Tax law fundamentals and applications

Tax Law

The Nature of Federal Income Tax

The Federal Income Tax, History & Implications

Issues in the Taxation process

The need for reform

The tax laws of a country determine the profitability and adaptability of any business. The fundamental consideration in any economic system is the income and income tax. Income tax provides the state with revenue more than any other type of tax, and it has a lot of impact on economic growth and macroeconomic equilibrium in the economy. Consequently individual income tax and corporate income tax are seen as vital source of revenue and also an instrument to control inflation and bring out the economy during recession. For business, the income tax is a deterrent tin many spending and investing avenues, while at the same time forming an important part of the balance sheet, salary consideration and payments. The law therefore is very important in transactions of any commercial nature. The penalties for even inadvertent violations can be quite severe. This paper aims at unraveling the relation between the business economy and the federal income tax which is itself a subject of controversy.

The Nature of Federal Income Tax

Federal taxation is the major factor of funding for the U.S. government. In other words the existence of the Federal government is based on the generation power of its tax policies. The federal government relies on a number of tax instruments; the chief being income tax, the government also relies on excise tax, gift tax and so on. Business decisions are often made without considering the incidence of tax, which proves to be erroneous. Individuals are concerned with personal income tax while corporate ought to be concerned with the corporate income tax. Cost difference exists even between the different types of business entities like companies, partnership and proprietary concerns. The consideration of the tax consequences of any financial transaction or activity is a vital need to be successful in personal and corporate savings on tax. Non-payment or miscalculation of tax payment can have very disastrous consequences.

In the U.S. individual form of income tax is considered to the important factor with regard to revenue, accounting for 55% of government revenue. Corporate income tax after the tax reform act of 1986 created revenue of 35% from corporate entities. Corporations are taxed to almost 52% on their income. Tax evasion is a crime but avoidance is not. When the tax payer does not report an income taxable by suppressing it, an offence is committed that can lead to heavy penalties and even imprisonment. On the other hand tax avoidance is legal and that is one of the economic considerations of transactions. The IRS which is the authority that collects tax considers understatement of income, wrong deduction or accounting lapses. Corporate tax avoidance is important in creating policies, for all transactions including payments to stock holders as these are also taxed. The Internal revenue code, which lays down the rules for assessing tax, does not limit an entity from saving taxes. With this information it is easily possible to see the importance of taxes especially federal income tax and its impact on business.

The chief contribution in tax revenue is by federal income tax - to the amount of over nineteen billion Dollars in 1996 followed by social security to ten billion Dollars, and all other state and property taxes following suit. The economy which is composed of agrarian and business sectors have different tax burdens. For example the agrarian sector can use the cash accounting method to compute tax while the business and individuals have to use the accrual method. The difference in tax on investment in real estate and development is designed to give a boost to the industry. The current subjects of tax in the income tax sphere are individuals and corporations. Every U.S. citizen is liable to be taxed on their annual income from all sources. The tax is computed after deductions legally allowed.

The IRS code defines income as being attained from any source and will also include gains from any situation like interests, alimony, pensions, insurances and most of the earnings will be treated as income. The income of the individual accrues from either service or business activity. Wages and salaries form the major tax subject for individuals. Corporations are legal entities and income of corporations and business is also taxed as for the case of individuals. Under this policy, the income of the company is also paid out as dividend to shareholders, and for this also the company would have paid tax, and the dividend holder also pays tax for the amount as added to his or her private income. This anomaly is called as 'double taxation'. The governments in the economic interest of the country must always strive to avoid double taxation. Some of the deductions allowed are contributions to specified charity, interest available on the mortgages, tax which is being paid on the property, and certain deductions allowed on other taxes paid to the state of residence. These exemptions are available to individuals and corporate entities.

The Federal Income Tax, History & Implications:

The power of the U.S. government to levy the Federal income tax is derived from the 16th amendment to the constitution. The act called as the Federal income tax law came into force in the year 1913. The procedures and codes were later codified into the internal revenue Code in 1939. The code was re written a number of times. The latest - the 'Internal revenue Code of 1986' came to be after the legislature had passed in 1986 the Tax reform Act of 1986. The official orders of the IRS are called revenue rulings, and are procedures to be followed in all aspects of the tax matters. Revenue rulings ought to be obeyed and must figure in transaction cost calculations. Sometimes the authority issues procedure guidelines which also help in keeping up with the tax incidence and if necessary be used of avoidance of tax.

Issues in the Taxation process

Former U.S. President Jimmy Carter has considered the income tax as being a shame for humanity. This opinion is probably based on the enormous complexity of the tax acts. The Internal Revenue code is Greek and Latin to most people and the resultant chaos has given birth to many industries catering to the demand for elucidation. There are over four hundred forms that have to be filled for appropriate filing and the Internal Revenue Service works with one hundred million tax payers, and deals with over eight billion forms, in the course of the year. For the economy, the tax caused two important costs for all entities, which can be called the compliance costs.

The other economic cost which retard growth is called 'excess burdens' also called 'welfare costs' which include the fall in output and production caused by a high rate of federal income tax. In 1985 the business tax compliance cost was estimated to be Dollar one hundred and two billion. The important distinction and power of this tax is the effect it has in reducing the returns from investment in trade of stocks. In this manner the tax indirectly affects the economy and has become too complex and costly to continue. The total loss caused by the deadweight is a critical factor in any economic consideration. It is a factor that economists consider to find "means of achieving the program's goals that involve less government financing." For example such a decision could have been involved in the estimate of deadweight loss "that would result from financing an increased level of spending can be decomposed usefully into two conceptually separate parts."

