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The Wall Street Journal Guide to Understanding Your Taxes

The Wall Street Journal Guide to Understanding Your Taxes

by Kenneth M. Morris, Alan M. Siegel, Virginia B. Morris

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History of Taxes

"Taxes are what we pay for civilized society."
Oliver Wendell Holmes Jr., 1904

Taxes figure in many of the oldest written records of civilization. Clay cones found in what is now Iraq indicate that there were heavy taxes there more than 4,000 years ago. Inscriptions made on the Rosetta Stone about 200 B.C. tell of tax immunity for Egyptian temples. Two centuries later came the biblical admonition of Jesus Christ during the Roman era: "Render therefore unto Caesar the things which are Caesar's, and unto God the things that are God's."

References to taxation pop up frequently in early art, literature and legend. Lady Godiva's legendary ride on horseback was part of a successful appeal for tax relief for medieval Coventry. William the Conqueror's Domesday Book of 1086 was a census of England designed to ensure accurate taxation. A fresco on a wall in the Brancacci Chapel in Florence, Italy, pictures a divine blessing for the income and property-tax system enacted by the Florentine Republic in 1427.


The rulers of cities and nations throughout history have demanded that their subjects pay tribute in a number of ways. There were taxes on property, income, status and occupation. Many taxes were paid in kind, with part of the grain, cattle or other wealth that someone raised or produced.

Taxes were used to pay for wars of expansion, to enrich kings and aristocrats, to control imports and exports and to crush conquered peoples. Some rulers striving to maintain power used tax cuts to win favor. Others levied to make their states strong militarily, while encouraging trade and individual enterprise.


The first graduated income tax was recorded in Greece 2,600 years ago. It imposed the highest rates on citizens with the greatest honors and wealth. Solon, the ruler at the time, also legalized and taxed prostitution and used the proceeds to erect a temple.

About 150 years later, under the statesman Pericles, democratic Athens had traffic tolls, harbor dues, import and export tariffs, per-head taxes (called poll taxes) on freemen and slaves, a sales tax, license fees and a levy on property with rates rising according to wealth.

The Ptolemy dynasty, the Greek dynasty that ruled Egypt after the death of Alexander the Great, set standards for efficient government and taxation. The rulers protected their own products, such as olive oil, with high tariffs on imports. Peasants paid fees to keep cattle and graze them on common land. Farmers gave as much as half their produce to the state.

There were tolls and poll taxes as well as taxes on salt, catches of fish, legal documents, legacies and the sale and rental of goods. An army of scribes registered private property and kept track of taxable products and transactions. The government hired tax collectors and held their possessions as security until they delivered the taxes they were responsible for collecting.


Rome's senate and later its emperors were adept at draining the resources of its vast domains. As the empire tottered toward collapse in the 4th and 5th centuries A.D., Rome became infected with an epidemic of tax evasion.

In the 4th century, a special police force was created to examine every man's property. Wives and children were tortured to make them reveal hidden wealth. Eventually, aristocrats refused to accept positions and honors simply to avoid the taxes the positions would bring. Skilled artisans left their trades and ordinary citizens abandoned their homes and found refuge among the so-called barbarians.

In the end, according to Will Durant in Caesar and Christ, Rome fell because of decaying morals, failing trade, bureaucratic despotism, consuming wars, declining population and "stifling taxes."

War and Taxes

Taxes were a cause of the American Revolution and the Civil War. They also helped pay for them.

The idea of paying for wars with income taxes came from British Prime Minister William Pitt, who instituted a tax on income in 1799 to pay for Britain's prolonged war with Napoleon. The British income tax remained in force until 1816, a year after Napoleon's defeat at Waterloo. A peacetime economic crisis in 1842 restored the income tax in Britain for good.


The colonies in America spent little for public purposes. Colonial government got most of the modest revenue it needed from per-head taxes (called poll taxes), property taxes and taxes on products.

In 1643, the colonists of New Plymouth, Massachusetts, adopted a forerunner of the income tax called a faculty tax. It was applied to people according to their "faculties," or their property and ability to earn income from commerce or a skilled trade. During the American Revolution, from 1775 to 1783, most of the 13 states levied faculty taxes.

