Income tax – definition and examples

Income tax is a tax that the government levies on people’s income. People’s incomes may be earned, such as salaries, wages, or commission, or unearned, such as rents, interest, or dividends. Most entities, i.e., people or businesses, are liable for income tax. It is a major source of revenue for the government, which uses the revenue to fund activities and pay its bills.

Most governments levy a progressive income tax system. This means that those on greater incomes pay a higher tax rate than those who earn less.

For example, somebody earning $30,000 per year may pay 25% of their income compared to those earning $300,000+, who pay 35%.

The Financial Times’ glossary of terms has the following definition of income tax:

“This is a tax on the earned and unearned income of individuals and trusts. Income includes earnings from employment, profits from a trade carried on by an individual (either alone or in partnership), income from pensions, and investment income such as interest, dividends, and rents.”

Most jurisdictions refer to income tax on businesses as corporate tax (USA), companies tax (Australia), or corporation tax (UK).

Income tax
Albert Einstein, once said: “The hardest thing to understand in the world is the income tax.” Einstein (1879-1955), a German-born theoretical physicist, developed the theory of relativity.

Income tax – brief history

Ancient Egypt and Rome

Taxes have been around for thousands of years. Taxes on incomes date back to ancient Egypt, about five thousand years ago.

The Roman Republic (500 BC) initially taxed people according to assessments of their wealth and property. The tax rate at the time was relatively low – just one percent.

When Rome had to pay for expensive wars, tax rates would climb to about three percent. This was still extremely low compared to rates people have to pay today.

In ancient Rome, the authorities levied taxies against homes, land, slaves, animals, monetary wealth, and other personal items.

Wealthy people paid more tax than their less affluent counterparts, but they did not pay a higher percentage rate.

Xin Dynasty

Wang Mang (45 BC – 23 AD), who founded the Xin Dynasty, introduced an unprecedented income tax rate of 10% for skilled labor and professionals.

However, thirteen years later, Mang was overthrown, and tax rates immediately went down.

Great Britain

King Henry II introduced the Saladin tithe in 1188. Henry, King of England and Lord of Ireland, needed money for the Third Crusade. This was one of the first recorded taxes on people’s income.

The Saladin tithe demanded that each layperson in England and Wales paid one-tenth of their movable property and personal income.

Great Britain’s Prime Minister William Pitt the Younger introduced income tax as we know it today. He introduced the tax in his 1978 budget to pay for equipment and weapons for the French Revolutionary War.

Pitt’s tax was a progressive one, i.e., rates increased according to the individual’s income. It began at a levy of 2 old pence in the pound for people earning more than £60 per year. £60 per year was the equivalent of £5,800 ($8,199) in 2016. There were 240 old pence in a pound, which meant the income tax rate was 0.83%.

People earning more than £200 per year had to pay two shillings in the pound, i.e., ten percent.

Pitt had hoped to collect more than £10 million per year. However, the government only managed slightly more than £6 million.

United States

The US federal government introduced income tax in the USA for the first time in 1861. The government needed money for its war effort in the American Civil War.

People whose incomes exceeded $800 per year were liable to a 3% income tax rate. $800 then was equivalent to $21,800 in 2017.

Lawmakers soon repealed this tax and replaced it with another income tax in 1862.

The Wilson-Gorman tariff of 1894 was the first peacetime income tax in the United States. The government levied a tax of 2% on incomes exceeding $4,000 (equivalent to $113,000 in 2017). This meant that fewer than one in every ten American households paid income tax.

Income tax today

Taxes on people’s incomes have come a long way over the past two hundred years. Today, we pay much higher rates, regardless of whether our country is fighting a war.

Today, US income tax rates range from 25% to 35%. What tax bracket people are on depends on their annual income.

The UK income tax rates range from 0% to 45%. What tax rate people are on also depends on how much they earn each year.

The US and UK have, therefore, progressive income tax systems.