What is Tax-Exempt?
Any kind of monetary exemptions of the people, individual, income, property or any transactions from the taxes which would otherwise be charged on them is termed as Tax Exemption and these kinds of exemptions either allows total relief from the taxes, or provide reduced rates, or it might charge tax on some portion of the items only.
Tax-Exempt means a part of the income or entire Income which is will not be taxed depending on the type of Income or nature of the person. In other words, this income will be excluded from total earned income while calculating taxable income. Generally, the government provides such tax-exemption to promote a particular business or profession or due to socio-economic reasons. For example, if a person purchases municipal bonds. Income earned on these Bonds will be exempt from tax.
Forms of Tax-Exemption
The government provides tax-exemptions in different forms stated as follows: –
- Tax-Exempt – Under this exemption, a person can avail tax benefits depending on tax filing status i.e. the category of Tax Payer and the number of dependents.
- Tax Deduction – The government allows certain types of income or expenses to be deducted from total taxable income, for example, Student loan interest, traveling, etc.
- Tax Credit – The government allows payment of tax to be carried forward as Tax Credit which can be subsequently utilized in the next financial year. This mechanism works by deducting the amount of tax credit available from total tax liability.
The most common Tax-Exemptions are – 1. Personal Exemption like if a person is married, and files a joint return, then his/her spouse will be eligible for exemption on the same form of taxation. 2. Exemption based on dependent i.e. single tax-exemption for each individual.
Examples of Tax-Exempt
Let us understand the concept with the help of numerical examples
Example #1
Calculate total taxable income and tax payable by Mr. Marc with the given the following information: –
Given Tax Rate applicable is 24%
Henry gives the following sources of income, expenses, and investments: –
Henry also gives the following information:
Solution:
Calculation of total taxable income and tax payable by Henry
Example #2
Calculate total taxable income and tax payable by Mr. Marc with the given the following information: –
Marc gives the following sources of Income: –
Marc also gives the following details:
Also given the following Information:
- Tax Rate for Individual is 22%
- Interest Income on Federal US Bonds is exempt from Tax
Solution:
Calculation of Total Taxable Income and Tax Payable: –
Advantages of Tax-Exempt
- Low Tax Burden – One of the most important objectives of Tax-Exemption is to lower down the tax burden on the specified categories of the business/form of the entity/increasing individual’s expense towards the eligible specified sector.
- Socio-Economic Benefits – The government usually provides an exemption to motivate people to expend towards a particular sector or form a specified category of business structure. For example, a Non-Profit Organisation.
- Reduces Chances of Understatement of Income – Given exemption on certain expenses, Income, a form of organization, people do not engage in misappropriating Income. This also increases transparency in the system.
Disadvantages of Tax-Exempt
- Cost of Compliance – To ensure compliance with tax laws requires lots of formalities to be complied with. This adds to the cost of the Organisation.
- Time and Paperwork – To ensure compliance, not only adds cost but also adds time and efforts to comply with conditions of the exemption.
- Misappropriation of Income/Expense – To pay less tax, sometimes people do engage in misappropriating their income to lower side or expenses on the higher side. Also, sometimes, the entity does not comply with the necessary formalities and avail tax-exemption benefits.
- Lower Collection of Tax – Due to Tax-Exemption, the government usually ends up with a lower collection of taxes. Exemption directly reduces the amount of net tax liability.
Important Points to Note
Tax-exemptions are not static. The government may wish to promote one form of business/Income today and may wish to promote another. For example, if the government feels the need to increase the production of a certain crop, it may provide exemption on income earned on such farming. Once the government feels the need is fulfilled, they may withdraw exemption.
Also, if the government feels need to increase people’s expenditure on a certain sector, let’s say expenditure on medical insurance, the government may provide exemption on such expenditure. Forms of Tax-Exemption change and vary with respect to the form of organization also. For example, the Non-Profit Organisation for social work. Income earned by such an organization is completely exempt from Taxation.
Conclusion
The government provides an exemption in varied forms like a tax deduction, tax-exemption, tax credit. Also, most common tax-exemptions available to an individual are based on tax filing status, the number of dependents, etc. With the changing country’s requirements, the country may provide tax-exemptions on different income, expenses, investment, business, forms of organization, etc. With advantages, there are also certain lacunas in providing tax-exemptions like misappropriation of income, expenses, investments, etc. which leads to the generation of black money.
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