© Goodheart-Willcox Co., Inc.
7
Income and Taxes
Objectives
• Identify different types of income and
employee benefits.
• Relate taxation to government spending.
• List goods and services government
provides.
• Identify different types of taxes.
• Identify common tax forms.
continued
Objectives
• Describe basic procedures for filing a tax
return.
• Explain the purposes and function of the
Social Security system.
The Many Forms of Income
• Income is money earned from
employment and investments
• Governments tax income and assets to
create revenue that is used to provide
public goods and services
Money Earned from Work
• Income received from employment is
earned income
continued
Money Earned from Work
• Earned income includes
– wage (minimum wage for many unskilled
and beginning workers)
– piecework income
– salary
– commission
– tip
– bonus
Employee Benefits
• Some of the most valuable forms of
employee compensation are not
monetary
• Employee benefits often include
– paid vacation, holiday, and sick leave
– life and health insurance
– employer-sponsored retirement savings
plan
Business Profit Income
• Income earned by the self-employed
• Disadvantages of self-employment:
– Must arrange and pay for own employee
benefits; can be costly
– Must pay entire Social Security and
Medicare tax, rather than half the cost
Payroll Deductions
• Net income (take-home pay) is gross
income minus payroll deductions
continued
Payroll Deductions
• Deduction can lower a paycheck by
20 percent or more
• Bonuses increase gross income
continued
Payroll Deductions
• Common payroll deductions:
– FICA (Federal Insurance Contributions
Act): Social Security and Medicare
– Federal withholding tax
– State and city withholding taxes, if
applicable
– Other benefits (insurance purchased
through employers)
Money Earned Outside Work
• Unearned income—income received
from sources other than employment
– earnings from investments, sale of assets,
and interest paid on savings and bonds
– Social Security and retirement account
payments
– rent, inheritance, awards, gifts, alimony
– unemployment compensation
The Importance of Taxes
• Government uses its
taxing authority to
– generate revenue to
provide goods and
services for public’s
benefit
– stabilize the economy
– address social
challenges
– influence behavior
Federal Government Spending
• Limited resources force governments
to make choices
• A budget reflects priorities and goals
of government and its people
• When government spends more than it
collects, it must borrow money
• Deficit spending increases the national
debt
continued
Federal Government Spending
In Your Opinion
• What changes
should be made
to the way the
government
spends taxpayers’
money?
Mandatory Expenses
• Payments that must be made, even if
the government must borrow money
to do so
• Make up more than 60 percent of
federal government’s budget
• Include entitlement programs and
interest on the national debt
continued
Mandatory Expenses
• Entitlement programs:
– Social Security
– Medicare
– Medicaid (for older adults and people with
disabilities)
– Veterans’ pensions and medical care
– Nutrition and housing assistance
– Unemployment compensation
– Federal employee retirement benefits
Discretionary Expenses
• An expense that can be adjusted
according to needs and revenues
• Include national defense expenses
• Include nondefense expenses:
– Costs of government operations and
programs
– Funds given to state and local
governments
State and Local Government
Spending
• Taxation and government spending
vary widely between states and
between cities
• Most state and local government
revenues come from
– personal and corporate income taxes
– sales tax
– real estate and personal property taxes
continued
State and Local Government
Spending
Types of Taxes
• Direct—paid directly to government
by taxpayers
• Indirect—imposed on one party, but
paid by another
• Progressive—imposes a higher tax rate
on those with higher incomes
continued
Types of Taxes
• Regressive—has effect of imposing a
higher tax rate on those with lower
incomes
• Proportional—imposes same tax rate
on all regardless of income differences
What Is Taxed?
• Personal income tax—your income
• Purchase tax—goods and services
• Excise tax—sale and transfer of certain
items, including air travel, phone
service, gasoline
continued
What Is Taxed?
• Property tax—
real estate
property tax and
personal
property tax
• Wealth tax—
assets (estate and
gift taxes)
Paying Income Taxes
• Internal Revenue Service (IRS) collects
federal income taxes
• State tax returns are filed with
departments of revenue in states that
collect taxes
Your Employer’s Role
• Employees fill out Form W-4
• Employers withhold taxes from
employees’ paychecks
• At start of year, employers mail Form
W-2 to employees
continued
Your Employer’s Role
• Form W-4—taxes withheld depend on
earnings and number of allowances
claimed
continued
Your Employer’s Role
• Form W-2—previous year’s pay and
tax deductions are given
Preparing Your Return
• Each year taxpayers must file a tax
report with the government showing
the taxes owed
• Choose one of three common forms:
1040EZ, 1040A, or 1040
Choosing a Tax Form
• Use Form 1040, long form,
– if income is over a certain amount
– when adjustments to income, itemized tax
deductions, and tax credits can reduce
taxes
continued
Choosing a Tax Form
• Use short forms,
1040A or 1040EZ,
if
– income falls into
certain limits
– deductions aren’t
itemized
Figuring Taxable Income
• Calculate gross income based on
Forms W-2 and 1099s
• Calculate adjusted gross income by
subtracting adjustments from total
income
• Subtract allowable exemptions and
deductions
Figuring Taxes Owed
• IRS tax tables show taxes owed based
on taxable income
• Reduce the amount owed with tax credits
Filing on Time
• Filing deadline for federal taxes and
most state taxes is April 15
• Tax avoidance—falsely reducing taxes
• Tax evasion—failing to declare all
income or falsifying documents
State and Local Tax Forms
• 43 states collect income taxes
• Taxpayers in states that collect
personal income taxes must submit
state tax forms
Electronic Filing
• Advantages of filing tax returns online:
– It’s simple and quick
– If refund is due, it arrives sooner
• TeleFile allows taxpayers to file simple
tax returns with touch-tone phones
Sources of Tax Information and
Assistance
• The IRS answers tax questions through
free booklets, recorded messages, and
a Web site
• Tax preparation services fill out tax
forms for a fee
• Many taxpayers use tax preparation
guides and software
IRS Audits
• A detailed examination of taxpayer’s
tax returns by the IRS
• During audit, taxpayers must answer
IRS’s questions and provide
documentation when asked
• Taxpayers have legal protections in
their dealings with the IRS
Tax System Reform
• Legislators make
laws that
– raise or lower taxes
– make the tax
burden fairer
– simplify the system
– achieve other
desired outcomes
Tax Legislation
• Many citizens are concerned about
rising taxes
• Questions asked when tax policy
changes:
– Will revenues generated by the new tax
exceed administration costs?
