Federal Individual Income Tax Terms: An Explanation

CRS Report for Congress
Federal Individual Income Tax Terms:
An Explanation
Updated June 20, 2006
Pamela J. Jackson
Analyst in Public Sector Economics
Government and Finance Division

Congressional Research Service ˜ The Library of Congress

Federal Individual Income Tax Terms: An Explanation
Summary
The most commonly used terms in discussing the federal individual income tax
are described in this report. Most of these tax terms are explained in the order that
they occur in the process of determining one’s income tax on the Form 1040. Even
before sitting down to calculate taxes, however, most individuals have a general idea
of their total economic income, which is the broadest measure of all income, whether
tax-relevant or not, and is an economic concept rather than one contained in the tax
code. Gross income is the sum total of all income required to be reported for tax
purposes before adjustments to income are made for special types of expenses which
Congress has determined should be considered in calculating gross income. These
adjustments function like deductions, except that unlike deductions, adjustments are
calculated in arriving at adjusted gross income, and thus can be claimed by all
taxpayers, not just those who itemize deductions. An exclusion from income refers
to an item specifically excluded from determination of gross income.
Adjusted gross income (AGI) equals gross income less qualifying adjustments
to income. It serves as the base for computing limits on certain itemized deductions
and is the income measurement before deductions and personal exemptions are taken
into account. Deductions from adjusted gross income are allowed for certain types
of expenditures for which income taxation is deemed inappropriate or inadvisable.
Deductions function like adjustments and exclusions in their effect on tax liability.
In addition to the standard deduction, an additional standard deduction amount is
available to elderly and blind taxpayers. Personal exemptions are allowed for the
taxpayer, his spouse and each of his dependents. Exemptions affect tax liability like
deductions, adjustments to income, and exclusions.
Taxable income is adjusted gross income reduced by either the standard
deduction (plus the additional standard deduction in some cases) or itemized
deductions along with personal exemptions. Taxable income is the base to which the
income tax rates are applied to calculate income tax liability. Gross tax liability is
calculated by applying the marginal tax rate and structure to taxable income; it serves
as a base amount prior to subtraction of tax credits. Tax credits are subtracted from
gross tax liability to arrive at a taxpayer’s final tax liability. Hence, tax credits
reduce tax liability directly, on a dollar for dollar basis. Tax credits are available to
all qualifying taxpayers, whether they itemize deductions or not. Final tax liability
is the amount of federal income tax owed by the taxpayer to the federal government
after taking into account allowable tax credits. When a taxpayer’s final tax liability
exceeds federal taxes withheld, estimated quarterly taxes paid, and certain other
credits, then the taxpayer has taxes due and must pay the federal government
additional federal income taxes to cover the shortfall. A refund is a payment by the
federal government to a taxpayer whose withheld taxes and/or estimated tax
payments or refundable credits exceeded his final tax liability.
A flow chart illustrating the relationship among the income tax terms discussed
in this report appears on the final page.
This report will be updated as warranted by legislative events.

Contents
Economic Income.................................................1
Gross Income.....................................................1
Exclusions .......................................................1
Adjustments to Income.............................................2
Adjusted Gross Income (AGI)........................................2
Deduct i ons ......................................................2
Exemptions ......................................................3
Taxable Income...................................................4
Gross Tax Liability................................................4
Credits ..........................................................5
Final Tax Liability.................................................5
Taxes Due.......................................................5
Tax Refund.......................................................5
List of Figures
Figure 1. Relationship Between Individual Income Tax Terms..............6
List of Tables
Table 1. Marginal Tax Rates and Tax Amounts for 2006..................4

Federal Individual Income Tax Terms:
An Explanation
Economic Income
Economic income is the broadest measure of all income, and is an economic
concept rather than one contained in the tax code. Commonly referred to by
economists as the Haig-Simons definition of income, total or “net” income is defined
as increases in a taxpayer’s net worth plus the monetary value of consumption over
a given time period. Often, it is difficult to determine the exact amount of such
income. For example, a health club employee may be allowed free access to the
facilities after work hours by his or her employer. Under an economic definition of
income the use of the health club constitutes income because others would have been
required to pay for the use of the same club facilities. Another example of economic
but not monetary income is the imputed rental value of owner-occupied housing,
which is not subject to income tax.
Gross Income
Gross income is the broadest measure of income used for tax purposes. It is the
total of all realized income recognized by the tax law that is not specifically tax
exempt. It is measured net of business expenses but before any other deductions or
adjustments. It includes employee compensation such as wages, salaries and tips,
taxable interest and dividend income, business and farm income (net of expenses),
realized capital gains, income from rents, royalties, trusts, estates, and partnerships,
and taxable pensions and annuities. Gross income does not include items of income
explicitly excluded from tax (see the following section on “Exclusions”).
Exclusions
An exclusion is an item of income that is not included in gross income because
the tax code explicitly exempts it from tax. Examples of items of income which are
exempt¹ from federal income taxation and, hence, excluded from gross income, are
state and local bond interest income, public assistance (welfare), small gifts, and the

