Purpose of the Income Tax System

The federal, state and sometimes even city governments collect a substantial slice of the nation's wealth in the form of income taxes. The main purpose of this taxation is to fund governmental operations but that is hardly the only reason and sometimes not even the most important.

Raising Revenue

First and foremost, all taxation is designed to raise revenue and fund government operations. The 2007 federal budget alone was $2.7 trillion; ideally, all that money should have been raised through taxation. Most state constitutions have "no budget deficit" clauses, and in all cases it is taxation that must meet these annual expenses. However, the states of Washington, Texas, Nevada, Florida, South Dakota, Wyoming and Alaska have no state income tax and meet their needs through other forms of taxation.

Data Collection

Tax returns are an excellent way to collect economic and financial information on U.S. citizens and corporations. This is not a widely-known purpose for income taxes, and the income tax was not created for the primary purpose of collecting data. However, the way many tax forms and the regulations for filing them were designed has collecting data specifically in mind.

Encouraging Behavior

Taxation is often used as a tool to encourage or discourage certain activities. In the case of income taxes, deductions and exemptions from taxation are used to encourage certain behaviors. The deduction for home mortgage interest from federal income taxes is the best-known example, as it rewards and encourages home ownership.

Progressive Taxation

Income taxes are progressive, meaning the more income you have, the higher your tax rate. The reason for this is that a flat tax of 33 percent on a person making $20,000 a year is a much more severe blow to the person's standard of living than the same 33 percent to someone earning $200,000 annually. By relying on progressive income taxes, and not other forms of taxation, government reduces the relative tax burden for poor, working and middle-income citizens. If the main means of raising tax revenue was the sales tax and not a progressive income tax, this would essentially be the same as the aforementioned flat tax. In the end, it would be a flat 33 percent, except it would be collected on consumption, not income. This is why American income taxes are usually higher than sales and excise taxes.

Capital Gains and Discouraging Behavior

The federal government considers capital gains, or the returns on investments, as income and taxes it accordingly if it is short term. This means if you buy stock, hold it for less than a year and then sell, you must pay income taxes on it. If the same asset is held for more than a year, it becomes a long-term capital gain and is handled under the capital gains tax, which has a lower rate. In this case, the income tax acts as a punishment to discourage short-term speculation and encourage long-term investment, which is covered under a lower tax rate.

Resources

• IRS