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 commissions, 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.
Understanding the nuances of income tax is crucial for financial planning, as it affects personal cash flow and can influence investment decisions and retirement planning.
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 – 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.
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.
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.
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.
Some countries implement a flat tax rate, where all individuals pay the same percentage of their income, regardless of the total amount earned, contrasting with progressive tax systems that adjust rates based on income levels.
Moreover, some countries implement a flat tax rate, where all individuals pay the same percentage of their income, regardless of the total amount earned, contrasting with progressive tax systems that adjust rates based on income levels.
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.
Exploring ‘income tax’ vocabulary
With the term ‘income tax,’ we can create many compound phrases. Let’s have a look at some of the most commonly used ones:
Income Tax Rebate
A refund on taxes when the tax liability is less than the taxes paid.
For example: “After filing her tax return, Lisa was pleased to receive an ‘income tax rebate’ due to deductible expenses.”
Income Tax Bracket
The ranges of income to which different tax rates apply.
For example: “As his earnings increased, he moved into a higher ‘income tax bracket’ and adjusted his savings accordingly.”
Income Tax Allowance
The amount of income that is not subject to tax, often due to deductions and exemptions.
For example: “The ‘income tax allowance’ for charitable donations can significantly lower your taxable income.”
Income Tax Return
The form(s) filed with a taxing authority that reports income, expenses, and other pertinent tax information.
For example: “Filing her ‘income tax return’ early allowed her to plan her finances for the rest of the year.”
Income Tax Statement
A document summarizing income and tax deductions over a financial year.
For example: “The accountant prepared the ‘income tax statement’ for the client’s review before submission.”
Video – What is income tax?
This video, from Marketing Business Network, our sister channel on YouTube, explains what Income Tax is using easy-to-understand language and examples.