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Taxation is the imposition of a mandatory levy on the citizens and/or the businesses of a country by their government. In almost every country, the government derives a majority of its revenues for financing public services from taxation. Most individuals will feel the impact of quite a number of taxes during their lifetimes. In addition, taxes have become a powerful instrument for policy makers around the world to use in attaining economic and social goals. As a result, the system of taxation in the United States and elsewhere has an impact on almost every business and investment decision that is made.

NATURE AND HISTORY OF U.S. TAXATION

In 1936, the U.S. Supreme Court defined a tax as "an exaction for the support of the Government." In this regard, there is no direct relationship between the exaction of revenue by the government and any benefit to be received by the taxpayer. As a result, a taxpayer—such as a corporate shareholder—cannot trace his or her tax payment to any particular governmental asset or program. Taxes may be distinguished in a similar fashion from licenses and from fees, which are payments made to the government for some special privilege granted or service rendered (such as a marriage license or a camping fee). They can also be distinguished from regulations and from penalties, which are charges imposed by government to eliminate or control a specific activity.

For taxes to pass constitutional muster, they must be levied on the basis of predetermined criteria. Not only must taxes be determined objectively, but also taxpayers must be able to calculate their tax liability ahead of time. Since most taxes are levied on a recurring or predictable basis, individuals can also engage in tax planning or in tax avoidance. In other words, they are free to conduct their lives in a way that minimizes the amount that must be transferred to the government in taxes.

Despite the adage that nothing is certain in the world but death and taxes, taxation has not always been the chief source of revenue for governments. While the primary goal of taxation is to provide the resources necessary to fund governmental expenditures, any taxing authority that has the power to control the money supply—such as the U.S. federal government—can satisfy its revenue needs merely by creating money. Complete reliance on this governmental power, however, would stimulate excess demand in the economy, which—in turn—would cause price inflation. Taxes, on the other hand, raise revenue with the opposite effect: They drain money from the private sector, causing a reduction in private consumption or investment expenditures.

Reflecting one of the rallying cries of the American Revolution—"No taxation without representation"—the system of taxation in the United States closely parallels the tax regime of England. At the time of its adoption in 1789, the U.S. Constitution gave Congress the power to levy and collect taxes. Promptly exercising this authority, Congress enacted was the Tariff Act of 1789, imposing a system of duties—called excise taxes—on imports. As a result, tariffs became the federal government's principal source of revenue.

As the scope of governmental activities and programs increased, additional sources of revenue were necessary to supplement the tariff system. However, the Constitution required that any direct tax imposed by Congress had to be apportioned among the states on the basis of their relative populations. Because the sizes of the states' populations differed, any tax on income would result in a different tax rate for the citizens of each state. Despite the apportionment requirement, Congress enacted the first federal income tax in 1861 to finance the vastly increased expenditures brought on by the Civil War.

While the original federal income tax was allowed to expire after the Civil War, it did lead to the successful effort to amend the Constitution. The Sixteenth Amendment to the Constitution became effective on February 25, 1913, providing that: "The Congress shall have the power to lay and collect taxes on incomes from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration." Without hesitation, Congress enacted the Revenue Act of 1913, on October 3, 1913 and made it retroactive to March 1, 1913.

As historical conditions changed and the federal government's need for additional revenues increased, Congress exercised its income taxing authority by the passage of many new revenue acts. Since each new piece of legislation simultaneously reenacted previous revenue acts and added new amendments to the law, it became necessary to research over one hundred separate statutory sources to determine what tax law was currently in effect. Eventually, in 1939, Congress resolved the confusion by systematically arranging all of the tax laws into the Internal Revenue Code of 1939, a permanent codification of the law that does not require reenactment.

MAJOR TYPES OF U.S. TAXES

Since its establishment in 1913, the income tax has played the dominant role in providing the funds with which the federal government operates. An income tax is an extraction of some of the taxpayer's economic gain, usually on a periodic basis. The federal government, and almost every state government, imposes a tax on the income of individuals, corporations, estates, and trusts. A final tax reckoning—involving the reporting of income and payment of taxes due—is made at the end of each year. However, in order to ensure tax collections, Congress has created a pay-as-you-go requirement, through a combination of payroll with holdings and estimated tax prepayments during the year.

