Fiscal policy is the means by which a government adjusts its spending levels

and tax rates to monitor and influence a nation's economy. It is the sister strategy
to monetary policy through which a central bank influences a nation's money
supply. These two policies are used in various combinations to direct a country's
economic goals. Here we look at how fiscal policy works, how it must be
monitored and how its implementation may affect different people in an economy.

Before the Great Depression, which lasted from Sept. 4, 1929, to the late 1930s
or early 1940s, the government's approach to the economy was laissez-faire.
Following World War II, it was determined that the government had to take a
proactive role in the economy to regulate unemployment, business
cycles, inflation and the cost of money. By using a mix of monetary and fiscal
policies (depending on the political orientations and the philosophies of those in
power at a particular time, one policy may dominate over another), governments
can control economic phenomena.

How Fiscal Policy Works

Fiscal policy is based on the theories of British economist John Maynard Keynes.
Also known as Keynesian economics, this theory basically states that
governments can influence macroeconomic productivity levels by increasing or
decreasing tax levels and public spending. This influence, in turn, curbs inflation
(generally considered to be healthy when between 2-3%), increases employment
and maintains a healthy value of money. Fiscal policy is very important to the
economy. For example, in 2012 many worried that the fiscal cliff, a simultaneous
increase in tax rates and cuts in government spending set to occur in January
2013, would send the U.S. economy back to recession. The U.S. Congress
avoided this problem by passing the American Taxpayer Relief Act of 2012 on
Jan. 1, 2013.

Balancing Act
The idea, however, is to find a balance between changing tax rates and public
spending. For example, stimulating a stagnant economy by increasing spending
or lowering taxes runs the risk of causing inflation to rise. This is because an
increase in the amount of money in the economy, followed by an increase in
consumer demand, can result in a decrease in the value of money - meaning that
it would take more money to buy something that has not changed in value.

Let's say that an economy has slowed down. Unemployment levels are
up, consumer spending is down, and businesses are not making substantial
profits. A government thus decides to fuel the economy's engine by decreasing
taxation, which gives consumers more spending money, while increasing
government spending in the form of buying services from the market (such as
building roads or schools). By paying for such services, the government creates
jobs and wages that are in turn pumped into the economy. Pumping money into
the economy by decreasing taxation and increasing government spending is also
known as "pump priming." In the meantime, overall unemployment levels will fall.

With more money in the economy and fewer taxes to pay, consumer demand for
goods and services increases. This, in turn, rekindles businesses and turns the
cycle around from stagnant to active.

If, however, there are no reins on this process, the increase in economic
productivity can cross over a very fine line and lead to too much money in the
market. This excess in supply decreases the value of money while pushing up
prices (because of the increase in demand for consumer products). Hence,
inflation exceeds the reasonable level.

For this reason, fine tuning the economy through fiscal policy alone can be a
difficult, if not improbable, means to reach economic goals. If not closely
monitored, the line between a productive economy and one that is infected by
inflation can be easily blurred.

And When the Economy Needs to Be Curbed

When inflation is too strong, the economy may need a slowdown. In such a
situation, a government can use fiscal policy to increase taxes to suck money out
of the economy. Fiscal policy could also dictate a decrease in government
spending and thereby decrease the money in circulation. Of course, the possible
negative effects of such a policy, in the long run, could be a sluggish
economy and high unemployment levels. Nonetheless, the process continues as
the government uses its fiscal policy to fine-tune spending and taxation levels,
with the goal of evening out the business cycles.

Who Does Fiscal Policy Affect?

Unfortunately, the effects of any fiscal policy are not the same for everyone.
Depending on the political orientations and goals of the policymakers, a tax
cut could affect only the middle class, which is typically the largest economic
group. In times of economic decline and rising taxation, it is this same group that
may have to pay more taxes than the wealthier upper class.

Similarly, when a government decides to adjust its spending, its policy may affect
only a specific group of people. A decision to build a new bridge, for example, will
give work and more income to hundreds of construction workers. A decision to
spend money on building a new space shuttle, on the other hand, benefits only a
small, specialized pool of experts, which would not do much to increase
aggregate employment levels.

