💰Federal Income Tax Accounting Unit 2 – Federal Income Tax: Policy and Structure

Key Concepts and Definitions

• Gross income encompasses all income from whatever source derived, unless specifically excluded by law
• Taxable income calculated by subtracting deductions from gross income determines the amount subject to federal income tax
• Progressive tax system imposes higher tax rates on taxpayers with higher levels of income (marginal tax rates increase as income increases)
• Tax credits directly reduce the amount of tax owed, while deductions reduce the amount of income subject to taxation
• Exemptions and exclusions refer to types of income or portions of income that are not subject to federal income tax (municipal bond interest, gifts, and inheritances)
• Withholding system requires employers to deduct and remit a portion of an employee's wages to the government as prepayment of income tax liability
• Marginal tax rate represents the tax rate applied to the last dollar of taxable income, while effective tax rate measures total tax paid as a percentage of total income

Historical Context of Federal Income Tax

• 16th Amendment to the U.S. Constitution, ratified in 1913, granted Congress the power to impose and collect income taxes
• Revenue Act of 1913 established the modern federal income tax system with a progressive rate structure and personal exemptions
• World War I and World War II led to significant increases in income tax rates and the expansion of the tax base to finance wartime expenditures
• Tax Reform Act of 1986 significantly reduced the number of tax brackets, lowered top marginal rates, and eliminated many deductions and exemptions
• Subsequent tax legislation, such as the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) and the Tax Cuts and Jobs Act of 2017 (TCJA), made significant changes to tax rates, deductions, and credits
  • EGTRRA gradually reduced marginal tax rates and increased child tax credit
  • TCJA reduced corporate tax rate from 35% to 21% and increased standard deduction

Tax Policy Objectives and Principles

• Equity and fairness aim to distribute the tax burden based on ability to pay (vertical equity) and treat similarly situated taxpayers equally (horizontal equity)
• Efficiency minimizes distortions to economic decision-making and encourages productive activities
• Simplicity and transparency make the tax system easy to understand and comply with, reducing administrative and compliance costs
• Revenue adequacy ensures that the tax system generates sufficient funds to support government programs and services
• Neutrality principle suggests that the tax system should not unduly influence economic choices or favor certain activities over others
• Benefit principle proposes that taxes should be based on the benefits received from government services
• Ability-to-pay principle holds that taxes should be levied according to a taxpayer's capacity to bear the burden

Structure of the Federal Tax System

• Individual income tax is the largest source of federal revenue, accounting for nearly half of total receipts
• Corporate income tax applies to the taxable income of corporations and is the third-largest source of federal revenue
• Payroll taxes, including Social Security and Medicare taxes, are the second-largest source of federal revenue and fund specific social insurance programs
• Estate and gift taxes apply to transfers of wealth and are designed to reduce concentrations of wealth across generations
• Excise taxes are levied on specific goods and services (gasoline, alcohol, and tobacco) and are often used to discourage consumption or fund specific programs
• Alternative Minimum Tax (AMT) is a parallel tax system designed to ensure that high-income taxpayers with significant deductions and exemptions pay a minimum level of tax

Major Components of Taxable Income

• Wages, salaries, and tips form the primary source of income for most taxpayers and are subject to federal income tax and payroll taxes
• Interest income from savings accounts, certificates of deposit (CDs), and bonds is generally taxable, with some exceptions (municipal bond interest)
• Dividend income from stocks and mutual funds is taxable and may be subject to different tax rates depending on whether the dividends are qualified or non-qualified
• Capital gains and losses result from the sale of assets (stocks, bonds, real estate) and are subject to special tax rates and holding period requirements
  • Short-term capital gains taxed at ordinary income rates
  • Long-term capital gains taxed at preferential rates (0%, 15%, or 20%)
• Business income from sole proprietorships, partnerships, and S corporations is reported on individual tax returns and subject to income tax and self-employment tax
• Rental income from real estate is taxable and may be offset by deductions for expenses, depreciation, and mortgage interest

Deductions and Credits

• Standard deduction is a fixed amount that taxpayers can deduct from their income, based on filing status, in lieu of itemizing deductions
• Itemized deductions allow taxpayers to deduct specific expenses (mortgage interest, state and local taxes, charitable contributions) from their income
• Above-the-line deductions, such as educator expenses and student loan interest, are subtracted from gross income to determine adjusted gross income (AGI)
• Refundable tax credits, like the Earned Income Tax Credit (EITC), can result in a net payment to the taxpayer if the credit exceeds the tax liability
• Non-refundable tax credits, such as the Child Tax Credit and education credits, can reduce tax liability to zero but do not result in a net payment to the taxpayer
• Business expense deductions allow self-employed individuals and businesses to deduct ordinary and necessary expenses incurred in operating the business
  • Section 179 expensing and bonus depreciation provide accelerated deductions for capital investments

Tax Calculation Process

• Determine gross income by aggregating income from all taxable sources and applying any exclusions
• Calculate adjusted gross income (AGI) by subtracting above-the-line deductions from gross income
• Subtract the greater of the standard deduction or total itemized deductions from AGI to determine taxable income
• Apply the appropriate tax rate schedule or tax table to taxable income to calculate the tentative tax liability
• Subtract tax credits from the tentative tax liability to determine the final tax liability or refund due
• Compare the final tax liability to the total amount withheld and estimated tax payments made during the year to determine any balance due or refund owed
• File the appropriate tax return (Form 1040) and accompanying schedules by the due date (typically April 15) or request an extension

Current Issues and Debates in Tax Policy

• Income inequality and the progressivity of the tax system have led to discussions about the fairness of the tax burden and potential reforms (wealth taxes, higher marginal rates for top earners)
• International tax competition and the global mobility of capital have prompted debates about the appropriate taxation of multinational corporations and foreign-source income
• The increasing national debt and long-term fiscal challenges have raised questions about the sustainability of current tax policies and the need for revenue-enhancing reforms
• The complexity of the tax code and the compliance burden on taxpayers have led to calls for simplification and streamlining of tax laws and regulations
• The role of taxes in addressing social and economic policy objectives, such as income redistribution, environmental protection, and healthcare access, is a subject of ongoing debate
• The impact of tax policy on economic growth, job creation, and investment has been a central theme in recent tax reform efforts (lowering corporate tax rates, expensing provisions)
• The trade-offs between tax cuts, government spending, and deficit reduction have shaped political discourse and legislative priorities in recent decades