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Individual Income Tax: Arin / Istock © Sk the Basics and New Changes PAGE ONE Economics® Individual Income Tax: arin / iStock © sk The Basics and New Changes Jeannette N. Bennett, Senior Economic Education Specialist GLOSSARY “In this world nothing can be said to be certain, except death and taxes.” Adjusted gross income: Gross income minus —Ben Franklin specific adjustments to income. (Gross income is the total amount earned before any adjustments are subtracted.) Earned income: Money you get for the work Introduction you do. There are two ways to get earned income: You work for someone who pays Taxes are certain. One primary tax is the individual income tax. Congress you, or you own or run a business or farm. initiated the first federal income tax in 1862 to collect revenue for the Income: The payment people receive for pro- expenses of the Civil War. The tax was eliminated in 1872. It made a short- viding resources in the marketplace. When lived comeback in 1894 but was ruled unconstitutional the very next year. people work, they provide human resources (labor) and in exchange they receive income Then, in 1913, the federal income tax resurfaced when the 16th Amend- in the form of wages or salaries. People also ment to the Constitution gave Congress legal authority to tax income. earn income in the form of rent, profit, and And today, the federal income tax is well established and certain. interest. Income tax: Taxes on income, both earned (salaries, wages, tips, commissions) and 16th Amendment to the U.S. Constitution (1913) unearned (interest, dividends). Income taxes can be levied on both individuals The Congress shall have the power to lay and collect taxes on incomes, from whatever (personal income taxes) and businesses source derived, without apportionment among the several States, and without regard (business and corporate income taxes). to any census or enumeration. Inflation: A general, sustained upward move- ment of prices for goods and services in SOURCE: http://www.ourdocuments.gov/doc.php?flash=true&doc=57. an economy. Revenue (government): The income received by government from taxes and other sources. However, the details of income taxation are uncertain and subject to Taxable income: Adjusted gross income minus change. The 16th Amendment does not identify specific details. It does allowable tax exemptions, deductions, and not define what portion of income should be taxed. It also does not define credits; the amount of income that is sub- key elements of income tax such as tax deductions, tax exemptions, ject to income tax. and expenses or how taxable income is determined. These omissions in Tax credit: An amount directly deducted from the total tax owed. the 16th Amendment allow federal income tax laws to change as lawmakers make decisions on raising revenue for government spending, making fairer Tax deduction: Allowable expenses defined by tax law that can be subtracted from adjusted tax laws, or stimulating the economy. And taxation laws have changed gross income to reduce taxable income. many times. The most recent change in tax laws came on December 22, Taxes: Fees charged on business and individ- 2017: President Trump signed the 2017 Tax Cuts and Jobs Act, which went ual income, activities, property, or products into effect on January 1, 2018. But it’s important to understand some basics by governments. People are required to pay taxes. of individual income taxation before these changes are addressed. Tax exemption: An amount allowed by the IRS that can be deducted from taxable income to reduce the amount of income tax owed. December 2018 Federal Reserve Bank of St. Louis | research.stlouisfed.org PAGE ONE Economics® Federal Reserve Bank of St. Louis | research.stlouisfed.org 2 PART 1: The Basics Figure 1 Federal Tax Revenue, 2017: $3.32 Trillion The Internal Revenue Service All Other Tax Regardless of changes in taxation laws, taxes must be 5.6% collected. In 1862, collection was the responsibility of a Excise Tax 2.5% Commissioner of Internal Revenue. In 1894, this was changed to the Bureau of Internal Revenue and renamed Corporate Income Tax 1 in the 1950s as the Internal Revenue Service (IRS). The 9.0% IRS is the branch of the Treasury Department responsible Individual Income Tax for implementing tax legislation, interpreting tax law, 47.9% ensuring taxpayers’ compliance with the law, and col- Payroll Tax lecting income tax. 35.0% Additionally, for each new tax year there are hundreds of forms and publications the IRS updates and adjusts for SOURCE: Oce of Management and Budget. Historical Tables 2.1 and 2.2. the cost of living. Adjustments for inflation are beneficial Accessed September 28, 2018; https://www.whitehouse.gov/omb/budget/Historicals. to taxpayers and prevent credits or deductions from hav- ing a reduced value. These adjustments also prevent tax- payers from