Federal Individual and Corporate Income Tax
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Contents |
Overview
The main source of general revenues for the federal government is the federal income tax. This is really two main taxes, a tax on individual income, and a tax on corporate income, plus a variety of loophole closing taxes such as the Personal Holding Company Tax, the Accumulated Income Tax, the Alternative Minimum Tax, the Unrelated Business Income Tax, the Built in Gains Tax, the tax on private foundations income, and so on. Certain types of income in the individual income tax, such as capital gains and qualified dividends receive special lower tax rates. And certain economic benefits received by a person (such as gifts, inheritances, certain fringe benefits and certain gains on the sale of a residence) are not included in income by statutory fiat even though they could arguably be considered income.
All income taxes are assessed on income, reduced by allowable deductions, resulting in taxable income against which tax credits are applied, to result in the tax due for a tax year. Business deductions and investment tax rules are largely the same for individuals and corporations. But, individuals receive a number of deductions for personal expenses as well. Various taxpayers qualify for various kinds of tax credits.
Partnerships, limited partnerships, limited liabilty partnerships, limited liabilty companies, and a kind of closely held corporation called an S corporation do not generally pay taxes on their income themselves, but must allocate their income to their owners for tax purposes. Trusts and estates are subject to tax rules similar to, but not identifical to individuals to the extent that they do not distribute their income, but to the extent that their income is distributed to beneficiaries, they are treated similarly to partnerships.
Real Estate Investment Trusts (REITs) and mutual funds are taxes similarly to partnerships (on a highly streamlined basis) except to the extent that income is retained for the management group, with that income taxed similarly to publicly held corporations. An entirely different set of rules applies to life insurance companies.
While the corporate income tax, in theory, applies to all "C corporations", in practice, it is a simple matter for owner-managers of closely held C corporations to convert most of their profits into salary bonuses (the "zeroed out C corporation") resulting in little or no corporate level tax. Thus, taxes on corporate profits are overwhelmingly paid by publically held corporations, which, because they are investor owned, cannot simply use employee compensation to avoid corporate level taxation.
While the tax is called an "income tax", the income tax is really a crude appoximation of what is commonly known as "disposable income". Basically, it attempts (with many distortions) to make people pay tax in an amount that approximates their ability to pay.
Individual Income Taxes
Individuals file a form 1040, 1040A or 1040EZ each year, unless their income is so low that no tax could be due. They may include income from partnerships, S corporations, trusts or estates by attaching that as a schedule to their returns (typically a K-1) and including that income in the appropriate places on a 1040. Individuals with wages and salaries have money withheld from the paycheck and paid directly by their employer to the IRS through the year. Self-employed individuals may estimated tax payments to the IRS on a quarterly basis. In either case the withholdings and/or estimated tax payments are credited against the tax due at the end of the year.
Income
Income (Internal Revenue Code Section 61) consists of just about any money a person receives, other than tax exempt bonds (issued by state and local governments), fringe benefits that are not in cash, reimbursements from an employer for business related expenses supported by receipts, gifts and inheritances, principal payments on loans (except to the extent that capital gains were not reported in an initial sale made in exchange for the loaned money), child support, money put directly into retirement plans by an employer, and gains reported in tax free exchanges such as certain barter transactions and real estate reinvestments.
One of the more controversial exclusions from income, which is subject to litigation right now, is the exclusion from income for housing allowances for clergy. This is one of the only tax breaks reserved only for expressly religious activities. Most other tax breaks available to churches are also available to other non-profits. (Internal Revenue Code Section 107).
Exclusions from income are usually better for a taxpayer than above the line deductions or below the line deductions, because they don't have to be reported on a tax return and that money received doesn't figure into various other calculations based on a percentage of gross income.
Wages, salaries, interest, dividends, capital gains, rent, royalties, business profits, pension distributions, and alimony payments are among some of the more common types of income.
Above the Line Deductions
An above the line deduction is a deduction that you get to take whether or not you itemize your deductions. Regular itemized deductions, such as the charitable deduction, benefit only middle class people, typically only home owners whose mortgage interest and property tax deductions make it possible for them to claim more itemized deductions than the standard deduction.