The distant British Parliament's efforts to dominate the colonies through import taxes on molasses, sugar and tea intensified the misunderstandings between the New World and the Old and led directly to the Revolution. "Taxation without representation is tyranny" became the watchwords of independent thinkers in the 1760s.

When the two-million-plus American colonists protested against taxation without representation, the British responded with more colonial taxes and sent more troops to the colonies to crack down on resisters. Until then, the colonies had been rivals only of each other.


There was no national U.S. tax system until several years after the Revolution. To pay for freedom from Britain, the Continental Congress printed paper money and borrowed money from France -- Britain's age-old enemy. When the war for liberty was won, the bankrupt national government defaulted on its debts.

The Constitution of 1789 gave taxation powers to the new federal government. The states agreed to a strong central government with ample power to collect taxes "to pay the debts and provide for the common defense and general welfare of the United States."

Under George Washington and John Adams, Congress enacted a broad system of taxes on carriages, liquor, salt, sugar, snuff, legal documents, bonds and auction sales. A tax on homes, land and slaves was added in 1798.

The third president, Thomas Jefferson, championed the common man and opposed the domestic taxes of his predecessors. He saw to it that many of their taxes were repealed.

In the 19th century, war brought new tax burdens to the American people. Various taxes were revived during the war of 1812 against the British. Still, until Abraham Lincoln's inauguration in 1861, taxes on American property and goods played only a small role in government revenues. Even in 1862, the second year of the Civil War, taxes on imported goods accounted for $49 million of the federal government's total receipts of $52 million.

Taxes on imported goods -- also called customs duties or tariffs -- were a bone of contention between the North and the South. Northern manufacturers wanted high tariffs to protect their products against lower-priced imports. Southern planters wanted low tariffs to keep their imported goods cheap.

To help pay for the Civil War, Lincoln approved a three percent tax on annual incomes between $600 and $10,000 and a five percent tax on higher incomes. The rates soon increased to 10 percent on income over $5,000.

Less than 1 percent of the population paid income tax during the Civil War, and income-tax revenues made only a small contribution to the war effort. The Civil War income tax was repealed in 1872.

The Constitutional Debate

The pros and cons of an income tax continued to divide the country after the Civil War.

In the 1890s, the country became embroiled in a fierce constitutional debate over the government's right to levy income taxes. Farm, labor and small-business groups led by Democrats and Populists in Congress won an enactment of a new 2 percent income tax in 1894. The tax applied to corporate net income and to personal income over $4,000, including gifts and inheritances. Like the Civil War income tax, this tax affected only a small percentage of the population, mostly well-to-do Easterners.

Opponents of the new tax, led by Republican business interests, filed lawsuits challenging its constitutionality. In 1895, the Supreme Court rejected the income tax as unconstitutional.

Political moods shifted at the turn of the century. Progressive Republican senators broke with their party's leaders on the income-tax issue. In 1908, his last year in office, Republican President Theodore Roosevelt called for an income tax and an inheritance tax.

The new Republican president, William Howard Taft, opposed income taxes. But, fearing defeat in Congress on the issue, Taft and conservative Republican leaders agreed in 1909 to the proposal of a constitutional amendment to permit a personal income tax. The conservatives hoped that the amendment would never be ratified by the 36 states it needed. But the maneuver failed.

The 36th vote for ratification was cast less than four years later, in February 1913. Adoption of the 16th Amendment made income tax as much a part of the Constitution as if the Founding Fathers had written it.

On October 3, 1913, Woodrow Wilson, a Democrat who had been elected president in 1912 on a platform supporting an income tax, signed a bill that enacted the modern income tax. The new law was written in 21 sections covering just 16 pages.

THE 1913 TAX

Wilson's new income tax was conceived more as an instrument of social fairness than as a revenue producer. It took effect starting March 1, 1913, and produced just $35 million in personal and corporate tax revenue for the remaining 10 months of the year. Only 357,598 personal returns were filed for 1913.

The basic rate was 1 percent on taxable personal income above $3,000 for a single person and $4,000 for a married person. There was a "super tax," or additional tax, on income above $20,000. The super tax rates rose to 6 percent on income above $500,000, making the highest rate 7 percent.

With the onset of World War I, income taxes soon became the mainstay of the federal revenue system and a major tool for carrying out government policy. After the U.S.'s entry into the war, 2.7 million Americans paid income taxes totaling $180.1 million for 1917.