That said, the markets also react to fiscal policy. For example, in response to
President Trump's proposed corporate tax deduction plans, the S&P has been
trading higher according to Barclays.

The Bottom Line

One of the biggest obstacles facing policymakers is deciding how much
involvement the government should have in the economy. Indeed, there have
been various degrees of interference by the government over the years. But for
the most part, it is accepted that a degree of government involvement is
necessary to sustain a vibrant economy, on which the economic well-being of the
population depends.

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Types of fiscal policy

There are two main types of fiscal policy: expansionary and contractionary.
Expansionary fiscal policy, designed to stimulate the economy, is most often used
during a recession, times of high unemployment or other low periods of the business
cycle. It entails the government spending more money, lowering taxes, or both. The
goal is to put more money in the hands of consumers so they spend more and stimulate
the economy.

Contractionary fiscal policy is used to slow down economic growth, such as when
inflation is growing too rapidly. The opposite of expansionary fiscal policy,
contractionary fiscal policy raises taxes and cuts spending.

Tools of Fiscal Policy

The first tool is taxation. That includes income, capital gains from investments, property,
sales or just about anything else. Taxes provide the major revenue source that funds
the government. The downside of taxes is that whatever or whoever is taxed has less
income to spend on themselves.

That makes taxes unpopular. Find out how the U.S. federal budget is funded in Federal
Income and Taxes.

The second tool is government spending. That includes subsidies, transfer payments
including welfare programs, public works projects and government salaries. Whoever
receives the funds has more money to spend. That increases demand and economic
growth.

The federal government is losing its ability to use discretionary fiscal policy. Each year,
more of the budget must go to mandated programs. As the population ages, the costs of
Medicare, Medicaid, and Social Security are rising. Changing
the mandatory budgetrequires an Act of Congress and that takes a long time. One
exception was the ARRA, or Economic Stimulus Act, which Congress passed quickly.
That's because legislators knew they must stop the worst recession since the Great
Depression.

Fiscal Policy vs. Monetary Policy

Monetary policy is when a nation's central bank changes the money supply. It increases it
with expansionary monetary policy and decreases it with contractionary monetary policy.
It has many tools it can use, but it primarily relies on raising or lowering the fed funds
rate. This benchmark rates then guides all other interest rates. When interest rates are
high, the money supply contracts, the economy cools down, and inflation is prevented.
When interest rates are low, the money supply expands, the economy heats up, and a
recession is usually avoided.
Monetary policy works faster than fiscal policy. The Fed can just vote to raise or lower
rates at its regular Federal Open Market Committee meeting. It may take about six
months for the impact of the rate cut to percolate throughout the economy.

What is 'Taxation'
Taxation refers to compulsory or coercive money collection by a levying authority,
usually a government. The term "taxation" applies to all types of involuntary levies, from
income to capital gains to estate taxes. Though taxation can be a noun or verb, it is
usually referred to as an act; the resulting revenue is usually called "taxes."

BREAKING DOWN 'Taxation'

Taxation is differentiated from other forms of payment, such as market exchanges, in that
taxation does not require consent and is not directly tied to any services rendered. The
government compels taxation through an implicit or explicit threat of force. Taxation is legally
different than extortion or a protection racket because the imposing institution is a government,
not private actors.

Tax systems have varied considerably across jurisdictions and time. In most modern
systems, taxation occurs on both physical assets, such as property, and specific events,
such as a sales transaction. The formulation of tax policies is one of the most critical
and contentious issues in modern politics.

Taxation in the United States

Originally, the U.S. government was funded on very little direct taxation. Instead, federal
agencies assessed user fees for ports and other government property. In times of need,
the government would decide to sell government assets and bonds, or issue an
assessment to the states for services rendered. In fact, Thomas Jefferson abolished
direct taxation in 1802 after winning the presidency; only excise taxes remained, which
Congress repealed in 1817. Between 1817 and 1861, the federal government collected
no internal revenue.

An income tax of 3% was levied on high-income earners during the Civil War. It was not
until the Sixteenth Amendment was ratified in 1913 that the federal government
assessed taxes on income as a regular revenue item. As of 2016, U.S. taxation applies
to items or activities ranging from income to cigarettes to inheritances and even winning
a Nobel Prize. In 2012, the U.S. Supreme Court ruled that failure to purchase specific
goods or services, such as health insurance, was considered a tax and not a fine.