possibly paying a higher tax rate when there is no actual increase in real income. For example, if your The Individual Taxpayer income increases by 3 percent in a year when the inflation Individual taxpayers are important for government fund- rate is also 3 percent, your real income hasn’t changed. ing. Individual income taxes are the leading source of However, unless income tax brackets are adjusted each revenue to support government spending. For example, year for inflation, you might find yourself in a higher tax in 2017, almost 48 percent of government revenue was bracket (and thus paying a higher tax rate) even though provided by individual income tax (Figure 1). in inflation-adjusted terms, your income hasn’t changed. It’s certain—the IRS is an important agency. Taxable Income All individuals who meet certain income requirements Collecting Income Tax must file an annual tax return—it’s the law. Taxpayers The Current Tax Payment Act was signed into law in 1943 must identify all forms of income and calculate the and has made collecting income tax easier. This law amount of taxable income to arrive at their tax liability. requires employers to withhold federal income tax from Taxable income is calculated based on the taxpayer’s an employee’s paycheck each pay period and to send the payment directly to the IRS on behalf of the employee.2 adjusted gross income for the tax year minus allowable In this way, income tax is collected on a pay-as-you-earn tax exemptions, deductions, and credits. But changes in basis. The amount withheld is determined by information taxation laws change the details and can make filing a the employee provides on an IRS W-4 form. The informa- tax return complicated. tion is used to calculate a reasonable estimate of the amount of income tax to be withheld from each paycheck. Filing Status and Tax Brackets By January 31 of each year, employers must furnish When filing a return, a taxpayer’s filing status is classified employees a W-2 Wage and Tax Statement. Employees as married or unmarried. Married taxpayers can choose use this form to complete individual tax returns. Among to either combine their incomes and file a joint return other things, it includes the total amount of income or file separately. Unmarried taxpayers are classified as earned and the amount of federal tax withheld over the either single taxpayers or heads of household if they meet given year. Generally, if too much federal income tax has certain guidelines. There is also an additional qualifying been withheld, a taxpayer will receive a refund. If not widow(er) status for those who meet special circum- enough has been withheld, the taxpayer must pay the stances. These taxpayers are allowed to use the joint additional tax owed. return tax rates. PAGE ONE Economics® Federal Reserve Bank of St. Louis | research.stlouisfed.org 3 Figure 2 Table 1 Top Income Bracket Tax Percentage Rate Sample Tax Brackets Tax Percentage Rate Years Number of tax brackets 100 94% 90 1918-1921 56 80 77% 67% 70% 70 63% 1988-1990 2 60 50 1993-2000 5 50% 40 39.60% 39.60% 2013-2018 7 30 35% 37% 20 25% 28% SOURCE: Table created with information from the following source: 10 7% 15% Chang, Alvin. “100 Years of Tax Brackets, In One Chart.” Vox, December 0 2016; https://www.vox.com/2015/10/26/9469793/tax-brackets. 1913 1916 1917 1918 1932 1944 1981 2018 1925-1931 1988-19911991-20022003-20122013-2017 1950s-1970s After calculating taxable income and identifying a filing SOURCE: Graph created with information from the following source: Chang, Alvin. status, the amount of tax liability can be determined “100 Years of Tax Brackets, In One Chart.” Vox, December 2016; https://www.vox.com/2015/10/26/9469793/tax-brackets. using percentage rates. Taxable income is divided into brackets that group income according to amounts. Income within each bracket is taxed at a specific rate for same percentage rate and a less progressive structure. that bracket. Income limits in each bracket are different The number of tax brackets has varied greatly from year 3 for each filing status. This process ensures the federal to year according to changes in taxation laws. (See exam- individual income tax is a progressive tax based on the ples in Table 1.) ability-to-pay principle. This progressive tax applies higher Tax Rates tax rates to higher income brackets than those applied to lower brackets. While that might seem complicated, Throughout the years, the tax percentage rates have the structure ensures that taxpayers with lower incomes varied greatly within tax brackets to support legislative pay a smaller overall tax rate than those with higher actions and government expenditures (Figure 2). For incomes. example, the extreme increase in percentage rates for top income earners changed in 1917 to support World The tax bracket system uses marginal tax rates when War I.
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