¹ The expression “tax-exempt” is used to describe types of income and organizations that
are not subject to taxation. Interest income from state and local bonds, for example, is
exempt from federal income taxes. Certain qualifying nonprofit organizations are exempt
from federal income taxation. The provisions are not, however, described as exemptions
on the tax return. They are more properly termed “exclusions.”

tax-exempt portion of pensions and annuities. Social security and railroad retirement
income may or may not be excluded from income subject to tax. The taxability of
social security and railroad retirement depends on the amount of other income the
taxpayer receives.
Also, not considered as taxable income are a clergy member’s tax-free housing
allowance, qualified foster care payments, and qualified scholarship and fellowship
grants. Under certain conditions, a taxpayer can exclude a limited amount of
disability pay such as workers’ compensation. Except for tax-exempt interest,
exclusions generally are not required to be reported to the Internal Revenue Service.
Adjustments to Income
Adjustments to income are those items of expenditure that are deducted from
gross income in arriving at adjusted gross income. These may include payments to
Keogh or traditional (but not Roth) individual retirement arrangements (IRAs),
forfeited penalty on early withdrawal of savings, interest paid on student loans,
moving expenses, and alimony payments. Adjustments to income function similarly
to deductions. However, unlike deductions, adjustments are made to arrive at
adjusted gross income, and hence can be claimed by all qualified taxpayers, whether
or not they use the standard deduction amount or have itemized deductions (see
“Deductions”).
Adjusted Gross Income (AGI)
Adjusted gross income (often referred to as AGI) is the basic measure of income
under the federal individual income tax. Adjusted gross income equals gross income
less qualifying adjustments to income. Components of adjusted gross income include
wages, salaries, tips, and other compensation, dividend and interest income, realized
capital gains, business and farm income, and income from royalties, trusts, estates,
partnerships, rents, and taxable pensions and annuities. The sum of income received
from these sources is reduced by the adjustments previously discussed to arrive at
adjusted gross income. Adjusted gross income serves as the base for computing
many limits under the tax law, such as those on the medical expense and
miscellaneous itemized deductions. Adjusted gross income is the income
measurement before deductions and personal exemptions are taken into account.
Deductions
Deductions from adjusted gross income are allowed for certain types of
expenditures of income for which income taxation is deemed inappropriate or
inadvisable. Deductions function like adjustments and exclusions in their effect on
tax liability. Deductions reduce a taxpayer’s tax liability, but only by a percentage
of the amount deducted. An individual in the 35% tax bracket would receive a
reduction in taxes of $35 for each $100 deduction while an individual in the 25% tax
bracket would receive a reduction in taxes of $25 for each $100 deduction. Hence,

the same deduction can be worth different amounts to different taxpayers depending
on their marginal tax bracket. More simply stated, the tax savings from deductions
is generally equal to the taxpayer’s tax rate times the amount of the deduction.
Deductions may be claimed by itemizing one’s deductible expenses or by taking
the standard deduction. Itemized deductions are allowed for many purposes,
including certain medical expenses²; state and local property, income, and a few other
taxes; home mortgage interest, points, and limited amounts of other interest paid (but
not personal interest); contributions to charitable organizations; certain casualty and
theft losses³ less $100 per event; investment expenses; tax preparation fees; certain
unreimbursed employee business expenses⁴; and a few other “miscellaneous”
expenses. These itemized deductions are then totaled and subtracted from AGI.
The alternative way in which deductions may be claimed is by using the so-
called standard deduction amount, which allows taxpayers to remove a fixed portion
of their adjusted gross income from taxation without itemizing deductible expenses.
The standard deduction amounts for 2006 are $10,300 for married taxpayers
who file a joint tax return; $5,150 for single taxpayers; and $7,550 for taxpayers who
qualify as the head of a household. An additional standard deduction amount is
available to those 65 or older and taxpayers who are legally blind. In 2006, this
additional standard deduction is $1,250 for each qualifying taxpayer filing a joint
return or qualifying widow(er) who is 65 or older or blind. The deduction rises to
$2,500 if the taxpayer is 65 or older and blind. If taxpayers are married and both
spouses are 65 or older or blind, an additional $2,000 is allowed on a joint return.
If both spouses are 65 or older and blind, an additional $4,000 is allowed on a joint
return. These amounts are adjusted annually for inflation.
Only individuals with deductions that can be itemized in excess of the standard
deduction find it worthwhile to itemize. These tend to be taxpayers in the middle to
high income ranges. The preliminary data for tax year 2003 indicate that
approximately 33.6% of taxpayers itemize their deductions.
Exemptions
Personal exemptions are allowed for the taxpayer, his or her spouse (if married
and filing a joint return), and each dependent. Each exemption claimed reduces
income subject to taxation by $3,300 for tax year 2006 (this amount is adjusted for
inflation annually). The personal exemptions combined with the standard deduction
amount are designed to remove low — income households from the tax rolls, and
exempt a minimum level of income from taxation for other families.

² Medical expenses in excess of 7.5% of AGI are deductible.
³ Casualty and loss expenses in excess of 10% of AGI are deductible.
⁴ Unreimbursed business expenses in excess of 2% of AGI are deductible.

