What is Income Tax?

Published by Thomas Herold in Accounting, Corporate Finance, Economics, Laws & Regulations

'Income Tax' is explained in detail and with examples in the Laws & Regulations edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.

Income tax refers to the tax on income which governments mandate for all personal and business entities and organizations which reside or are based in their jurisdiction. The law states that both individuals and businesses have to file their income tax returns once each year. Such filing demonstrates if they owe the government taxes or are instead able to claim a tax refund. This makes the tax on income a critical source of funding for governments. They employ it to pay for their various activities, goods, and services which they provide to the citizens and residents of their home country.

Income tax systems are usually progressive in nature. This is because national governments tend to understand that higher income earners have the broadest shoulders to bear the heaviest burdens of higher tax rates. The lower income earning individuals (and businesses) can not pay so much of their gross incomes.

The United States first imposed an income tax on its citizens in the time of the War of 1812. The goal for this tax was only to help repay the still-fledgling nation’s $100 million worth of debt. They ran this up in the expenses related to the costly war on both land and sea. The government actually made good on its promise to repeal this tax on income after the conclusion of the war and repayment of the national war debt.

Despite this fact, income tax in America became a permanent fixture in the country in the early years of the twentieth century. The United States’ entry into the First World War especially ran up enormous costs and debts for the nation. The tax never again disappeared in the U.S. The story is similar in many Western economically developed nations such as Great Britain, Canada, and others.

Within the U.S. today, it is the IRS Internal Revenue Service which carries the responsibility of enforcing tax laws and collecting these income taxes. They utilize a complicated and bureaucratic system of regulations and rules on incomes that have to be reported. They also monitor and decide which credits and deductions those filing individuals and businesses may claim. This agency collects the taxes from any type of income including wages, commissions, salaries, bonuses, investment earnings, and business income.

Individual income tax is one of the largest revenue generators for the Federal government of the United States today. The majority of citizens and residents within the country do not have to pay taxes on the entirety of their full earnings. Instead, the government utilizes a system of deductions on many different items to reduce the people’s taxable income. Among these important deductions are dental and medical bills, interest on a mortgage, and educational expenses.

Taxpayers are allowed to minus these from their gross income in order to decide how much of their income is actually taxable. Should a taxpayer make $120,000 income and receive $20,000 worth of deductions, then the IRS will only impose taxes on the remainder of $100,000. After this, the tax agency will apply credits against the taxes which individuals owe. This means that an individual who owed $25,000 worth of taxes and received $5,000 in credits will only have to pay $20,000 total taxes.

Besides federal income taxes, a great number of the fifty states within the U.S. also collect their own state income taxes. Only seven states did not levy such taxes on their residents as of 2016. These lucky state residents lived in Wyoming, Washington state, Texas, South Dakota, Nevada, Florida, and Alaska. The two states of Tennessee and New Hampshire only levy such income taxes on any earnings realized from investments and dividends.

Businesses and corporations must also pay taxes on their earnings. The IRS deems any type of partnerships, corporations, small businesses, and even self-employed contractors to be businesses. Such groups must first report all of their business income and then subtract out their capital and operating expenses. What remains is called taxable business income.

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The term 'Income Tax' is included in the Laws & Regulations edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.