Definition of Income Tax
To discuss income tax, it is useful to be aware of a possible confusion in terminology and definition.
In many countries, the tax payable by persons who earn income from employment (e.g. wages, salaries, bonuses, etc., from a job) or self-employment (e.g. the profits earned by a sole trader in his/her business) is what is meant by income tax.
However, in the USA, income tax also includes the tax that companies pay on their corporate profits.
For the avoidance of confusion, the latter will be referred to as corporate or corporation tax Opens in new window. However, until the introduction of corporation tax in the UK in 1965, company profits were taxed by means of the then existing income tax legislation.
Income tax is a relative newcomer to the list of taxes, and many countries introduced it even later than the UK. For instance, it was introduced in the USA in 1861, in 1951 in Australia and in 1917 in Canada and France — all introductions being linked to war.
Some of the very early taxes, such as the tithe and the levies of a seventh, thirteenth, etc. mentioned in taxation history Opens in new window, carry some suggestion of being forerunners of income tax in their taking of an agreed proportion of something as tax, though the ultimate value of the taxes collected would be imprecise.
Similarly, the window tax levied in the years 1696–1851 in Great Britain was often seen as a proxy for income tax. If you could afford to have a large number of glazed windows in your house, you had to be a person of substance — or so the thinking went.
How Income Tax Works
Generally, a percentage rate of income tax is applied to the taxable income of an individual, and the amount calculated is then the income tax he/she is liable to pay to a revenue authority.
In practice, things are more complicated than this. First of all, there is the question of what exactly constitutes income, but, even assuming that this is reasonably straightforward, an individual may still have income from different sources, such as property (rent), investments (interest and/or dividends) or a job (salary, etc.).
Often certain expenses may be permitted by tax law as deductions from income to reduce the amount that is ultimately taxable.
A common example is where individuals contribute some of their salary to a pension scheme to provide income for their retirement.
It is the salary less the pension contributions that comprises the taxable income.
However, one must not forget that income from an employment is not just the cash that someone is paid at the end of every week or month, but will also include any benefits (‘perks’ or ‘perquisites’) derived from employment, such as a company car or subscriptions paid by the employer to a private health scheme, etc., which need to be converted into monetary terms.
Some of these are easier than others to ‘convert’. A private health scheme subscription, for example, is straightforward, as this will be paid in money in any case, but conversion ‘mechanisms’ need to be set up for items that an employee is given outright or has the right to use, such as company cars.
Most countries have detailed legal rules about how specific types of income must be calculated for tax purposes, the types of expenses that can be deducted from income and how non-monetary benefits can be converted into monetary terms.
In addition, most countries allow a portion of an individual’s income to remain tax free, so that individuals will only pay tax on income over and above a certain amount. In the UK, this is referred to as a personal allowance
Let us assume that John a UK resident citizen, has the following income from various sources:
|Table I | John’s income||£|
|Income (after (or ‘net of’) allowable expenses)||65,000|
|Less: Personal allowance (= tax-free income)||(10,000)*|
|*It is conventional for figures that are to be deducted to be within parentheses.|
Let us assume that the rate of income tax is 20% on all income. John’s tax bill would be:
|£55,000 x 20% = £11,000|
|This would be an example of a proportional or flat tax.|
If, however, the tax rate were 20% on the first £40,000 and 25% on amounts in excess of £40,000, then the tax due would be:
|Table II | Progressive taxation of John’s income||£|
|£40,000 x 20% =||8,000|
|£15,000 x 25% =||3,750|
|This would be an example of a progressive tax.|
Income tax is rarely regressive, but this is possible, for example:
|Table III | Regressive taxation of John’s income||£|
|£40,000 x 20% =||8,000|
|£15,000 x 25% =||2,250|
Regressive taxes are often considered unfair, as they take a declining proportion of income as tax, as income increases — and it is persons with higher incomes, it is often argued, who should pay taxes at higher rates overall.
So many people were subject to income tax by the end of World War II that gradually the perception of income tax as an emergency measure to raise revenue in troubled times changed: it is now seen as one of the measures to achieve the economic, social and political aims of government.
