Like many other government programs, the U.S. Income Tax has changed since its inception. Rates have changed, more individuals are subject to the tax, and tax deductions and tax credits were added to the system. With these changes, the income tax is more than just a means for the government to raise revenue, it is also a means for politicians to gain favor with special interest groups who help them gain election to office.
When the income tax was first instituted in 1913, the bottom tiered rate was only one percent and it did not kick in until an individual earned $20,000 (Tax Foundation, 2010). $20,000 in 1913 was worth much more than it is in 2010. In fact, accounting for inflation, $20,000 in 1913 is equivalent $439,659 in today’s dollars (U.S. Inflation Calculator, 2010). This means that the initial income tax only affected the wealthy.
Through the years additional tax brackets were added, making more individuals subject to the tax. For example, in 1962 there were 24 tax brackets with a low rate of 20% starting at zero income up to 91% for individuals making $400,000 plus. In 1982, the number of brackets was reduced to 12 with a low rate of 12% and a high rate of 50%. In 2009, there are six brackets with a low of 10% and a high of 35% (Tax Foundation, 2010).
The lowering of the threshold where individuals are required to pay income tax has broadened the tax base to where not only the wealthy but also the middle class and lower income individuals are now required to pay income tax. However, tax deductions and credits have been introduced to the tax code with the intention of making it fairer.
The difference between tax deductions and tax credits is that a tax deduction reduces an individual’s taxable income. This has the effect of lowering the individual’s tax liability but only by the percentage of the tax bracket the individual is in. A tax credit, however, is a direct reduction in an individual’s tax liability dollar for dollar (Phillips, 2003).
The home mortgage interest deduction and the charitable contribution deduction are examples of tax deductions. Individuals who own a home are able to deduct the interest they pay on their mortgage. In addition, they are able to deduct the property taxes they pay for their home. Many believe that this deduction has encouraged more individuals to buy their own home as opposed to renting.
However, in a study conducted by Glaeser and Shapiro (2003) the findings showed that the percentage of home ownership has remained unchanged through the years of this deduction, in spite of many changes that have occurred. The deduction has caused more individuals to itemize their deductions as opposed to taking the standard deduction, but the research concluded that the deduction did little to cause renters to move into home ownership. However, home consumption did increase in relation to the deduction. This is most likely do to current homeowners moving into a more expensive home, possibly to receive a higher deduction.
Another common deduction for individuals is the charitable contribution deduction. It is believed that individuals giving to charities relieve the government of some responsibility for taking care of the needy in society, so giving individuals a deduction would encourage more charitable giving.
In his doctoral dissertation, Toolson (1986) conducted a study of individuals with the goal of determining if the deductibility of charitable contributions caused individuals to give more. Interestingly, unlike the home mortgage deduction, individuals did give more when their contributions were tax deductible. This might me because individuals must obligate themselves to a long-term mortgage to take advantage of the home mortgage deduction whereas contributing to a charity usually does not carry such a long-term obligation. We can therefore, conclude that use of a tax deduction to encourage certain behavior works best when no long-term obligation is required to take advantage of the deduction.
Tax credits come in two different varieties. They can be either refundable or non-refundable. A refundable tax credit is given to an individual even if their tax liability is less than the amount of the credit. If the amount of the credit exceeds their tax liability, the additional amount is given to the individual in the form of a tax refund. Non-refundable tax credits are limited by the amount of the individual’s tax liability (Lattanzi, 2009).
The energy credit is an example of a non-refundable tax credit. It is a credit offered to individuals for energy saving improvements to their home (i.e. installing an energy efficient air conditioning unit). In individual can earn a tax credit for purchase of such a unit but if the amount of the tax credit exceeds their tax liability, they can only deduct the amount of their tax liability, bringing their liability to zero. Their tax liability cannot be less than zero due to this type of credit (Lattanzi, 2009).
The (EITC) is a refundable tax credit implemented to assist lower income individuals. Individuals making under a specific income qualify for this credit. Since it is a refundable credit, they receive the entire credit regardless of their tax liability. For example, if an individual qualifies for an (EITC) of $2000 but only has $500 of tax liability, their tax liability will be eliminated and they will receive a refund of the additional $1500 (Bartlett, 2003).
Tax deductions and credits may have made the tax code fairer but they have also had an unintended consequence. Any attempt to change a deduction or credit is met with lobbyists who want to block the change. In addition, depending on the demographics of a representative’s district, congresspersons will make promises to increase or reduce a deduction or credit in order to gain votes. This has had the unintended consequence of politicizing the tax code.
For example, many view the EITC as a welfare program contained in the current tax code (Bartlett, 2003). Congresspersons with wealthy constituents will promise to reduce or even eliminate the credit to gain more votes whereas congresspersons with poor constituents will promise to increase the amount of the credit by taxing the wealthy. The resulting class warfare in congress creates many heated debates.
The original intent of the income tax was to create a means for the government to raise revenue based on the incomes of individual citizens. However, changes to the tax code through the years have created a politicized tax system. In our next lesson, we will begin looking at some alternatives to the current income tax code that make it fairer and eliminate the politicization that has crept into the system
References
Bartlett, B. (2003, June 30). Tax-credited welfare. Human Events, 59 (22), pp. 1-3. Retrieve
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Glaeser, E. L., & Shapiro, J. M. (2003). The benefits of the home mortgage interest
deduction. NBER/Tax Policy & the Economy (MITPress), 17, pp. 37-82. Retrieved April
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Lattanzi, M. (2009, October). Explaining the federal tax credit. Air Conditioning,
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Phillips, M. J. (2003, February). Tax zone; credits vs deduction. The Atlanta Tribune,
16(10), 17. Retrieved April 18, 2010, From Ethic NewsWatch (ENW). (Document ID:
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Tax Foundation (2010). U.S. federal individual income tax rates history, 1913-2010.
Retrieved April 17, 2010, http://www.taxfoundation.org/publications/show/151.html
Toolson, R. B. (1986). The tax incentive effect of the charitable contribution deduction,
Ph.D. dissertation, Arizona State University, United States -- Arizona. Retrieved April
18, 2010, From Dissertations & Thesis: Full Text (Publication No. AAT 8702940).
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Lattanzi, M. (2009, October). Explaining the federal tax credit. Air Conditioning,
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