Income tax

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Definition

An income tax is a tax that is levied on, and is generally an increasing function of, income. Income taxes are levied on persons (individuals or households). There is a related notion of income tax for corporations, which is discussed on the separate corporate tax page.

Mechanics

Burden of remitting the tax

  • Income taxes are usually paid by the individual or household as part of an annual process of filing a tax return. The tax return is a statement of the income over the tax year as well as the calculation of tax based on the income. A tax return includes filled versions of forms created by the taxing authority.
  • Many payers of income, including employers paying wage income, as well as banks offering interest income, may be required to deduct taxes from the employee's income and send it to the taxing authority. These deducted taxes are called tax withholdings, and represent an advance payment of the eventual tax obligation of the individual or household. Tax withholdings help the tax authority obtain a steady stream of income tax revenue throughout the year, increase tax compliance, and reduce the visibility of taxation to individuals and households.

Structure of tax rates

Income tax rates are quoted inclusively. For instance, an income tax rate of 10% means that the taxpaper pays 10% of income, leaving the taxpayer with the remaining 90%. This is in contrast with sales taxes, which are quoted exclusively.

Structure and applicability

Generally progressive structure

In most jurisdictions, the income tax formula is progressive: the higher the income, the higher the average tax rate. Marginal income tax rates are generally constant over income ranges and jump discretely. These income ranges are sometimes called tax brackets or tax slabs. The lowest marginal tax rate is generally zero (though this might be operationalized in the form of a "standard deduction" or "personal exemption" on taxable income rather than a 0% marginal tax rate) and the highest marginal tax rate can vary from 1% to 90% depending on jurisdiction.

Some jurisdictions have a flat income tax rate, though even these jurisdictions support some basic exemption, so they effectively have a two-tiered tax rate: 0% for the exempted income, and then a fixed rate.

Income taxes are almost never regressive; however, social security taxes, which are in many ways similar to income taxes, may be regressive or even capped.

Types of income

There are a few categories of income to which income tax applies:

  • Earned income: Income earned by doing work. This is the most common kind of income for the majority of people who file income tax returns, in most jurisdictions. Earned income is subject not just to income tax but also to social security tax in some jurisdictions.
  • Capital gains: Income earned through a gain in the value of assets held. Capital gains are realized at the time of sale, though they may also be realized using a "mark-to-market" method. Capital gains are most likely to have a lower tax rate, possibly even a zero tax rate. There are theoretical arguments for a different treatment of capital gains than other kinds of income.
  • Interest and dividend income: Income earned from deposits in bank accounts, and dividends earned from shares held in companies. Although the arguments for lower tax rates on capital gains may also apply to interest income, interest income is generally taxed the same way as regular earned income, though it is not subject to social security tax.
  • Other income: Any other kinds of income that does not fall within the above categories.

Sensitivity to distribution across persons and time periods

Since income tax rates are progressive and not flat, the total income tax burden over a multi-year time period cannot be determined by looking at the total income over the time period. Rather, the distribution of income across the multi-year time period determines the amount of tax. In general, assuming no significant changes to tax rates or tax brackets between the years, the tax is least when the income is evenly distributed across the time periods.

Similarly, the total income tax burden across a set of people is not determined purely by the total income of those people, but also by the distribution, The closer to even the distribution of income, the lower the total income tax.

Individual versus household

Tax treatment generally provides lower tax rates on the same income to a married couple filing jointly than to an individual, but the tax rates are higher than if they both reported their separate incomes as individuals. Households with children may have to pay less in taxes for each child, up to some limit.

Deductions

Taxes in general have three justifications: revenue justification, incentive justification, and group/class warfare justification. Tax laws include a large number of deductions for politically or socially favored categories of expenses, such as charitable donations or healthcare payments. This ties with the incentive justification, as the tax law wants to incentivize people to donate to charity and take care of their health.

Deductions generally add to the complexity of the tax code, significantly adding to the overhead of tax preparation.

Taxation by multiple jurisdictions

In some cases, an individual or household may be required to pay taxes to multiple jurisdictions on the same income. There are two kinds of situations:

  • Jurisdictions at different levels, such as a national government and a state or provincial government: Generally, since a given state or provincial governments is inside a fixed national government, the state's tax laws already take into account the nation's tax laws. In fact, many of the tax calculations for the state's taxes may rely on tax calculations for the nation's taxes. Generally, the same income is subject to being taxes at both levels; however, taxes paid to one level may be a deduction one can take for taxes paid to another level.
  • Multiple independent jurisdictions, such as two countries (for people who have citizenship and/or residency and/or income sources in multiple countries): In such cases, it may be possible to exclude income that has been taxed in one jurisdiction from taxation in the other.

