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An income tax is a government levy (tax) imposed on individuals or entities (taxpayers) that varies with the income or profits (taxable income) of the taxpayer. Details vary widely by jurisdiction. Many jurisdictions refer to income tax on business entities as companies tax or corporation tax. Partnerships generally are not taxed; rather, the partners are taxed on their share of partnership items. Tax may be imposed by both a country and subdivisions thereof. Most jurisdictions exempt locally organized charitable organizations from tax.
Income tax generally is computed as the product of a tax rate times taxable income. The tax rate may increase as taxable income increases (referred to as graduated rates). Tax rates may vary by type or characteristics of the taxpayer. Capital gains may be taxed at different rates than other income. Credits of various sorts may be allowed that reduce tax. Some jurisdictions impose the higher of an income tax or a tax on an alternative base or measure of income.
Taxable income of taxpayers resident in the jurisdiction is generally total income less income producing expenses and other deductions. Generally, only net gain from sale of property, including goods held for sale, is included in income. Income of a corporation's shareholders usually includes distributions of profits from the corporation. Deductions typically include all income producing or business expenses including an allowance for recovery of costs of business assets. Many jurisdictions allow notional deductions for individuals, and may allow deduction of some personal expenses. Most jurisdictions either do not tax income earned outside the jurisdiction or allow a credit for taxes paid to other jurisdictions on such income. Nonresidents are taxed only on certain types of income from sources within the jurisdictions, with few exceptions.
Most jurisdictions require self-assessment of the tax and require payers of some types of income to withhold tax from those payments. Advance payments of tax by taxpayers may be required. Taxpayers not timely paying tax owed are generally subject to significant penalties, which may include jail for individuals or revocation of an entity's legal existence.
While tax rules vary widely, there are certain basic principles common to most income tax systems. Tax systems in Canada, China, Germany, Singapore, the United Kingdom, and the United States, among others, follow most of the principles outlined below. Some tax systems, such as India, may have significant differences from the principles outlined below. Most references below are examples; see specific articles by jurisdiction (‘’e.g.’’, Income tax in Australia).
Individuals are often taxed at different rates than corporations. Individuals include only human beings. Tax systems in countries other than the USA treat an entity as a corporation only if it is legally organized as a corporation. Estates and trusts are usually subject to special tax provisions. Other taxable entities are generally treated as partnerships. In the USA, many kinds of entities may elect to be treated as a corporation or a partnership. Partners of partnerships are treated as having income, deductions, and credits equal to their shares of such partnership items.
Separate taxes are assessed against each taxpayer meeting certain minimum criteria. Many systems allow married individuals to request joint assessment. Many systems allow controlled groups of locally organized corporations to be jointly assessed.
Tax rates vary widely. Some systems impose higher rates on higher amounts of income. Example: Elbonia taxes income below E.10,000 at 20% and other income at 30%. Joe has E.15,000 of income. His tax is E.3,500. Tax rates schedules may vary for individuals based on marital status.
Residents are generally taxed differently from nonresidents. Few jurisdictions tax nonresidents other than on specific types of income earned within the jurisdiction. See, ‘’e.g.’’, the discussion of taxation by the United States of foreign persons. Residents, however, are generally subject to income tax on all worldwide income. A very few countries (notably Singapore and Hong Kong) tax residents only on income earned in or remitted to the country.
Residence is often defined for individuals as presence in the country for more than 183 days. Most countries base residence of entities on either place of organization or place of management and control. The United Kingdom has three levels of residence.
Most systems define income subject to tax broadly for residents, but tax nonresidents only on specific types of income. What is included in income for individuals may differ from what is included for entities. The timing of recognizing income may differ by type of taxpayer or type of income.
Income generally includes most types of receipts that enrich the taxpayer, including compensation for services, gain from sale of goods or other property, interest, dividends, rents, royalties, annuities, pensions, and all manner of other items. Many systems exclude from income part or all of superannuation or other national retirement plan payments. Most tax systems exclude from income health care benefits provided by employers or under national insurance systems.
Nearly all income tax systems permit residents to reduce gross income by business and some other types of deductions. By contrast, nonresidents are generally subject to income tax on the gross amount of income.
Expenses incurred in a trading, business, rental, or other income producing activity are generally deductible, though there may be limitations on some types of expenses or activities. Business expenses include all manner of costs for the benefit of the activity. An allowance (as a capital allowance or depreciation deduction) is nearly always allowed for recovery of costs of assets used in the activity. Rules on capital allowances vary widely, and often permit recovery of costs more quickly than ratably over the life of the asset.