Also, because of the large numbers of people subject to income tax at that time, in 1944 the PAYE (Pay as You Earn) system was introduced, whereby employers deducted income tax from an individual’s pay before he/she received it. This continues, and a similar system has been adopted in many different countries (e.g. Pay As You Go, or PAYG, in Australia).
This has made administration of the tax easier, and also means that individuals do not face a large tax bill at the end of the tax year, as the tax due is collected as the individual earns.
In the case of John above, with taxable income of £55,000 and taxed at 20%, the tax due of £11,000, assuming he is paid per calendar month, would be collected in 12 installments of £916.66, which his employer would pay over to HMRC on his behalf.In the case of a self-employed person paying tax on profits from a trade, the rules are different.
He/she does not have an employer to deduct and pay over income tax on his/her behalf. Such an individual in the UK is responsible for paying tax at two points in the tax year by installments, the amount being due being based on the profits of the year immediately preceding.
However, as trading profits are very unlikely to be the same from one year to another, there is a final payment due, based on actual profits. If profits have decreased in comparison with the prior year, then an individual will have paid more tax than is due, so would be due a repayment of any excess income tax paid.
The starting point for calculating the profit on which a self-employed person will pay income tax is the amount of profit a company makes in an annual accounting period, which will most usually be found in a set of the individual’s annual business accounts.
However, accounting profit and taxable profit are not the same thing: an accounting profit will usually have to be adjusted to derive the taxable profit.
- This is because certain sorts of costs or expenses deducted in calculating profit are not allowed for tax purposes;
- because certain kinds of income that are taxable might not be included in accounting profits;
- because some kinds of expenditure are permitted deductions for tax purposes but not for accounting purposes; and because certain kinds of income included in accounts are not taxable, either under corporations tax (a typical example would be capital profits) or at all.
The adjustments necessary could be summarized as follows.
|Table IV |Proforma adjustment of business profits||£|
|Net profit per accounts|
— Disallowable (or non-deductible) expenditure
|— Taxable income excluded from accounts||X|
— Unchanged, tax-deductible expenditure
|— Profits/income not chargeable to income tax||(X)|
A self-employed person will always have to complete a formal tax return to advise HMRC Opens in new window of income earned in any tax year, and thus any income tax due.
However, this is not always necessary for an employed person. If the latter has no income other than that which is earned, then all the tax due will have been collected through the PAYE system, so completion and submission of a tax return would be superfluous. It is an obligation to advise HMRC and thus complete and submit a tax return.
Partners in partnerships receive their agreed share of the partnership profit, adjusted as above, which is treated as business profit for tax purposes, and they will pay income tax on it.
Local Income Taxes
In countries that have many states or counties (e.g. the USA and Australia), in addition to a nationally levied income tax, there are often local income taxes, levied at state or country levels.
The UK has had something similar in a local tax that took the form of a tax levied on property values (rates), payable to a local authority, which was the forerunner of the Community Charge and later Council Tax.
Although not an income tax per se, this tax might, arguably, be considered a proxy for income tax, in the same way as window tax, as wealthier individuals would be more likely to buy their own houses. There was also a business version of this tax, business rates, which still exist.
Income tax deducted or withheld at source is sometimes referred to as an employee payroll tax. There are other payroll taxes, referred to as such because they relate to amounts people earn. Such taxes may be borne by the employee and the employer, such as National Insurance Contributions (NICs) Opens in new window in the UK, which were originally levied to support the National Health Service (and were thus hypothecated).
However, revenue raised now just forms part of the general ‘pot’ of tax monies available to the government to help achieve all economic, social and political aims.
Both employee and employer NICs are calculated by reference to how much an employee earns, and the employee NIC is collected and paid over using the PAYE system. Employer NICs are, however, an expense to the employer. They are, nonetheless, paid over at the same time to the revenue authority as income tax due on salaries and employee NICs.
Although not hypothecated in the UK, payroll taxes are in other countries, and are used specifically to fund social programmes, such as unemployment benefit, health care, etc.
They are typically a fixed or progressive percentage of employee earnings (like UK NICs) or a fixed charge per employee. If employer payroll taxes increase, it makes it more expensive to employ people generally, so this can have an adverse effect on the number of people in employment.