Income Tax Systems

Income Tax Systems

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A subject of much public policy debate amongst politicians, economists, and accounting professionals, income tax systems levy revenues for purposes of government budgetary spending. The question of how the tax burden should be distributed across a population of taxpayers, is the subject of much deliberation. While individual obligation to direct taxes on income (i.e., wealth, salaries, interest) are compounded by policy mandated indirect taxes (i.e., sales tax, tariffs etc.), income tax systems are generally discussed from the perspective of U.S. Generally Acceptable Accounting Principles (“GAAP”) and International Financial Reporting Standards (“IFRS”) reporting rules. This includes tax reporting of income from abroad.

Income Tax Systems Theory

Theoretically, there are three main income tax system models: 1) progressive; 2) proportional; and 3) regressive.

1) Progressive Tax Model

The progressive taxation model applies scalable calibration of fractional tax obligation. The model automatically adjusts the percentage of tax owed in line with income level. In other words, as taxpayer income fluctuates, the percentage of tax reported is adjusted accordingly. The progressive tax system is calculated on the “margin”, thus distributing tax attribution on a periodic basis. “Progressive” tax policies propose high-wealth taxpayers should pay more than taxpayers earning less, rather than assume there is an equal right to retained earnings regardless of income differentiation. Supporters of the progressive tax model reduce overall inequalities while inducing economic growth through a broadening of purchasing power across society.

2) Proportional Tax Model

The egalitarian assumption of the proportional taxation model states that all taxpayers are to pay an equal fraction of their income, regardless of income level. A “flat tax” model, tax rate does not fluctuate with changes in income increase (or decrease). Some economists criticize this model in the belief that proportional taxation is an unfair burden for those taxpayers occupying a lower income bracket.

3) Regressive Tax Model

The regressive tax model affords high-income taxpayers the smallest fractional obligation. The theory states that equality lies in the obligation to total tax owed, rather than proportional tax burden to income. The theory of regressive tax is more often applied to government incentives levied by sellers of goods and services (e.g. tax rebate of emissions-free vehicles). In this case, a regressive tax benefits higher-income taxpayers by incentivizing the sales tax environment. As a result, total income rises and the fractional assignment of tax decreases.

U.S. GAAP & IFRS Rules

The regulatory authority of the U.S. GAAP and IFRS rules for business income tax expense reporting require identification of any temporary effects of the difference between assets and liabilities within the entity’s book basis and tax basis. This is the substance of business tax reporting.

Both IFRS and U.S. GAAP require firms to measure income tax expense by reporting the balances in Deferred Tax Assets and Deferred Tax Liabilities at the beginning and the end of each annual cycle. Income tax expense is equal to current income tax payable plus or minus the credit or debit adjustments in the deferred tax accounts. The required deferred tax accounts on the balance sheet are: 1) cumulative temporary differences; 2) tax-rate applicable to future reversals of temporary differences; and 3) current GAAP valuation allowances for deferred tax assets. Any changes in those items during a reporting period, affect the amount of income tax expense for the year.

IRS Tax Reporting Requirements

In addition to U.S. GAAP and IFRS income taxation requirements, U.S. Internal Revenue Service (IRS) income tax rules mandate 1040 and 1040A form(s) tax filing of income from capital gains by individual owners of sole proprietorships, limited liability corporations (LLC), and partnership pass through entities as well as other tax reporting categories: Customs duties and tariffs; Estate and gifts taxes; Licenses and occupational taxes; Payroll tax; Property taxes; Sales and excise tax; Social Security and Medicare taxes; Unemployment tax; and User fees.

Periodic reporting of income tax expense in a firm’s audited financial statement equals the tax payable for the current period, plus estimated deferred tax liabilities owed minus any future retention of deferred tax assets when temporary differences are projected to be reversed. Depending on circumstance, temporary differences may dictate deferred tax asset status rather than deferred tax liabilities.

Deferred tax asset status arises when an audit recognizes earlier expense within a reporting period. For example, record of warranty costs includes sale for book purposes, yet is not claimed as a tax deduction in the same period and withheld for a future reporting period as an actual expenditure for the warranty repair. Similarly, bad debt reporting is customarily withheld for a future reporting period and recorded as an uncollectible account write-off.

U.S. GAAP rules provide that firms recognize valuation allowance reduction of the balance of deferred tax asset accounts to the amount of future estimated tax savings. Firms with future tax deductions (i.e. bad debts and warranty costs) are ineligible for tax deduction benefit. Downward adjustment of valuation allowance on a tax account balance is advised in cases where uncertainty of tax benefit in the future is estimated for the record of deferred tax assets.

The IFRS does not apply valuation allowance but permits firms to recognize deferred tax assets solely when there is estimate of sufficient taxable income for the future periods in which the deductible temporary differences are stipulated. Under the IFRS the amount of deferred tax assets must equal the net amount recognized minus the valuation allowance required by U.S. GAAP rules. In both circumstances, the estimated amount realizable is the reported value.

 Foreign Income Tax Systems

For those reporting income tax overseas, there are three international tax system models in existence: 1) Full inclusion model; 2) Territorial model; 3) Blended model. The full inclusion model is the traditional tax framework applied to expatriate income.

• Full Inclusion Model

All income regardless of source is taxed by the taxpayer’s native country in the full inclusion model. Allowable foreign tax credits are generally observed in cases where the same income is taxed by the host country or other jurisdiction where income has been accumulated. Under this model, the taxpayer owes the same tax amount regardless of current domiciliary or location of business. The full inclusion model is distinct from the two other standards of international taxation, in that rules of citizenship are discretionary.

• Territorial Model

The territorial model states that entities are subject to taxation by the taxpayer’s native jurisdiction, and solely for income earned within the country of origin. The fact that income is taxed only once means adjustment for foreign tax credit is unnecessary. The model applies to income tax reporting by entities with foreign operations with resident entities.

• Blended Model

Considered a solution to tensions between capital import neutrality and capital export neutrality, the blended model treats tax according to geographical source of income and location. In the blended model, income classification is defined by source, determining rules for apportionment and deductions.

Depending on jurisdiction the issue of double-taxation may arise for taxpayers reporting from a foreign income tax system. In jurisdictions signatory to bi-lateral income tax reporting agreements with the U.S. IRS are in force. Foreign jurisdiction tax treatment of offshore investment income and other income under treaty immunity makes exploitation of tax haven laws, transfer pricing, or other tax practices considered to be violations of IRS reporting transparency customarily pre-emptive under law. 

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Bibliography

“IAS 12 Income Taxes.” IFRS nd.

Agarwal, Prateek. ”Types of Taxes.” Intelligent Economist 30 Sept 2019. 

Chen, James. “Capital Gains Distribution.” Investopedia, 18 Mar 2020. 

Hall, Robert Rigley. “International tax systems and how to prepare for them.” IAMEXPAT 14 Nov 2017. 

“International tax systems, global mobility and wealth transfer.” International Adviser  16 Sept 2019. https://international-adviser.com/international-tax-systems-global-mobility-and-wealth-transfer/

Zader, Raphael. “Three Types of Tax Systems.” Quickonomics 13 Oct 2020.