The U.S. federal tax system is complicated and fascinating. Many parts of the tax code are far from intuitive, and the nitty gritty of tax reform and debates seem difficult to comprehend. Regardless, the tax system quietly affects many aspects of our economy, interacts with social policies, create distributional effects, and shapes business and personal decisions. For example, tax policies incentivize investments by creating a lower tax rate than for wage income. They also encourage charitable donations, retirement savings, and higher education through deductions. At the same time, the system makes room for strategy and planning, which can trap the unwary and uninformed, while giving the wealthy and resourceful a big advantage.
I would highly recommend all law students, regardless of interest, to take a course on the federal income tax system. Even if you do not plan to practice tax law or a closely related area, understanding how the tax system works will be helpful as a practicing lawyer, as well as for filing your and your family’s annual tax returns or figuring out income based repayment. Here is my primer on Federal Income Tax, in which I highlight a few key topics discussed in my class.
Filing status and tax rates
The United States does not have a flat tax system, where everyone pays the same tax rate regardless of their total income. Rather, the system attempts to promote fairness and equity by treating individuals differently, depending on their filing status and income level. Thus, an individual’s tax burden varies based on whether they file as single, married filing separately, married filing jointly, or head of household, and based on how much they make. There is also a lower tax rate for capital gains, which most commonly occur when a stock goes up in price, resulting in profit when it is sold.
Realization and deferral
While all income is supposedly taxed, when this income is taxed is a separate question. There is a realization requirement in the tax system, which means that no tax is paid on the increase (or decrease) in value until a realization event, often a sale of the asset. For example, if you purchase a home and the value goes up threefold during your period of ownership, you do not paid taxes on the increase in value during the interim, not until you sell the house. The rationale is to avoid a valuation problem: Especially when the asset is not publicly traded, like a one-of-a-kind painting, it is difficult to value. The system prefers to look to a concrete transaction in order to measure the gain (or the loss) from the sale.
This realization requirement has two major consequences. One, individuals have control over when to sell their assets, and thus control over when to pay the tax liability. Two, this allows people to defer their tax liability to the future by not selling, which is advantageous due to the time value of money. The drawback is a lock-in effect: people hold on to assets that may be more useful or valued in other hands.
Tax and redistribution of wealth
The tax system offers two types of credits as anti-poverty measures. First, the Earned Income Credit is a subsidy for low-income working families – it is the largest cash transfer program in the country and the credit is claimed by approximately one in five taxpayers. Second, the Child Tax Credit reduces taxes for families with “qualifying children.” Both credits assist low-income families, while encouraging them to work by instituting a work requirement. While these programs were incorporated in the tax system for efficiency reasons, the unfortunate reality is that some of the neediest household and children do not receive the credits, or the benefits go unclaimed due to failure to file. Thus, these credits are imperfect and have become the subject of debates and reforms.
Evolution of tax
The tax system is everchanging due to legislation in Congress, regulations issued by the Internal Revenue Service, and decisions issued by courts. As I write, reforms to the Child Tax Credit are being implemented, and there is intense debate about how tax policies should treat the basis of gifts of property transferred upon death, an area that has greatly benefited already wealthy families and promoted intergenerational wealth. It has been incredibly stimulating and challenging to consider how the existing tax system is bound up with social policies and goals, and how it should evolve to better meet societal needs and problems.
While tax is not an easy subject, it has been one of my favorite classes. This introduction does not do justice to the depth of the subject matter and its many nuances. I hope you will enroll in a federal income tax course at your law school and see it for yourself!
For why every law student should take a tax class, check out this article.
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