Purposes and Justifications for Taxation

The most basic function of taxation is to fund government expenditures. Varying
justifications and explanations for taxes have been offered throughout history. Early
taxes were used to support ruling classes, raise armies and build defenses. Often, the
authority to tax stemmed from divine or supranational right.

Later justifications have been offered across utilitarian, economic or moral

considerations. Proponents of progressive levels of taxation on high income earners
argue that taxes encourage a more equitable society. Higher taxes on specific products
and services, such as tobacco or gasoline, have been justified as a deterrent on
consumption. Advocates of public goods theory argue taxes may be necessary in
instances in which the private provision of public goods is considered sub optimal, such
as with lighthouses or national defense.

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What are 'Taxes'

Taxes are generally an involuntary fee levied on individuals or corporations that is
enforced by a government entity, whether local, regional or national in order to finance
government activities. In economics, taxes fall on whomever pays the burden of the tax,
whether this is the entity being taxed, like a business, or the end consumers of the
business's goods.

BREAKING DOWN 'Taxes'

Taxes are levied by states upon their citizens and corporations to fund public works and
services. Payment of taxes at rates levied by the state is compulsory, and tax evasion,
the deliberate failure to pay one's full tax liabilities, is punishable by law. Most
governments utilize an agency or department to collect taxes; in the United States, this
function is performed by the Internal Revenue Service.

There are several very common types of taxes:

Income Tax (a percentage of individual or corporate earnings filed to the federal

government)
Sales Tax (taxes levied on certain goods and services)
Property Tax (based on the value of land and property assets)
Tariff (taxes on imported goods imposed in the aim of strengthening internal
businesses).

However, tax systems vary widely among nations, and it is important for individuals and
corporations to carefully study a new locale's tax laws before earning income or doing
business there.
Like many developed nations, the United States has a progressive tax system by which
a higher percentage of tax revenues are collected from high-income individuals or
corporations rather than from low-income individual earners. Taxes are imposed at
federal, state and local levels. Generally speaking, the federal government levies
income, corporate and payroll taxes, the state levies sales taxes, and municipalities or
other local governments levy property taxes. Tax revenues are used for public services
and the operation of the government, as well as the Social
Security and Medicare programs. As baby boomer populations have aged, Social
Security and Medicare have claimed increasingly high proportions of the total federal
expenditure of tax revenue. Throughout United States history, tax policy has been a
consistent source of political debate.

Capital gains taxes are of particular relevance for investors. Levied and enforced at the
federal level, these are taxes on income that results from the sale of assets in which the
sale price was higher than the purchasing price. These are taxed at both short-term and
long-term rates. Short-term capital gains (on assets sold less than a year after they
were acquired) are taxed at the owner's normal income rate, but long-term gains on
assets held for more than a year are taxed at a lower rate, on the rationale that lower
taxes will encourage high levels of capital investment.

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Objectives of Taxation:
The primary purpose of taxation is to raise revenue to meet huge
public expenditure. Most governmental activities must be financed by
taxation. But it is not the only goal. In other words, taxation policy has
some non-revenue objectives.

Truly speaking, in the modern world, taxation is used as an

instrument of economic policy. It affects the total volume of
production, consumption, investment, choice of industrial location
and techniques, balance of payments, distribution of income, etc.

Here we will discuss the objectives of taxation in modern

public finance:
ADVERTISEMENTS:

1. Economic Development
2. Full Employment

3. Price Stability

4. Control of Cyclical Fluctuations

ADVERTISEMENTS:

5. Reduction of BOP Difficulties

6. Non-Revenue Objective

Objective # 1. Economic Development:

One of the important objectives of taxation is economic development.
Economic development of any country is largely conditioned by the
growth of capital formation. It is said that capital formation is the
kingpin of economic development. But LDCs usually suffer from the
shortage of capital.

To overcome the scarcity of capital, governments of these countries

mobilize resources so that a rapid capital accumulation takes place. To
step up both public and private investment, government taps tax
revenues. Through proper tax planning, the ratio of savings to national
income can be raised.