Above the line deduction are also removed before determing adjusted gross income, which is important for many phaseouts in the tax code.
The some of the main above the line deductions are self-employed health insurance deductions, IRA contributions, alimony payments, self-employment taxes paid, business and income earning related expenses, moving expenses, and student loan interest.
Democrats typically want to make deductions above the line to benefit working class taxpayers, while Republicans often want to make deductions below the line to reduce the cost of a tax benefit.
Below the Line Deductions
Taxpayers get either an itemized deduction or a standard deduction depending upon which is larger.
The nice thing about the standard deduction is that it provides tax benefits regardless of actual expenditures and makes it unnecessary to keep the kind of records and list detailed expenses on a return. This make filing a tax return much less complicated, and lower income tax payers are often least able to deal with the complexities and record keeping involved in reporting itemized deductions. All you need to know to claim a standard deduction is your age, your spouse's age, and whether or not you or your spouse is blind.
The standard deduction keeps tens of millions of low income taxpayers from having to file tax returns at all. The standard deduction for the 2003 tax year was $9,000 for married couples filing jointly, $7,000 for heads of households (i.e. mostly single parents), and $4,750 for those who are single or married filing separately. (Note that this reflects the end to the "marriage penalty" in the standard deduction).
On the other hand, the standard deduction prevents low income taxpayers from taking advantages of itemized deductions.
The main itemized deductions are mortgage interest, investment interest, casualty and theft losses not covered by insurance (subject to a per percentage of adjusted gross income threshold), medical and dental expenses (to the extent that they exceed 7.5% of adjusted gross income), general investor expensees, charitable contributions (subject to a cap which is for many kinds of contributions 50% of adjusted gross income), and state and local taxes paid (generally income or property taxes, but not sales taxes). Many miscellaneous itemized deductions, such as unreimbursed employee business expenses are deductable only to the extent that they exceed 2% of adjusted gross income.
Itemized deductions are partially phased out for high income taxpayers (starting at adjusted gross income of $139,500 in 2003).
In addition to itemized or standard deduction, a taxpayer gets one "exemption" for himself, his or her spouse, and each dependent who lives with the taxpayer. This is a flat dollar amount similar to a standard deduction, but everyone gets to take it, whether or not they itemized. This is also phased out for high income taxpayers (starting at adjusted gross income of $104,625 in 2003). In 2003, the personal exemption was $3,050 per person. Thus, for a family of four, the combined standard deduction and personal exemption was $21,200 (and the child care credit and earned income credit discussed below are also available to that family to allow income to be federal income tax free).
Income minus above the line deductions, minus below the line deductions and minus exemptions is called "Taxable Income".
Common Personal Tax Credits
Individuals may get tax credits for a variety of reasons. Tax credits are generally better for low income people than deductions or exemptions. The tax benefit from a dollar of deduction or exemption is the amount of the deduction or exemption times your marginal tax rate (10% for many low income people and up to 35% for higher income people). Thus, deductions and exemptions are worth more to higher income people, than they are to lower income people. But, credits are worth the same to a taxpayer ($1 of tax reduced for every $1 of credit) regardless of your tax bracket.
The only caveat to that is that some tax credits are non-refundable, and thus, if the credit is non-refundable and more than your total tax bill, you get no benefit from it. Tax credits are also important to the Tax Expenditures debate as a tax credit comes very close to a spending program. Your entire tax liability is determined and they a tax credit hands you money that would otherwise have gone towards that tax bill.
The only personal tax credits which doesn't look much like a spending program is the "Foreign Tax Credit" which you get for taxes already paid in a foreign country paid on income earned in a foreign country. Basically, this treats taxes you've already paid on foreign income as if you had paid it to the United States, since the country where income is earned gets the "first shot" at taxing that income.
The main personal tax credits are the "Child Tax Credit" which gives you $1000 for each child you have (yes, there are a few more details to it), the credit for child and dependent care expenses which subsidized a portion of child care expenses pursuant to a rather complicated formula. The education credits which has the government pay for a certain part of tuition cost incurred based on several complex Clinton administration formulas, the adoption credit which helps pay for adoption expenses incurred (with extra large amounts allowed special needs adoptions), and the elderly and disabled credit. The child tax credit is sometimes refundable, the others are not.
