I INTRODUCTION TO TAXATION

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Taxation


I

INTRODUCTION


U.S. Federal Revenues


The federal government of the United States obtains most of its revenues from income taxes on individuals and corporations. Social insurance taxes help pay for government programs that benefit the poor, the elderly, the unemployed, and the disabled.



Taxation, system of raising money to finance government. All governments require payments of money—taxes—from people. Governments use tax revenues to pay soldiers and police, to build dams and roads, to operate schools and hospitals, to provide food to the poor and medical care to the elderly, and for hundreds of other purposes. Without taxes to fund its activities, government could not exist.

Throughout history, people have debated the amount and kinds of taxes that a government should impose, as well as how it should distribute the burden of those taxes across society. Unpopular taxes have caused public protests, riots, and even revolutions. In political campaigns, candidates’ views on taxation may partly determine their popularity with voters.

Taxation is the most important source of revenues for modern governments, typically accounting for 90 percent or more of their income. The remainder of government revenue comes from borrowing and from charging fees for services. Countries differ considerably in the amount of taxes they collect. In the United States, about 30 percent of the gross domestic product (GDP), a measure of economic output, went for tax payments in 2000. The 30 percent figure is relatively low from a historical standpoint. As a result of a new round of tax cuts in 2003, the tax percentage share of GDP was expected to be lower than at any time since 1959 when many major government programs, such as Medicare and Medicaid, did not exist. In Canada about 35 percent of the country’s gross domestic product goes for taxes. In France the figure is 45 percent, and in Sweden it is 51 percent.

In addition to using taxation to raise money, governments may raise or lower taxes to achieve social and economic objectives, or to achieve political popularity with certain groups. Taxation can redistribute a society’s wealth by imposing a heavier tax burden on one group in order to fund services for another. Also, some economists consider taxation an important tool for maintaining the stability of a country’s economy.

II

TYPES OF TAXES

Governments impose many types of taxes. In most developed countries, individuals pay income taxes when they earn money, consumption taxes when they spend it, property taxes when they own a home or land, and in some cases estate taxes when they die. In the United States, federal, state, and local governments all collect taxes.

Taxes on people’s incomes play critical roles in the revenue systems of all developed countries. In the United States, personal income taxation is the single largest source of revenue for the federal government. In 2002 it accounted for about 48.8 percent of all federal revenues. Payroll taxes, which are used to finance social insurance programs such as Social Security and Medicare, account for 36.4 percent of federal revenues. The United States also taxes the incomes of corporations. In 2002 corporate income taxation accounted for 10.4 percent of federal revenues.

State and local governments depend on sales taxes and property taxes as their main sources of funding. Most U.S. states also tax the incomes of individuals and corporations, although less heavily than the federal government. All Canadian provinces collect income taxes from individuals and corporations.

A

Individual Income Tax

An individual income tax, also called a personal income tax, is a tax on a person’s income. Income includes wages, salaries, and other earnings from one’s occupation; interest earned by savings accounts and certain types of bonds; rents (earnings from rented properties); royalties earned on sales of patented or copyrighted items, such as inventions and books; and dividends from stock. Income also includes capital gains, which are profits from the sale of stock, real estate, or other investments whose value has increased over time.

The national governments of the United States, Canada, and many other countries require citizens to file an individual income tax return each year. Each taxpayer must compute his or her tax liability—the amount of money he or she owes the government. This computation involves four major steps. (1) The taxpayer computes adjusted gross income—one’s income from all taxable sources minus certain expenses incurred in earning that income. (2) The taxpayer converts adjusted gross income to taxable income—the amount of income subject to tax—by subtracting various amounts called exemptions and deductions. Some deductions exist to enhance the fairness of the tax system. For example, the U.S. government permits a deduction for extraordinarily high medical expenses. Other deductions are allowed to encourage certain kinds of behavior. For example, some governments permit deductions of charitable contributions as an incentive for individuals to give money to worthy causes. (3) The taxpayer calculates the amount of tax due by consulting a tax table, which shows the exact amount of tax due for most levels of taxable income. People with very high incomes consult a rate schedule, a list of tax rates for different ranges of taxable income, to compute the amount of tax due. (4) The taxpayer subtracts taxes paid during the year and any allowable tax credits to arrive at final tax liability.

After computing the amount of tax due, the taxpayer must send this information to the government and enclose the amount due. In 2001 the average taxpayer in the United States paid about 15 percent of his or her income in income taxes. Many taxpayers, rather than owing money, receive a refund from the government after filing a tax return, typically because they had too much tax withheld from their wages and salaries during the year. Low-income workers in the United States may also receive a refund because of the earned income tax credit, a federal government subsidy for the working poor.

Income taxation enjoys widespread support because income is considered a good indicator of an individual’s ability to pay. However, income taxes are hard to administer because measuring income is often difficult. For example, some people receive part of their income “in-kind”—in the form of goods and services rather than in cash. Farmers provide field hands with food, and corporations may give employees access to company cars and free parking spaces. If governments tax cash income but not in-kind compensation, then people can avoid taxation by taking a higher proportion of their income as in-kind compensation.

The Internal Revenue Service (IRS), an agency of the Department of the Treasury, administers the federal income tax in the United States. Canada Customs and Revenue Agency, which operates under the Minister of National Revenue, administers the tax in Canada.









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