Why Taxes Go Up and Down

While it is certain that taxes will never go away, every now and then they actually do go down.

After the income tax became a permanent fixture in American life, wars proved to be the chief catalyst for income-tax increases. Taxes were raised to pay for the two world wars, the Korean War and the Vietnam War. Taxes were also raised in times of economic stress, as they were in the Great Depression of the 1930s to pay for increased government spending.

Taxes were lowered during peacetime prosperity. They were cut four times during the 1920s and again in 1948, 1962 and 1964. In the 1970s, they were lowered five times.


After 1945, the federal government sought revenues to help other countries recover from World War II. As a world leader, the U.S. also financed foreign resistance to aggression by the Soviet Union and China.

At home, the government used the income-tax as a lever to promote prosperity, solve economic problems and achieve the American promise of social welfare and equality. As a result, the income-tax laws grew more and more complicated.

But the government also saw the need to make taxes fairer, simplify the rules and block tax avoidance by those clever enough to spot unintended loopholes. These forces were at work in the tax acts passed in the 1950s, 1960s and 1970s.


Today, tax increases and decreases are the result of political compromises in Washington. These tax debates often pit the theories of the nation's leading economists against each other.

The tax cut of 1981 is a good example of how economic theory can change national tax policy. The tax cut, led by Republican President Ronald Reagan, was guided by a group of economists known as the supply-siders. They argued that cutting tax rates across the board would stimulate the economy. The theory was that thriving businesses, invigorated by the tax cut, would eventually contribute more tax revenue than they had before.


Besides tax rates themselves, the chief reason taxes go up or down for most individual taxpayers is the enactment or the repeal of tax deductions, tax shelters and tax credits. Many of these tax breaks have worthwhile economic and social purposes. Some goals are to stimulate investment in new businesses, step up research, encourage long-term saving, help charities, ease the burden of medical expenses and promote individual home ownership.

On the negative side, tax breaks tend to distort financial decisions. Consider two families earning the same income and occupying homes of equal value. By owning its borne, one family deducts mortgage interest and pays less income tax than the other family, which rents its home. Ultimately, tax breaks divert the course of the economy. People and companies invest and spend money to avoid taxes -- not always with the best results.

The effects of tax breaks ate often hard to understand. Many ordinary Americans believe the tax system works against them -- and for the rich. Consequently, since 1986, curbing tax breaks has become one of the chief objectives of tax legislation. The efforts have been only moderately successful.


While tax payments per person have risen steadily in dollars since the 1960s, the tax burden on Americans has stayed about the same. Economists measure tax burden by computing the total taxes paid as a percentage of gross domestic product (GDP). Federal taxes of all kinds took 18.6 percent of the GDP in 1993, not far off the 18.1 percent figure of 1968.

For federal, state and local taxes combined, the story is the same. Taxes at all levels of government claimed 27.8 percent of the GDP in 1991. That figure was in the middle of the range over the previous 25 years.

While the tax burden on Americans has remained fairly constant, sources of revenue frequently seesaw. As one kind of tax is reduced, another is likely to increase. When income-tax rates went down in the 1980s, Social Security and Medicare taxes went up. When the federal government gave less aid to state and local governments, state and local taxes went up.

Tinkering with Taxes

Taxes in the 1980s and 1990s have been altered almost annually by reforms and revenue demands.

Revenue, rates and general tax policy became a prime focus of public and political attention in the 1980s and 1990s. The 14 years from 1981 through 1993 brought eleven major tax acts -- including six since 1986.

The 1981 tax act was designed to deliver the largest tax cut ever to businesses and individuals. The cuts were supposed to total more than $748 billion over six years.

For individuals, the act lowered the tax rate for the top income bracket to 50 percent from 70 percent and lowered the maximum tax rate on capital gains to 20 percent from 28 percent. The act also cut estate taxes and added incentives for contributions to pension plans and individual retirement accounts.

The 1982 and 1984 tax acts reversed, rewrote or temporarily suspended many major provisions of the 1981 tax act. The two acts also cracked down on tax shelters and provided tougher measures to enforce compliance.

A surprising coalition of conservatives and liberals in both political parties came together in 1986 with the common goals of lower tax rates and tax-code simplification. They forged a sweeping bill that made many fundamental changes in the tax code.

