Taxation in the United States

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Taxation in the United States is a complex system which may involve payments to at least four different levels of government:

Contents

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Federal taxation

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History

The first federal income tax was imposed by Congress in 1862, to finance the Union's waging of the Civil War. It levied a 3% tax on incomes above $600, rising to 5% for incomes above $10,000. Rates were raised in 1864. The Civil War income tax was repealed in 1872, but a new income tax was enacted in the late 1800s. [1] However, the Supreme Court struck down the income tax in 1895. It ruled that the portion of the income tax that applied to income on property was a direct tax that, under the US Constitution, could not be levied without apportioning the tax by population.

In 1913, however, the states ratified the Sixteenth Amendment to the United States Constitution, which made possible modern income taxes. That same year, the first Form 1040 appeared after Congress levied a 1% tax on net personal incomes above $3,000 with a 6% surtax on incomes of more than $500,000. As the nation sought greater revenue to finance the World War I effort, the top rate of the income tax rose to 77% in 1918. It dropped sharply in the post-war years, down to 24% in 1929, and rose again during the Depression. During World War II, Congress introduced payroll withholding and quarterly tax payments.

At first the income tax was incrementally expanded by the U.S. Congress, and then inflation automatically raised most persons into tax brackets formerly reserved for the wealthy. Income tax now applies to almost 2/3 of the population [2]. The lowest earning workers ($20,000 in 2000) pay no income taxes as a group and actually get a small subsidy from the federal government because of child credits and the Earned Income Tax Credit.

Notably, however, some lower income individuals pay a proportionately higher share of payroll taxes for Social Security and Medicare than do some higher income individuals in terms of the effective tax rate. All income earned up to a point, adjusted annually for inflation ($94,200 for the year 2006) is taxed at 7.65% on the employee with an addition 7.65% payment incurred by the employer. The annual limitation amount is sometimes called the "Social Security tax wage base amount." Above the annual limit amount, only the 1.45% Medicare tax is imposed. In terms of the effective rate, this means that a worker earning $20,000 for 2006 pays at a 7.65% effective rate ($1530) while a worker earning $200,000 pays at an effective rate of about 4.37% ($8740).

Self employed people pay the entire 15.3%. Above these payroll taxes presumably pay into the Social Security Trust Fund and Medicare Trust Funds that they will then draw on when the worker grows older.

The federal government is now financed primarily by personal and corporate income taxes. While it was originally funded via tariffs upon imported goods, tariffs now represent only a minor portion of federal revenues. There are also non-tax fees to recompense agencies for services or to fill specific trust funds such as the fee placed upon airline tickets for airport expansion and air traffic control. Often the receipts intended to be placed in "trust" funds are used for other purposes, with the government posting an IOU ('I owe you') in the form of a federal bond or other accounting instrument, then spending the money on unrelated current expenditures.

The federal government collects several specific taxes in addition to the general income tax. Social Security and Medicare are large social support programs which are funded by taxes on personal earned income. Estate taxes are levied on inheritance. Net long-term capital gains, including certain types of qualified dividend income, are taxed preferentially.

Federal excise taxes are applied to specific items such as motor fuels, tires, telephone usage, tobacco products, and alcoholic beverages. Excise taxes are often, but not always, allocated to special funds related to the object or activity taxed.

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Federal Tax Code

The U.S. tax code is known as the Internal Revenue Code of 1986. The Code's complexity generally arises from two factors: the use of the tax code for purposes other than raising revenue, and the feedback process of amending the code.

While its main intent is to provide revenue for the federal government, the tax code is frequently used to direct the behavior of businesses and individuals in an attempt to achieve social, economic, and political goals. For example, the tax law provides a deduction for mortgage interest in order to encourage home ownership. A theoretically pure income tax would not allow this deduction, which is not an expense incurred for the production of income. The allowance of the mortgage interest deduction is seen by some as discrimination against taxpayers who rent, rather than own, their home: the payment of rent for one's home is not deductible. (One might suppose that landlords generate tax savings on their mortgage interest payments, and pass these savings on to renters, since mortgage interest is deductible for landlords similar to other expenses such as property repairs and advertising.)