In addition to all of these, there is the extremely important "Earned income credit" (EIC). This is a refundable credit that reduces the amount of tax paid by low income working people, which is then phased out rather dramatically, giving working class people the same effective marginal tax rates (i.e. the amount of money the tax system takes out of the next dollar you would earn). It is quite complex and most people simply use the table and charts without really understanding where it comes from, which leads to lots of mistakes, and large IRS audit efforts directed to very low income people on very low dollar cases who are making good faith mistakes.
The net effort of the standard deduction, personal exemptions, child tax credit and earned income credit, is that the break even point at which a family of four pays no net federal income tax is in the vicinity of about $30,000.
Individual Tax Rates
Individuals, trust and estates have more than one set of tax rates depending on the type of taxpayer and also on the type of income. One set of tax rates applies to "ordinary income". But, a variety of tax rates also apply to "capital gains", and special tax rates also apply to "qualified dividends". The special tax rates for capital gains and qualfied dividends, as well as the rules for determining how large a "capital gain" is in a transaction are discussed in the entry entitled capital gains tax.
The main tax brackets under the existing tax code for taxable ordinary income in 2003 where: 10%, 15%, 25%, 28%, 33% and 35%. The tax brackets are marginal tax rates. For example, in 2003, a single individual paid tax at the 10% rate on the first $7,000 of taxable income, at the 15% rate on the next $21,400 of taxable income, at the 25% rate on the next $40,400 of taxable income, at the 28% rate on the next $74,700 of taxable income, at the rate of 33% on the next $168,450 of income, and at the rate of 35% on any remaining income.
Thus, if a single taxpayer has a taxable income of $7,100, he pays tax on $7,000 of that income at the 10% rate and he pays tax on just $100 of that income at the 15% rate. Many people incorrectly believe that if you are in the 15% bracket, for example, that all of your income is taxed at the 15% rate. This simply is not the case.
There are five different sets of ordinary income tax brackets. One applies to single people, a second to heads of households, a third to married filing jointly taxpayers, a fourth to married filing separately taxpayers, and a fifth to trusts and estates. The cutoffs are higher for heads of households (mostly single parents) than for single people, are higher again for married filing jointly than heads of households (the "marriage penalty" has been elimnated by making the married filing jointly rates double the single rates at the 10% and 15% bracket cutoffs), are exactly half of the married filing jointly cutoffs for those who are married filing separately, and a very low for trusts and estates. The 35% rate kicks in for trust and estates at less than $10,000 of income, and trusts and estate have to file returns and pay some taxes if they have more than $600 a year of income.
Alternative Minimum Taxes
The Alternative Minimum Tax recalculates an individual's income while allowing fewer deductions and apply a different set of tax rates. It was intended as a way to prevent high income people from paying no tax without actually getting into the nitty gritty of why that was possible in the first place. Currently only a small percentage of high income individuals owe any alternative minimum tax. But, as scheduled tax cuts come into force, this will be the tax paid by most upper middle class or higher income taxpayers and many middle class taxpayers. Current administration projections for revenues assume that the Alternative Minimum Tax will remain in place. If it does, many existing tax breaks for higher income taxpayers are meaningless, because they will simply push higher income taxpayers into the Alternative Minimum Tax. But, if the Alternative Minimum Tax is adjusted as most predict it will be if tax cuts remain in place, then the revenue projections of the adminsitration vastly underestimate the size of the Deficit that will result. (There is also a corporate alternative minimum tax, but it has little or no practical effect).
The alternative minimum tax applies two tax rates to ordinary alternative minimum taxable income (AMTI), 26% to the first $175,000 (this may have been adjusted since the source relied upon for this entry), and 28% for the balance. Additional rules beyond the scope of this entry apply to capital gains and qualified dividends, which, generally speaking apply preferential rates to such income.