Few laws have affected so many Americans as deeply as the Tax Reform Act of 1986. It took four million people off the income-tax rolls and demolished most tax shelters, making it harder for the wealthy to escape taxes. The act also brought the largest tax increase ever for corporations. Key business deductions and credits were restricted or repealed.


The costs of lobbying Congress and government agencies became a deductible business expense in 1962. Former congressmen and government bureaucrats who could exert influence for special-interest groups soon ranked among the highest-paid people in the country. Meanwhile, businesses represented by lobbyists enjoyed hefty tax write-offs.

The 1993 tax act repealed the deduction for most lobbying activities at the federal, state and local levels.

Main provisions of the 1986 Tax Reform Act:

* The 1986 Tax Reform Act trimmed the number of tax-rate brackets to two: 15 percent and 28 percent. A 5 percent surcharge raised the top effective rate to 33 percent. Previously, there had been 15 brackets ranging from 11 percent to 50 percent.

* It increased personal exemptions and the standard deduction.

* Long-term capital gains on investments were taxed at the same rates as other income. The lower rate was abolished.

* Deductions far sales taxes and for interest on consumer debt -- such as credit cards -- ended.

* The Act laid more restrictions on deductions for medical expenses, payments to individual retirement accounts, miscellaneous items and interest costs of money borrowed for investment.

* The deduction for interest on a home mortgage was limited to two homes.

* The alternative minimum tax (AMT) paid by people who escaped the regular tax went up by one percentage point to 21 percent.

The 1990 tax act phased out the benefits of personal exemptions and some itemized deductions claimed by many well-heeled taxpayers. It also raised the alternative minimum tax (AMT) to 24 percent from 21 percent and imposed luxury taxes on expensive automobiles, boats, planes, jewelry and furs. But it revived the tax break for long-term capital gains and set a maximum rate of 28 percent.

In 1993, a fourth rate bracket of 36 percent was added. A 10 percent surtax at the highest income level created ah effective top rate of 39.6 percent. Here are other highlights of the 1993 tax act:

* The alternative minimum tax (AMT) was raised to two tiers -- 24 percent and 28 percent.

* Some business-expense deductions were limited further.

* The tax on Social Security benefits was raised for upper-income people.

* Pension contributions for upper-income people were restricted.

* Most of the new luxury taxes were repealed -- but not the one on expensive autos.

Tax Brackets and Marginal Rates

The U.S. income tax is a progressive (or graduated) tax designed so that people pay an increasing percentage rate as their income rises.

The range of income subject to a particular tax rate is known as an income or tax bracket. For tax year 1994, there are five brackets: 15 percent, 28 percent, 31 percent, 36 percent and 39.6 percent.

The highest rate you pay, on your last dollar of income, is known as your marginal tax rate. If you earn enough to be taxed above the lowest tax rate, the effective or average tax rate you pay on all your taxable income is lower than your marginal tax rate. That's because the amount of income you have in each bracket is taxed at that bracket's rate.


In times of high inflation, taxpayer income rises, but buying power doesn't. In the past inflation also meant that rising income nudged taxpayers into higher tax brackets. They more tax even though the real value of their earnings stayed the same or went down.

This event became known as "bracket creep." It was, in effect, a hidden tax increase Congress didn't have to legislate. Many felt it was unfair. To remedy this, tax brackets, along with the personal exemption, the standard deduction and some other tax factors, have been indexed for inflation since 1985. That means the brackets and other factors are raised automatically every year in proportion to the increase in the cost-of-living index.

Indexing stops bracket creep and even provides a tax cut for people whose income stays the same from year to year.


Social Security taxes are called FICA taxes, short for the Federal Insurance Contributions Act. For 1994, an employee pays a tax of 6.2 percent on salary up to a ceiling of $60,600. The employer pays ah equal amount. (There is no Social Security tax on pay above that ceiling.) Self-employed people are taxed at 12.4 percent, up to the same pay ceiling.

The Medicare tax is 1.45 percent for an employee and 1.45 percent for an employer on all wages and salaries. If you're self-employed, you pay both halves, or 2.9 percent. There is no ceiling for the Medicare tax.

The share of federal revenue derived from these taxes has more than doubled since 1962. That share was 35 percent in 1993, or nearly $412 billion.

