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PART IV. THE FEDERAL TAX SYSTEM
Section 1. The Individual Income Tax
A. HISTORICAL INTRODUCTION
An income tax was first enacted in the Revenue Act of 1862 (Ch. 119, 12 Stat. 432) to finance the Civil War. The tax was repealed a decade later in 1872. The individual income tax made a second, brief appearance as part of a 1894 revenue act enacted during the second administration of President Cleveland. The tax was abolished as a result of the Supreme Court decision in Pollock v. Farmer's Loan and Trust Company, 158 U.S. 601 (1895), that the imposition of the individual income tax was a violation of clause 4 of Article I, section 9 of the United States Constitution, which prohibits "direct" taxation without apportionment among the States. As a result of Pollock, it was clear that in the absence of a constitutional amendment, Congress lacked the power to levy an individual income tax.
Nearly 20 years after the Supreme Court's decision in Pollock, the 16th amendment was ratified on February 25, 1913. Under the 16th amendment, Congress has the power to collect taxes "on incomes from whatever source derived," without apportionment among the States. Several months later, Congress enacted the individual income tax as part of the Revenue Act of 1913. In its initial form, the income tax was designed to affect only a small number of households, and by the standards of today, in a modest way. For married couples, the tax did not apply to taxable incomes less than $3,000. The top marginal rate was 7 percent, and applied to taxable income over $500,000 (table 1).
Since that time, the individual income tax has grown to be the most significant single source of Federal revenue. In 1992, the individual income tax raised $476.5 billion, or 44 percent of all Federal receipts (table 2). Over the last 3 decades, the individual income tax has represented a fairly stable share of total revenues—almost half. During the 1980s, its share slipped slightly as legislated increases in payroll taxes caused that share to grow relative to other tax sources (table 3 of this section and tables 1 and 3 of Part V, "Historical Tables").
Two basic economic principles underlie the structure of the individual income tax: efficiency and equity. These two principles can conflict with one another. Some measures designed to increase equity may result in less economic efficiency; similarly, measures which achieve greater economic efficiency may be less equitable.
The principle of efficiency implies that the best tax is one which interferes as little as possible with individuals' choices regarding
their economic activity. A completely efficient tax would tax all economic income, from whatever source derived, in exactly the same manner and, consequently, would distort economic behavior as little as possible. Of course, the individual income tax system departs in large measure from this model. Income spent on certain activities earned in certain ways may be taxed at a lower rate than other income. This is because Congress has decided to use the tax system to encourage or discourage certain forms of behavior, or because it may view conforming the tax system to the economic model as administratively difficult or unfair.
The principle of equity embodies commonly held notions of what makes a tax system fair. Under the principle of horizontal equity, individuals in similar economic situations are taxed alike. Under the principle of vertical equity, individuals in different economic circumstances are taxed differently, and their tax payments should reflect their economic differences. For example, those with more income pay more taxes than those with less. Traditionally, the principle of vertical equity has embraced the notion of progressivity, under which individuals with higher incomes pay a higher percentage of their income in taxes than individuals with lower incomes. The higher-income person's greater "ability to pay" often justifies the case for progressivity. Progressivity is also supported by the theory that as an individual's income increases, each additional dollar is less necessary to ensure that individual's basic well-being. It is only fair, under this view, to require that higher income individuals pay a higher percentage of income in taxes than low-income individuals for whom a greater percentage of income is required for the necessities of life. This theory is sometimes denoted the principle of declining marginal utility of income. Critics of the theory, however, question the empirical support for its assumptions. They argue that, taken to its extreme, the theory should lead one to equalize all incomes. According to this view, a tax strictly proportional to income is sufficient to meet the goals of vertical equity.
In today's income tax system, the goal of vertical equity is accomplished in three ways. First, as a taxpayer's income grows, it is subject to higher marginal rates. Second, income below certain thresholds is exempt from taxation altogether through the provision of personal exemptions and the standard deduction. Third, the refundable earned income tax credit (EITC) is available to reduce the tax liability of low-income taxpayers. The refundability of the EITC means that it is first used to offset any tax liability, then any additional credit is "refunded" to the taxpayer as a direct transfer payment. Thus the EITC serves as a reverse, or "negative," income tax and results in income support payments from the Government to the household.
