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Although several countries in Europe, including France and Great Britain, hadbegun a personal income taxation system in the 1700s, the United States didnot adopt an income tax until 1862, during the Civil War. A few years later,however, this wartime measure was repealed.
In 1894 Congress tried again by initiating a two percent tax on individual and corporate income. But in 1895 the Supreme Court declared the levy unconstitutional. Article 1 of the U.S. Constitution states that "direct taxes shall be apportioned among the several states." Direct taxes are those which are levied on the property, business, or income of the individual who pays the tax.The Court ruled that the U.S. Constitution prohibited the federal governmentfrom enacting an income tax because revenue derived from the tax would not bedistributed in direct proportion to the nation's population.
It would take the ratification of the Sixteenth Amendment in February of 1913to pave the way for creation of a national income tax. The amendment provided Congress with the power to levy "taxes on income, from whatever source derived, without apportionment among the several States." The Tariff Act of 1913included a provision for a tax on individual and corporate incomes. Before anational income tax was adopted, the U.S. government relied primarily on income generated from tariffs. Today, that has shifted and income taxes are a major budget revenue.
The Internal Revenue Service (IRS) enforces the Internal Revenue Code, whichincludes federal laws regarding the payment and collection of taxes, such asincome, employment, and estate. The individual income tax is determined usinga progressive tax rate. This means that tax rates are allocated to income brackets and as income rises, so does the tax rate percentage. In theory, thisstructure shifts a greater tax burden to those who have higher incomes and thus have a greater ability to pay. In the late 1990s, the tax rates started at15 percent in the lowest income bracket and gradually increased to an upperlimit of approximately 40 percent in the highest income bracket. Corporate taxation has a less progressive structure and is based on a company's net profits.
To determine taxable net income, taxpayers are allowed to subtract certain types of deductions from their gross income. Many of these deductions are intended to stimulate specific types of savings or spending that benefit our society, such as a deduction for charitable contributions. The mortgage deductionis designed to encourage home ownership. A taxpayer is allowed to subtract interest paid on a loan that has been assured of payment by the pledging of a home. The home may be a house, cooperative apartment, condominium, house trailer, or houseboat. In a mortgage loan, property is temporarily transferred tothe creditor until the borrower has paid the loan in full. To qualify for themortgage deduction, the loan may be a mortgage to purchase a home, a secondmortgage, a line of credit, or a home equity loan. The points, or fees, paidby a borrower to obtain a home mortgage loan can also be deducted.
Capital gains and losses are taxed at a different rate than ordinary income.Capital gains or losses are created by the sale or trade of a capital asset.Property held for personal use is considered a capital asset. Examples of capital assets include stocks or bonds, a house, a car, furnishings, land, a coin or stamp collection, jewelry or gems, or precious metals.
The sale of noncapital assets is treated as ordinary gain or loss and taxed accordingly. Noncapital assets are often used in the course of a trade or business and include depreciable property (items whose value can be written off on taxes over multiple years), property held for future sale to customers, real property, and accounts or notes receivable. Creative endeavors are also considered noncapital assets and include a copyright on a literary, musical, orartistic composition.
Capital assets are classified as either short term or long term. Long-term capital assets are generally items held for more than one year. Net capital gain is net long-term capital gains less net short-term capital losses. The resulting net capital gain is taxed at a more favorable rate than ordinary income. As an example, during most of the 1990s, ordinary income was subject to a top rate of almost 40 percent while the highest tax rate for net capital gainswas 28 percent.
There are additional deductions or credits that taxpayers can subtract from gross income but they are subject to limitations as set forth by the InternalRevenue Code. These deductions include medical and dental expenses, contributions to individual retirement accounts (IRAs), casualty and theft losses, andemployee business expenses.
Social Security and Medicare
In 1935, Congress enacted the Social Security Act to provide old-age benefits. The plan created the Old-Age, Survivors, and Disability Insurance (OASDI) to assist workers and their families and Medicare, a health insurance plan forpeople over 65. These benefits, in addition to other programs to aid those in need, were to be financed through a payroll tax. Employers make automatic deductions, or withholdings, from an employee's wages for Social Security andMedicare taxes. However, the withholdings account for only one-half of the taxes due and employers are required to match the employee's contribution. Theemployer is responsible for making the payment of Social Security and Medicare taxes to the U.S. Treasury. While there is a maximum amount of wages that are subject to Social Security taxes, all wages are subject to Medicare tax. The amount of the taxes and the benefits for Social Security and Medicare areadjusted frequently to keep pace with inflation. In addition to Social Security and Medicare withholdings, employers may also be responsible for making automatic payroll deductions for federal, state, and municipal taxes.