Alternative Minimum Taxable Income treatment applies to taxpayers who tax depreciation deductions (or similar costs related to long term contracts and mineral activities), exercise incentive stock options, receive tax-exempt interest from quasi-municipal bonds known as private activity bonds, have certain kinds of non-purchase money home equity loan interest, take business losses, have income from certain kinds of passive activities, and certain other kinds of "unusual" tax treatments. AMTI does not include the first $58,000 of a married couple's income or the first $40,250 of a single person's income.
Note that alternative minimum taxable income does not take into account many matters like the standard deduction and personal exemptions used to calculate regular taxable income. A person with a very large family may have to pay AMT despite having none of the specially treated deduction used to figure AMT at all.
Corporate Income Taxes
Corporate taxes are collected from C corporations on their gross income less their business deductions (i.e. their profits). Corporations don't have personal expenses, and don't get personal exemptions, standard deductions or perseonal tax credits. (About half of corporations are closely held S corporations which pay no corporate level tax).
Small closely held corporations typically arrange their affairs such that the shareholder-owners have high enough salaries and bonuses that the corporation has little or no taxes due after receiving all available tax credits. About 10% of C corporations do earn profits at the corporate level, largely because they have sufficient difference in identity between the top management and the shareholders that they can no longer just turn all profits into bonuses and get away with it. The vast majority of corporate taxes come from just a few thousand publicly held corporations.
Taxation of Corporate Level Transactions
While most corporate business activity is taxed just as sole proprietorships are taxed, there are some transactions specific to corporations. These include the payment of dividends, the issuance and purchase of a corporation's own stock by a corporation, corporate mergers, divisions of corporations into more than one corporation, and corporate liquidations. The rules here apply only to "C corporations" those subject to corporate taxation. Other entities have their own rules and aren't generally taxed at the corporate level.
The way the U.S. treats dividend transactions is controversial. A corporation pays taxes on its profits. It gets a deduction from taxable income for interest paid to bond holders. But, it does not get a deduction for dividends paid to shareholders, and shareholders must include the dividends in income. As a result when income is earned by a corporation it is taxed once at the corporate level and again if it is distributed to a shareholder, at the shareholder level. This phenomena is known as corporate double taxation.
Many of the effects of corporation taxation could be worked around with rather elaborate loopholes designed around the fact that capital gains in corporate property that was distributed in kind weren't taxed upon distribution. This changed in the 1986 overhaul of the Tax Code. This in turn made it important for corporations to look for ways to reduce their taxable income in the first place, made corporate reorganizations (i.e. mergers and divisions) important (since they are an excpetion to the rule that gains are taxed when assets leave the corporation), and created pressure from investors, which has slowly built over the decades to reform corporate tax law.
Most corporations responded to this shift in the tax code by dramatically curtailing dividend distributions, in part by shifting from equity to debt financing and in part by accumulating earnings and thereby increasing stock value which resulted in capital gains subject to lower tax rates. Thus, while double taxation could occur in theory if profits were distributed as dividends, in practice, a majority of profits were not distributed as dividends thus avoiding the most obvious and direct form of double taxation.
In the Bush Administration, a half-way step to end double taxation was adopted when qualified dividends were taxed as capital gains tax rates, rather than individual tax rates. While this change still leaves some "double taxation" of distributed earnings it has problems and still helps favor unearned income over earned income. But, there is great revenue pressure to put dividend tax breaks at the individual level, rather than the corporate income tax level, because many dividend recipients such as 401(k) plans, corporate pension plans, IRAs, private foundations, non-profit organizations, other C corporations, and to some extent life insurance companies, don't pay any or only pay partial income taxes on dividends received. So, tax breaks at the shareholder level don't impact revenue to the extent the dividends would have gone to non-taxable shareholders anyway, while tax breaks for dividends at the corporate level reduce revenues regardless of who the ultimate recipient of a dividend would have been had it been received. Discussions of different approaches to the "double taxation" issue are reviewed here.
Business Tax Deductions
The general rule is that businesses get to deduct business expenses from their business income so that only business profits are taxed.