Because the government uses the tax code as an instrument of social policy, the code as a whole appears to some critics to lack a coherent organizing principle. The purported lack of a coherent organizing principle arguably has become magnified over time, due to the interplay between successive legislative amendments and regulatory changes to the law and the private sector responses to those amendments and changes. For instance, suppose that Congress enacts a tax credit to encourage a particular type of activity. In response, a group of taxpayers who are not the intended beneficiaries of the credit re-order their affairs, or the superficial aspects of their affairs, to qualify for the credit. Congress responds by amending the code to add restrictions and target the credit more effectively. Certain taxpayers manage to use this change to claim additional benefits, so Congress acts again, and so on. The result is a feedback loop of enactment and response, which, over an extended period of time, produces significant complexity.

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Local government taxation

U.S. states are recognized as having a plenary power to assess taxes on their citizens and on activities that occur within their borders, so long as those taxes do not infringe on a power reserved for the federal government. The Supreme Court has found, in various cases, that states can not impose taxes designed to impede interstate commerce or influence international relations. States are also prohibited from assessing taxes in ways that discriminate on the basis of race, gender, religion, alienage, or nationality.

Local government is now typically financed by value-based property taxes, mainly on real estate. Additional taxes may be in the form of fixed sales taxes and use taxes. Local government fees such as building permit fees may reflect the added capital cost and operating costs of services such as schools and parks. Local governments may also collect fines (parking and traffic tickets), income tax, gross receipts or gross payroll tax, or a portion of sales taxes (such as meal taxes) collected by the state. In California, seeds, bulbs, starter plants and trees obtained from a garden center are taxed if adjudged for decorative purposes while plants for food production are untaxed, as is food in California.

Almost every state imposes "sin taxes" on products frowned upon by the community, including cigarettes and liquor. Many states also impose a gas tax. The power of the state to tax encompasses the ability to empower jurisdictions within the state such as counties, cities and school districts to impose taxes on their residents. These jurisdictions may impose any of the kinds of taxes that the state may, within the boundaries established by state law.

One once-common form of local taxation that has been constitutionally barred is the poll tax. The Twenty-fourth Amendment, ratified in 1964, outlawed the use of this tax (or any other tax) as a pre-condition in voting in Federal elections. The 1966 Supreme Court case Harper v. Virginia Board of Elections held that the poll tax as applied to state elections violated the Equal Protection Clause of United States Constitution.

Note: See below for additional State issues
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Income and Related Taxes

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Federal Income Tax

As of June 2001, the income tax forms the bulk of taxes collected by the U.S. government. Depending on individual income, the tax ranges from zero to 35% of one's taxable income.

The income tax is called a progressive tax because it is higher as a percentage of the income of higher-income individuals. For an example showing the tax rates imposed by Congress in 1954 on the taxable income of unmarried individuals -- with rates as high as 91% -- see the chart at Internal Revenue Code of 1954.

The tax is also imposed on the taxable income of most corporations. This results in double-taxation of the dividends paid to stockholders, although individuals usually pay a preferential tax rate on dividends. See Income tax in the United States.

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Tax Withholding

Federal payroll taxes in the United States are primarily collected by employers on behalf of the Internal Revenue Service (IRS). The Federal income tax uses a system of direct withholding. Employers deduct part of a taxpayer's income directly from their payroll checks. The amount of withholding is calculated based on an employee's expected annual salary and the employee's living situation (married or unmarried, number of dependents, other factors). Withholding does not perfectly calculate an individual's tax each year. The difference between the amount withheld and the actual tax is either paid to the government after the end of the year, or refunded by the government. Withholding is done on a honor system with penalties imposed on individuals who do not have enough withheld (or made enough estimated tax payments) during the year. The amounts deducted can be found in IRS Publication 15, also referred to as Circular E. For farmers the rules are outlined in Publication 51 (Circular A). The IRS's Publication 505 can also be used to estimate the amount of tax withheld.

Some individuals choose to withhold more to the government than necessary, using the withholding and the refund check at the end of the year as a way of "forced savings" (at zero percent interest). Conversely, other individuals withhold as little as possible, using the rule that withholding need only be 100% of the previous year's tax liability, and thus pay a large amount on April 15. Most individuals fall somewhere in the middle.

