Module 1 – overview of individual taxation

Individual federal income taxation is the system established by the U.S. government to fund its operations through taxes levied on the income of individuals. It’s a fundamental aspect of our society, providing the financial backbone for essential public services and infrastructure. Think beyond just paying taxes; understand it as participating in a collective effort to support the nation’s well-being. From funding national defense and maintaining our roads and bridges to supporting education programs and providing a safety net for those in need, federal taxes are the engine that makes these vital functions possible. Understanding this system isn’t just about compliance, it’s about understanding your role in the larger economic and social welfare of the United States.

The federal and state income tax systems in the U.S. operate largely independently, although some interdependencies exist. Individuals typically file separate tax returns with the federal government and their respective state government (if the state imposes an income tax). While federal tax law does not directly govern state tax laws, there are indirect connections. For instance, some states use federal AGI as a starting point for their own income tax calculations and then apply state-specific adjustments. Other states may have tax systems entirely decoupled from the federal system, focusing primarily on income sourced within the state. Historically, taxpayers could deduct their state and local taxes (SALT) on their federal income tax returns, offering a degree of integration, although this deduction is currently subject to a cap (I.R.C. § 164). Conversely, federal income taxes paid are generally not deductible on state income tax returns. Each level of government establishes its own set of tax rates, deductions, and credits, resulting in distinct tax obligations for individuals at the federal and state levels.

The design and evaluation of income tax systems are often guided by several fundamental principles that aim to create a fair, efficient, and workable system. These principles provide a framework for understanding the rationale behind various tax policies and regulations.

1. Equity and fairness — Similarly situated taxpayers should be taxed similarly.
2. Certainty — The tax rules should clearly specify how the amount of payment is determined, when payment of the tax should occur, and how payment is made.
3. Convenience of payment — Facilitating a required tax payment at a time or in a manner that is most likely convenient for the taxpayer is important.
4. Effective tax administration — Costs to collect a tax should be kept to a minimum for both the government and taxpayers.
5. Information Security — Tax administration must protect taxpayer information from all forms of unintended and improper disclosure.
6. Simplicity — Simple tax laws are necessary so that taxpayers understand the rules and can comply with them correctly and in a cost-efficient manner.
7. Neutrality — Minimizing the effect of the tax law on a taxpayer’s decisions as to how to carry out a particular transaction or whether to engage in a transaction is important.
8. Economic growth and efficiency — The tax system should not unduly impede or reduce the productive capacity of the economy.
9. Transparency and visibility — Taxpayers should know that a tax exists and how and when it is imposed upon them and others.
10. Minimum tax gap — Structuring tax laws to minimize noncompliance is essential.
11. Accountability to taxpayers — Accessibility and visibility of information on tax laws and their development, modification and purpose are necessary for taxpayers.
12. Appropriate government revenues — Tax systems should have appropriate levels of predictability, stability and reliability to enable the government to determine the timing and amount of tax collections.

Source:  Guiding Principles of Good Tax Policy: A Framework for Evaluating Tax Proposals

At the forefront of these principles is equity and fairness, often considered the cornerstone of a just tax system. Equity in taxation is generally discussed in two dimensions: horizontal and vertical. Horizontal equity dictates that individuals or entities in similar economic circumstances should bear similar tax burdens. This implies that taxpayers with the same level of income and comparable situations should owe approximately the same amount of tax. Conversely, vertical equity addresses the tax treatment of individuals or entities in different economic situations. It posits that those with a greater ability to pay should contribute more to the tax system. This concept often underpins progressive tax systems, where higher earners pay a larger percentage of their income in taxes, reflecting a greater capacity to absorb the tax burden. Closely related to vertical equity is the ability to pay principle. This principle suggests that taxes should be levied based on an individual’s capacity to shoulder the financial obligation. Income is widely accepted as a primary indicator of this ability, representing an individual’s access to economic resources. The ability-to-pay principle justifies progressive taxation as a means of distributing the tax burden in proportion to taxpayers’ economic strength.

This module will commence with an overview of the individual income tax formula before delving into its specific components. The primary objective of this module is to provide a comprehensive understanding of the fundamentals of individual taxation in the United States.