When you get your paycheck at the end of the first pay period at a new job, it's always interesting to see your net pay. Most of us expect more than we get. By the time you get your check, it has been cut up like a pizza, with several entities taking a piece of the pie. The entities that take money differ from person to person, company to company and state to state. However, almost every income earner has to pay federal income tax.
We generally don't think much about taxes except during the annual tax season. It's probably the most dreaded time of the year for millions of Americans, yet we circle it on our calendars along with holidays and birthdays. But little joy is connected to April 15, which is the deadline for filing tax forms. (This deadline doesn't always fall on the 15th. For example, in 2001, April 15 fell on a Sunday, so Americans got an automatic one-day extension on tax-filing.)
The American tax system is a huge machine with a tax code that seems more complex than rocket science. Now, we will examine how individual income taxes work, take a look at the history of income taxes in the United States and consider two alternative tax plans that are often discussed.
Establishing a Federal Income Tax
Taxes have always left a sour taste in the mouth of American citizens. This national hatred for taxes dates back to the tax burden placed on the American colonies by Great Britain. Colonists were taxed for every consumer good, from tea and tobacco to legal documents. This "taxation without representation" led to many revolts, such as the Boston Tea Party, in which colonists dumped tea into the Boston Harbor rather than pay the tax on it.
Although the American colonists fought for independence from British rule and British taxes, once the United States government formed, its main source of revenue was derived from placing customs and excise taxes on the same items that were taxed by Great Britain. In 1812, in an effort to support an expensive war effort, the U.S. government imposed the first sales tax, which was placed on gold, silverware, jewelry and watches. In 1817, internal taxes were terminated and the government relied on tariffs to support itself. It wasn't until 1862 that the United States imposed the first national income tax.
To support the Union Army, Congress passed tax laws in both 1861 and 1862. The office of Commissioner of Internal Revenue was established by the Tax Act of 1862, which stated that the commissioner would have the power to levy and collect taxes. The office was also given the authority to seize property and income in order to enforce the tax laws. These powers remain pretty much the same today, although the IRS will tell you that enforcement tactics have been toned down a bit.
By the Numbers
- 7 million - Words in the U.S. tax code
- 700,000 - Words in the Bible
- 14 - Pages in the tax code in 1913
- 3,500 - Pages in the tax code in 1998
- 110,000 - IRS employees in 1998
- 109,000 - Combined employees of Intel and Microsoft in 2000
- 1913 - Year in which 16th Amendment is passed, allowing for federal income tax
- 1942 - Year in which payroll tax withholding begins
- 15 - Usually, the day in April by which taxes must be filed
In 1863, the federal government collected the first income tax. This graduated tax was similar to the income tax we pay today. Those who earned $600 to $10,000 per year paid at a rate of 3 percent. A higher rate was paid by those who earned in excess of $10,000. A flat-rate tax was imposed in 1867. Five years later, in 1872, the national income tax was repealed altogether.
Spurned on by the Populist Party's 1892 campaign, Congress passed the Income Tax Act of 1894. This act taxed 2 percent of personal income that was more than $4,000, which only affected the wealthiest citizens. The income tax was short-lived, as the U.S. Supreme Court struck it down only a year after it was enacted. The justices wrote that, in their opinion, the income tax was unconstitutional because it failed to abide by a Constitutional guideline. This guideline required that any tax levied directly on individuals must be levied in proportion to a state's population.
In 1913, the income tax became a permanent part of the U.S. government. Congress avoided the constitutional roadblock mentioned above by passing a constitutional amendment. The 16th Amendment reads, "The Congress shall have 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." The 16th Amendment gave the government the power to levy taxes on individuals regardless of state population. The Underwood Tariff Act of 1913 included an income-tax section that initiated the system we use today. During World War II, the federal government began withholding taxes, also known as the pay-as-you-earn taxation system. This gave the government the steady flow of money needed to finance the war effort.
The Tax Process
Today, the American tax system can be likened to a perpetual motion machine. While most Americans tend to only think about the tax system and the Internal Revenue Service (IRS) as the month of April approaches, it's actually a never-ending process. Let's take a look inside the tax system and examine its various steps. For our purposes, a good way to explain how the system works is to watch one American income earner -- let's call him Joe -- as he goes through a year of the American tax process.
The tax process begins when Joe starts his new job. He and his employer agree on his compensation, which will be figured into his gross income at the end of the year. One of the first things he has to do when he's hired is fill out all of his tax forms, including a W-4 form. The W-4 form lists all of Joe's withholding allowance information, such as his number of dependents and child care expenses. The information on this form tells your employer just how much money it needs to withhold from your paycheck for federal income tax. The IRS says that you should check this form each year, as your tax situation may change from year to year.
Once Joe is hired and given a salary, he can estimate how much he will pay in taxes for the year. Here's the formula:
- Start by assessing gross income, which includes work income, interest income, pension and annuities.
- Subtract any adjustments (examples: alimony, retirement plans, interest penalty on early withdrawal of savings, tax on self-employment, moving expenses, education loan interest paid). The difference is the adjusted gross income (AGI).
- Once the AGI is calculated, there are two choices: Either subtract a standard deduction, or subtract itemized deductions, whichever is greater. Itemized deductions might include, but aren't limited to, some medical and dental expenses, charitable contributions, interest on home mortgages, state and local taxes and casualty loss.
- Next, subtract personal exemptions to end up with taxable income.