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Tax Deductions/Credits

The U.S. government rewards certain behavior with tax deductions or tax credits. For example, amounts used to pay mortgage interest on a personal home may be deductible, if the taxpayer elects to itemize. Taxpayers who do not participate in an employer-sponsored pension plan may contribute up to $4,000 ($4,500 if age 50 or above) into an individual retirement account, and deduct that contribution from their gross income. The Earned Income Tax Credit benefits low- to moderate-income working families. It is also possible to receive a child and dependent care credit for amounts spent on daycare.

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Methods of calculating income tax

There are two ways to calculate income tax. The regular way is based on the gross income minus any applicable deductions and then a marginal tax percentage is applied according to the taxpayer's income bracket. From this result, any applicable tax credits are subtracted and the result is the income tax owed. If the result is a negative number due to refundable tax credits and/or if the Federal Withholding Tax was greater than the income tax that was actually owed, the taxpayer is entitled to a tax refund. A taxpayer eligible for a refundable credit (such as the earned income tax credit) may receive a refund even without paying any federal income tax.

The second way, the Alternative Minimum Tax (AMT) is based on the gross income, computed without regard to certain tax preference items (such as tax-exempt interest on certain private activity bonds) and with a reduced number of exemptions and deductions. This higher income base is taxed in two rate brackets, 26% and 28%, depending on taxpayer income. The taxpayer pays the higher of the two computed tax liabilities.

In the tax year 2000, many taxpayers in Silicon Valley were caught unprepared by the AMT due to the sudden decline in technology stock prices. Under AMT rules, unrealized gains on incentive stock options (ISOs) are taxed at the date the options are exercised. In contrast, under the regular tax rules capital gains taxes are not paid until the actual shares of stock are sold. For example, if someone exercised a 10,000 share Nortel stock option at $7 when the stock price was at $87, the bargain element was $80 per share or $800,000. Without selling the stock, the stock price dropped to $7. Although the real gain is $0, the $800,000 bargain element still becomes an AMT adjustment, and the taxpayer owes thousands of dollars in AMT.

The AMT was designed to prevent people from using loopholes in the tax law to avoid tax. However, the inclusion of unrealized gain on incentive stock options imposes difficulties for people who cannot come up with cash to pay tax on gains that they have not realized yet. As a result, Congress has taken action to modify the AMT regarding incentive stock options. In 2000 and 2001, people exercised incentive stock options and held onto the shares, hoping to pay long-term capital gains taxes instead of short-term capital gains taxes. [3] Many of these people were forced to pay the AMT on this income, and by the end of the year, the stock was no longer worth the amount of AMT tax owed, forcing some individuals into bankruptcy. In the Nortel example given above, the individual would receive a credit for the AMT paid when the individual did eventually sell the Nortel shares.

Another perceived flaw in the AMT is that it hasn't been changed at the same rate as regular income taxes. The tax cut passed in 2001 lowered regular tax rates, but did not lower AMT tax rates. As a result, certain middle-class people are affected by the AMT, even though that was not the original intent of the law. People with large deductions, particularly mortgage interest and state income tax deductions, are affected the most. The AMT also has the potential to tax families with large numbers of dependents (usually children), although in recent years, Congress has acted to keep deductions for dependents, especially children, from triggering the AMT.

Statistics from the U.S. Internal Revenue Service (IRS) for 2000 show that returns showing less than $15,000 in adjusted gross income amounted to 30% of total returns filed but accounted for less than 1% of tax paid. By contrast, although they made up only 2% of all taxpayers that year, taxpayers reporting $200,000 or more in adjusted gross income paid 45% of all federal income taxes. (See: Lucky duckies)

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Tax protester arguments

Various individuals and groups have questioned the legitimacy of United States federal income tax. One such group [4] argues that the 16th Amendment to the United States Constitution was not approved by the requisite number of States, and therefore never came into effect. The argument that the Sixteenth Amendment was "never ratified" has been rejected by the Internal Revenue Service and by the courts [5] and found to be a frivolous argument. Many other arguments have been raised by taxpayers and uniformly rejected by the courts. See generally Tax protester.

