Income tax

An income tax is a tax levied on the financial income of persons or corporations. Various income tax systems exist, ranging from a flat tax to a progressive tax system. A tax levied on the income of companies is often called a corporate tax, corporate income tax or corporation tax. Individual income taxes generally tax the total income of the individual (with some deductions permitted), while corporate income taxes often tax net income, the difference between gross receipts and expenses.

Principles of Income Tax

Income tax is a tax on earnings – money that individuals receive in different ways and from different sources.

The ‘tax net’ refers to what types of money payments are charged the tax. Generally, tax will be charged on personal earnings (wages, welfare), capital gains, and business income. The rates for different types of income may vary and some may not be taxed at all. Capital gains may be taxed when realised (e.g. when shares are sold) or when incurred (e.g. when shares appreciate in value). Business income may only be taxed if it is ‘significant’ or based on the manner in which it is paid. Some types of income, such as interest on bank savings, may be considered as personal earnings (similar to wages) or as a realised property gain (similar to selling shares). In some tax systems ‘personal earnings’ may be strictly defined to require that labour, skill, or investment was required (e.g. wages); in others they may be defined broadly to include windfalls (e.g. gambling wins).

Tax rates may be progressive or flat. A progressive tax taxes differentially based on how much has been earned. For example, the first $10,000 in earnings may be taxed at 5%, the next $10,000 at 10%, and any more income at 20%. Alternatively, a flat tax taxes all earnings at the same rate. A tax system may use both progressive and flat taxes for different types of income.

Often income tax systems will have deductions available. Deductions lessen the total tax liability by reducing total taxable income.

Income tax systems may allow losses from one type of income to be counted against another. For example, a loss on the stock market may be deducted against tax paid on wages. Other tax systems may isolate the loss, such that business losses can only be deducted against business tax, by carrying forward the loss to later tax years.

History of Income Tax

The income tax was first implemented in Britain by William Pitt the Younger in his budget of December 1798 to pay for weapons and equipment in preparation for the Napoleonic wars. Pitt's new graduated tax began at a levy of 2d in the pound (0.8333%) on incomes over £60 and increased up to a maximum of 2s (10%) on incomes of over £200. Pitt hoped that the new income tax would raise £10 million but actual receipts for 1799 totalled just over £6 million.

Income tax was levied under 5 schedules—income not falling within those schedules was not taxed. The schedules were:

Schedule A (tax on income from U.K. land)
Schedule B (tax on commercial occupation of land)
Schedule C (tax on income from public securities)
Schedule D (tax on trading income, income from professions and vocations, interest, overseas income and casual income)
Schedule E (tax on employment income)

Later a sixth Schedule, Schedule F (tax on U.K. dividend income) was added.

Pitt's income tax was levied from 1799 to 1802, when it was abolished by Henry Addington during the Peace of Amiens. Addington had taken over as prime minister in 1801, after Pitt's resignation over Catholic Emancipation. The income tax was reintroduced by Addington in 1803 when hostilities recommenced, but it was again abolished in 1816, one year after the Battle of Waterloo.

Finally, U.K. income tax was reintroduced by Sir Robert Peel in the Income Tax Act 1842. Peel, as a Conservative, had opposed income tax in the 1841 general election, but a growing budget deficit required a new source of funds. The new income tax, based on Addington's model, was imposed on incomes above £150.

U.K. income tax has changed over the years. Originally it taxed a person's income regardless of who was beneficially entitled to that income, but now a person only owes tax on income to which he or she is beneficially entitled. Most companies were taken out of the income tax net in 1965 when corporation tax was introduced. Also the Schedules under which tax is levied have changed. Schedule B was abolished in 1988, Schedule C in 1996 and Schedule E in 2003, though the Schedular system and Schedules A, D and F still remain. Rates peaked in the late 1970s at 99%.

Income Tax Systems

Income tax in the UK

Income tax is an annual tax and is reimposed each year in the annual Finance Act.

The British income tax has a number of bands: 10% (lower rate), 20% (basic rate for interest), 22% (basic rate), 32.5% (higher rate for UK dividends), and 40% (higher rate for other income). There are also a number of untaxed allowances to which tax bands do not apply.

Income tax in the United States

The United States imposes an income tax on individuals and corporations. This tax is levied from the happening of an event, such as the payment of a wage or the purchase of property - the appreciation on the value of property, for example, can not be taxed until that property is sold. The U.S. income tax was first imposed during the Civil War.

U.S. state income tax

Income tax may also be levied by individual U.S. states. In addition, some states allow individual cities to impose an additional income tax. However, not all states levy income tax. States that do not levy income tax include:

Alaska
Florida – no tax on individuals but there is a state corporate income tax
Nevada
New Hampshire – does have tax on interest and dividends
South Dakota
Tennessee – does have tax on interest and dividends
Texas
Washington
Wyoming

Income tax in Australia

Since 1942, income tax in Australia has been collected solely by the Federal Government, to the exclusion of the Australian States (see Constitutional basis of taxation in Australia). Australia uses a system of progressive taxation on personal income that is collected as a pay-as-you-go tax (known a PAYG), a flat rate tax on business income (company tax), and a property tax limited to realised capital gains. Australia’s income tax system contains a complex array of deductions and offsets, and is administered by the Australian Taxation Office (ATO).

Income tax in Sweden

Sweden has a taxation system that combines a direct tax (paid by the employee) with an indirect tax (paid by the employer). In practice, the employer provides the state with both means of taxation but the employee only sees the direct tax on his declaration form. Below is a compilation of the taxes that compose the final income tax (2003):

Tax on "gross" income "from the employer": 32.82% (indirect, fixed)
Pension "fee" on "gross" income: 6.95% (indirect, fixed)
"State tax" on, "gross" income less pension tax and a "base deduction": ~32% (direct, varies by state)
"Federal tax" on, "gross" income less pension tax and a "base deduction": 0%, 20% or 25% (direct, progressive)

Income tax in the Netherlands

The Netherlands taxes income on personal income (wages, profits, social security); some business income; and savings and investments.

The tax on personal income is a progressive tax and casts a wide tax net over wages, profits, social security, and pensions. The highest marginal rate is 52%. Tax is withheld from wages. As an example of the breadth of the tax net, value gains in owner-occupied homes are treated as personal income, even though those gains are not realised (i.e. do not equate to cash in hand). Interest can be deducted as a cost incurred in earning the income.

The tax on business income is a flat tax of 25% only applied to ‘substantial business interests’ which are generally a shareholding of 5%. A flat tax is paid on savings and investments, even if the gain is not realised.

Income tax in Singapore

Individual income tax is a progressive tax with a highest marginal rate of 22%. The tax net includes employment income, dividends, interests, and rental incomes. A range of deductions are available.