What is Income Tax?

Income tax is a tax that is imposed by governments on individuals and businesses with respect to income or profits earned by them. To determine the amount of income tax that should be paid by individuals or businesses, entities must file an income tax return every year.

How It Works

The income or profits that can be taxed is known as taxable income. Taxable income is total income less allowable deductions. Income tax is generally calculated by multiplying an entity’s taxable income by the respective income tax rate in a respective jurisdiction. There can be different levels of income tax rates. For example, in the United States, there is a federal income tax rate, and for most states, there is also a separate state income tax rate.

Additionally, the tax rate is not the same for every taxpayer. In most jurisdictions, corporations and individual taxpayers are subject to different income tax rates and different rules surrounding their income taxes. In most jurisdictions, corporations commonly pay a flat tax rate, which is known as the corporate tax rate.

Regarding individual taxpayers, the level of taxable income that an individual earns in a given year will also determine the amount of income taxes they will pay. The income tax rate varies for individuals based on the amount of income that they make in a year. The different levels of individuals’ income that determine the level of the income tax rate for an individual are commonly referred to as tax brackets.

Further, the personal tax rate is often progressive in the sense that the tax rate grows as income grows and is only applied to an additional unit of income. For example, the first $50,000 an individual makes is taxed at 5%; the next $50,000 is taxed at 10%, and so on.

In addition to income earned by individuals and corporations, investment income is also taxed, typically at a capital gains tax, and is less than income tax.

Income Tax and Tax Rates

Different tax rates reflect the type of fiscal policy that a government is running. When income tax rates are high, governments receive more tax revenue holding everything else constant. This may be consistent with a contractionary fiscal policy where a government collects more taxes than it spends. A contractionary fiscal policy may be used in order to decrease inflation and contract the economy.

Further, when income tax rates are low, governments receive less tax revenue holding everything else constant. This may be consistent with an expansionary fiscal policy where a government spends more than it collects via taxes. An expansionary fiscal policy is typically used to boost economic activity and incentivize spending. 

Income Tax Deductions

Both individuals and corporations can access income tax write-offs or deductions to reduce their income tax bills.

For individuals, common allowable deductions are available if the individual is above a certain age, is in school full or part-time, and with dependents (e.g., children). Regarding businesses, income taxes can be reduced by decreasing their taxable income. It can be done by applying business expenses, such as depreciation costs.

Income Tax and the Laffer Curve

It is argued that there is an optimal level for the tax rate that is set by the government (including the income tax rate), which follows the principles outlined by the Laffer Curve.

If the tax rate, including the income tax rate, is set too high, individuals and corporations would be encouraged to leave the jurisdiction and go to another one that offers a lower tax rate. Yet, if the tax rate is too low, the government may not generate enough tax revenues to adequately run the jurisdiction.

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