Tax Definition: Types, Who Pays, and Why
What is Tax?
In the most basic sense, taxes are money you must pay to the government. This can be done through things like income tax (money that you earn from your job), property tax (money that you pay for owning a home or land), or sales tax (money that you pay for buying goods and services).
Read more here: What is Tax?
Governments must collect mandated contributions in the form of taxes.
In the United States, federal income taxes are collected by the Internal Revenue Service (IRS).
There are numerous types of taxes, and most are levied as a percentage of a financial transaction (For instance, whenever money is received or a sale is made).
Other taxes, like property taxes, are levied by the asset's assessed value.
Taxpayers can manage their finances to lessen the effects of taxes by clearly understanding what causes a tax situation.
Governments tax their citizens to raise money for public works and services. The taxes collected are used to improve the economy and the quality of life for all citizens.
The government uses the money it collects from taxes to pay for things like roads and schools, to run the government, and to provide Social Security and Medicare. Social Security and Medicare are programs that help older Americans, and they are claiming more and more of the government's money as the baby boomer generation gets older. This has been a controversial issue throughout American history.
Most governments use an agency or department to collect taxes. The Internal Revenue Service (IRS) manages taxes in the United States.
Types of Taxes
There are several types of taxes that are very common:
Income tax is a percentage of earned income paid to the state or federal government.
Payroll tax is a percentage of an employee's pay withheld by an employer and paid to the government on the employee's behalf to fund Medicare and Social Security programs.
Corporation tax is a portion of corporate profits that the government withholds as revenue to support governmental programs.
Sales tax levied on certain goods and services varies according to jurisdiction.
Property tax based on the value of land and property assets
Tariffs on imported goods are imposed to help domestic businesses
An estate tax is levied on the fair market value (FMV) of property in a person's estate at the time of death; the total estate must exceed state and federal government thresholds.
The following sections will examine various tax situations in the United States. The federal government collects income, corporate, and payroll taxes; states collect income and sales taxes; municipalities or other local governments collect property taxes.
The United States has a progressive income tax system, which means that high-income individuals or corporations pay a higher percentage of their income in taxes than low-income earners. The tax system is designed so that the more income an individual or corporation has, the higher their marginal tax rate will be. In addition to income taxes, the United States also imposes payroll taxes on wages. These taxes are generally levied at a flat rate, meaning that everyone pays the same percentage of their income in taxes.
Payroll taxes are a tax imposed on employers or employees and are usually calculated as a percentage of the employee's wages. The money collected through payroll taxes funds Social Security and Medicare programs.
The amount of corporate tax a company owes is based on its taxable income - which is its total income minus any deductions and exemptions. The corporate tax rate is a percentage set by the government that determines how much tax a company owes on its taxable income.
The steps to calculate a company’s taxable income are as follows:
Sales revenue - the cost of goods sold (COGS)= gross profit
Gross profit - operating expenses such as general and administrative expenses (G&A), selling and marketing, research and development (R&D), depreciation, etc. = earnings before interest and taxes (EBIT) EBIT - interest expense = taxable income
Sales taxes are added to the price of goods or services at the point of sale. The customer pays the tax, and the company remits the funds to the government. Sales taxes are usually imposed on retail transactions but can also be applied to services.
Real estate taxes are calculated using a millage rate, the sum per each $1,000 of an assessed value for a property. A property assessor chosen by the local government establishes the property's assessed value. Typically, reassessments are carried out every one to five years.
For example, if a millage rate is 20 mills and a property's assessed value is $100,000, the real estate taxes owed would be $2,000.
A government typically imposes a tariff to protect domestic industries from foreign competition. Consumers are more likely to purchase domestically produced alternatives by making imported goods and services more expensive. This can help keep domestic industries afloat and even encourage new domestic businesses' growth. Taxes can also be used to negotiate better trade deals. A country might agree to lower its tariffs on imported goods in exchange for the other country lowering its tariffs on exported goods.
The purpose of a tariff is to encourage domestic purchases by making imported goods and services more expensive. This makes domestic products more competitive and helps to protect and grow domestic industries.
There are two main types of tariffs: fixed fee and ad valorem. Fixed fee tariffs are typically used on items where the item's value is not easily determined, such as on imports of services. Ad valorem tariffs are typically used on items where the item's value is easily determined, such as on imports of goods.
The exclusion limit is the maximum value of an estate exempt from estate taxes. In 2023, the federal exclusion limit is $12.92 million, up from $12.06 million in 2022. Any estate worth more than $12.92 million will be subject to estate taxes. Surviving spouses are exempt from estate taxes if a married couple's estate is worth less than $12.92 million. This means that if you are a single person with an estate worth more than $12.92 million, your estate will be subject to estate taxes. If you are married, your estate will only be subject to estate taxes if it is worth more than $12.92 million.
The tax code is complex, and many taxes have different due dates. Failure to pay on time and/or the correct amount will result in tax delinquency.
After failing to pay the correct amount of tax to the taxation authorities, several penalties may be charged, including:
A penalty assessment that results in a single fee or charge.
An interest assessment with escalating penalties based on the length of the delinquency.
A lien is placed on the underlying assets if the delinquent party cannot pay their debts.
Access or service denial for transaction-related taxes (i.e., tariffs).
A tax lien or seizure on firm property tied to a business transaction.
Why Do We Pay Taxes?
We pay taxes to support the Government. Most governments rely on taxes to fund their operations. This revenue is used to improve and maintain public infrastructures, such as roads and bridges, and to provide public services, such as education and law enforcement.
How Do Income Taxes Work in the U.S.?
The U.S. has a progressive tax system, meaning taxpayers who earn more pay a higher percentage of their income in taxes than those who earn less. There are seven federal tax brackets in the U.S., with rates ranging from 10% to 37%.
Are U.S. Taxes Low?
The Tax Policy Center states that in 2018, the taxes in the United States only represented 24% of the country's gross domestic product. However, in other developed nations, the average was 34%. This means that taxes make up a more significant portion of the GDP in other countries, meaning that people are paying more taxes.
Who Needs to Pay Taxes?
The taxpayer will vary depending on the kind of tax and related regulations. People who earn income from wages or investments are subject to federal income tax. Businesses may be subject to corporate taxes, depending on the type of business and where it does business. Federal income tax only applies to people who have earned a certain amount, while corporate taxes may only apply to companies that have done business in a specific area. Each tax has different rules and qualifications.
The Bottom Line
Taxes come in various forms, and there are numerous methods to start them. Taxpayers can manage their money and employ strategies like annual tax-loss harvesting and estate planning to lessen the effects of taxes.