C. STRUCTURE OF THE INDIVIDUAL INCOME TAX
The individual income tax is levied on "taxable income." Taxable income equals the taxpayer's total income minus certain exclusions, exemptions, and deductions. Tax liability is computed by applying the appropriate tax rates to his or her taxable income. The taxpayer may reduce that tax liability by subtracting tax credits from
the otherwise-owed tax liability. The earned income tax credit is the only refundable credit, and thus may reduce the household's tax liability below zero, i.e., may generate transfer payments.
Deductions and exclusions allowed are generally intended to measure income more accurately by allowing, for example, deductions for costs of earning income. In addition, some exclusions and deductions are allowed for amounts or items in excess of what is necessary to measure income accurately, because lawmakers feel they need or want to provide incentives for certain types of activities. Revenue losses to the Government in excess of what would be necessary to measure economic income are generally referred to as "tax expenditures." (Part VI discusses the theory of tax expenditures, dissenting views, and revenue estimates of major tax expenditure items.)
Appendix 1 (after table 9), prepared by the Congressional Research Service,1 provides an explanation for a number of commonly used Federal individual income tax terms. The terms covered are explained in the order that they occur in the process of determining one's income tax.
Adjusted Gross Income
Under the Internal Revenue Code, a taxpayer's gross income is "all income, from whatever source derived." That is, unless specifically exempt or excluded by statute, all sources of income, including compensation for services, investment income (such as interest, dividends and capital gains), alimony, prizes, and awards, are included in the taxpayer's gross income.
The most important statutory exceptions to this all-inclusive definition of gross income are exclusions for certain employer-provided fringe benefits, including health care, dependent care assistance and educational assistance and the deferral of tax on accrued pension benefits. The tax expenditure attributable to the deferral of tax on pension contributions and the income on accrued pension benefits totaled $311 billion over the 1994-98 period. The tax expenditure attributable to the exclusion of employer-provided health care totaled $213 billion. (See Part VI, "Tax Expenditures" for further data.) In addition, certain items of compensation are excluded from gross income, such as employer-provided meals, lodging, employee discounts, free travel, and so forth. These items are excluded because keeping track of their value to individual employees might impose recordkeeping problems disproportionate to the value of the benefit.
Having computed gross income by totaling all income (except income excluded by statute), the taxpayer computes adjusted gross income by deducting certain items as permitted by statute. These deductions are colloquially known as "above the line" deductions to distinguish them from itemized deductions (discussed below). The most important deductions allowable from gross income are deductions for trade and business expenses, capital losses, contributions to Individual Retirement Accounts (IRAs), contributions to the pension plans of self-employed individuals, and alimony payments.
1Source: "Federal Individual Income Tax Terms: An Explanation" by Louis Alan Talley, Congressional Research Service, the Library of Congress.
Taxable income is computed by deducting from adjusted gross income the sum of two items: personal exemptions and deductions.
a. Personal exemptions.-In 1993, each personal exemption is worth $2,350. The taxpayer may deduct one personal exemption for the taxpayer, the taxpayer's spouse, and each of the taxpayer's dependents. For example, a married couple filing jointly with four dependent children is entitled to six personal exemptions, worth a total deduction of $14,100.
Beginning in 1991, the personal exemption is phased out, or gradually eliminated, for high-income taxpayers. The value of a taxpayer's personal exemptions is reduced by 2 percentage points for every $2,500 or portion thereof by which the taxpayer's adjusted gross income exceeds $162,700 in 1993 in the case of a married couple filing jointly ($108,450 for an unmarried individual). The income thresholds are indexed each year for inflation. In 1993, each personal exemption will be reduced by $47 (2 percent of $2,350) for every $2,500 of income over the applicable threshold. All personal exemptions are phased out over a fixed dollar range of $125,000; thus, the greater the number of personal exemptions, the more tax benefit lost as a result of each income increment of $2,500.
For a married couple, exemptions are totally phased out at adjusted gross income of $285,200 in 1993 ($230,950 for an unmarried individual). This end point is also indexed for inflation.
