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What are Income Taxes?

Updated for Tax Year 2014


OVERVIEW

Part of the 16th Amendment, income taxes are a part of our lives. Here are the details.


Introduction

Since governments cannot operate without revenue, most charge you an income tax which is generally based on how much money you earn in a year. Most of the money you receive is income and subject to the tax. This not only includes your salary, but also the interest, dividends, rents, royalties, lottery winnings, unemployment compensation and the earnings from a business you own. Income taxes are the single biggest source of revenue for the federal government in the United States.

Who pays income tax?

When people speak of income taxes, they're usually talking about what taxing agencies call "individual income taxes" -- those paid by workers and other people with income. However, corporations, trusts, estates and many other types of entities also pay income tax on their profits.

In addition to the federal income tax system, most states impose a similar form of taxation on individuals and entities that have a significant connection to the state. As of 2014, only seven states do not charge an income tax. If you live in Alaska, Florida, Nevada, South Dakota, Texas Washington or Wyoming, then it’s likely you are only responsible for the federal income tax.

Purpose of income taxes

According to the Congressional Budget Office, individual income taxes are the federal government's top source of revenue. In 2008, for example, individuals paid about $1.15 trillion in income taxes, amounting to 45 percent of federal revenue. Corporate income taxes contributed an additional $304 billion, or 12 percent of federal revenue. At the state level, the percentage of revenue that income taxes provide can vary greatly since each state imposes different tax rates and has other sources of revenue such as sales taxes, property taxes and federal assistance.

Voluntary reporting of income tax

The U.S. income tax system is a voluntary system. However, this doesn't mean paying income tax is optional. The federal government relies on each taxpayer to voluntarily report all of their income on a tax return and calculate the appropriate tax using current tax laws.

The IRS has safeguards in place to insure you comply. For example, the agency receives a copy of your W-2 every year, and if you don’t file a return, it can easily calculate the tax for you and send you a bill. Additionally, the IRS can charge you interest and penalties, and even commence a criminal action against you, but only in the most severe and egregious of cases. This is a fundamental difference between income taxes and other forms of taxes, such as sales taxes, which retailers calculate and consumers pay at the time of purchase.

History of income taxes

The first federal income tax was imposed in the 1860s when the government was in desperate need of money to fund the Civil War. Years later, in response to various court rulings declaring the income tax unconstitutional, Congress passed the 16th Amendment to the U.S. Constitution. The amendment, which took effect in 1913, specifically authorizes direct taxes on income and is the basis for the federal income tax system as we know it today.

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The above article is intended to provide generalized financial information designed to educate a broad segment of the public; it does not give personalized tax, investment, legal, or other business and professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other business and professional matters that affect you and/or your business.

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