Entities do not have meaningful "personal expenses" other than the distribution of profits to its members. These distributions are generally not deductible by corporations in the United States. Trusts and estates do get a deduction for distributions to their beneficiaries -- a distribution takes income from the trust or estate and makes that income the beneficary's income (subject to elaborate rules for determining precisely which income is representated by a distribution as different kinds of income have different tax treatments). In partnerships, limited partnerships, limited liabilty partnerships, limited liability companies, S corporations and the like, distributions to members are neither a deduction for the distributing company, nor income to the receiving owner, who is treated as if he or she personally earned the entity's income and losses at the time they were earned or lost
Individuals who run businesses as sole proprietorships may deduct business expenses "above the line", while personal expenses may be deducted only "below the line" and only where a specific provision of the tax code allows it. Certain expenses like life insurance which benefits a key employee, business meals, and other business expenses which give employees personal benefits are subject to special rules that limit the tax advantages of deductions for those expenses. Other business expenses which have personal benefit to employees are allowed and not taxed to the employee that benefits (such as group life insurance and employee health insurance), something which is called "fringe benefit treatment).
Among the most common business expenses are compensation paid to employees, non-federal income taxes paid by the business, charitable contributions (subject to certain limitations), interest expenses, and monies paid to independent contractors for business services.
Certain compensation expenses, such as cash salaries more than $1,000,000 a year and excessive Golden Parachute plans are not deductible as business expenses which basically treat these excessive payments to management teams similarly to dividends paid to shareholder, rather than as a cost of doing business.
In many cases that timing of when a business expense deduction can be taken is important. Generally speaking, inventory purchase expenses are deducted when inventory is sold rather than when it is purchased. Prior to that point it is considered an "investment" rather than an "expense".
Major purchases of equipment and buildings are called "capital expenditures" which are also treated as an "investment" rather than an "expense". Business expense deductions for these purchases are normally taken in part each year over a period of time through what is called a "depreciation deduction" rather than at the time of purchase. In accounting theory, the depreciation deduction should be taken over the useful life of the item purchased. Under U.S. tax law, however, we have an "accellerated depreciation recovery system" and an "expensing rule" for small purchases, which allows businesses to take deductions for capital expenditure purchases over a period of time much shorter than the useful life of the item purchased. This is the single biggest tax break for business in the existing tax system. This is also the biggest reason that companies which are profitable in reports given to investors under standard accounting rules, are not profitable on their tax returns.
"Amortization" is the word used to described a depreciation expense when the capital expenditures is an intangible item like a business start up expenditures or patent or the "goodwill value" of a business purchased as a going concern, as opposed to a tangible piece of property, such as equipment or a building.
"Depletion" is the word used to describe the analog of the depreciation expense used when the item purchased is a mineral producing asset such as an oil well.
There are limits on how much of a loss from a business can result in a tax refund in a given year. Elaborate rules govern when losses from one year can be applied to reduce the taxes a business owes in another year. Rules also govern when money "earned" for goods provided and services rendered can be removed from income because the promise to pay given in exchange for the goods or services was not honored, producing a "bad debt".
Business Tax Credits
Most business tax credits are simply government subsidies for doing something that the tax code prefers run through the tax system. Among the better known business tax credits are the research and development tax credit, the low-income housing tax credit, the enhanced oil recovery tax credit (for producing oil from wells where it is difficult to recover oil), the disabled access credit (for accessibility projects of small businesses), various credits related to alternative energy sources, various credits for creating jobs in places that are classified as depressed or for groups who are seen as really needing jobs (e.g. Indian tribe members and welfare recipients, ex-felons, "high risk youth", etc.), clinical testing on "Orphan Drugs", reforestation expenses, etc.
Much of this is Corporate Welfare.
Corporate Tax Rates
Corporate tax rates (for C corporations) do not distinguish between ordinary income and capital gains. This is quite remarkable, because the main justification for capital gains tax cuts is to encourage productive investment that will lead to economic growth, and most productive investment in "means of production" in our economy is made by C corporations.
In contrast, capital gains of individuals are typically thinks like shares of stock, real estate, collectables, or other investments which are less directly associated with means of production that promote economic growth. This distinction supports the notion that capital gains tax rate cuts are largely a sop for the rich, rather than an economic growth tool. (Of course, for a variety of reasons, large corporations don't actually pay all that much corporate level tax anyway).