By raising the existing rate of taxes or by imposing new taxes, the

process of capital formation can be made smooth. One of the
important elements of economic development is the raising of savings-
income ratio which can be effectively raised through taxation policy.

However, proper care has to be taken, regarding investment. If

financial resources or investments are channelized in the unproductive
sectors of the economy the economic development may be
jeopardized, even if savings and investment rates are increased. Thus,
the tax policy has to be employed in such a way that investment occurs
in the productive sectors of the economy, including the infrastructural
sectors.
Objective # 2. Full Employment:
Second objective is the full employment. Since the level of
employment depends on effective demand, a country desirous of
achieving the goal of full employment must cut down the rate of taxes.
Consequently, disposable income will rise and, hence, demand for
goods and services will rise. Increased demand will stimulate
investment leading to a rise in income and employment through the
multiplier mechanism.

Objective # 3. Price Stability:

Thirdly, taxation can be used to ensure price stabilitya short run
objective of taxation. Taxes are regarded as an effective means of
controlling inflation. By raising the rate of direct taxes, private
spending can be controlled. Naturally, the pressure on the commodity
market is reduced.

But indirect taxes imposed on commodities fuel inflationary

tendencies. High commodity prices, on the one hand, discourage
consumption and, on the other hand, encourage saving. Opposite
effect will occur when taxes are lowered down during deflation.

Objective # 4. Control of Cyclical Fluctuations:

ADVERTISEMENTS:

Fourthly, control of cyclical fluctuationsperiods of boom and

depressionis considered to be another objective of taxation. During
depression, taxes are lowered down while during boom taxes are
increased so that cyclical fluctuations are tamed.

Objective # 5. Reduction of BOP Difficulties:

Fifthly, taxes like custom duties are also used to control imports of
certain goods with the objective of reducing the intensity of balance of
payments difficulties and encouraging domestic production of import
substitutes.
Objective # 6. Non-Revenue Objective:
Finally, another extra-revenue or non-revenue objective of taxation is
the reduction of inequalities in income and wealth. This can be done
by taxing the rich at higher rate than the poor or by introducing a
system of progressive taxation.
BASIC PRINCIPLES OF A SOUND TAX SYSTEM. (IMPT!)

1. Fiscal Adequacy- The sources (proceeds) of tax revenue should coincide with and
approximate needs of government expenditures. The sources of revenue should be
sufficient and elastic to meet the demands of public expenditures;

2. Theoretical Justice- The tax system should be fair to the average taxpayer and based
upon his ability to pay.

3. Administrative Feasibility- The tax system should be capable of being properly and
efficiently administered by the government and enforced with the least inconvenience
to the taxpayer.
Toll is basically a cost recovery tax against some use for service or infrastructure. For example the
highway projects are given to huge infrastructure develiloping companies on a model to make it , to
operate it and cover their costs and then hand it over to the govt as a public infrastructure.

While on the contrary tax is simply the charge on your income imposed by the govt to render the
basic public services, like transportation, defence, education etc.
Tax Distinguished From Other Fees
Tax distinguished from other fees. IMPT

1. From TOLL. Toll is a sum of money for the use of something, generally applied to
the consideration which is paid for the use of a road, bridge or the like, of a public
nature.

A toll is a demand of proprietorship, is paid for the use of anothers property and
may be imposed by the government or private individuals or entities; while a tax
is a demand of sovereignty, is paid for the support of the government and may be
imposed only by the State.
2. From PENALTY. Penalty is any sanction imposed as a punishment for violation of
law or acts deemed injurious. Violation of tax laws may give rise to imposition of
penalty.

A penalty is designed to regulate conduct and may be imposed by the government

or private individuals or entities. Tax, on the other hand, is primarily aimed at
raising revenue and may be imposed only by the government.

3. From SPECIAL ASSESSMENT. Special Assessment is an enforced proportional

contribution from owners of lands for special benefits resulting from public
improvements.

Special Assessment is levied only on land, is not a personal liability of the person
assessed, is based wholly on benefits and is exceptional both as to time and place.
Tax is levied on persons, property, or exercise of privilege, which may be made a
personal liability of the person assessed, is based on necessity and is of general
application.

4. From PERMIT or LICENSE FEE. Permit or License Fee is a charge imposed under
the police power for purposes or regulation.