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Progressive Nature of Income Tax

Template:Sectfact In general, the U.S. income tax is highly progressiveTemplate:Citation needed, at least with respect to individuals that earn wage income. As of 2004, the top 1% of individual taxpayers paid approximately 32% of all federal taxes. The top 5% paid approximately 44%, and the top 10% paid 50% of all federal taxes. The bottom 20% of taxpayers paid a little over 1% of all federal taxes. Moreover, the progressivity of the U.S. tax system has gradually increased over recent decadesTemplate:Citation needed. The top 20% of taxpayers paid approximately 56% of all taxes in 1980, and this figure gradually has risen to 65%, as of 2001. In recent years, however, a reduction in the tax rates applicable to capital gains has significantly reduced the income tax burden on non-wage income. In this regard, the general structure of the U.S. tax system has begun to resemble a partial consumption tax regime. [6]

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Social Security Tax

The next largest tax is social security tax. This tax is 6.2% of an employees' income paid by the employer, and 6.2% paid by the employee. This tax is paid only on earned income and, as noted above, only up to a certain threshold income amount, sometimes called the "Social Security tax wage base amount" (for the year 2006, on the first $94,200 of income). The wage base amount increases every year, and has been increasing faster than inflation. Social Security taxes are taken from earned income (wages), but not from other sources of income, such as interest or dividends. Thus, the amount of earned income subject to the tax is limited at the upper end. The tax is effectively limited on low income earners by being ameliorated by an earned income tax credit, essentially a regressive tax. Self-employed people are responsible for both halves of the social security tax.

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Medicare Tax

The Medicare tax funds the Medicare program, a health insurance program for the elderly and disabled. 1.45% of the employee's income is paid by the employer as Medicare tax, and 1.45% is paid by the employee. Unlike Social Security, there is no cap on the Medicare tax.

Dividend and interest income is not subject to Social Security or Medicare taxation.

Together, Social Security and Medicare taxes compose the Federal Insurance Contributions Act (FICA) tax. These taxes are based on income, but unlike the Federal income tax, they are set aside for their specific purposes.

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State Taxes: Income, Sales, and Property

Each state also has its own tax system.

Typically there is a tax on real estate. Real estate taxes are often imposed on the value of real estate by reason of its ownership. For example, in Texas the real estate tax is imposed on the real estate and in particular on the owner of the real estate as of January 1 of each tax year. The tax is computed by applying a tax rate to the appraised value of the real estate as of the tax date.

There may be additional income taxes, sales taxes, and excise taxes (including use taxes). Taxable income for state purposes is usually based on federal taxable income with certain state specific adjustments. For example, some states tax municipal bond interest derived from other states that are otherwise exempt from federal income tax. Thus, this income must be added to the federal taxable income to compute the income amount for state income tax purposes. Oil and mineral producing states often impose a severance tax, similar to an excise tax in that tax is paid on the production of products, rather than on sales. Similarly, most New England states have yield taxes on timber/firewood cutting, payable as a percentage of the value cut, not the profit. Taxes on hotel rooms are common, and politically popular because the taxpayers usually do not vote in the jurisdiction levying the tax.

Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming do not levy an individual income tax. New Hampshire and Tennessee only tax interest and dividend income. Delaware, Oregon, Montana and New Hampshire have no state or local sales tax. Alaska has no state sales tax, but allows localities to collect their own sales taxes up to a state-specified maximum.

Many states also levy personal property taxes, which are annual taxes on the privilege of owning or possessing items of personal property within the boundaries of the state. Automobile and boat registration fees are a subset of this tax; however, most people are unaware that practically all personal property is also subject to personal property tax. Usually, household goods are exempt; but virtually all objects of value (including art) are covered, especially when regularly used or stored outside of the taxpayer's household.

States permit the creation of special assessment districts (typically for provision of water or removal of sewage, or for parks, public transit, emergency services or schools) whose boundaries may be independent of other boundaries and whose income may be from one or more of service assessments, property taxes, parcel taxes, a portion of road or bridge tolls, or an additional increment upon sales taxes in addition to the non-tax fees for services provided (such as metered water). State government is financed mainly by a mix of sales and/or income taxes and to a lesser extent by corporate registration fees, certain excise taxes, and automobile license fees.