Effect of income tax

It is worth keeping in mind that because income tax laws affect large numbers of people, the study of behavioral responses to income taxes, to be done properly, must take into account the interaction between responses. This section will discuss the effect of income taxes at the micro level, but a fuller understanding would require unfolding what this does to the whole economy. In particular, the secondary and tertiary effects of changes to income tax policies would result in changes to the general price level of the economy.

Effect on earned income

Income taxes have incentive effects on earned incomes in both directions:

Explanation of effect What does this effect predict about the effect on earned income of increasing income tax rates? What does this effect predict about the effect on tax revenue of increasing income tax rates? What kind of people would this effect be strongest in
The marginal benefit (financial) of earning more is less, because the after-tax income is reduced. This reduces people's incentive to work more, or to look for higher-paying (but potentially less pleasant) jobs. This is a substitution effect in action. Decreases Ambiguous People who are already earning enough to meet their basic needs; people who have a range of options either for the kind of job or the amount of time spent on the job, that differ significantly in the amount of personal pleasantness or satisfaction. This may also apply to families that already have some earners, and where additional earners have a choice between working and not working.
To have a given amount of after-tax income (needed to sustain a lifestyle) the person needs to earn more pre-tax income. This is an income effect in action. Increases Increases People who have a relatively inflexible budget, and who come close to spending most of their income (living paycheck-to-paycheck), or have very specific financial savings goals.


Although there is ambiguity about the effect on earned income, there are other, less ambiguous things we can conclude:

  • The progressive structure of tax rates incentivizes people toward having a more steady income rather than having large incomes in one year and small incomes in other years. This may not change behavior much for salaried workers, but for contract workers, who have more flexibility in how to distribute their work between years, it could affect behavior. This could also affect the way employers structure bonuses (so that bonuses that have less-than-annual frequency would be rare).

Effect on interest income

Income taxes on interest income cause the effective interest rate on savings to be correspondingly lower than the interest rate offered by the bank or financial institution. Generally speaking, this should move people away from saving money in interest-bearing accounts, toward one of these:

  • Consumption.
  • Saving money in cash or non-interest-bearing accounts, if saving money in this way offers some other advantages.
  • Buying assets, on which taxes would be paid as capital gains, and likely only at the time of sale (thus allowing for more tax-free compounding over time). Also, capital gains may have a lower tax rate.
  • Putting money in interest-bearing accounts that are exempt from taxes; usually, some kinds of retirement accounts enjoy this exemption.

Effect on capital gains

Capital gains tax rates are generally lower than tax rates on earned income or interest income. Some jurisdictions make a distinction between short-term capital gains, which are taxed at ordinary income tax rates, and long-term capital gains, which are taxed at a reduced rate. Moreover, capital gains taxes are generally paid only at the time of sale, though some assets may be taxed on a "mark-to-market" basis where the appreciation in value every year is taxed.

  • The gap between ordinary income tax rates and capital gains tax rates is one factor that determines whether people save in the form of deposits or assets. The larger the gap, the more likely savings are to be in the form of assets.
  • If capital gains tax rates are based on total income level, this might incentivize people to time the sale of their capital assets to years when their other income is lower, so as to pay a lower effective tax rate on the capital gain.
  • If tax law itself is subject to changes, people with the flexibility to time things may time the sales of capital assets to years when capital gains treatment is particularly favorable.

Effect on favored activities

Tax code often provides favorable treatment in the following forms:

  • Deductions are allowed for charitable contributions, some healthcare expenses, health insurance, and education expenses. As is partly the intent of such deductions, these deductions cause more of these expenses than would otherwise be the case. This money may substitute away from money that would be spent on other forms of consumption or saving.
  • Money (income or otherwise) saved in special kinds of savings accounts called retirement accounts may benefit from reduced tax rates relative to money saved in normal interest-bearing accounts. This may encourage people to use retirement accounts rather than ordinary savings accounts or direct purchase of assets, even though ordinary savings accounts and purchase of assets offer more liquidity. It may also shift people to move money away from consumption toward retirement accounts.