License fee is imposed for regulation and involves the exercise of police power
while tax is levied forrevenue and involves the exercise of the taxing power. Failure
to pay a license gee makes an act or a business illegal, while failure to pay a tax
does not necessarily make an act or a business illegal.

5. From DEBT. Debt is generally based on contract, is assignable and may be paid in
kind while a tax is based on law, cannot generally be assigned and is generally
payable in money. A person cannot be imprisoned for non-payment of debt while
he can be for non-payment of tax except poll tax.

A tax is considered a debt for purposes of remedies for its enforcement;

 6. From REVENUE. Revenue is broader that tax since it refers to all funds or income
derived by the government taxes included. Other sources of revenues are
government services, income from public enterprises and foreign loans.

7. From CUSTOM DUTIES. Custom duties are taxes imposed on goods exported from
or imported to a country. Custom duties are actually taxes but the latter is broader
in scope

Classification of Taxes
Classification of taxes

1. As to subject matter or object

A. personal, poll or capitation- tax of a fixed amount on individuals residing

within a specified territory, without regard to their property, occupation or business.
Ex. Community tax (basic)

B. property- imposed on property, real or personal, in proportion to its value, or in

accordance with some reasonable method or apportionment. Ex. Real estate Tax

C. Excise- imposed upon the performance of an act, the enjoyment of a privilege,

or the engaging in an occupation, profession or business. Ex. Income tax, VAT,
Estate Tax, Donors Tax

2. As to who bears the burden of the tax

a. Direct- the tax is imposed on the person who also bears the burden thereof
Ex. Income tax, community tax, estate tax

b. Indirect imposed on the taxpayer who shifts the burden of the tax to another,
Ex. VAT, customs duties.

3. As to determination of amount

a. specific imposed and based on a physical unit of measurement as by head

number, weight, length or volume. Ex. Tax on distilled spirits, fermented liquors,
cigars

b. Ad Valorem of a fixed proportion of the value of the property with respect to

which the tax is assessed. Ex. Real estate tax, excise tax on cars, non essential
goods.

4. As to purpose

A. general, fiscal, or revenue- imposed for the general purpose of supporting the
government. Ex. Income tax, percentage tax

B. special or regulatory- imposed for a special purpose, to achieve some social or

economic objective. Ex. Protective tariffs or custom duties on imported goods
intended to protect local industries.

5. As to scope or authority imposing the tax

a. national- imposed by the national government ex. NIRC, custom duties

b. municipal or local- imposed by municipal corporations or local governments
ex. Real estate tax,

6. As to graduation of rates.

a. proportional- based on a fixed percentage of the amount of the property,

receipts or on other basis to be taxed ex. Real estate tax, VAT

b. progressive and graduated- the rate of the tax increases as the tax base or
bracket increases ex. Income tax, estate tax, donors tax

c. regressive- the rate of tax decreases as the tax base or bracket increases.

d. degressive- increase of rate is not proportionate to the increase of tax base.

Progressive taxation is the policy of taxing people who earn greater amounts of money in greater
proportions, such that the rich pay taxes at a higher rate. During the 2008 Presidential Election, John
McCain, Sarah Palin, and Joe the Plumber tried to argue that progressive taxation equated with that
old communist maxim, "from each according to his ability, to each according to his need." But
although progressive taxation is often a part of a communist or socialist program, it is not exclusively
a socialist idea, and is also advocated by many non-socialist political groups. Many believe
progressive taxation is necessary to prevent an oligarchy from usurping a social democracy.
Progressive taxation has a long history in the western world: in his Early History of Rome, Livy
described approvingly the early Roman monarch Servius Tullius' attempt to impose a progressive
tax system in the levying of armies (1:42), but later read the utter (though temporary) elimination of
any taxation on the plebeian class as an attempt at bribery (2:9).

What is a 'Regressive Tax'

A regressive tax is a tax that takes a larger percentage of income from low-income
earners than from high-income earners. It is in opposition with a progressive tax, which
takes a larger percentage from high-income earners. A regressive tax is generally a tax
that is applied uniformly to all situations, regardless of the payer.