Types of Taxes

Not all taxes are equal: Some take more from the rich; others are tougher on lower incomes.

Flat taxes are the simpliest of all taxes because they rail on everyone at the same rate. Besides simplicity, the advantages of flat taxes are that they offer the lowest rates possible and eliminate tax breaks.

While some states have used flat taxes on income, repeated proposals at the federal level have yet to win broad support. This is because flat taxes are regressive taxes which shift much of the tax burden away from those with the highest incomes to those with middle and low incomes. A sales taxes, for example, is a regressive tax because it is levied on everyone at the same rate. Sales taxes take a bigger slice of income from poor people, who spend most of it on life's necessities.

The federal income tax is a progressive tax because it takes more from those who are able to pay more. The progressive income tax has long been in favor because it is based on the ability to pay.

A surtax is a tax placed on top of another tax. It is a way to collect additional taxes on incomes that exceed a threshold without changing the basic tax rate. The 1993 tax act, for example, placed a 10 percent surtax on the highest tax rate.

Income Tax

There are many types of taxes beside the progressive personal income tax we are all familiar with.

Corporations pay income taxes on their profits. Then individual shareholders pay personal income taxes on dividends that corporations pay.


The corporate income tax is imposed on net corporate income -- total income minus deductions for business expenses. The top corporate income.tax rate generally is lower than the top individual rate. From 1988 to 1992, however, it was one percentage point higher.


The 1921 tax act first established a lower rate for gains from the sale of assets than for ordinary income. The lower rate for capital gains reflects the strong belief that tax law should encourage investment -- particularly in risky ventures -- and shouldn't overtax gains caused simply by inflation.

Luxury Taxes

Luxury taxes are excise taxes levied on specific high-ticket purchases. They are aimed squarely at high-income taxpayers, and are therefore a good example of a tax that targets a specific income group. The 1990 tax act, for example, imposed a 10 percent luxury tax on the purchase of expensive cars, boats, planes, jewelry and furs.


The VAT -- short for Value-Added Tax -- is a national sales tax used throughout Europe and in many other countries. It's often proposed as a simple way to supplement or even to replace the U.S. income tax.

The VAT is imposed on sales at each stage in the production of something of value. The tax starts on the sale of raw materials and follows the item through the normal production cycle. Manufacturers, distributors and retailers pay the VAT on their purchases and collect it on their sales to the next link in the economic chain.

As with a sales tax, the total accumulated tax tab is passed on to consumers. In some countries, consumers pay a VAT that exceeds 20 percent.

Many tax experts in and out of government expect the U.S. to have a VAT some day. But at the moment, the odds are against it. Like a sales tax, the VAT is regressive. Beyond that, imposing a VAT increases prices sharply.

A VAT can be complicated for businesses and tax collectors. It Interferes with the ability of states and cities to levy sales taxes. Critics also say it would be much too tempting for Congress to raise lots of spending money with what looked like a small VAT increase.

Excise Taxes

Excise taxes are imposed on the manufacture, sale or consumption of certain items. The best-known excise taxes are on tobacco, alcohol, motor fuels, crude oil, automobile tires, guns, fishing equipment, telephone services and airline tickets.

The revenues from some excise taxes end up in special trust funds that are used to improve highways and airports and to clean up hazardous chemical spills. The Treasury's Bureau of Alcohol, Tobacco and Firearms, not the IRS, collects the excise taxes on the products specified in its name.

Sales Taxes

Since the 1930s, 45 states have added taxes on retail sales to their revenue-collection arsenal. Only five states -- Alaska, Delaware, Montana, New Hampshire and Oregon -- do not have sales taxes.

Although taxes on retail sales continue to creep upward, the most notable trend is to apply sales taxes to more kinds of services. Many states are also trying to force out-of-state catalogue merchants to collect state sales taxes.

The highest sales tax in the U.S. is collected at New Orleans International Airport. The rate is 10.75 percent.

Property Taxes

Property taxes are taxes on the value of property -- primarily real estate. Some states have taxes on autos and personal property other than real estate.

Until the Great Depression, property taxes were the mainstay of state revenues. With the prevalence of state sales taxes, property taxes generally became the province of local governments. Today some 75 percent of the total revenue of all cities, counties and other local governments across the country comes from property taxes.

