder is paid a dividend from the corporation or sells the
stock at a profit, the income earned is taxed again. Some people argue that
corporate income should not be taxed in order to avoid double taxation, while
others argue that those who earn corporate income can best afford to pay
taxes. The question is closely related to the issue of who ultimately pays
the corporate income tax, since corporations really only collect taxes that
are paid by individual stockholders and customers.
TAX POLICY AND TAX REFORM
Originally, the income tax was seen solely as a method of raising revenue,
but since World War II it has been used as a tool for furthering other goals
as well. In 1964 a tax cut designed by Presidents Kennedy and Johnson was
enacted to help the sagging economy. The logic was that a tax cut would give
consumers more money to spend, which would stimulate business activity. This
was the first time that income tax reform was undertaken primarily to try to
fine-tune the economy.
President Kennedy also instituted the investment tax credit to encourage
investment, and throughout the 1960s and 1970s many other tax benefits were
added to the tax system. Among them were oil depletion allowances that made
oil exploration more profitable, an energy tax credit that provided an
incentive for energy-efficient investment, and tax exemptions under certain
conditions for retirement savings and health insurance. Each change, taken
by itself, had an individual rationale, but the cumulative effect of such
reforms was to reduce the amount of income subject to taxation, which
required higher average rates to raise the same amount of revenue.
Throughout the 1960s and 1970s inflation had the effect of continually
pushing taxpayers into higher income tax brackets, which provided additional
revenue to compensate for the increase in tax benefits. Inflation provided
enough additional revenue that rate reductions to partially offset the
effects of inflation were also common. The 1981 tax reform act contained a
provision to automatically index tax brackets to offset inflation, making
this type of tax reform unnecessary.
The Tax Reform Act of 1986 was the most comprehensive change in the
structure of the U.S. income tax since it was enacted. The cumulative effect
of many small tax reforms over the preceding several decades was to increase
the number of deductions, credits, and exemptions, which resulted in less
income being subject to taxation. The 1986 reform was designed to lower tax
rates while collecting about the same amount of revenue, by eliminating most
tax preferences and thus increasing the amount of income that could be taxed.
Reduced tax rates also have the advantages of increasing the incentive to
earn income, while lowering the incentive for taxpayers to look for tax
shelters to avoid taxation. One measure of the success of the 1986 tax
reform is that only minor changes were made to the income tax structure in
the five years following that reform.
Randall G. Holcombe
Bibliography: Bradford, D. F., Untangling the Income Tax (1986); Davies,
David G., United States Taxes and Tax Policy (1986); Hall, Robert E., and
Rabushka, Alvin, The Flat Tax (1985); Holcombe, Randall G., Public Sector
Economics (1988); Peacock, Alan, and Forte, Frances, eds., The Political
Economy of Taxation (1981); (1985); Strassels, Paul N., The 1986 Tax Reform
TITLE(s): Treasury, U.S. Department of the
Department of the Treasury is the department of the executive branch of
government that oversees the nation's finances. The department was created
in 1789, and its first secretary was Alexander Hamilton. The secretary of the
treasury is the second-ranking officer (after the secretary of state) in the
president's cabinet. The secretary is the president's chief advisor on
fiscal affairs and is responsible for managing the public debt. The law
requires the secretary to report each year to the Congress on the
government's fiscal operations and its financial condition. The secretary is
also involved in financial dealings with other nations. The secretary has
special staffs dealing with such matters as defense lending, debt analysis,
financial analysis, international finance, international tax affairs, and
The Treasury Department's operating bureaus include the COMPTROLLER OF THE
CURRENCY, who supervises national banks; the United States Customs Service,
which collects taxes on goods brought into the country from abroad; the
Bureau of Engraving and Printing, which produces currency, bonds, Federal
Reserve notes, and postage stamps; the Bureau of Government Financial
Operations, which is responsible for the government's cash management
program and central accounting and reporting system; the Bureau of the Public
Debt; the INTERNAL REVENUE SERVICE, which collects taxes; the United States
Mint, which manufactures coinage; the Bureau of Alcohol, Tobacco and
Firearms, which enforces federal laws on production, use and distribution;
and the SECRET SERVICE, which protects top U.S. officials and presidential
candidates and enforces laws against counterfeiting.