BREAKING DOWN 'Regressive Tax'

A regressive tax affects people with low incomes more severely than people with high
incomes. While it may be fair in some instances to tax everyone at the same rate, it is
seen as unjust in other cases. As such, most income tax systems employ a progressive
schedule that taxes high earners at a higher percentage rate than low earners, while
other types of taxes are uniformly applied. Examples of regressive taxes include sales
taxes, user fees and, arguably, property taxes.

Sales Tax
Governments apply sales taxes uniformly to all consumers based on what they buy.
Even though the tax may be uniform (such as 7% sales tax), lower-income consumers
are more affected by it.

For example, imagine two individuals each purchase $100 of clothing per week, and
they each pay $7 in tax on their retail purchases. The first individual earns $2,000 per
week, making the sales tax rate on her purchase 0.35% of income. In contrast, the other
individual earns $320 per week, making her clothing sales tax 2.2% of income. In this
case, although the tax is the same rate in both cases, the person with the lower income
pays a higher percentage of income, making the tax regressive.

User Fees
User fees levied by the government are another form of regressive tax. These fees
include admission to government-funded museums and state parks, costs for driver's
licenses and identification cards, and toll fees for roads and bridges.
For example, if two families travel to the Grand Canyon National Park and pay a $30
admission fee, the family with the higher income pays a lower percentage of its income
to access the park, while the family with the lower income pays a higher percentage.
Although the fee is the same amount, it constitutes a more significant burden on the
family with the lower income, again making it a regressive tax.

Property Taxes
Property taxes are fundamentally regressive because, if two individuals in the same tax
jurisdiction live in properties with the same values, they pay the same amount of
property tax, regardless of their incomes. However, they are not purely regressive in
practice because they are based on the value of the property. Generally, it is thought
that lower income earners live in less expensive homes, thus partially indexing property
taxes to income.

Flat Tax
Often bandied around in debates about income tax, the phrase "flat tax" refers to a
taxation system in which the government taxes all income at the same percentage
regardless of earnings. Under a flat tax, there are no special deductions or credits.
Rather, each person pays a set percentage on all income.

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What Is the Difference Between Tax Avoidance and Tax Evasion?

The terms "tax avoidance" and "tax evasion" are often used interchangeably, but they are
very different concepts. Basically, tax avoidance is legal, while tax evasion is not.

Businesses get into trouble with the IRS when they intentionally evade taxes. But your
business can avoid paying taxes, and your tax preparer can help you do that.

What Is Tax Avoidance?

Tax avoidance is the legitimate minimizing of taxes, using methods approved by the
IRS. Businesses avoid taxes by taking all legitimate deductions and by sheltering income
from taxes by setting up employee retirement plans and other means, all legal and under
the Internal Revenue Code or state tax codes.
Some Examples of Tax Avoidance:

Taking legitimate tax deductions to minimize business expenses and thus lower
your business tax bill.
Setting up a tax deferral plan such as an IRA, SEP-IRA, or 401(k) plan to delay
taxes until a later date.
Taking tax credits for spending money for legitimate purposes, like taking a Work
Opportunity Tax Credit

What Is Tax Evasion?

Tax evasion, on the other hand, is the illegal practice of not paying taxes, by not
reporting income, reporting expenses not legally allowed, or by not paying taxes owed.

Tax evasion is most commonly thought of in relation to income taxes, but tax evasion can
be practiced by businesses on state sales taxes and on employment taxes.

In fact, tax evasion can be practiced on all the taxes a business owes.

Tax evasion is the illegal act or practice of failing to pay taxes which are owed. In
businesses, tax evasion can occur in connection with income taxes, employment taxes,
sales and excise taxes, and other federal, state, and local taxes.

Examples of Practices Which Are Considered Tax Evasion:

It's considered tax evasion if you knowingly fail to report income.

Under-reporting income (claiming less income than you actually received from a specific
source

Providing false information to the IRS about business income or expenses

Deliberately underpaying taxes owed
Substantially understating your taxes (by stating a tax amount on your return
which is less than the amount owed for the income you reported).

