Income Tax, a tax levied by a government on the income of individuals and business firms. Taxes on personal income and business profits are major revenue sources for most industrialized nations; they play a growing role in the taxation structures of many developing countries as well.
The income tax is a modern development. The earliest instances of a general income tax were those levied in France in 1793, in Great Britain in 1799, in Switzerland in 1840, in Austria in 1849, and in Italy in 1864. An income tax was first levied in the United States in 1862, during the American Civil War, but was abandoned a few years later. In 1894 the US Congress adopted an income tax on individuals and businesses at a rate of 2 per cent; this levy was declared unconstitutional by the US Supreme Court in 1895. Consequently, a constitutional amendment was required to give full legal sanction to federal use of an income tax. With the ratification in 1913 of the 16th Amendment to the Constitution, the United States joined numerous other nations—including Germany, the Netherlands, Australia, New Zealand, and Japan—in taxing incomes.
III MODERN INCOME TAX SYSTEMS
The income tax systems in most countries share certain common features. The first is a general exemption from paying income tax on a certain portion of a person’s income. This exemption (often known as a “personal allowance”) is designed to remove those with very low incomes from the income tax net. The second general feature of income tax systems is their graduated tax rates. Most systems have progressive rates, meaning that the income tax rate increases as taxable income rises. For example, in Great Britain, income tax rates in 1995 ranged from 20 percent to a top rate of 40 percent. Third, most income tax systems allow certain expenses or payments to be tax deductible for income tax purposes. Examples include costs associated with employment (special clothes, professional memberships etc.), health insurance, mortgage interest, alimony payments etc. Countries differ considerably in their treatment of these various categories of expenditure.
Income tax policy is inevitably controversial because it rests essentially on judgements that must be constantly reconsidered as social values change. The complex task of delineating the many deductions and exclusions to be allowed from income because they either make for greater fairness among taxpayers or promote worthy social goals (such as charitable contributions) is one of the most difficult and politically sensitive problems faced by governments.
Another major area of controversy is whether wages and salaries should be taxed the same way as business profits or investment income. While some countries explicitly apply separate sets of rules to the measurement of different kinds of taxable income, others seek to treat all sources of income in the same way. Even so, dissimilarities inevitably arise. Some costs of earning income are more readily deducted from business and self-employment receipts than they are from wages and salaries. Inflation, by eroding the value of capital, distorts the measurement of income from that source. Complex adjustments to the tax law could in principle eliminate these imbalances, but most countries have preferred simpler, more arbitrary solutions such as taxing capital gains on long-held assets more leniently than other types of income.
European countries typically give corporation shareholders some credit for taxes paid on their profits by corporations, but the United States has yet to adopt such relief from the double taxation of dividend income. In 1986, however, the federal government did lower its corporate tax rate significantly below the levels prevailing in most other developed nations.
How steep the progressive tax rate schedule should be is another sensitive issue. Inherent in this problem is the effect of taxes on incentives to work, save, and invest. Although some people work less when they are subject to high marginal rates, others work more to have more after-tax income. The net effect on the economy has been hard to measure, but there is a general belief that very high marginal rates of income tax can entail significant disincentives to work and entrepreneurship. Effects on investment decisions are much clearer, ranging from those deliberately stimulated by the tax law (through accelerated depreciation and tax credits) to unintentional ones such as the discouragement to investment because of overtaxing inflation-swollen profits and capital gains.
Worldwide experience has shown that the income tax can be fairly and efficiently administered only where taxpayer compliance is high. This requires public record keeping and reporting as well as an educated and cooperative populace. Where any of these elements are lacking, as in most developing nations, the personal tax tends to fall inequitably on income, such as wages, that can be readily traced.