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Taxation in the United States

This article is a brief overview of some aspects of US taxes.

Table of contents

Overview

Taxation in the United States involves payments to three different levels of government, local government, state government, and the federal government. Local government is financed by property taxes. State government is financed mainly by sales taxes although most states also have an income tax. The federal government is financed primarily by income taxes.

Income and Related Taxes

Federal Income Tax

As of June 2001, the income tax forms the bulk of taxes collected by the U.S. government. Depending on individual income, it ranges from nothing to 35% of one's income. The income tax is called a progressive tax[?] because it takes a larger percentage of the income from higher income individuals. It is assessed on most publicly held corporations, as well, so that the dividends paid to stockholders are subject to a double tax. Federal payroll taxes in the United States are primarily collected by employers, for the U.S. Internal Revenue Service.

The U.S. government rewards certain behavior with tax deductions[?] or tax credits[?]. The most famous reduction in taxes is that income used to pay mortgage interest on a personal home is exempted from taxes, if the taxpayer elects to itemize[?]. Taxpayers who do not participate in an employer-sponsored pension plan may contribute up to $3,000 ($3,500 if age 50 or above) into an individual retirement account[?], and deduct that contribtion from their gross income. The Earned Income Tax Credit benefits low- to moderate-income working families.

There are two ways to calculate income tax. The regular way is based on the gross income minus any appicable deductions and then a marginal tax percentage is applied according to the taxpayer's income bracket. From this result, any applicable tax credits are subtracted and the result is the income tax owed. If the result is a negative number due to refundable tax credits, the taxpayer is entitled to a tax refund[?] even if no tax had been paid!

The second way, the Alternate Minimum Tax (AMT) is based on the gross income plus any tax preference items such as paper gain on exercised stock options with no deduction from any tax shelters. The lack of tax shelter and added unrelealized income almost guarantee a much higher taxable income in the alternate calculation. This higher income base is multiplied by 24% or 28% depending on taxpayer income. The taxpayer pays the higher of the two computed tax liabilities. In the tax year 2000, many taxpayers in the Silicon Valley were caught unprepared by the AMT due to the sudden stock market crash. For example, if someone exercised a 10,000 share Nortel stock option at $7 when the stock price was at $87, the paper gain was $80 per share or $800,000. Without selling the stock, the stock price dropped to $7. In effect his paper gain is $800,000 but his real gain is $0. Now the tax due from AMT comes to $192,000 which is 28% of $800,000. It takes a miracle to pull a fifth million dollars out of an empty pocket. The AMT was designed to prevent people from using loopholes in the tax law to avoid tax. However, the inclusion of unrealized gain, as described in the example above, does impose difficulties for people who cannot come up with money to pay tax on income that they have not earned yet. As a result, the Congress has taken action to modify the AMT regarding stock options. In 2000 and 2001, people exercised stock options and held onto the shares, hoping to pay long-term capital gains taxes instead of short-term capital gains taxes. However, these people were forced to pay the AMT on this income, and by the end of the year, the stock was no longer worth the amount of AMT tax owed, forcing many individuals into bankruptcy. In the Nortel example given above, the individual would receive a credit for the AMT paid when the individual did eventually sell the Nortel shares.

IRS statistics for 2000 show that returns showing less than $15,000 in adjusted gross income amounted to 30 percent of total returns filed but accounted for less than 1 percent of tax paid. By contrast, although they made up only 2 percent of all taxpayers that year, taxpayers reporting $200,000 or more in adjusted gross income paid 45 percent of all federal income taxes.

Social Security Tax

The next largest tax is social security tax. This tax is 6.2% of an employees' income paid by the employer, and 6.2% paid by the employee. Self-employed people are responsible for both halves of the social security tax. This tax is paid only on the employee's first $87,000 of income, but that threshold increases every year, and has been increasing faster than inflation.

There is a medicare tax, 1.45% of the employee's income paid by the employer, and 1.45% by the employee. This is used to pay for medical care for qualifying persons, usually people over the age of 65.

Dividend and interest income is not subject to social security or medicare taxes.

The U.S. has an income tax to support unemployment insurance. This is 1.2% of the first $7,000, but coordinated with state unemployment agencies and taxes in such a way that most employees are not double taxed in states that have unemployment insurance.

The U.S. also has a tax to pay for retraining of displaced workers, but it is only 0.1% of the first $7,000 of income, and it is assessed only on employers.

Employers pay these taxes directly to federal banks, which use it to retire short-term treasury debt. For this reason, most employers maintain an account at a federal bank.

The U.S. also maintains federal excise taxes on gasoline and other fuels used by vehicles. At this time, they are $0.183 per gallon for gasoline. Higher profile exise taxes exist on distilled spirits, tobacco products, and some firearms.

