About Federal Income Taxes

An old joke says "Nothing is more certain than death and taxes," and the taxes most people have in mind are income taxes. While there are other prominent taxes, such as the sales tax or the payroll FICA tax, when people grumble about their taxes or politicians vow tax cuts, they almost always have the Federal Income Tax in mind. This system of progressive and direct taxation and its poorly understood set of exemptions and deductions is easily the most prominent in America.

History

The first Federal Income Tax was levied to finance the Civil War. This was 3 percent for all incomes over $800 and was repealed in 1872. The income tax was re-instituted in 1894 as part of a tariff bill. A 2 percent tax income over $4,000 was levied to make up for the loss of income due to the tariff reductions mandated by the bill. Less than 10 percent of households were taxed under this law. However, this law ran into difficulty with the Supreme Court, which led directly to the passage of the 16th Amendment in 1913. This amendment gave the Federal Government a clear power to levy a direct tax on citizens, something which was either prohibited or murky according to the original wording of the Constitution. The U.S. government has had direct income taxes of some kind ever since.

Identification

The U.S. government currently imposes progressive income taxes on companies, corporations, decedents' estates, partnerships, private citizens and trusts. "Progressive" means that the more income you have, the higher your tax rate. This income basically includes all gross income, except things specifically excluded by law (such as health benefits). This amount is then adjusted by subtracting deductions (like interest on educational loans and alimony payments) to form taxable income.

Features

As a progressive tax, Federal Income Taxes work on a graduated schedule so that the more you earn, the higher your tax rate. So, for example, the 2008 schedule for a single person was: up to $8,025 (10 percent); up to $32,550 (15 percent); up to $78,850 (25 percent); up to $164,500 (28 percent); up to $357,700 (33 percent); over $357,700 (35 percent). These rates are variable, according to the law, and may either rise or decrease according to circumstances. For example, the existing tax rates were set by George W. Bush's 2001 and 2003 tax cuts, and are set to expire in 2010.

Considerations

Short-term capital gains (returns on investments) are taxed as ordinary income. Long-term capital gains are covered by a separate income tax commonly called "the capital gains tax." Long-term in this case means that the investment asset was held for longer than 1 year and is taxed at a lower rate than the income tax.

Expert Insight

During the Second World War, the top income tax rate reached 94 percent. However, that does not mean that the richest people in America were paying out 94 percent of their income in taxes. This is because of deductions. Income tax rates taken out of the context of income tax deductions and exemptions are actually quite meaningless. In theory, with the right mix of income sources (long-term capital gains, for example), exemptions and deductions, it is quite possible for a millionaire to escape without paying any income taxes. This is where the Alternative Minimum Income Tax (AMT) comes into play. To prevent corporations and wealthy private citizens from manipulating their way out of paying income taxes, the AMT prevents them from using certain deductions and imposes a tax of either 28 or 26 percent for individuals, and 20 percent for corporations. However, the law has not been substantially revised since 1986, and due to inflation an increasing number of upper middle class families and individuals are being subjected to a tax plan that was only intended for the very wealthy.

Resources

• Internal Revenue Service