Why the Federal Income Tax is Important
The federal government relied mostly on excise taxesexcise taxTax imposed by federal, state, and local governments similar to a sales tax and charged on gasoline, liquor, and alcohol. for the U.S.’s first century. It was not until the Civil War when both the Union and Confederate governments began collecting income taxes. The income tax was repealed after the Civil War, and a new tax was not successfully implemented until a corporate income tax was enacted in 1909.
After the ratification of the Sixteenth Amendment to the Constitution in 1913, the Revenue Act of 1913 was enacted, and the first federal Form 1040 was due in 1914. The tax rate was 6% and applied only to taxable income over $500,000!
Various revenue acts were passed during the next two decades and by 1939, the first codification of revenue laws became the Internal Revenue Code of 1939. There have been two major recodifications—in 1954 and 1986.
When the Corporation Trust Co., now known as CCH, first published its Standard Federal Tax Reporter in 1913, the tax law was about 31 pages long, but an additional 369 pages were added for Treasury Department rulings and explanations. As of 2003, the Reporter is a 25-volume publication with approximately 55,000 pages!
The Internal Revenue Code received this review by a reader on Amazon.com in 2005:
“This is an overly turgid work that suffers from constant rewrites; there have been nearly one-hundred editions issued each slightly different from the last. There are times when the entire book seems self-contradictory. For some reason, for example, the authors feel compelled to follow the elegant and simple statement that ‘gross income means all income from whatever sources derived’ with endless, often monotonous exceptions.
“Significant parts of this work are relevant only to those with special interests, while other parts are likely to be universally appreciated (or depreciated, as the case may be). While often eminently practical, there are times when the authors become incredibly vague (they never seem to define ‘ordinary and necessary’, for example, yet insist on using the phrase an inordinate number of times)….Still, despite its flaws, it’s recommend that everyone read this book. By April 15.”
In the spring 2008 volume of Statistics of Income, the Internal Revenue Service (IRS)Internal Revenue Service (IRS)U.S. Department of Treasury agency responsible for administering the tax laws. reported that 138.4 million individual income tax returns were filed for the 2007 tax year with a total tax liability of $1.1 trillion. Itemized deductions comprised 65.9% of all deductions. In addition, the IRS reported over 85 million tax returns were filed electronically and the average refund was $2,383.
The largest portion of federal revenues comes from individual income taxes—almost 45%. Social security taxes add another 35%, corporate income tax adds about 10%, and excise and other taxes make up the remainder. Individual income taxes, then, are the largest source of funds to pay for federal expenditures. Those revenues are spent, for example, to build roads, to guide airplanes carrying 300 passengers on their flight paths, to pay the elderly a source of income so that they may pay for rent and medicine, and to defend our country.
Other types of taxes paid by most Americans include sales, property, excise, and employment taxes. Sales (or sometimes called “use”) taxes are imposed by state and local jurisdictions and are computed as a percentage of the items purchased. Property taxesproperty taxAlso know as an ad valorem, it is a tax based on the value of real or personal property usually by local and state governments. (ad valorem or based on value) are imposed on personal and real property usually by local and state governments. Excise taxes are similar to sales taxessales taxTax based on the value of items purchased; imposed by state and local governments, also known as a “use” tax; stated as a percentage. and are usually charged on purchases of gasoline, liquor, and tobacco products. Excise taxes are imposed by federal, state, and local governments. Employment taxes including Social Security and Medicare are federally imposed. In addition to these taxes there are death taxes: estate and inheritance taxes imposed by federal and state governments.
Taxes are said to be regressive or progressive. A regressive taxregressive taxTax rate decreases with an increase in the tax base; e.g., Social Security tax. rate decreases with an increase in the tax base. For example, Social Security (FICA) tax is regressive because its 6.2% rate is fixed from the first dollar collected to the ceiling ($102,000 in 2008). A taxpayer who earns $40,000 pays 6.2% of her income into Social Security while a taxpayer who earned $120,000 pays 5.27% ($102,000 × .062 = $6,324; $6,324/$120,000 = 5.27%).
Federal and most state income taxes are progressive because the rate of tax increases with the amount of income. For example, a single taxpayer with a taxable income of $7,000 pays federal tax at a rate of 10%, while a single taxpayer with a taxable income of $100,000 pays federal tax at a 28% rate. The tax rate increases with increases in the tax base.
In Congress, it is argued that the use of a progressive income tax rate provides equity among taxpayers. Congress has also used the individual income tax system to achieve economic, charitable, and societal objectives. Using tax laws to try to achieve these objectives contributes to the complexity of the income tax system. As we learn about those complexities, we often find that they were actually created as “tax breaks.” One person’s tax break is another person’s loophole.
The interest deduction for home mortgages encourages people to buy their own homes and reduces the overall cost. Deducting charitable contributions reduces the tax paid but also encourages individuals to help others in need. Being able to deduct the cost of health insurance, doctors’ bills, and hospital costs provides financial relief to those who often need help when sick. Congress encourages business investment when it allows a deduction for the entire cost of an asset in the year of purchase.
The U.S. income tax system is partly based on an honor system. While much of the income most Americans earn is reported to the U.S. Department of Treasury’s Internal Revenue Service (IRS), certain types of income only get reported by the taxpayer. For example, self-employed individuals—especially those in cash-generating businesses—self report the amount of income earned. Deductions on individual income tax returns often are self-reported (claimed) reductions in income. An income tax system that relies on an honor system must be perceived to have taxpayers paying their fair share in order for the system to continue to function.
Based on a study completed by Congress’s General Accountability Office (GAO), there were up to 1.2 million paid tax preparers in 1999 who prepared tax returns for over half of the 130 million individual tax filers. Those taxpayers paid an estimated $14.7 billion to have the tax returns prepared. Despite the importance of the paid preparers’ role in the tax system, there is little data on the quality of the services. The GAO did estimate that from just one error—using the standard versus itemized deductions—taxpayers overpaid by $945 million.
Despite a complicated federal income tax system, most individual income tax returns are not complicated. About 38% of the tax returns filed are on the two simpler forms: 1040EZ and 1040A. The mass of information and the jargon used in income tax does, however, create an uneasiness or, in some cases, a fear in many taxpayers.
As you gain a greater understanding of the income tax system, you will be in a position to guide your paid preparer in completing your tax return. Most of you will choose to complete your own tax return. You might even gain the knowledge and experience to help others in preparing their income tax returns. At a minimum, you need the knowledge to be able to pay just your fair share and not more.
