What Is an Income Tax?

An income tax is a 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. Certain investments, like housing authority bonds, tend to be exempt from income taxes.


Income Tax

How Income Tax Works

Most countries employ a progressive income tax system in which higher-income earners pay a higher tax rate compared to their lower-income counterparts. 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 After the war, the tax was repealed and then reinstated during the early 20th century.

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

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

Key Takeaways

  • Income taxes pay for several programs and services such as Social Security and Medicaid.
  • Individual income tax is also known as personal income tax.
  • Business income taxes apply to corporations, partnerships, small businesses, and people who are self-employed.

Individual Income Tax

Individual income tax is also referred to as personal income tax and is levied on wages, salaries, and other types of income. This tax is usually a tax 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 deductions (e.g. deductions for health care, investments and education expenses) which taxpayers use to reduce their taxable income. 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). Tax credits are used to reduce the taxpayer's tax obligation or amount owed. To illustrate, if an individual owes $20,000 in taxes but qualifies for $4,500 in credits, his tax obligation reduces to $15,500 ($20,000 - $4,500).

Business Income Taxes

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

State and Local Income Tax

Most U.S. states also levy income taxes. As of 2019, there are seven states with no income tax: Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. Alike these seven, New Hampshire and Tennessee do not tax earned income; however, they do tax interest and dividend income.