Most systems allow individuals some sort of notional deductions or an amount subject to zero tax. In addition, many systems allow deduction of some types of personal expenses, such as home mortgage interest or medical expenses.
Only net income from business activities, whether conducted by individuals or entities is taxable, with few exceptions. Many countries require business enterprises to prepare financial statements which must be audited. Tax systems in those countries often define taxable income as income per those financial statements with few, if any, adjustments. A few jurisdictions compute net income as a fixed percentage of gross revenues for some types of businesses, particularly branches of nonresidents.
Nearly all systems permit residents a credit for income taxes paid to other jurisdictions of the same sort. Thus, a credit is allowed at the national level for income taxes paid to other countries. Many income tax systems permit other credits of various sorts, and such credits are often unique to the jurisdiction.
Some jurisdictions, particularly the United States and many of its states and Switzerland, impose the higher of regular income tax or an alternative tax. Switzerland and U.S. states generally impose such tax only on corporations and base it on capital or a similar measure.
Income tax is generally collected in one of two ways: through withholding of tax at source and/or through payments directly by taxpayers. Nearly all jurisdictions require those paying employees or nonresidents to withhold income tax from such payments. The amount to be withheld is a fixed percentage where the tax itself is at a fixed rate. Alternatively, the amount to be withheld may be determined by the tax administration of the country or by the payer using formulas provided by the tax administration. Payees are generally required to provide to the payer or the government the information needed to make the determinations. Withholding for employees is often referred to as “pay as you earn” (PAYE) or “pay as you go.”
Nearly all systems require those whose proper tax is not fully settled through withholding to self assess tax and make payments prior to or with final determination of the tax. Self-assessment means the taxpayer must make a computation of tax and submit it to the government.
Income taxes are separately imposed by sub-national jurisdictions in several countries with federal systems. These include Canada, Germany, Switzerland, and the United States, where provinces, cantons, or states impose separate taxes. In a few countries, cities also impose income taxes. The system may be integrated (as in Germany) with taxes collected at the federal level. In Income tax in Canada#Personal income taxesQuebec and the United States, federal and state systems are independently administered and have differences in determination of taxable income.
Income taxes of workers are often collected by employers under a withholding or Pay-as-you-earn tax system. Such collections are not necessarily final amounts of tax, as the worker may be required to aggregate wage income with other income and/or deductions to determine actual tax. Calculation of the tax to be withheld may be done by the government or by employers based on withholding allowances or formulas.
Retirement oriented taxes, such as Social Security or national insurance, also are a type of income tax, though not generally referred to as such. These taxes generally are imposed at a fixed rate on wages or self-employment earnings up to a maximum amount per year. The tax may be imposed on the employer, the employee, or both, at the same or different rates.
Some jurisdictions also impose a tax on employers to fund unemployment or similar government outlays. Such taxes are generally not considered income taxes.
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Multiple conflicting theories have been proposed regarding the economic impact of income taxes. Income taxes are widely viewed as a Progressive tax, meaning the incidence of tax increases as income increases.
Tax avoidance strategies and loopholes tend to emerge within income tax codes. These get created when tax payers find legal methods to avoid paying taxes. Lawmakers then attempt to close the loopholes with additional legislation. This leads to a vicious cycle of ever more complex avoidance strategies and legislation. This vicious cycle tends to benefit large corporations and wealthy individuals that can afford the professional fees that come with ever more sophisticated tax planning, thus challenging the notion that even a marginal income tax system can be properly called a progressive tax.
The higher costs to labour and capital imposed by income tax causes deadweight loss in an economy, being the loss of economic activity from people deciding not to invest capital or use time productively due to the burden tax would impose on those activities. There is also a loss from individuals and professional advisors devoting time to tax avoiding behaviour instead of economically productive activities.
The concept of taxing income is a modern innovation and presupposes several things: a money economy, reasonably accurate accounts, a common understanding of receipts, expenses and profits, and an orderly society with reliable records. For most of the history of civilization, these preconditions did not exist, and taxes were based on other factors. Taxes on wealth, social position, and ownership of the means of production (typically land and slaves) were all common. Practices such as tithing, or an offering of first fruits, existed from ancient times, and can be regarded as a precursor of the income tax, but they lacked precision and certainly were not based on a concept of net increase.