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City and County Tax

Cities and counties may levy additional taxes, for instance to improve parks or schools, or pay for police, fire departments, local roads, and other services. As in the case of the IRS, they generally require a tax payment account number. Other local governmental agencies may also have the power to tax, notably independent school districts.

Local government taxes are usually property taxes but may also include sales taxes and income taxes. Some cities collect income tax on not only residents but non-residents employed in the city. At least some counties levy an Occupational Privilege Tax (OPT), usually for a small amount, in some cases less than $100/yr.

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Other Taxes

The U.S. has a payroll tax to support unemployment insurance. This is 1.2% of the first $7,000, but coordinated with state unemployment agencies and taxes in such a way that most employees are not double taxed in states that have unemployment insurance.

The U.S. also has a tax to pay for retraining of displaced workers, but it is only 0.1% of the first $7,000 of income, and it is assessed only on employers.

The U.S. also maintains federal excise taxes on gasoline and other fuels used by vehicles. At this time (2005) they are 18.4¢ per gallon (4.9¢/l) for gasoline and 24.4¢ per gallon (6.4¢/l) for diesel (for highway use). Higher profile excise taxes exist on distilled spirits, tobacco products, and some firearms.

The government tracks tax payment by an account number and payment date. For the IRS, the account number is a social security number (or tax ID number assigned by the IRS if the individual does not have a social security number), or for corporations, partnerships or other synthetic persons, an employer ID number.

For more information, including tax and report calendars, information about forms, filing addresses and other information, see IRS Publication 15, circular E, "Employer's Tax Guide", available for free from http://www.irs.gov/forms_pubs/pubs.html

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Inflation and Tax Brackets

Most tax laws are not accurately indexed to inflation. Either they ignore inflation completely, or they are indexed to the consumer price index, which tends to understate real inflation. In a progressive tax system, not indexing the brackets to inflation has the effect that there is a tax increase every year, even if Congress passes no tax law. That is because an individual's income will naturally go up at the inflation rate, and the progressive taxation system causes him to pay a greater percentage of his income in taxes.

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Transfer Taxes

The transfer tax is targeted at wealthy individuals and families and generates less than 2% ($30 billion) of the federal government's annual revenue ($2 trillion). It consists of the gift tax, the estate tax and the generation-skipping transfer tax ("GSTT"). Opponents of the transfer tax refer to these taxes cumulatively as "death taxes". This term is technically inaccurate because the tax is not levied on the "amount of the taxpayer's death," but rather on the amount of the taxpayer's inter-generational transfers. The term "death tax" was invented by Frank Luntz, a Republican political consultant. (He was interviewed on PBS's Frontline [7])

The gift tax is a tax levied on wealth transfers during the transferor's life while the Estate Tax is levied on transfers made after the transferor's death. The GSTT is a tax in addition to Gift or Estate Tax and is levied (in rough terms) on transfers made during life or after death to individuals removed by more than one generation from the transferor, for example, from a grandmother to a grandson. Usually transfer tax liabilities are paid by the transferor or the transferor's estate. Payment of transfer taxes by the transferor when the liability is due from the recipient is also a taxable gift.

As of December 2002, tax rates for Gift and Estate Taxes begin at 18% and rise to 50% for gifts or taxable estates over $2.5 million under the Unified Transfer Tax Rate schedule. The GSTT is a flat 50%. Each individual is granted a Unified Credit (currently $345,800) the effect of which exempts estates under $1 million. Each individual is also granted an annual exclusion amount the effect of which exempts total gifts to any one individual during the year up to the annual exclusion amount (currently $11,000). If the transferor does not elect to pay the Gift Tax on the value of gifts totaling more than the annual exclusion amount, the individual is deemed to have used a portion of his Unified Credit. An exemption (currently $1.1 million) for transfers subject to the GSTT is also granted to each individual during his lifetime. The Unlimited Marital Deduction allows (non-foreign) spouses to transfer any amount of wealth with no Transfer Tax consequences.

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Taxes and fees imposed by Federal, state or local laws

The Internal Revenue Code (title 26 of the United States Code) lists taxes and "fees" such as:

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See also

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External links

Template:US tax acts

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