Estate and Gift Taxes

The federal estate tax is imposed on the property of someone who dies if the total value of the property, or estate, is more than $600,000. The federal gift tax is imposed on someone who makes a personal gift with a value above a certain amount. It doesn't apply to charitable gifts. The rules for both taxes are covered on p. 23.

State and Local Taxes

Governments close to home are responsible for providing the major services of daily life.

State and local governments impose a broad variety of taxes on income, sales and property that bring in nearly a third of all U.S. tax revenue. Since 1980, the tax load has moved ever closer to home as the federal government cuts back on its financial aid to states and states have trimmed aid to localities. Local governments' share of all taxes collected from Americans rose to 12.7 percent in 1991 -- an increase of 15 percent from 1981's share.


State income-tax rates are much lower than federal rates. The structure of state taxes varies widely. Some are fiat taxes (see p.18), some are tied to the federal tax, and others are similar to the federal tax, but with variations.

Hawaii, then a U.S. territory, adopted personal and corporate income taxes in 1901, 12 years before the federal income tax. Now 43 states have some kind of income tax. Most recently, Connecticut adopted an income tax in 1991. It was the first to do so since New Jersey in 1976.

Taxpayers in a few states may deduct their federal income taxes on their state returns.

Over half the states don't tax Social Security benefits. Some-including Hawaii, Illinois, and Pennsylvania -- exempt all or part of a retiree's pension income from tax. Yet California not only taxes the pension income of its residents, but also demands tax payments on the pension income of former residents who have moved to other states.

Although the income tax generally is considered to be the fairest kind of levy, resistance to it is high in states that don't have one. Seven states don't tax any personal income. They are Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. New Hampshire and Tennessee tax only interest and dividend income.

States that don't tax income tend to rely on sales or property taxes. Only two states, Alaska and New Hampshire, have neither income or sales taxes.


Taxes on retail sales and real estate produce the largest portion of state and local revenue. Other state taxes fall on alcoholic beverages, cigarettes, motor fuels, and the extraction of natural resources such as oil, gas, coal, metals and timber.


Seventeen states still have inheritance taxes, which are paid by heirs on the bequests that they receive. But the trend is toward estate taxes like the federal government's, which apply to a whole estate before its assets are parcelled out. All the other states do that.

LOCAL INCOME TAXIS Personal income taxes account for about 5 percent of local tax revenue nationwide. In Pennsylvania, 2,800 municipalities and school districts get revenue from income taxes. Over 1,000 local jurisdictions in 12 other states have income taxes.

Taxes on the Wealthy

The wealthy must cope with special taxes ordinary taxpayers don't have to pay.

Whether or not you believe that wealthy people pay their fair share of taxes, they pay a much higher percentage of the total income tax collected than average Americans pay.


While wealthy people pay a share of total income taxes that is out of proportion to their numbers, some have been able to manipulate their taxes so well that they pay far less tax than seems fair.

That is because they take advantage of legal tax breaks, called preferences, which are significant deductions and credits for expenses that affect only certain kinds of income. Preferences usually involve complex financial arrangements like incentive stock options (ISOs), which give executives the right to buy stock at favorable rates, as well as major deductions for state and local income taxes, tax-shelter losses and the depreciation of business property (activities like drilling and mining are a major category here).

In 1969, Congress tried to limit the financial manipulations open to wealthy taxpayers by enacting a minimum tax. The law now requires that certain people pay an alternative minimum tax, orAMT. The AMT involves complicated calculations. Taxpayers who benefit from preferences must figure out the tax they would pay under the regular tax rules, and then figure what they would pay under the AMT rules. If their AMT tax bill is higher than the regular tax bill, then they have to pay the AMT.

Generally speaking, the AMT is harsher than conventional taxes because many of the preferences are disallowed. Therefore, the AMT is something you'll want to avoid.

You calculate the AMT on Form 6251. For more information, see the instructions for Form 6251 and Publication 909, "Alternative Minimum Tax for Individuals."

The IRS estimates that only 273,000 taxpayers paid the AMT for 1992. But it's likely that several hundred thousand more paid tax experts to calculate whether they owed the AMT or not.


Historically, estate and gift taxes have been seen as a way to discourage the handing down of concentrated wealth from generation to generation. This reasoning is still questioned and debated but the taxes remain.