Sole proprietors, or people who work for themselves, are subject to a self-employment tax, which is composed of a Social Security tax and a Medicare tax.The self-employment tax is separate from the federal income tax and is basedon net earnings from business operations. The tax is calculated by subtracting business-related expenses from gross income. Allowable deductions include expenditures such as rent, insurance, depreciation of property, and business and travel entertainment. However, many of these expenses are deductible subject to certain limitations. A self-employed individual may also have to make estimated quarterly tax payments for both federal and state taxes.
Levies, Tariffs and Duties
The federal government also imposes taxes on the manufacture, purchase, sale,or consumption of certain commodities. These levies, called excise taxes, are assessed on items such as alcohol, tobacco, and firearms. There is an excise tax imposed on gasoline and diesel fuel and the revenue derived from this motor-fuel tax is earmarked for highway construction, improvement, and maintenance. There also is a luxury tax, which has been repealed on all items exceptautomobiles. The tax is assessed on the amount that the vehicle's price exceeds the base sticker amount. This tax will be phased out by the year 2002.
Import duties are also considered excise taxes. Import duties are taxes, or tariffs, on merchandise imported into the United States from other countries.The purpose of the tariffs is to protect the interests of U.S. manufacturersagainst foreign competitors. The duty is meant to level the playing field with countries, such as Japan, who have imposed strict import limits on U.S. goods into their country. Additionally, U.S. residents may have to pay a duty tothe U.S. Customs Service on items they have purchased in other countries andare bringing into the United States.
State and local governments also assess a variety of revenue-generating taxes. Most states and some cities levy individual income taxes with the lower rates than federal tax rates. Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming do not impose state income taxes. Sales taxes, especiallyat the retail level, are a major source of income for many local governments. The sales tax is considered a regressive tax because both the poor and therich pay the same amount. Thus the tax consumes a larger portion of income ofthe low-income taxpayers. To correct this problem, some goods, which are considered essentials, are exempt from a sales tax altogether or taxed at a lower rate. Examples of essential goods include food, clothing, and drugs.
State taxes are also imposed on real and personal property. Real property ispermanent and nonmovable and includes land and buildings. By its nature, realproperty can only be taxed by the state where it is located. The process ofdetermining and listing the value of real property for taxation purposes is called an assessment. A tax is then levied based on a certain percentage of the assessed value. Additions or improvements to real estate will cause the assessed value of a property to increase. If a taxpayer fails to pay property taxes, a tax lien will be imposed against the owner and the property will not be able to be sold until the back taxes are paid.
Personal property is movable and classified as either tangible or intangible.Tangible property is physical property that has value in and of itself, suchas automobiles or equipment. The value of intangible property does not comefrom the property itself but from the rights it assigns. Examples of intangible property include accounts receivable, stocks, and bonds. Tangible personalproperty that is in a permanent location can only be taxed by one state. Intangible personal property, however, may be subject to taxation by several states.
Corporations or manufacturers are often assessed special business-related taxes. Sales taxes may be levied on goods at various stages throughout the production and distribution of a product. Because these taxes are often assessed on gross receipts that have not had expenses deducted, it is possible that thetaxable value of the product at a given stage includes the taxes already paid at an earlier stage. To avoid this situation from happening, a value-addedtax method is often used. The value-added tax is determined using net receipts calculated by subtracting expenses from total sales. Corporations are alsoliable to pay corporate franchise taxes. These taxes are measured by income and considered a cost of the privilege of doing business in a state. Franchise, in this case, is a privilege conferred by a government grant to a company;for instance, a franchise to operate a train system.
Employers must pay taxes to their state for unemployment compensation, an insurance program for employees who lose their jobs through no fault of their own. A person who is fired for good cause, such as misconduct, does not qualifyfor unemployment insurance. The program was instituted by the federal government through the Social Security Act of 1935 but it is administered by individual states. Unemployment compensation provides unemployed individuals a certain amount of money each week for a specified time.
There are also state and federal estate and inheritance taxes. The estate taxis a levy for the privilege of transferring property when someone dies and is assessed on the entire estate before its distribution to heirs. The inheritance tax is the tax imposed to each heir for the privilege of transferring the descendent's property to them.

Further Readings

  • Duarte, Joseph S. The Income Tax Is Obsolete. New Rochelle, NY: Arlington House Publisher, 1974.
  • Internet Revenue Service Web site. Available at: http://www.irs.ustreas.gov
  • Reader's Digest Family Legal Guide. Pleasantville, NY: Reader's Digest Association, Inc., 1981.
  • Bernstein, Peter W. (ed.)The Ernest & Young Tax Guide 1997. New York: John Wiley & Sons, Inc., 1997.

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