Taxestags: Teacher's Edition, backgrounders, taxes, David Austin Walsh
How does the federal income tax – due on April 15 each year – work in the United States?
Since the passage of the 16th Amendment, incomes have been classified according to particular tax brackets, under which income made within a particular bracket is taxed accordingly.
In other words, say a single person person makes $500,000 a year in income. That puts him in the top income bracket of 35%, which applies to those making over $388,351. But he will only pay that 35% on the income he’s made over $388,351 – he will pay the lowest marginal rate of 10 percent on his first $8,700 in income, then 15% on income between $8,700 and $35,350, then 25% on income from $35,350 to $85,650, then 28% on income between $85,650 to $178,650, then 33% from $178,650 to $388,350, then the top rate of 35% from $388,351 on for the rest of his income.
So, his taxes break down thusly:
Our hypothetical taxpayer theoretically pays a total of $151,610.65 in federal taxes on an income of $500,000, meaning he is actually taxed at 30.3% of his income.
This is what is referred to as a progressive income tax. As the amount of money liable for taxation increases, the tax rate increases. If our example had made $1,000,000, he would have paid the top tax rate of 35% on $611,650, meaning he’d pay $214,077.50 at the top rate and $326,611 in taxes overall, a rate of 36.2%.
If that’s not confusing enough, that doesn’t take into account tax deductions for home mortgages, dependents, charitable contributions, state and local taxes. Especially at the upper end of the income bracket, relatively few pay their theoretical tax rate.
That also doesn’t take into account other kinds of income, such as capital gains tax (income generated from assets like stocks, bonds, or real estate), which has a top tax rate of 15%, payroll taxes on Social Security and Medicare, and other kinds of personal taxes.
What the Left Says
The left has long been a proponent of the progressive income tax – the argument is more fair (those who have the ability to pay more should do so), that progressive taxation reduces income inequality, and that there is a correlation between the perception that a tax is fair and the general happiness of a citizenry. However, some critics on the left point out that the American system of taxation – handing out exemptions as a form of social policy – is ineffective, and that a fair tax policy should also target consumption, i.e. sales tax.
What the Right Says
Since the 1990s, thanks largely to anti-tax advocates like Grover Norquist, the Republican Party has become the “no new taxes” party – a Republican in Congress hasn’t voted for a tax increase since 1990. But the right has long been skeptical of the progressive income tax, arguing that progressive income tax disincentivizes people to make more money (because it will be taxed at a higher rate), and encourages loopholes. Higher tax rates are ineffective, other conservative economists argue – in particular Arthur Laffer – because after a certain tax rate is reached, federal income will actually decline. This theory, known as the Laffer curve, remains controversial to this day.
Americans have never liked paying taxes – we started a revolution in no small part because Great Britain was levying taxes against American colonists without their direct consent. It’s not surprising that under America’s first constitution – the Articles of Confederation – Congress has no power to levy taxes. It’s also not surprising that this ended up being a disaster, and that in the U.S. Constitution ratified in 1789, Article I, Section 8, Clause 1 specifically states that Congress has the power to impose “Taxes, Duties, Imposts, and Excises” on the states.
In practice, this meant that Congress could tax states on the basis of population (including the slave population) and property (again, including slaves), but could not directly impose income taxes on U.S. citizens. This was less of an issue in the eighteenth century, when a person’s wealth was mainly measured by property and land as opposed to income (and indeed, property taxes of the day affected mainly the wealthy).
By 1861, though, the country faced a problem: how to pay for the Civil War? The first federal income tax was levied that same year (and replaced by another income tax in 1862). They were repealed after the end of the war in 1865. The Supreme Court ruled that these income taxes were “indirect” and therefore perfectly constitutional, but thirty years later, in 1895, the first peacetime federal income tax was struck down by the Court as a “direct” tax.
Twenty years after that, in 1913, the 16th Amendment was ratified by the states, explicitly granting Congress “power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.”
Since the passage of the 16th Amendment, the primary source of federal revenue has been through the federal income tax, especially during wartime. Top tax rates soared to 77% on income over $1,000,000 during World War I, and the highest top tax rate in history was 94% of income over $200,000 during World War II (but remember, income under $200,000 was taxed at a much lower rate.) Tax rates steadily declined throughout the 1960s and 1970s, to the point where our current top tax rate, at 35%, is less than half that of six decades ago.
But it’s also important to remember that relatively few people paid the highest tax rate on their income, since there were so many deductions available through the tax code.
This is an IMPORTANT POINT: Congress has repeatedly shown a preference for adding exceptions/deductions in the federal tax code to benefit certain groups as a form of social policy. For example, tax deductions are handed out to encourage child-rearing, home ownership, small businesses, clean energy, and a variety of other social policies favored by the government.
These special provisions are one of the biggest sources of criticism, both by anti-tax activists and even by IRS employees, as they complicate the tax code and make it much harder to collect taxes.
Which brings us to the Internal Revenue Service, the dreaded IRS.
The Internal Revenue Service, founded in 1862 but which got its current name in 1918, is a bureau of the Department of the Treasury and is responsible for collecting federal income taxes. For perspective, it has around 106,000 employees and collects $2.4 trillion dollars from around 234 million tax returns, 140 million of which are individual income tax returns (which in turn nets $1.1 trillion in revenue).
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