- Go to the IRS tax tables if taxable income is less than $100,000, or to the IRS tax rate schedules if it's more than $100,000. This is where it gets a little complicated, because the United States uses a marginal tax rate system. There are five tax brackets: 15 percent, 27.5 percent, 30.5 percent, 35.5 percent and 39.1 percent. How the tax rate works depends on income and marital status.
- For those using the tax table, look for taxable income on the chart and to find gross tax liability.
- For those making more than $100,000, use the tax-rate schedule to figure gross tax liability.
- From your gross tax liability, subtract any credits. Credits may include such items as child care. The difference is the net tax, which is how much to pay or how much of a refund to expect.
At the end of each pay period, Joe's company takes the withheld money, along with all of withheld tax money from all of its employees, and deposits the money in a Federal Reserve Bank. This is how the government maintains a steady stream of income while also drawing interest on your tax dollars.
Moving ahead to the end of the tax year, Joe's company has to send Joe a W-2 form in the mail by January 31. This form details how much money Joe made during the last year and how much federal tax was withheld from his income. This information can also be found on Joe's last paycheck of the year, but he'll need to send the W-2 to the IRS for processing purposes.
At some point between the time Joe receives his W-2 and April 15, Joe will have to fill out and return his taxes to one of the IRS's nine service and processing centers. The IRS received 127 million returns in 2000. Also in that year, 35 million people filed their taxes online through e-File, and more than 3 million filed using the TeleFile phone-filing system. Once the IRS receives Joe's tax returns, an IRS employee keys in every piece of information on Joe's tax forms. This information is then stored in large magnetic tape machines. If Joe is due a tax refund, he is sent a check in the mail in the next few weeks. About 94 million taxpayers received refunds in 2000, according to the IRS. If Joe uses e-File or TeleFile, his refund can be direct-deposited into his bank account.
Celebrate Tax Freedom Day
Americans are working longer than ever before to pay their taxes. In 2000, the average U.S. citizen had to work until May 3 to pay for his or her taxes, according to the Tax Foundation. Economists at the Foundation have tracked Tax Freedom Day for the last 25 years. This is the day on which you've worked enough to pay all of your taxes and you can start spending money on yourself.
Tax Freedom Day has been celebrated later and later since Americans began paying federal income taxes in 1913. Back then, Tax Freedom Day fell on January 30. In 2000, the average American income earner worked 50 days to pay individual income tax, 30 days to pay social insurance taxes, 16 days to pay sales taxes, 10 days to pay property taxes, 12 days to pay corporate income taxes, three days to pay business taxes and two days to pay all other taxes.
Alternative Tax Ideas
Humorist and travel writer Stanton Delaplane once offered this lighthearted suggestion for a simplified tax form: "How much money did you make last year? Mail it in." While that may be a drastic way to change the tax system, there has been no shortage of people proposing new tax systems since the 16th amendment was passed in 1913. If you follow presidential campaigns, there is usually talk from some of the candidates on revising the tax system. Here's a quick look at two of these alternative tax plans.
The Flat Tax
We currently use a marginal tax system, also called a graduated tax, in which the percentage you pay in taxes varies based on your income. Under a flat tax system, you pay a flat rate on your income. In other words, there is a single tax bracket for all taxpayers. A common percentage thrown out for a flat-tax system is 17 percent. This is the rate proposed by former presidential candidate Steve Forbes and U.S. Representative Dick Armey.
Proponents of a flat-tax system say that it would do away with the complicated tax code and tax forms. The flat tax would need only one form, about the size of a postcard and consisting of only 10 lines. You would merely add up wage, salary and pension income, subtract any personal allowances and pay 17 percent of your taxable income. Deductions and credits would be eliminated under this type of plan.
Critics of the flat tax say that it would favor the wealthy and could put a higher tax burden on those who make less money. Under Dick Armey's proposed flat tax, any family with a taxable income less than $36,800 would pay no taxes. However, it would raise the taxes of some people who now may pay only 15 percent in taxes. The group who would benefit the most is wealthy Americans who now pay upward of 33 percent in federal income tax.
National Sales Tax
Even more controversial than the flat tax is the idea of abolishing the federal income tax entirely by repealing the 16th amendment. In place of an income tax, some propose the use of a national sales tax. Former U.S. President William Clinton pointed out that one flaw with this system is that it leaves the government without a steady flow of income.
Alan Keyes, who ran unsuccessfully for the 2000 Republican presidential nomination, is one of the biggest supporters of doing away with a federal income tax. He believes that we could finance the government through sales taxes, tariffs and duties. Keyes has argued that a national sales tax would put more money back into the pockets of the consumers, letting them decide how to spend their own money. He says that the income tax should be replaced with the kind of taxes that people already pay. This plan would do away with the IRS and any need for a tax code.
Opponents have said that replacing the income tax with a national sales tax would put a heavy burden on the less wealthy, who buy a lot of the products that would be taxed. They say that in order for a national sales tax to be fair, it would have to be applied to the purchase of stocks and bonds in addition to consumer goods. Another problem facing a national sales tax is that it would probably double the current taxes on consumer goods, and could force local and state governments to initiate or increase state income taxes.
Taxes are a bitter subject in almost every country, and the United States has had a decidedly tumultuous relationship with the issue. America has one of the most complicated tax systems in the world, and it grows more complex every year. In the end, whether you agree with paying taxes or not, you probably have April 15 circled on your calendar, embedded in your brain and on your list of dreaded days.
For more information, check out the links on the next page.
Lots More Information!
Related stuff.dewsoftoverseas.com Articles
More Great Links