Gavin Howe
The US tax system is a complex network of federal, state, and local laws that determine how much individuals and businesses pay in taxes. While the US Constitution grants Congress the power to tax, the Internal Revenue Service (IRS) is responsible for implementing and enforcing these laws. Over the years, there have been concerns about the fairness and effectiveness of the US tax system, with some arguing that it favours the wealthy. The system allows for various deductions, exemptions, and credits, which can result in lower effective tax rates for some high-income individuals. As such, there have been calls for tweaks to the US tax laws to address these concerns and ensure a more equitable distribution of the tax burden.
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What You'll Learn
Tax laws and tax brackets
The US has a progressive tax system, meaning that people with higher incomes are subject to higher federal tax rates, and vice versa. The government decides how much tax an individual owes by dividing their taxable income into chunks, also known as tax brackets, with each chunk being taxed at a corresponding rate. For example, in 2024, a single filer with $50,000 of taxable income would pay 10% on the first $11,600 and 12% on the chunk of income between $11,601 and $47,150. They would then pay 22% on the rest of their income, as it falls into the 22% tax bracket.
In 2024 and 2025, there are seven federal income tax rates: 10%, 12%, 22%, 24%, 32%, 35%, and 37%. These rates will remain the same through the end of 2025 due to the Tax Cuts and Jobs Act (TCJA). The top marginal income rate of 37% will apply to single filers with taxable income of $626,350 and, for married couples filing jointly, taxable income above $751,600. It is important to note that tax rates are based on taxable income, which is an individual's adjusted gross income (AGI) minus the standard deduction or itemized deductions.
Federal income tax brackets are updated annually to reflect the current rate of inflation, which is a critical part of the tax code. These adjustments, formally known as inflation adjustments, help prevent taxpayers from ending up in a higher tax bracket as their cost of living rises, a scenario called "bracket creep". They can also lower taxes for those whose compensation has not kept up with inflation.
Additionally, the US system allows for the reduction of taxable income for both business and some non-business expenditures, called deductions. Businesses can reduce their gross income directly by the cost of goods sold and may also deduct most types of expenses incurred in the business.
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US tax code and marginal tax rates
The US tax code is based on a progressive marginal tax rate system, which means that as a person's income increases, the tax rate on the next layer of income is higher. This progressive system ensures that not all income is taxed at the highest marginal rate, making the taxes owed more moderate than many people assume. For instance, if a person's income is approaching the 32% bracket threshold, their effective tax rate will be lower than 32%.
Marginal tax rates are the percentage of tax applied to each additional dollar of income within a specific bracket. In other words, it represents the percentage taken from your next dollar of income above your current income level. So, if you're in the 24% tax bracket, each additional dollar you earn will be taxed at 24 cents until you reach the next bracket threshold. If your income increases to the point where it enters a higher tax bracket, only the portion of your income earned above that threshold is taxed at the higher rate, not your entire income. This is meant to create a more equitable distribution of the tax burden across different income levels.
The marginal tax rate is also useful for understanding the multiple layers of taxes, such as income tax and payroll tax, alongside relevant deductions and credits. For example, a couple with two children may face negative marginal tax rates at low levels of income due to the Earned Income Tax Credit (EITC) and Child Tax Credit (CTC). As their income rises, the marginal tax rate increases due to the phase-out of these credits and the payroll tax.
The US tax code and marginal tax rates are subject to change and adjustment over time. For example, the 2025 tax rates include a top marginal income rate of 37% for single filers with taxable income of $626,350 and married couples filing jointly with taxable income above $751,600. The standard deduction, which represents the amount of income that can be excluded from taxes, also increased in 2025 by $400 for single filers and $800 for joint filers.
Proactive tax planning and understanding the marginal tax rates can help individuals reduce their tax liabilities and make more effective financial decisions.
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Tax evasion and pseudo-legal arguments
Tax evasion is a serious offence in the United States, and the Internal Revenue Service (IRS) and the courts have consistently rejected pseudo-legal or "frivolous" arguments used to justify non-payment of taxes. These arguments are often circulated in certain circles, particularly those of libertarians and conspiracy theorists, and can lead to significant legal consequences. Approximately 400 people per year are jailed for tax evasion, serving an average sentence of 16 months. In addition to jail time, filing a return based on a frivolous argument can result in a fine of $5,000.
One common pseudo-legal argument is that paying taxes is voluntary. This argument has been rejected by multiple courts, including in United States v. Drefke, where the court described the argument as "an imaginative argument, but totally without arguable merit." Similarly, in United States v. Gerads, the court stated that the claim that paying federal income tax is voluntary "clearly lacks substance" and imposed sanctions of $1,500 for bringing a frivolous appeal.
Another argument used by some individuals is that they have rejected US citizenship in favour of state citizenship and are therefore not subject to federal income tax obligations. This argument has also been consistently rejected by the courts, which have affirmed that the Fourteenth Amendment to the US Constitution establishes simultaneous state and federal citizenship. In United States v. Sloan, the court rejected Sloan's argument that he was a "freeborn, natural individual, a citizen of the State of Indiana, and a 'master' - not 'servant' - of his government" and affirmed his tax evasion conviction.