In the year 10 AD, Emperor Wang Mang of the Xin Dynasty instituted an unprecedented income tax, at the rate of 10 percent of profits, for professionals and skilled labor. He was overthrown 13 years later in 23 AD and earlier policies were restored during the reestablished Han Dynasty which followed.
One of the first recorded taxes on income was the Saladin tithe introduced by Henry II in 1188 to raise money for the Third Crusade. The tithe demanded that each layperson in England be taxed a tenth of their personal income and moveable property. However, the inception date of the modern income tax is typically accepted as 1799.
Income tax was announced in Britain by William Pitt the Younger in his budget of December 1798 and introduced in 1799, to pay for weapons and equipment in preparation for the Napoleonic wars. Pitt's new graduated income tax began at a levy of 2d in the pound (0.8333%) on annual incomes over £60 and increased up to a maximum of 2s in the pound (10%) on incomes of over £200 (£170,542 in 2007). Pitt hoped that the new income tax would raise £10 million (£8,527,100,000 in 2007), but actual receipts for 1799 totalled just over £6 million.
The tax was repealed in 1816 and opponents of the tax, who thought it should only be used to finance wars, wanted all records of the tax destroyed along with its repeal. Records were publicly burned by the Chancellor of the Exchequer but copies were retained in the basement of the tax court.
In order to help pay for its war effort in the American Civil War, the US federal government imposed its first personal income tax, on August 5, 1861, as part of the Revenue Act of 1861 (3% of all incomes over US $800) ($20,999 in 2014 dollars).[verification needed] This tax was repealed and replaced by another income tax in 1862.[verification needed]
In 1894, Democrats in Congress passed the Wilson-Gorman tariff, which imposed the first peacetime income tax. The rate was 2% on income over $4000 ($109,030.77 in 2014 dollars), which meant fewer than 10% of households would pay any. The purpose of the income tax was to make up for revenue that would be lost by tariff reductions. In 1895 the United States Supreme Court, in its ruling in Pollock v. Farmers' Loan & Trust Co., held a tax based on receipts from the use of property to be unconstitutional. The Court held that taxes on rents from real estate, on interest income from personal property and other income from personal property (which includes dividend income) were treated as direct taxes on property, and therefore had to be apportioned among the states by population. Since apportionment of income taxes is impractical, this had the effect of prohibiting a federal tax on income from property. However, the Court affirmed that the Constitution did not deny Congress the power to impose a tax on real and personal property, if apportioned, and it affirmed that such would be a direct tax. Due to the political difficulties of taxing individual wages without taxing income from property, a federal income tax was impractical from the time of the Pollock decision until the time of ratification of the 16th Amendment in 1913.
In 1913, the Sixteenth Amendment to the United States Constitution made the income tax a permanent fixture in the U.S. tax system. The United States Supreme Court in its ruling Stanton v. Baltic Mining Co. stated that the amendment conferred no new power of taxation but simply prevented the courts from taking the power of income taxation possessed by Congress from the beginning out of the category of indirect taxation to which it inherently belongs. In fiscal year 1918, annual internal revenue collections for the first time passed the billion-dollar mark, rising to $5.4 billion by 1920. With the advent of World War II, employment increased, as did tax collections—to $7.3 billion. The withholding tax on wages was introduced in 1943 and was instrumental in increasing the number of taxpayers to 60 million and tax collections to $43 billion by 1945.
Income taxes are used in most countries around the world. The tax systems vary greatly and can be progressive, proportional, or regressive, depending on the type of tax. Comparison of tax rates around the world is a difficult and somewhat subjective enterprise. Tax laws in most countries are extremely complex, and tax burden falls differently on different groups in each country and sub-national unit. Of course, services provided by governments in return for taxation also vary, making comparisons all the more difficult.
Countries that tax income generally use one of two systems: territorial or residential. In the territorial system, only local income – income from a source inside the country – is taxed. In the residential system, residents of the country are taxed on their worldwide (local and foreign) income, while nonresidents are taxed only on their local income. In addition, a very small number of countries, notably the United States, also tax their nonresident citizens on worldwide income.
Countries with a residential system of taxation usually allow deductions or credits for the tax that residents already pay to other countries on their foreign income. Many countries also sign tax treaties with each other to eliminate or reduce double taxation.
Countries do not necessarily use the same system of taxation for individuals and corporations. For example, France uses a residential system for individuals but a territorial system for corporations, while Singapore does the opposite, and Brunei taxes corporate but not personal income.
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