A Glossary of Tax Policy Terms

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A Glossary of Tax Policy Terms

August 26, 2002 7 min read
The Heritage Foundation

alternative minimum tax (AMT)
A provision in the tax code that requires certain individuals and businesses to calculate their taxes two ways and pay the government the larger of the two amounts. In general, the AMT takes effect when deductions are "too large" relative to income. This means that the tax often applies during economic downturns, when income falls but expenses remain relatively unchanged.

average tax rate
The overall share of income taken by the government. A taxpayer with $50,000 of income who pays $10,000 in taxes faces an average tax rate of 20 percent.

capital gains tax
A tax that applies when an asset is sold for more than its original purchase price. The tax applies to the "gain" that has occurred, but the taxpayer is not allowed to adjust for inflation.

charitable contributions deduction
Provision in the current tax code that allows taxpayers to deduct contributions made to charities which have been granted special status by the IRS.

consumption tax
Often associated with taxes collected at the cash register, but any system that does not double-tax savings and investments is a consumption tax. The flat tax and the "consumed-income" tax (basically an unlimited individual retirement account) are consumption-based income taxes.

consumption tax base
A tax system that treats all income equally. All income is taxed, but only once (though not necessarily at the same rate). In the case of the income tax, this means that there are no deductions, and income that is exempt (such as fringe benefits) is subject to the tax. Conversely, it also means that no income is taxed more than once, thus precluding capital gains or estate taxes.

death tax
A form of taxation under which the assets of taxpayers who accumulate "too much" savings during their lifetime are subject to a tax upon death. The rate for this tax reaches 50 percent. The 2001 Bush tax cut repeals the death tax in 2010, but the levy re-appears in 2011.

Amounts or types of income that can be excluded from taxable income. In addition to personal exemptions, taxpayers can take either a standard deduction or itemized deductions, such as home mortgage interest and charitable contributions.

Provision by which, for example, a business that invests $1 million buying a new machine is not allowed to fully deduct that cost when calculating its taxable income. Instead, it may deduct only a portion of the cost each year. Depreciation is complex, and it increases the tax burden on investment.

double taxation
A form of taxation under which any dollar of income is subject to more than one level of tax. The classic example is income that is taxed at the corporate level and then taxed again as dividend income when received by the shareholder. With capital gains taxes and estate taxes, it is possible for a single dollar of income to be taxed four times.

estate tax
See death tax.

flat tax
A single-rate tax system. A flat tax and sales tax are almost identical in that a flat tax imposes one layer of tax when income is earned and a sales tax imposes one layer of tax when income is spent. In either case, all income is taxed, but only once and presumably at a very low rate.

Robert Hall and Alvin Rabushka, the two economists at Stanford University who developed the simple and pure flat tax model.

itemized deductions
Write-offs for such expenses as charitable contributions, home mortgage interest, and state and local income and property taxes. A taxpayer may not use both itemized deductions and the standard deduction. Under the current system, more than 70 percent of taxpayers use the standard deduction.

marginal tax rate
The amount of additional earnings taken by government. The taxpayer with $50,000 of income may face a 28 percent tax rate on the next dollar of income earned, even though the average tax rate for this taxpayer's income is 20 percent. The marginal tax rate affects incentives to offer additional labor and/or capital to the economy.

marriage penalty
The many provisions in the tax code that cause married couples to pay more in taxes than they would pay if they were single and living together. Graduated tax rates account for the largest share of the marriage penalty.

mortgage interest deduction
Provision which allows taxpayers who itemize to deduct from their income each year the money they pay in mortgage interest.

national sales tax
A nationwide tax imposed on final retail sales of goods and services to the consumer. This tax presumably would apply to all goods and services and usually is discussed in conjunction with total repeal of the income tax.