Estate and gift taxes are known as transfer taxes. They are imposed on the privilege of transferring property to someone else, most often a relative. Estate taxes are imposed on the estate', gilt taxes are imposed on the giver.

A single rate structure applies to estate and gift taxes. That rate structure applies to estates as well as to gifts made while the donor is still alive. The rates range up to 55 percent on transfers over $3 million.

Gifts and bequests to spouses aren't taxed. Neither is $600,000 of a total estate left to others.

The law also permits you to give up to $10,000 a year to each one of any number of people without paying tax on the gifts.

Taxes on the personal gifts that people give while they are alive and on the estates they leave after they die provide about 1 percent of federal revenue. In 1993, they came to less than $13 billion.

How Tax Law Is Made

A tax can be fair or it can be simple, but not both.

The conflict between fairness and simplicity arises in the drafting of almost every tax law. Tax experts often cite this rule of thumb: The fairer a tax law is, the more complicated it gets. It's extremely difficult to make a tax fair to everyone and simple at the same time.

The earned-income credit is a good example. It provides tax relief to the working poor. But while it is fair, it is extremely complicated. So complicated, in fact, that many of the poor who use the credit have to pay tax-return preparers to calculate it for them.


Entertainer George M. Cohan is remembered for composing "I'm a Yankee Doodle Dandy" and "Give ,My Regards to Broadway. He has a memorable niche in tax-law annals, too.

When Cohan couldn't produce receipts to support deductions of $55,000, the government refused to let him deduct them. Cohan took his claim to the courts. Luckily for Cohan, a U.S. Court of Appeals believed he had legitimate expenses, even if he couldn't prove the exact amount.

In 1930, the court ordered the government to "make as close an approximation as it can, bearing heavily, if it chooses, upon the taxpayer whose inexactitude is of his own making."

The decision established the "Cohan rule" which lets taxpayers estimate deductions in certain circumstances. While still a viable rule, taxpayers should not rely upon it. The IRS is increasingly requiring substantiation of claims with paper documentation. And the courts are supporting the IRS.


When Congress pulled the tax laws together in 1939 to form the first Internal Revenue Code, it created a single volume of 502 pages. By 1993, the code had more than quadrupled in size.


The Constitution explicitly bars Congress from taxing exports from any state. The courts have decided that the Constitution also implies that the federal government may not tax state government functions. That's why interest income from state and local bonds is tax-exempt.

The Senate changes or adds to the tax bill

The Senate may debate and even adopt a resolution on taxes before the House does. But the Senate resolution must wait to be attached to a tax bill passed by the House. If the Senate changes or adds to a bill passed by the House, the House may vote on it again.

Usually, if the two houses disagree, they refer the legislation to a third committee drawn from the two tax committees. This "conference committee" works out a compromise to submit to both houses.

The Joint Committee on Taxation drafts the final bill

The Joint Committee on Taxation is a full-time congressional committee composed of 10 senior members of the House Ways and Means and Senate Finance committees. This bipartisan committee has the power to review taxes and their effects. Its large staff of experts advises lawmakers on the technical drafting of tax legislation and estimates the revenue effects of pending legislation.

The tax bill passes both houses and is signed into law by the president

After the House and Senate approve a tax bill, it goes to the president for his signature or veto. Republican President George Bush, for example, vetoed a major tax bill passed by the Democratic,controlled Congress in 1992 because he didn't like several of its provisions.

After the president sign. s it, the bill becomes law. It is then subject to review by the courts.

The IRS must then interpret and modify the tax forms and its instructions to reflect the new tax law.


The judiciary branch reviews tax law as it does any other law. Taxpayers who dispute an IRS ruling may ask a federal court to interpret part of the Internal Revenue Code in their favor. They may also challenge the constitutionality of a law.

Decisions of the courts that rule on tax legislation or tax regulations become "case law." While the IRS must follow the decisions of the U.S. Supreme Court as precedents for other cases, it may choose not to accept a lower court's ruling as a general precedent.


Overwhelming as it is, the Internal Revenue Code is just the starting point for many parts of the tax law. The Treasury Department and the IRS are authorized to issue official regulations that spell out the meaning of the code in more detail. These regulations -- or "regs" as they are known in the trade -- have the force of law unless they are overturned by the courts.

The sheer volume of federal tax regulations has increased over six-fold from 1954 to 1994.


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