– Will it be fair to all taxpayers?
– Will it impact the economy negatively?
Paying Social Security Taxes
• FICA taxes calculated as a percentage
of income; deducted from gross pay
• Employers and workers split FICA
taxes
– Employees pay 6.2 percent for Social
Security and 1.45 percent for Medicare
– Employers contribute an additional 7.65
percent
continued
Paying Social Security Taxes
• The self-employed
pay all FICA taxes
themselves
• Federal government
receives FICA
contributions and
credits them to
employees’ accounts
Your Social Security Number
• Social Security Administration uses
SSNs to keep records of earnings;
records determine benefit amounts
• IRS uses SSN as taxpayer ID number
• Each SSN is unique
• Safeguard your SSN
Social Security Benefits
• If you work, your Social Security taxes
pay for benefits others receive
• When you no longer work (retire,
become disabled, or die), you and your
dependents will get benefits provided
by other workers’ Social Security taxes
continued
Social Security Benefits
• Types of benefits:
–
–
–
–
Retirement
Disability
Survivors’
Benefits for divorced people
Social Security System Reform
• Benefits paid out will soon exceed tax
collection
• Social Security fund will be depleted;
no money to pay benefits of workers
paying into the system now
• Taxes may have to be raised, benefits
decreased, or both
Central Ideas of the Chapter
• Taxes reduce each individual’s income and
wealth.
• The taxes of many make it possible for
government to provide public goods and
services that benefit all.
Glossary of Key Terms
Back
• bonus. Money added to an employee’s base
pay. It is usually a reward for performance
or a share of business profits.
• commission. Income paid as a percentage of
sales made by a salesperson.
• compensation. Payment and benefits
received for work.
• disability. A limitation that affects a person’s
ability to function in major life activities.
Glossary of Key Terms
Back
• earned income. Income from employment.
• employer-sponsored retirement savings
plan. A tax-deferred investment program
that helps employees save for retirement.
• employee benefit. A form of nonmonetary
compensation received in addition to a wage
or salary.
Glossary of Key Terms
Back
• entitlement. A government payment or
benefit promised by law to eligible citizens,
such as Social Security and Medicare
benefits, unemployment benefits, veterans’
services, food stamps, and housing
assistance.
• exemption. A tax benefit that reduces the
amount of income a person is taxed on.
Glossary of Key Terms
Back
• FICA (Federal Insurance Contributions
Act). The law that requires the collection of
social security payroll taxes.
• Form W-2. A Wage and Tax Statement that
states the amount an employee was paid in
the previous year. It also gives the amounts
of income, Social Security, and Medicare
taxes withheld from an employee’s income
during the year.
Glossary of Key Terms
Back
• Form W-4. The Employee’s Withholding
Allowance Certificate that tells the employer
how much tax to withhold from an
employee’s paycheck.
• gross income. A worker’s earnings before
deductions.
• interest. Payments from financial
institutions, businesses, and government to
use customers’ money.
Glossary of Key Terms
Back
• Medicaid. A government program
administered by the states that pays certain
health care costs for eligible low-income
individuals and families.
• Medicare. A federal government program
that helps pay the medical expenses of
people 65 and older and others with certain
disabilities.
Glossary of Key Terms
Back
• minimum wage. The lowest hourly wage
employers can pay most workers by law.
• net income. Gross income (plus bonuses)
minus payroll deductions.
• payroll deduction. An amount subtracted
from gross income.
• piecework income. A wage that is based on
a rate per unit or item completed.
Glossary of Key Terms
Back
• salary. Payment for work that is expressed as
an annual figure.
• Social Security. The federal government’s
program for providing income when
earnings are reduced or stopped because of
retirement, disability, or death.
• tax credit. An amount that can be subtracted
from the taxes a worker owes, if eligible.
Glossary of Key Terms
Back
• tax deduction. An expense that can be
subtracted from a worker’s taxable income.
• tip. Money paid for service beyond what is
required.
• unearned income. Earnings from sources
other than work.
• wage. A payment in exchange for an
employee’s labor or services. The payment,
which is usually in money, is paid by the
hour, day, or by the piece.