A concept which argues that the tax system should not affect economic decisions. A neutral tax system, for instance, would not encourage either savings or consumption. Nor would it bias choices among types of consumption or types of savings.

personal exemption
An amount of income which the taxpayer is allowed to shield from tax. The current tax code, as well as most proposed reforms, grants exemptions for each additional dependent member of a household. This "zero-bracket" amount would increase with family size.

preferential treatment
Treatment which occurs if certain incomes or activities receive favoritism. In the case of a sales tax, for instance, a narrow base would mean that major items like food, shelter, clothing, and health care are not subject to the tax. Assuming that policymakers intend to collect a given amount of tax revenue, allowing preferential treatment for some items usually has the effect of increasing the tax rate on all other activities.

A system under which people with higher incomes must pay a higher percentage of tax on taxable income. This can occur because of a "graduated rate structure" that imposes higher statutory (or marginal) tax rates as income rises. Alternatively, the tax code can achieve "effective progressivity" by having a large personal exemption. Under the Armey-Shelby flat tax, for instance, a family of four making $30,000 pays no income tax (a zero percent rate), a family of four making $40,000 pays less than 3 percent of their income in taxes, a family of four making $50,000 pays 5.5 percent, and so on until the "effective" rate approaches 17 percent for those with very high incomes (16.94 percent for an income of $10 million).

savings bias
Double taxation of savings (with some exceptions, such as IRAs) by the current tax system. Income is taxed the year it is earned, and if the taxpayer chooses to save, the interest received is taxed. Income that is consumed, by contrast, escapes additional taxation. There are two ways to alleviate this anti-savings bias: tax-deferred or universal front-ended IRA treatment or yield-exempt, back-ended IRA or municipal bond treatment.

Sixteenth Amendment
An amendment to the U.S. Constitution which, ratified more than 80 years ago, allows the federal government to levy an income tax. Supporters of replacing the income tax with the national sales tax or VAT typically call for its repeal.

social engineering
Attempts by politicians to steer behavior by granting tax breaks or imposing tax penalties.

special-interest groups
Groups that seek favoritism in government policy.

standard deduction
Additional amount of money, similar to the personal exemption and based on filing status, that non-itemizing taxpayers may shield from income.

supermajority amendment
A proposed amendment to the U.S. Constitution that would require a two-thirds vote of both the House and Senate to increase taxes (either by raising rates or by expanding the amount of income that is taxable).

supply-side economics
School of thought which holds that taxes affect incentives to work, save, invest, and take risks.

tax base
What is being taxed, or the activity that bears the burden of the tax. How a particular tax reform defines the tax base is one of the most important elements of that reform.

tax credit
Amount of money that can be deducted directly from a taxpayer's tax liability, and thus is more valuable than a deduction. A $500 credit, for instance, reduces a taxpayer's total bill by $500, while a $500 deduction simply reduces the taxpayer's taxable income by that amount. (For a taxpayer in the 15 percent tax bracket, a $500 deduction produces a tax saving of $75).

individual retirement accounts (IRAs)
Accounts which allow taxpayers to protect savings from double taxation. With traditional IRAs, income that is saved is free from tax, but there is a tax levied on principal and interest when the money is withdrawn (taxing all income only one time). With back-ended (Roth) IRAs, the income is taxed the year it is earned, but there is no second layer of tax on any future interest.

tax expenditure
Provisions of law granting preferential tax status on the basis of how income is earned or spent. The word "expenditure" is used to highlight the similarity between the use of the tax code to provide advantages to a select group and the more traditional method of giving the group a slice of the federal budget. The proper definition of a tax expenditure, needless to say, would require a proper definition of the tax base.

tax limitation amendment
See supermajority amendment.

tax shelter
A loophole in the Internal Revenue Code that people use to lower their tax liability.

value-added tax (VAT)
A form of sales tax under which the tax is levied on the value to a product that is added at each stage of the production process.

wealth tax
A tax levied on wealth directly, on changes in the value of wealth, or on transfers of wealth. Estate taxes and capital gains taxes are wealth taxes. Assuming that the income used originally to create the wealth has already been taxed, most wealth taxes are examples of double taxation.


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