The personal exemption is designed to adjust for family size. A larger family with the same amount of income as a smaller family would have a more limited ability to pay taxes. The personal exemption is also an important element in ensuring the progressivity of the income tax system. Even without the phaseout of the exemption, the exemption excludes a higher percentage of income for lower income households than for higher income households. For example, as noted above, a family of six may deduct up to $14,100 through personal exemptions. In the case of a family with income of $40,000, six personal exemptions protect 35 percent of family income from taxation; with income of $100,000, six personal exemptions protect only 14 percent of family income from taxation.
Before enactment of the Tax Reform Act of 1986, personal exemptions were generally available to all taxpayers regardless of income. The Tax Reform Act of 1986 phased out personal exemptions for high-income taxpayers. The method of phasing out personal exemptions was modified by the Omnibus Budget Reconciliation Act of 1990 (OBRA of 1990) (described above). The phaseout of personal exemptions is scheduled to expire after December 31, 1996.
b. Standard deduction.-In addition to allowable personal exemptions, the taxpayer may also deduct an amount equal to the "standard deduction." The standard deduction varies according to filing status. In 1993, the standard deduction is $6,200 for a married couple filing jointly; $5,450 for a head of household; and $3,700 for a single individual. Like the personal exemption, the standard deduction is indexed for inflation and so grows over time.
An individual who is blind or elderly is entitled to an additional standard deduction amount. For a married taxpayer who is either blind or elderly, the additional standard deduction is $700 in 1993. If both spouses are elderly (or blind), the couple's additional stand
ard deduction is $1,400. For an unmarried taxpayer who is blind or elderly, the additional standard deduction is $900.
Table 4 shows personal exemptions and standard deductions for 1993 and 1994.
c. Itemized deductions.-Instead of taking the standard deduction, taxpayers have the option of itemizing their deductions. That is, they can elect to deduct expenses for State and local income and property taxes; mortgage interest; charitable gifts; certain investment interest; medical expenses (to the extent they exceed 72 percent of adjusted gross income); miscellaneous itemized deductions related to earning income, such as safety deposit rental fees, employee business expenses, and investment advisory expenses (to the extent they exceed 2 percent of adjusted gross income); and casualty losses (to the extent they exceed 10 percent of adjusted gross income).
Under prior law, a taxpayer's itemized deductions were generally not limited in any way for high-income taxpayers. OBRA of 1990 required a partial cutback of some itemized deductions for high-income taxpayers, for taxable years beginning on or after January 1, 1991. Under this provision, a taxpayer's itemized deductions are reduced by 3 percent of the excess of the taxpayer's adjusted gross income over $108,450. This income threshold is the same for married and single taxpayers, and is indexed for inflation. Regardless of the size of a taxpayer's income, this limitation on some itemized deductions is itself limited so that a taxpayer's deductions are not reduced by more than 80 percent. This limitation is currently scheduled to expire after December 31, 1995.
The following hypothetical example illustrates how this provision works. In 1993, Taxpayer A has adjusted gross income of $150,000 and itemized deductions of $30,000. Taxpayer A's income exceeds $108,450 by $41,550. Three percent of $41,550 equals $1,246. Taxpayer A's itemized deductions are reduced by $1,246-from $30,000 to $28,754.
In tax jargon, this provision is called a "floor" under itemized deductions for high-income taxpayers, because only amounts over the floor are deductible. The 3 percent floor operates in addition to other floors set under specific itemized deductions (e.g., the floors on medical expenses, casualty losses, and miscellaneous itemized deductions).
In general. After calculating taxable income, the taxpayer determines actual tax liability. Historically, the income tax has been structured so that as a taxpayer's income increased, the tax rate applicable to the taxpayer's additional income increased. The rate applicable to the last dollar of income earned by the taxpayer is termed the taxpayer's "marginal" rate. The taxpayer's average rate is generally lower than his or her marginal rate because, while the taxpayer's last dollar of income is taxed at the highest marginal rate, other income is taxed at the lower marginal rates applicable to lesser amounts of income. The range of income subject to each increasingly higher marginal rate is termed an income "bracket." Before the Tax Reform Act of 1986, there were 15 marginal rates, and thus 15 income brackets. The Tax Reform Act of 1986 created