This is considered to be an important element if made application to the federal income tax, need in-depth and thorough analysis about the amount of deadweight it has created. In alternate to it economists suggest a flat tax structure in its place which ought to be simple to comply and the incidence and burden of taxation curtailed. Flat taxes are not new, only that it is suggested to modify the income tax act to make it a type of flat tax. It is argued that at present the social security is a type of flat tax. Uniform rates are levied from all employed. A similar arrangement for the income tax has been mooted. There is no denying that individual and corporate income tax is the most important of the tax array that plays crucial roles in national development and the fate of business in the U.S. economy.

The payroll tax and income tax produce as was seen before, more than fifty percent of the revenue. Taxation is a major method to bring about social progress. Federal tax gains are inversely responsive to business trends. The tax serves to offset spending of private income, and the tax is progressive, that is higher the income, greater the tax. In contrast to the flat tax theory advocated, progressive taxation is advocated for the reason that tax burdens must be proportionate to the taxable surplus. With regard to the salaried people the federal tax system has improvised a method to flush the surplus spending funds in advance by the mandatory provision of requiring employers to withhold tax from payments in advance which on remitting will be computed as part of the total tax liability of the employee. This method of advance collection is an important feature said to be the pillar of the tax system. The collected amounts are either adjusted to the next year tax if surplus, or credited if equal. This collection method raises revenue to the tune of seventy billion Dollars annually.

The taxation of company income is the subject of a debate. While individual income is taxed, the taxing of corporate income by legal fiction of considering it an entity has caused ire to noted economists and business persons. Heavy burden is shouldered by the stock holder, who also pays the tax for the income received as part of his personal income tax which is one instance of double taxation. The deductions allowed to the tax must allow costs for earning income, according to an argument. There is a cost involved in earning the income which must be allowed as deduction. However the principle "is hard to apply because of the difficulty of distinguishing between costs and personal consumption. Among doubtful items, a strong case can be made for more liberal deductions for educational expenditures that increase earning capacity." Some deductions that could be considered would be commuting expenses, income of working wives, are mooted. There must be a method of computing the cost of earning income and then deducting it, other wise the taxation is unfair.

The need for reform

The confusion and the mind boggling procedures, arguments and counter arguments with disgruntlement in the system of progressive taxation and double taxation has prompted alternate suggestions which include separating the income from stocks and limiting its tax. Similarly the insurance companies which could hold a part of their income as future liability have now been restricted in the amount that can be held in this manner. This passes on the incidence of taxation to the end users.

It is pointed out that the subject of the federal income tax both in a legal context and in the context of economic discussions has become so complex that there is no one single solution to alter it and make it universal and functional and keep the principles of the cannons of taxation intact. Some other tax structuring alternatives like VAT or value added tax has come in vogue. However the income tax remains! Some of the alternate to income tax which was promoted as being simple and whole were a national sales tax as discussed, the VAT, and consumption tax which will be flat and for the business a cash flow tax. The income tax was sought to be kept 'pure' with the narrowed down proposal of income. The globalization of the economy and the prospect of American ventures abroad and Joint Corporation or partnering with corporate from other countries have thrown up a plethora of new demands. The opinion held by experts now is that there must be a reform, a reform such that the federal income tax is completely eliminated, which will lower the cost of capital. It is argued that the lowering of the cost of capital will have two implications, one the fund for expansion overseas and second by simplifying the process attract the investment from abroad.

The Opinions and alternate suggestions to the federal income tax are plenty and the arguments for its removal as explored above are also numerous. Some scholars have come out with workable alternate suggestions. The savings in the economy, it is argued is very important for investment and stability. Savings if made is taxed by the income tax and therefore in today's economy the trend is to save less. The savings rate in the U.S. economy is declining very fast. Its impact will be on investments in the future because in a macroeconomic model, savings ought to be equal to investments. Eminent economists like Laurence J. Kotlikoff studied the impact of tax on "U.S. saving, investment, and growth of the total elimination of federal personal and corporate income taxes in favor of a uniform national sales tax." The argument goes to show that when ever a person purchased something a uniform sales tax will ensure that it is paid at the final point of sale thus distributing the tax burden while at the same time doing away with the entangled and complicated law regarding income tax.

Such a switch will be a total departure from the current government system and the new tax must be made so clear and unambiguous that there will not be any room for confusion over assessment. The argument is that "in choosing a national sales tax we also would finally be making a choice between taxing consumption and taxing income, and we would be picking the tax base, namely consumption, that is most conducive to growth of saving, investment, labor supply, and output."

Taxing is based on changes as it is perceived by the authorities and the subject of the tax has been varying from unit to unit. Tax and its subjects are kept changing continuously and this coupled with targeting, like targeting consumption in 1981, and finally the last reform in 1986 has created destabilization in the economy and also a mixed tax structure half way suited to income tax and another half an amalgam of all the policies that were experimented with. It is argued that the solution is to do way with the federal income tax and replace it with a flat national income tax. Eminent personalities and thinkers are of the uniform opinion that the federal income tax is a mammoth that serves the treasury but depletes the economy with un-computed cost in its collection to all the components of the economy and is therefore too costly to maintain further. The general opinion is that it must be scrapped. Various authors have given various view points as to what must replace it. Some of the suggestions like VAT have been implemented in Europe and Asia. However the personal income tax still remains. Corporate tax avoidance can be interpreted by the IRS under section 249 as a sham.