Bibliography: Adams, S., The United States Treasury System (1979);
Gaines, Tilford C., Techniques of Treasury Debt Management (1962); Gurney,
Gene and Clare, The United States Treasury: A Pictorial History (1977);
Taus, Esther R., Central Banking Functions of the United States Treasury,
1789-1941 (1943; repr. 1966); Walston, M., The Department of the Treasury
TITLE(s): Internal Revenue Service
The U.S. government's tax collecting agency, the Internal Revenue Service,
was created in 1862.
However, it did not assume its present shape until the federal power to
tax incomes was sanctioned by the 16TH AMENDMENT (1913) and revenues
increased enormously after World War II. The IRS, a division of the
Department of the Treasury, administers all of the internal revenue laws
except those relating to alcohol, tobacco, firearms, and explosives; its
most important assignments are to collect personal and corporate INCOME
TAXES, SOCIAL SECURITY taxes, and excise, estate, and gift taxes.
The IRS seeks to obtain voluntary compliance with the tax laws as far as
possible. To this end it stresses communication with taxpayers by providing
assistance and information for those who need it. Most of the approximately
118,000 employees of the IRS work in field offices throughout the country.
There are 7 regions, each headed by a regional commissioner, and 64 districts
administered by district directors. Tax returns are processed in separate
tax service centers. The national office in Washington, D.C., develops
policies and supervises the field organization.
By the early 1980s the IRS was confronting increasing tax evasion and
taxpayer resistance, fueled by perceptions that the tax laws were unfair and
administered unfairly. The IRS must interpret the tax laws through the
regulations it issues, although the IRS is not responsible for writing the
laws themselves. Despite a massive overhaul of the tax system in 1986, the
IRS's interpretations are regularly challenged in cases brought to the U.S.
TAX COURT; and, in adjudication, IRS tax assessments are sometimes rejected.
It is, however, often possible for businesses and individuals to negotiate
settlements directly with the IRS.
Another source of taxpayer unhappiness is the complexity of many of the
tax forms. They are often so cumbersome and difficult to understand that
ordinary taxpayers may require the services of an accountant merely to file a
In its efforts to discover tax evaders, the IRS has invested in
computerized systems that allow it to gather information from many different
sources and match it with data in its own files, in order to root out, for
example, individuals whose life-styles indicate larger incomes than their tax
returns list. Thus, the IRS can collect information from the 50 states on
automobile and boat registration, professional licenses issued, and business
activities that require state permits. It has also attempted to buy
computerized lists from private marketing organizations. Such activities
have raised questions relating to the issue of invasion of privacy.
IRS information has been used by other state and government agencies. In
most cases--the enforcement of child-support laws, for example, or the
attempt to find those who have defaulted on student loans--the disclosure of
information has been authorized by Congress.
Bibliography: Burnham, David: A Law unto Itself: Power, Politics, and the
IRS (1990); Saltzman, Michael, IRS Practice and Procedures (1981);
Shafiroff, I., Internal Revenue Service Practice and Procedure Deskbook, 2d
TITLE(s): Tax Court, U.S.
The United States Tax Court is a court of the federal government that
hears cases brought by taxpayers who challenge decisions of the Internal
Revenue Service (IRS) dealing with overpayment or underpayment of taxes.
In many instances the decisions of the U.S. Tax Court can be appealed to
the U.S. Court of Appeals and ultimately to the Supreme Court. When
taxpayers exercise an option to agree to the use of simplified court
procedures in disputes involving $10,000 or less, however, the cases tried
under these procedures cannot be appealed to a higher court. The U.S. Tax
Court also decides disputes over the rights of taxpayers to see documents and
other materials that are related to their cases and that are contained in
The court is composed of 19 judges appointed for life and 17 special trial
judges appointed by the chief judge who serve at the pleasure of the court.
It is augmented by retired judges when the case load is heavy. The court's
offices are in Washington, D.C., but it maintains a field office in Los
Angeles and holds trial sessions throughout the United States.
Bibliography: Taylor, M. W., and Simonson, K. J., Tax Court Practice, 7th