Income is generally defined as any permanent increment to wealth. It does not include loans or any other temporary increments. As a general rule, Congress considers any incremental wealth to be taxable income, unless specific statutory authority excludes it. These increments to wealth can take many forms, such as cash, property other than cash, and services that are ren dered to the taxpayer. While state governments set their own tax rules and rates, a majority of the states use the same definition of gross income as the federal government.

Unlike federal and state income taxes, wealth-transfer taxes are not significant revenue producers. Historically, the primary function of wealth-transfer taxes has been to hinder the accumulation of wealth by family units. Since 1976, the federal estate tax and the federal gift tax have been combined into one tax, known as the unified transfer tax. This unified system eliminates the distinction previously made between taxable lifetime transfers and transfers at death. Under this system, the value of a decedent's taxable estate is treated as his or her final gift.

Like federal income taxes, the tax rates on unified transfers are progressive. This means that an increasing percentage rate is applied to increasing increments of the tax base. Unlike the annual assessment of federal income taxes, the federal transfer tax is computed cumulatively on gifts made during a lifetime as well as on transfers at death. In addition, many states impose an inheritance tax on the right to receive property at death. Unlike an estate tax, which is imposed according to the value of property transferred at death, an inheritance tax is imposed on the recipient of property from an estate, although many wills provide that the estate should pay any inheritance taxes imposed on recipients of property.

In addition to income taxes and wealth transfer taxes, the federal government and most states impose some form of employment tax. The most common form of state employment tax is levied on wages, with the proceeds used to finance that state's unemployment compensation benefits program. In addition to its own unemployment tax, the federal government also imposes a Social Security tax on employers, employees, and self-employed individuals. The federal government uses proceeds from the Federal Insurance Contribution Act (FICA) tax to finance the payment of Social Security benefits as well as Medicare health insurance. If an employee will be eligible for Social Security and Medicare, the FICA tax is paid by both the employee and by his or her employer. Although subject to a different tax rate, self-employed individuals are required to pay FICA taxes on their net earnings from self-employment.

With only a few exceptions, state and local units of government in the United States also use the income tax and wealth transfer taxes as a source of revenue. In addition, these taxing jurisdictions have customarily relied on two other tax sources that generally escape taxation by the federal government:

1. The annual assessment of property tax has traditionally been the backbone of the local revenue system. It is a tax on the value of property—usually only real property, such as land and buildings— owned within a jurisdiction by nonexempt individuals or organizations.
2. In addition, most states and many local units of government impose sales taxes. This is a tax on the gross receipts from the retail sale of tangible personal property—such as automobiles and clothing— and certain services. Each taxing authority determines its own tax rate as well as the services and articles to be taxed. The seller collects the tax at the time of the sale, and then periodically remits the revenue to the appropriate taxing authority.

TAX PLANNING

In the United States and other democracies, a majority of citizens—or their duly elected representatives—vote to impose taxes on themselves in order to finance public services on which they place value but which are not adequately funded by market processes. However, determining which individuals or households or businesses actually reduce their private consumption or wealth as a consequence of a tax is not always a straightforward matter. After all, although taxes affect numerous aspects of our lives, their impact is not uncontrollable.

Tax planning is simply the process of arranging one's actions in light of their potential tax consequences. After all, a character in Gone with the Wind improves on the earlier adage by ob serving, "Death and taxes and childbirth! There's never any convenient time for any of them!" Despite the inconvenience that taxes impose, the average individual will feel the impact of quite a number of taxes during his or her lifetime. As a result, almost any attempt to accumulate or pre serve wealth requires diligent tax planning.

The process of minimizing the tax liability— of an individual or of a transaction—is usually referred to as tax avoidance. Not to be confused with tax evasion, tax avoidance is the perfectly legal effort by taxpayers, and by paid tax advisers on behalf of their clients, to take those steps necessary to reduce one's taxes. As a result, any one interested in minimizing their tax liabilities in the United States should take their cue from a 1947 opinion by Justice Learned Hand: "Over and over again courts have said that there is nothing sinister in so arranging one's affairs so as to keep taxes as low as possible. Everybody does so, rich or poor, and all do right, for nobody owes any public duty to pay more than the law demands: taxes are enforced exactions, not voluntary contributions. To demand more in the name of morals is pure cant."