Taxable Income
Taxable income, the narrowest measure of income used on the income tax
return, is equivalent to adjusted gross income reduced by either the standard or
itemized deductions and the personal exemptions. Taxable income is the base upon
which the income tax rates are applied to calculate income tax liability.
Gross Tax Liability
Gross tax liability is calculated by applying the marginal tax rate and structure
to taxable income. Gross tax liability serves as a base amount prior to subtraction of
tax credits. The marginal tax rate and tax amounts on taxable income for tax year

2006 are provided in Table 1.

Table 1. Marginal Tax Rates and Tax Amounts for 2006
If taxable income is:Then, tax is
Joint Returns
$ 0 - $15,10010% of the amount over $ 0
$ 15,100 - $61,300$1,510 + 15% of the amount over $ 15,100
$ 61,300 - $123,700$8,440 + 25% of the amount over $ 61,300
$123,700 - $188,450$24,040 + 28% of the amount over $123,700
$188,450 - $336,550 $42,170 + 33% of the amount over $188,450
$336,550 +$91,043 + 35% of the amount over $336,550
Single Returns
$ 0 - $7,55010% of the amount over $ 0
$ 7,550 - $30,650$755 + 15% of the amount over $ 7,550
$ 30,650 - $74,200$4,220 + 25% of the amount over $ 30,650
$ 74,200 - $154,800$15,108 + 28% of the amount over $ 74,200
$154,800 - $336,550$37,676 + 33% of the amount over $154,800
$336,550 +$97,653 + 35% of the amount over $336,550
Heads of Households
$ 0 - $10,20010% of the amount over $ 0
$ 10,750 - $41,050$1,075 + 15% of the amount over $ 10,750
$ 41,900 - $106,000$5,620 + 25% of the amount over $ 41,050
$106,000 - $171,650$21,858 + 28% of the amount over $106,000
$171,650 - $336,550 $40,240 + 33% of the amount over $171,650
$336,550 +$94,657 + 35% of the amount over $336,550

Credits
Tax credits are subtracted from gross tax liability to arrive at a taxpayer’s final
tax liability. Hence, tax credits reduce tax liability directly, on a dollar for dollar
basis.⁵ Tax credits are available to all qualified taxpayers, whether they itemize
deductions or not.
Tax credits can be divided into two categories, refundable and nonrefundable.
Refundable credits are those which can exceed tax liability, resulting in a direct
payment from the Treasury. (The direct payment is called a “refund” even when
nothing has been paid to be refunded.) Non-refundable credits can only be used to
the extent they eliminate tax liability; they cannot result in a payment that exceeds
original tax liability.
Examples of nonrefundable credits are the credit for the elderly and the
permanently and totally disabled, the credit for child and dependent care expenses,
and the foreign tax credit. The primary refundable credits are the earned income tax
credit and the child credit.
Final Tax Liability
Final tax liability is the amount of federal income tax owed by the taxpayer to
the federal government after taking into account allowable tax credits. Thus, final
tax liability represents the taxpayer’s total federal income tax bill for the tax year.
A taxpayer’s final tax liability may be negative, if the amount of refundable tax
credits exceeds his or her calculated tax bill before allowing for the credits.
Taxes Due
When a taxpayer’s final tax liability exceeds federal taxes withheld over the
course of the tax year, estimated quarterly taxes paid, and certain other credits, then
the taxpayer will owe the federal government an additional amount to cover the
shortfall in withheld or previously paid taxes.
Tax Refund
A tax refund is a payment by the federal government to a taxpayer whose
withheld taxes, estimated tax payments, or credits exceeded final tax liability,
entitling him or her to a refund to remedy having overpaid the tax bill. A taxpayer

⁵ A tax credit of a given amount reduces a taxpayer’s taxes by more than a deduction of the
same amount since it is subtracted directly from tax liability. For example, for each $1 tax
credit a taxpayer’s tax liability is reduced by $1, while each $1 deduction reduces income
subject to tax by the marginal tax rate of the taxpayer (e.g., $0.35 for someone in the 35%
tax bracket).

with negative tax liability may also be entitled to a tax refund, although this refund
is not a refund of overpaid taxes, but a payment of a negative tax.
A flow chart illustrating the relationship among the income tax terms discussed
in this report appears in Figure 1.

Figure 1. Relationship Between Individual Income Tax Terms
TOTAL INCOME
*
Less Exclusions
*
GROSS INCOME
*
Less Adjustments to Income
*
ADJUSTED GROSS INCOME
*
Less
+)))))))))))))))))))2))))))))))))))))))),
Itemized DeductionsorStandard Deduction Amount
.)))))))))))))))))))0)))))))))))))))))))-
*
Less Personal and Dependency Exemptions
*
TAXABLE INCOME
Use
+)))))))))))))))))))2))))))))))))))))))),
Tax Rate SchedulesorTax Tables
.)))))))))))))))))))0)))))))))))))))))))-
*
GROSS TAX
*
Less Tax Credits
*
FINAL TAX LIABILITY
*
Less Estimated Tax Payments and Withholding
*
+))))))))))))))))))))))))2)))))))))))))))))))))))),
ADDITIONAL or TAX REFUND
TAXES DUE