What Is Income Tax and How Are Different Types Calculated?

Income Tax Definition

Mira Norian / Investopedia

What Is Income Tax?

The term “income tax” refers to a type of tax that governments impose on income generated by businesses and individuals within their jurisdiction. By law, taxpayers must file an income tax return annually to determine their tax obligations.

Income taxes are a source of revenue for governments. They are used to fund public services, pay government obligations, and provide goods for citizens. In addition to the federal government, many states and local jurisdictions also require that income tax be paid.

Certain investments, like housing authority bonds, tend to be exempt from income taxes.

Key Takeaways

  • Income tax is a type of tax that governments impose on income generated by businesses and individuals within their jurisdiction.
  • Income tax is used to fund public services, pay government obligations, and provide goods for citizens.
  • The federal government and many states, as well as local jurisdictions, require that income tax be paid.
  • Personal income tax is a type of income tax that is levied on an individual’s wages, salaries, and other types of income.
  • Business income taxes apply to corporations, partnerships, small businesses, and people who are self-employed.
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Income Tax

History of Income Tax

The United States imposed the nation’s first income tax in 1862 to help finance the Civil War. After the war, the tax was repealed, but it was reinstated after passage of the Revenue Act of 1913. That same year, Form 1040 was introduced.

Most countries, including the U.S., employ a progressive income tax system in which higher-income earners pay a higher tax rate compared with their lower-income counterparts. The idea behind progressive tax is that those who earn high incomes can afford to pay more tax. In 2022, federal income tax rates range from 10% to 37%.

How Income Tax Works

The Internal Revenue Service (IRS) collects taxes and enforces tax law in the United States. The IRS employs a complex set of rules and regulations regarding reportable and taxable income, deductions, credits, etc. The agency collects taxes on all forms of income, such as wages, salaries, commissions, investments, and business earnings.

The personal income tax that the government collects can help fund government programs and services, such as Social Security, national security, schools, and roads.

Types of Income Tax

Individual Income Tax

Individual income tax is also referred to as personal income tax. This type of income tax is levied on an individual’s wages, salaries, and other types of income. This tax is usually a tax that the state imposes. Because of exemptions, deductions, and credits, most individuals do not pay taxes on all of their income.

The IRS offers a series of income tax deductions and tax credits that taxpayers can use to reduce their taxable income. While a deduction can lower your taxable income and the tax rate that is used to calculate your tax, a tax credit reduces your income tax by giving you a larger refund of your withholding.

The IRS offers tax deductions for healthcare expenses, investments, and certain education expenses. For example, if a taxpayer earns $100,000 in income and qualifies for $20,000 in deductions, the taxable income reduces to $80,000 ($100,000 - $20,000 = $80,000).

Tax credits exist to help reduce the taxpayer’s tax obligation or amount owed. They were created primarily for those in middle-income and low-income households. To illustrate, if an individual owes $20,000 in taxes but qualifies for $4,500 in credits, their tax obligation reduces to $15,500 ($20,000 - $4,500 = $15,500).

Taxable income is your adjusted gross income (AGI) minus any itemized deductions or your standard deduction.

Business Income Tax

Businesses also pay income taxes on their earnings; the IRS taxes income from corporations, partnerships, self-employed contractors, and small businesses. Depending on the business structure, the corporation, its owners, or shareholders report their business income and then deduct their operating and capital expenses. Generally, the difference between their business income and their operating and capital expenses is considered their taxable business income.

State and Local Income Tax

Most U.S. states also levy personal income taxes. But eight states don’t impose personal income taxes on residents: Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming. Tennessee repealed its Hall tax, which taxed dividends and interest, on Jan. 1, 2021.

New Hampshire also has no state tax on income, but residents must pay a 5% tax on any dividends and interest that they earn. The state passed a bill in 2018 that would phase out the state 5% tax on interest and dividends on Jan. 1, 2024. This will bring the number of states with no income tax to nine by 2024.

Keep in mind, though, that it may not necessarily be cheaper to live in a state that does not levy income taxes. This is because states often make up the lost revenue with other taxes or reduced services. What's more, other factors determine the affordability of living in a state, including healthcare, cost of living, and job opportunities. For instance, Florida residents pay a 6% sales tax on goods and services, while the state sales tax in Tennessee is 7%.

To further complicate matters, states continually tinker with their tax systems in ways both large and small, making it impossible to predict what sort of tax burden their residents will face in the years to come. In the 2022 U.S. midterm elections, for example, Massachusetts voters narrowly approved (51.9% yes) an additional 4% tax on taxable income over $1 million—a so-called Millionaires Tax. California voters, meanwhile, rejected a measure that would have raised their state's highest marginal tax bracket from 13.3% to 15.05% to raise money to subsidize the electric vehicle industry.

If you don’t have a complicated tax situation, a tax calculator can give you an idea of how much income tax you might owe.

What percent of income is taxed?

The percent of your income that is taxed depends on how much you earn and your filing status. In theory, the more you earn, the more you pay. The federal income tax rate ranges from 10% to 37%.

How can I calculate income tax?

To calculate income tax, you’ll need to add up all sources of taxable income earned in a tax year. The next step is calculating your adjusted gross income (AGI). Once you have done this, subtract any deductions for which you are eligible from your AGI.

Which states have no income tax?

Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming do not collect state income taxes. New Hampshire doesn’t tax earned wages, but it does tax income earned from interest and dividends. At the end of 2023, New Hampshire will begin phasing out these taxes, and all personal income in the state will be tax free by 2027.

The Bottom Line

All taxpayers pay federal income tax. Depending on where you live, you may have to pay state and local income taxes, too. The U.S. has a progressive income tax system, which means that higher-income earners pay a higher tax rate than those with lower incomes. Most taxpayers do not pay taxes on all of their income, thanks to exemptions and deductions.

Article Sources
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