Employment Tax Fraud Examples

Tax evasion isn't limited to income tax returns. Businesses that have employees may
be committing tax evasion in several ways:
 Failure to withhold/pyramiding: An employer fails to withhold federal income
tax or FICA taxes from employee paychecks, or withholds but fails to report and
pay these payroll taxes.
Employment leasing, which the IRS explains is hiring an outside payroll service
that doesn't turn over funds to the IRS.
Paying employees in cash and failing to report some or all of these cash
payments.
Filing false payroll tax reports or failing to file these returns.

Here are some other tax mistakes business owners make that are considered tax evasion.

This is not an exhaustive list, but just a sample of the kinds of tax-evasion strategies the
IRS is on the lookout for.

Tax Evasion vs. Tax Fraud

Tax fraud is basically the same as tax evasion. Fraud can be defined as "an act of
deceiving or misrepresenting," and that's what someone evading taxes does deceiving
the IRS about income or expenses.

How to Avoid Tax Evasion Charges

While tax evasion might seem willful, you may be subject to fines and penalties from the
IRS for tax strategies they consider to be illegal and which you were unaware you were
practicing.

The best way to avoid being charged with tax evasion is to know the tax laws for income
taxes and employment taxes. For example, knowing what deductions are legal and the
record keeping requirements for deductions is a big factor in avoiding an audit. For
employers, knowing the payroll tax reporting and payment requirements will help keep
you out of trouble.

Get an honest, careful tax professional to help you with your taxes. Listen to your tax
preparer and keep excellent records of all income and expenses, even if you have a cash-
based business. And keep reading articles from this site and others, to learn more about
what constitutes tax evasion.
The Cost of Tax Evasion
Some tax evasion cases may be reviewed in tax court, but others are turned over to
the IRS criminal division for prosecution. Even if the taxpayer is eventually found not
guilty, the costs in time and money are enormous.

Because tax evasion is considered intentional and "willful," the IRS can bring criminal
charges against those convicted of tax evasion. The penalties can include jail time as well
as substantial fines and penalties. This page from the IRS on the penalties for tax fraud is
a sobering reminder of the cost of attempting to cheat on taxes.

What is 'Tax Exempt'

Tax exempt refers to income earnings or transactions that are free from tax at the
federal, state or local level. When a taxpayer earns wages or sells an asset for a gain,
that individual is creating a tax liability. While a tax deduction refers to an amount that
reduces a tax liability, a tax-exempt item is excluded from any tax calculations.

BREAKING DOWN 'Tax Exempt'

A tax deduction is a deduction from gross income that is based on certain expenses
incurred by a taxpayer, and deductions are subtracted from gross income to arrive
at taxable income. Federal and state tax codes provide many types of tax deductions,
such as an individual taxpayers deduction for home mortgage interest payments. Tax-
exempt items, on the other hand, may be reported on the tax return for informational
purposes, but the item is not part of any tax calculations.

Factoring in Tax-Exempt Interest

One common type of tax-exempt income is interest earned on municipal bonds, which
are bonds issued by states and cities to raise funds for general operations or for a
specific project. When a taxpayer earns interest income on municipal bonds issued in
his state of residence, the income is exempt from both federal and state taxes.
Taxpayers receive a form 1099-INT for any investment interest earned during the year,
and tax-exempt interest is reported in box 8 of the form. Tax-exempt interest is reported
for informational purposes only and is not included in the calculation of personal income
taxes.

Examples of Capital Gain Tax Exemption

When a taxpayer buys an asset and subsequently sells the asset for a gain, the capital
gain is a taxable event. Several type of capital gains are exempt from taxation. A
taxpayer can offset capital gains with other capital losses for the tax year. For example,
an investor with $10,000 in gains and $5,000 in losses pays tax on only $5,000 in
capital gains, and a large amount of capital losses and can be carried forward to offset
gains in future years. The tax code also allows taxpayers to exclude a portion of capital
gains on a home sale from federal tax, up to a specific dollar amount; this rule was put
in place to allow homeowners to keep more of their home sale gains to fund retirement.

How Alternative Minimum Tax Works

The alternative minimum tax (AMT) is a second tax calculation required on
the individual tax return. AMT adds back certain tax-exempt items into the personal tax
calculation. Municipal bond income, for example, is added to the AMT tax calculation. A
taxpayer must include the AMT calculation with the original tax return and pay tax on
the higher tax liability.

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