In addition to these, there have been various other pseudo-legal arguments rejected by the courts, including the claim that federal laws apply only to US territories and Washington, D.C., and the argument that the taxpayer is not a "person liable for taxes." Individuals using these arguments have been subject to criminal penalties, fines, imprisonment, and civil penalties.
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State and local tax (SALT)
The State and Local Tax (SALT) deduction allows taxpayers to subtract up to a certain amount in paid property, income, or sales taxes from their taxable incomes. This deduction is an itemized deduction that taxpayers can use when they file their annual tax returns. The SALT deduction is a long-standing feature of the US tax system, dating back to the Revenue Act of 1913, which introduced the federal income tax.
The SALT deduction is used by taxpayers across all income levels and locations in the United States, with the highest percentage of users in the East and Northeast regions. It is particularly beneficial to taxpayers who pay significant amounts of deductible taxes, such as property taxes. The average SALT deduction ranged from about $11,000 to more than $103,000 before the introduction of a cap.
In 2017, as part of the Tax Cuts and Jobs Act (TCJA), a $10,000 cap on the SALT deduction was adopted, provoking debate and criticism. This cap is set to expire at the end of 2025, and there have been various proposals to eliminate or increase it. The SALT deduction is an important aspect of the US tax system, and any changes to it can significantly impact taxpayers and state and local government finances.
The SALT deduction provides taxpayers with relief from double taxation on the same income. It allows them to deduct state and local taxes from their federal taxable income. The cap on the SALT deduction has been a subject of discussion and contention, with some arguing for its removal or an increase. The limit stands at $10,000, or $5,000 for married individuals filing separately. This cap is set to expire at the end of 2025, and there is ongoing discussion about potential adjustments.
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Federal tax laws and revenue losses
Federal tax laws in the United States allow for a reduction in taxable income for both business and some non-business expenditures, known as deductions. Businesses can reduce their gross income directly by the cost of goods sold and may also deduct most types of expenses incurred in the course of business operations. Additionally, individuals can claim deductions for capital losses, which occur when a capital asset, such as a stock or bond, is sold for less than its purchase price. These capital losses can be used to offset capital gains or other income, thereby reducing taxable income.
The US tax code also includes provisions for revenue losses, known as tax expenditures. These are revenue losses attributable to specific sections of federal tax laws that allow for exclusions, exemptions, or deductions from gross income. They may also provide special credits, preferential tax rates, or deferrals of tax liability. Examples of tax expenditures include the standard deduction, which is the amount of income that can be excluded from taxes, and the Child Tax Credit, which provides a maximum credit of $2,000 per qualifying child.
Revenue losses can also occur due to penalties for taxpayers who underreport their income or fail to comply with tax regulations. The Internal Revenue Service (IRS) can impose a "Negligence or disregard of rules and regulations" penalty for taxpayers who fail to correctly follow tax laws when filing their returns. Additionally, a "Substantial understatement of income tax" penalty applies when a taxpayer understates their tax liability by 10% of the tax shown on their return or $5,000, whichever is greater.
Furthermore, revenue losses can result from the treatment of casualty, disaster, and theft losses. Personal casualty losses, which are not connected to a business or profit-seeking transaction, are generally not deductible for tax years 2018 through 2025, except in the case of federally declared disasters. In such cases, individuals can deduct losses related to their homes, household items, and vehicles on their federal income tax returns.
The US tax system also allows for certain trusts and holding company structures that can facilitate revenue losses. For example, trusts in South Dakota can exist indefinitely, shielding assets from tax and protecting them in cases of divorce or bankruptcy. Additionally, holding companies can establish subsidiaries in states like Delaware, which has no income tax on intangible assets, thereby reducing their overall tax liability.
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Frequently asked questions
The current top marginal income tax rate is 37%. This applies to single filers with a taxable income of $626,350 and above, and for married couples filing jointly, the rate applies to taxable income above $751,600.
There are several issues with the American tax system, including:
- The system allows certain deductions and exclusions, which can result in lower effective tax rates for some very high-income individuals compared to lower-income earners.
- Special low rates for capital gains and dividends enable taxpayers with significant investment returns to pay lower rates than those with ordinary income, such as salaries or wages.
- The federal tax system has been criticised for being unfair and ineffective, with concerns that wealthy individuals can reduce or avoid their tax liability through aggressive strategies.
- The system is complex, and some groups have encouraged others not to comply with the tax laws.
There are a few ways to reduce tax liabilities in the USA, including:
- Taking advantage of deductions for business and some non-business expenditures.
- Contributing to retirement accounts such as a 401(k), 403(b), or an IRA.
- Using a trust to protect assets and shield them from tax, especially in states like South Dakota, which has favourable trust laws.
- Taking advantage of tax-exempt interest paid on state and local government bonds.