Corporate tax rates are found at Section 11 of the Internal Revenue Code. The largest corporations (those with $18.333 million or more in income) and "personal service corporations" (doctors, lawyers and consultants) pay a flat rate of 35%. Medium sized corporations (those with $335,000 to $10,000,000 of income) pay a flat rate of 34%. There is a phase in of the slightly higher rate for corporations with income between $10 and $18.33 million.
Corporations with $50,000 or less of income pay corporate income taxes at the 15% rate, and corporations with $50,000 to $75,000 of income pay corporate income taxes on the next $25,000 at the 25% marginal rate. There is a phase in of the 34% rate for corporations with between $100,000 and $335,000. The lower graduated rates combined with new low rates on corporate dividends make total taxes lower for C corporations than sole proprietorships for a small sliver of small corporations for the first time in many decades, although some of these advantages are scheduled to be phased out.
Groups of interrelated companies generally benefit from the lower graduated rates only once for the entire group under a couple of interrelated tax rules.
Foreign companies pay a 30% flat tax rate on income "not effectively connected with a U.S. trade or business" which is subject to U.S. taxes.
Special rates apply to personal holding companies and under the accumulated earnings tax (which are designed to prevent corporations from earning money at less than individual rates than then just sitting on money with no relationship to the business).
There is no particularly compelling tax reason for lower graduated tax rates for small corporations, because even a low income corporation may be, and indeed often is, owned by a very high income individual, and the justifications for graudated tax rates for individuals (mostly progressive taxation and harmonization of income tax rates with payroll tax burdens) simply do not apply to corporations. Because the total tax collection impact is fairly modest in the larger scheme of things, and the biggest loophole (small personal service corporations) has been closed, there has never been the political will to shut down this absurdity.
Of course, the law means little if there is not meaningful enforcement, and the administration of George W. Bush has reduced IRS attention to business audits.
International Taxation
Generally speaking, U.S. citizens and permanent residence (including corporations and trusts classified as domestic for tax purposes) are subject to taxation on their worldwide income, subject to a foreign tax credit. The foreign tax credit reduces U.S. tax attributable to foreign income by the tax paid where the income was earned, but never below zero.
Foreign corporations, trusts and non-resident aliens are generally speaking subject to U.S. income taxation only on income "effectively connected" with the United States (such as business income from a U.S. business). Interests, dividends, rents and royalties from U.S. sources are generally taxed to foreigners at a flat 30% tax rate. Capital gains of foreigners are generally not taxed by the U.S. unless they involve U.S. real estate or a U.S. business actively conducted by the foreign taxpayer. Taxpayers who give up U.S. citizenship or permanent residency are often treated for tax purposes as U.S. citizens for a period of ten years after the U.S. connection ends for some tax purposes in order to avoid tax avoidance.c
A variety of special tax regimes, such as the Controlled Foreign Corporation rules, the Foreign Personal Holding Company rules, and "transfer payment" rules are designed to prevent evasion of this regime through foreign entities that have important connections to U.S. taxpayers. The focus of this enforcement regime is primarily centered on "hot money", i.e. liquid investments and elements of business income that can be domiciled in a variety of places with only slight inconvenience.
Analysis of the Implications of the Federal Income Tax
Macro Trends
The federal income tax remains one of the most progressive parts of the United States tax structure. But, it is continually in flux. Conservatives have made a concerted but piecemeal effort to make the federal income tax a tax on work, but not on unearned income.
The tax reforms of 1986, after which the current Internal Revenue Code is named (brokered between Ronald Reagan and a democratic Congress), eliminated all distinctions between ordinary income and capital gains, tightened corporate taxation, and broadened the tax based. The reforms have since been eroded.
Both capital gains and dividends are now taxed at preferrential rates (the top marginal rate for both forms of income when earned by non-corporate taxpayers is 15% compared to 35% for ordinary income). Only interest, rents and short term capital gains (under a year) are taxed at ordinary income rates. Corporate tax collections are at record lows, see here at page 9, due to a variety of factors, most prominently among them, increased use of multinational entities to avoid or postpone U.S. taxation, numerous corporate tax credits, and depreciation schedules which permit corporations to deduct capital expenditures completely long before non-tax accounting principals would permit such deductions.