The government tracks tax payment by an account number and payment date. For the IRS, the account number is a social security number (or tax ID number assigned by the IRS if the individual does not have a social security number), or for corporations, partnerships or other synthetic persons, an employer ID number.

For more information, including tax and report calendars, information about forms, filing addresses and other information, see IRS Publication 15, circular E, "Employer's Tax Guide", available for free from http://www.irs.gov/forms_pubs/pubs

Transfer Taxes

The Transfer Tax[?] is targeted at wealthy individuals and families and generates less than 2% ($30 billion) of the federal government's annual revenue ($2 trillion). It consists of the Gift Tax[?], the Estate Tax[?] and the Generation-Skipping Transfer Tax[?] ("GSTT"). Opponents of the Transfer Tax refer to these taxes cumulatively as "Death Taxes[?]".

The Gift Tax is a tax levied on wealth transfers during the transferor's life while the Estate Tax is levied on transfers made after the transferor's death. The GSTT is a tax in addition to Gift or Estate Tax and is levied (in rough terms) on transfers made during life or after death to individuals removed by more than one generation from the transferor, for example, from a grandmother to a grandson. Usually transfer tax liabilities are paid by the transferor or the transferor's estate. Payment of Transfer Taxes by the transferor when the liability is due from the recipient is also a taxable gift.

As of December 2002, tax rates for Gift and Estate Taxes begin at 18% and rise to 50% for gifts or taxable estates[?] over $2.5 million under the Unified Transfer Tax Rate schedule. The GSTT is a flat 50%. Each individual is granted a Unified Credit[?] (currently $345,800) the effect of which exempts estates under $1 million. Each individual is also granted an annual exclusion amount[?] the effect of which exempts total gifts to any one individual during the year up to the annual exclusion amount (currently $11,000). If the transferor does not elect to pay the Gift Tax on the value of gifts totalling more than the annual exclusion amount, the individual is deemed to have used a portion of his Unified Credit. An exemption (currently $1.1 million) for transfers subject to the GSTT is also granted to each individual during his lifetime. The Unlimited Marital Deduction[?] allows (non-foreign) spouses to transfer any amount of wealth with no Transfer Tax consequences.

The Bush Administration and Congress passed The Economic Growth and Tax Relief Reconcilliation Act of 2001[?] which reduced federal taxes across the board. The Act increased the Unified Credit and GSTT exemption amounts and provided for gradual reduction of the Unifed Transfer Tax Rate to 45% by the year 2007. In 2010 the Gift Tax will fall to 35% and the Estate Tax and the GSTT will be eliminated. In 2011 a sunset provision[?] repeals all changes made to the Transfer Tax code and reverts to the Transfer Tax rules in place in 2001. The sudden elimination and then sudden reversion of Transfer Taxes has lead to some jokes (viewed as distasteful by some) about potential heirs sustaining the life of their benefactors until 2010. With a Republican-controlled Congress and White House in 2003, the Bush Administration is likely to seek acceleration of Transfer Tax credits, exemptions and reduced rates and/or seek to make the Transfer Tax cuts permanent. The reduction and/or elimination of Transfer Taxes at this time is particularly significant in that the largest transfer of wealth ever to be seen in the U.S. from one generation to the next will occur over the next couple of decades.

History

Federal Income Tax

There was no federal income tax until 1913.

The power of the US Government to tax income is given in the Sixteenth Amendment to the United States Constitution which was ratified in 1913.

At first the income tax was incrementally expanded by the United States Congress, and then inflation automatically raised most persons into tax brackets formerly reserved for the wealthy. Income tax now applies to almost 2/3 of the population. The lowest earning workers ($20,000 in 2000) pay no income taxes as a group and actually get a small subsidy from the federal government because of child credits and the Earned Income Tax Credit. Notably, however, lower income individuals pay a disproportionate share of payroll taxes for Social Security, Medicare, Unemployment Insurance[?], and the like. These payroll taxes can amount to 7-10% of every dollar and since they do not show up on tax forms their impact is less noticed.

State Income Tax

Most states also tax. Typically there is a tax on land, and there may be additional income taxes, sales taxes, and excise taxes. Oil and mineral producing states often have a separation tax, which is similar to an exise tax in that tax is paid on products produced, rather than on sales. Taxes on hotel rooms are common, and politically popular because the taxpayers usually do not vote in the jurisdiction levying the tax.

City and County Tax

Cities and counties may levy additional taxes, for instance to improve parks or schools, or pay for police, fire departments, local roads, and other services. As in the case of the IRS, they generally require a tax payment account number. Other local governmental agencies may also have the power to tax, notably independent school districts.

These states do not levy an individual income tax: Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. New Hampshire and Tennessee only tax interest and dividend income. Oregon and Montana have no state sales tax. California has all the mentioned taxes, and can result in taxes that exceed 51% of income for many workers.

See also: non-profit organization



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