Close-up: Income Tax

Physician's Money Digest, March 2006, Volume 13, Issue 3

n.

Income Tax: Annual tax levied by the federal government, most states,and some local governments on an individual's or a corporation's net profit.

Personal income tax has been around for as long asany of us can remember. We've grown used to thefact that when we examine our paychecks, a substantialchunk will have been removed in the form of a taxpayment to the federal, state, or local government, butthat does not necessarily mean we like it. As April 15approaches, we are certain to grumble about how muchmoney we pay to support Uncle Sam.

Our country's tax system did not always operate in themanner it does today. There was a time when there was nopersonal income tax. During the early stages of our developingnation up until 1802, the US government was supportedsolely through internal taxes on commodities suchas distilled spirits, refined sugar, tobacco, and propertysold at auction. Over the years, the tax structure haschanged, and many individuals would probably like toreturn to the old ways.

Arrival of Income Tax

In order to support the Civil War, Congress enacted thecountry's first income tax law in 1862. According to theTax Foundation (www.taxfoundation.org), it was much liketoday's system of graduated, or progressive, taxation ofwithholding income at the source. During that time, anindividual earning between $600 and $10,000 per yearpaid tax at the rate of 3%. Additional sales and excisetaxes were added that year, an inheritance tax appearedfor the first time, and the office of Commissioner ofInternal Revenue was established.

What came next might be hard to believe. Six yearslater, Congress actually eliminated the income tax andfocused its attention on tobacco and distilled spirits. Thetax reappeared briefly with the Revenue Act of 1894. Butin the next year, the US Supreme Court decided that theincome tax act was unconstitutional because it did notconform among the states, and it was repealed.

The freedom from income tax ended for good in 1913,when the 16th Amendment to the Constitution made theincome tax a permanent fixture in our tax system. Theamendment gave Congress the authority to tax income,and established a revenue law that taxed the incomes ofboth individuals and corporations. The Tax Foundationreports that in 1918, annual internal revenue collectionspassed the billion-dollar mark for the first time, rising to$5.4 billion by 1920.

Rise and Fall of Rates

Over the next 2 decades, events ranging from the GreatDepression to World War II led to various and frequent taxincreases. During that time, the Social Security Act waspassed in 1935 to provide compensation for the unemployed.The face of the tax system had changed dramaticallysince its inception in 1913; tax rates began at 1%and rose to 7% for those with income in excess of$500,000. By the end of World War II, the bottom tax ratewas 23% while the top rate stood at 94%.

The period from 1981 through the present has seenmyriad efforts to reform and reconcile the income tax. Itbegan with the Economic Recovery Tax Act of 1981, whichfeatured a 25% reduction in individual tax brackets.President Reagan signed the Tax Reform Act of 1986,thereby lowering the top tax rate on individual incomefrom 50% to 28%—its lowest level in 50 years. PresidentClinton signed the Revenue Reconciliation Act of 1993into law, aimed at reducing the $496-billion federaldeficit, and President George W. Bush signed tax cuts intolaw every year from 2001 through 2004.

Clearly, the days of supporting the government throughproducts like alcohol and tobacco are long gone. The faceof income tax has been reconstructed more times thanthat of an aging Hollywood movie star, and still it remains.We can grumble all we want, but we might as well realizethat no matter how it's molded or reshaped, the incometax is a permanent fixture of the American financial landscape.

Why Do We Pay Taxes?

How many times have we uttered the aboverhetorical question? Probably more times than wecare to remember. We don't necessarily expect ananswer, but it is important to understand how ourincome tax dollars are spent.

Former US Supreme Court Justice Oliver WendellHolmes once noted that,"Taxes are what we pay fora civilized society." That's not completely inaccuratebecause taxes paid to state and local governmentshelp pay for police and fire protection. The moniesalso support the operation of these governments, aswell as maintaining recreation areas, such as parksand public facilities, and public transportation.

On the national level, federal income taxes helppay for our country's defense and keep our nation'sinfrastructure sound. Medicaid, Medicare, andSocial Security help the elderly and the poor in thiscountry obtain affordable medical care, as well aspurchase food and clothing.

We may complain about taxes, and perhaps wishthat income tax did not exist. But the bottom line isthat when we live together in a society, everyonehas a hand in keeping that society functioning.Taxes are the vehicle that make that possible.

POP QUIZ

1) The country's first income tax law was enacted in

  1. 1860
  2. 1862
  3. 1864
  4. 1890

2) Income tax became a permanent fixture in our system in

  1. 1894
  2. 1985
  3. 1913
  4. 1918

3) The base and high-end tax rates in 1913 were

  1. 1% and 7%
  2. 2% and 9%
  3. 3% and 10%
  4. 5% and 10%

4) The Tax Reform Act of 1986 lowered the top tax rateon income from 50% to

  1. 32%
  2. 30%
  3. 28%
  4. 25%

5) Federal income taxes help pay for

  1. Medicare
  2. Medicaid
  3. Social Security
  4. All of the above

Answers: 1) b; 2) c; 3) a; 4) c; 5) d.