Many people now received almost all of their investment income through tax preferrenced accounts. Defined contribution retirement account rules have been liberalized, a new "Roth IRA" eliminates all taxation on gains in these retirement accounts, stock options and nonqualified deferred compensation have created tax preferenced compensation on a massive scale for senior executives at large corporations. Education saving accounts (similar to IRAs) and high education savings plans called 529s have taken a large proportion of all education savings out of the taxable realm, and into the tax free realm. Postponement of gain on the sale of a principal residence has been replaced with an exclusion of gain on the sale of a princpial residence. The "1031 exchange" (named after the code section creating it), has been liberalized to the point where taxation on almost all gains on the sale of investment real estate can be postponed for as long as the investment remains in the investment real estate sector. Interest on municipal bonds is tax exempt, as are increases in the cash value of life insurance.
Conservative economists and politicians have proposed going even further with proposals sometimes called "consumption taxes" or "flat taxes", which are really just income taxes that impose no tax on investment earnings and no tax on money which is invested.
This shift away from investment income as a part of the federal income tax base, combined with the flexibility that highly compensated executives have to control the manner in which they are compensated, has had the effect of transforming the federal income tax into increasingly a tax on wages and salaries.
Along with this change in the income taxation of investment, has been a change, in part for political cover for the other changes, away from using the income tax to collect funds from low income Americans. A married couple with two minor children with income primariily from earnings now starts making net income payments in the vicinity of twice of poverty line, which has kept record numbers of Americans off the income tax rolls. This does not, however, mean that those individuals are not taxed. The payroll tax (FICA) has become the dominant tax burden for working class Americans and has increased in response to economic pressures on the Social Security system. Likewise, the middle class (defined in this cases as those with incomes between about $30,000 and $80,000), must pay both FICA taxes (currently 7.65% of payroll paid by the employee and a like amount paid by the employer), and a substantial income tax burden.
Micro Effects
The tax code is not economically neutral and not intended to be economically neutral. It favors marriage over single status (particularly in light of recent changes in the tax code to eliminate the so called "marriage penalty" without rolling back the "marriage bonus" which had already been experienced by half of married couples). It favors home ownership over renting (with the mortgage interest deduction and exclusion of gains on the sale of a residence).
It favors unearned income over earned income (e.g. in an "S corporation" the owner pays fewer taxes if he characterized his income as profit as opposed to wages). It favors dividends and capital gains over interest income. (Yet, also favors corporations that pay no dividends over those that pay many dividends). It favors investments in government over investments in the private sector (due to tax exemptions for interest on municipal bonds).
It encourages individuals to buy appreciating assets (due to capital gain tax prefences) and generally encourages corporations to buy depreciating assets (due to an absence of capital gain tax preferences and accellerated deprecation).
Some of the differences in tax treatment serve policies which aren't entirely clear. For example, child support and alimony are treated very differently for tax purposes, despite the fact that both involve payments from one party in a divorce to another for the purpose of income support, and despite the fact that the parties have a great deal of freedom to choose one characterization or the other.
High Income Taxpayers Who Owe No Taxes
Several thousand of the more than two million taxpayers with incomes in excess of $200,000 each year pay no taxes. The detailed numbers and methods by which this is done are explained by this IRS Study.
One class of taxpayers pay no income tax predominantly because they live abroad and pay taxes to a foreign government for which they receive a credit against their U.S. taxes (or receive an exclusion from taxable income).
Another class of taxpayers, about half of those with no foreign tax credits, pay no taxes predominantly because they receive large amounts of money from tax exempt state and local bonds. These are the least sympathetic of the non-taxpayers. In theory, they are paying taxes indirectly to local governments in lieu of paying federal taxes, by receiving a lower rate of return than they would have if they had invested in Treasury bonds or corporate bonds. At an emotional level, however, it is jarring to see thousands of people making $200,000 a year or more in passive investment income paying absolutely no federal tax.
Some of the other more common reasons for not paying income tax include business loss deductions, large amounts of investment income financed with debt with interest charges that result in no net gain from the investments, major medical expenses, and major casualty and theft losses.
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