Individual Income Tax

Rationale for taxation

Acceptance of income taxation as the fairest kind of tax is based on

the premise that an individual’s income is the best single index of
one’s ability to contribute to the support of government. Moreover,
compared with sales taxes or property taxes, an income tax is easier to
change when the taxpayer’s ability to pay taxes is affected by various
life-course circumstances (such as the number of dependents the
taxpayer supports or extraordinary medical expenses).

Another argument for income taxation proceeds from its relation to a

nation’s economic performance. Compared with the amounts
produced by sales taxes or wealth taxes, the receipts from the
individual income tax tend to rise more steeply in economic booms
and drop more sharply in recessions. This occurs in part because
individual income itself is quite sensitive to changes in the level of
overall economic activity. In addition, income taxation is regulated by
a progressive rate structure (which can be thought to include the
personal exemption as a zero tax rate). As a result, a rise in individual
income creates additional income that is taxed at a higher rate.
Conversely, a drop in individual income causes some taxpayers to be
taxed at lower bracket rates. Because of this, taxpayers’ tax liabilities
fluctuate more than their incomes—the individual income tax actually
offsets some effects of expansionary and contractionary forces
during business cycles. Exceptions to a tax code—such as deductions,
the indexation of exemptions, and the measurement of income from
capital for inflation—reduce the potential for stabilization.
(See progressive tax; regressive tax.)

The individual income tax reduces the amount of income individuals

have available to spend, save, or invest. Of course, any tax has this
result. The question is whether other taxes may achieve the same end
more efficiently or with fewer undesirable side effects. It has been
argued that a tax on income discriminates against saving and is less
favourable to economic growth than a tax on spending because an
income tax is levied on all income—even that which is saved and made
available for investment—while a consumption tax is not levied on
moneys that are put into savings. On the other hand, an income tax
does not distort consumer spending patterns the way that selective
excise taxes tend to (causing buyers to shift from taxed to untaxed
items). The income tax does, however, contain distortions and
inequities of its own.

It is difficult to determine the extent to which an income tax reduces

the incentive to work. To the extent that the tax reduces total income
after taxes, it may lead some persons to work longer in an effort to
maintain an established standard of living (the income effect). To the
extent that the tax reduces the reward for an extra hour’s work, it may
make the taxpayer decide to work less and to indulge in more leisure
(the substitution effect); presumably, the larger the income and the
more steeply progressive the tax, the greater this substitution effect
will be. Finally, a progressive income tax is sometimes said to have an
adverse effect on investment, especially in the case of risky ventures,
but this has been shown to depend on the provisions a tax law makes
for allowing investors to write off their losses.