What Are Taxes?
Taxes are mandatory contributions levied on individuals or corporations by a government entity—whether local, regional or national. Tax revenues finance government activities, including such public works and services as roads and schools, or programs like Social Security and Medicare. In economics, taxes fall on whomever pays the burden of the tax, whether this is the entity being taxed, such as a business, or the end consumers of the business's goods.
From an accounting perspective, there are various taxes to consider, including payroll taxes, federal and state income taxes, and sales taxes.
- Taxes are mandatory contributions collected by governments.
- The IRS collects federal income taxes in the United States.
- There are many forms of taxes; most are applied as a percentage of a monetary exchange (for example, when income is earned or a sales transaction is completed).
- Other forms of taxes, such as property taxes, are applied based on the assessed value of a held asset.
- Understanding what triggers a tax situation can enable taxpayers to manage their finances in order to minimize the impact of taxes.
To help fund public works and services—and to build and maintain the infrastructures used in a country—a government usually taxes its individual and corporate residents. The tax collected is used for the betterment of the economy and all living in it. In the U.S. and many other countries in the world, income taxes are applied to some form of money received by a taxpayer. The money could be income earned from salary, capital gains from investment appreciation, dividends or interest received as additional income, payment made for goods and services, etc.
Tax revenues are used for public services and the operation of the government, as well as for 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.
A tax requires a percentage of the taxpayer’s earnings or money to be taken and remitted to the government. Payment of taxes at rates levied by the government is compulsory, and tax evasion—the deliberate failure to pay one's full tax liabilities—is punishable by law. (On the other hand, tax avoidance—actions taken to lessen your tax liability and maximize after-tax income—is perfectly legal.) Most governments use an agency or department to collect taxes. In the United States, this function is performed federally by the Internal Revenue Service (IRS).
There are several very common types of taxes:
- Income tax—a percentage of generated income that is relinquished to the state or federal government
- Payroll tax—a percentage withheld from an employee's pay by an employer, who pays it to the government on the employee's behalf to fund Medicare and Social Security programs
- Corporate tax—a percentage of corporate profits taken as tax by the government to fund federal programs
- Sales tax—taxes levied on certain goods and services; varies by jurisdiction
- Property tax—based on the value of land and property assets
- Tariff—taxes on imported goods; imposed in the aim of strengthening internal businesses
- Estate tax—rate applied to the fair market value of property in a person's estate at the time of death; total estate must exceed thresholds set by state and federal governments
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.
Below, we will take a look at various tax situations in the United States. Generally speaking, the federal government levies income, corporate, and payroll taxes; the state levies income and sales taxes; and municipalities or other local governments levy sales and property taxes.
Like many nations, the United States has a progressive income tax system, through which a higher percentage of tax revenues are collected from high-income individuals or corporations than from low-income individual earners. Taxes are applied through marginal tax rates. A variety of factors affect the marginal tax rate a taxpayer will pay, including their filing status—married filing jointly, married filing separately, single or head of household. Which status a person files can make a significant difference in how much they are taxed. The source of a taxpayer's income also makes a difference in taxation. It's important to learn the terminology of the different income types that may affect how income is taxed.
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 one year or less after they were acquired) are taxed at the owner's ordinary income tax rate, but long-term gains on assets held for more than a year are taxed at a lower capital gains rate, on the rationale that lower taxes will encourage high levels of capital investment. Tax records should be maintained to substantiate the length of ownership when the assets were sold and the tax return was filed.
Payroll taxes are withheld from an employee's paycheck by an employer, who remits the amount to the federal government to fund Medicare and Social Security programs. Employees pay 6.2% into Social Security on the first $142,800 earned (the wage base limit for 2021) and 1.45% into Medicare on all wages. Because there is a cap on wages subject to Social Security portion of the payroll tax, it is considered to be regressive, with higher paid earners paying a smaller percentage of their total wages.
There is no salary limit for Medicare tax, but anyone who earns more than $200,000 as a single filer (or $250,000 for married couples filing jointly) pays an additional 0.9% into Medicare.
Payroll taxes have both an employee and employer portion. The employer remits both the employee portion, described above, as well as a duplicate amount for the employer portion. The employer rates are the same 6.2% for Social Security, up to the wage base limit, and 1.45% for Medicare on all wages. The total remitted is therefore, 15.3% (6.2% employee Social Security + 6.2% employer Social Security + 1.45% employee Medicare + 1.45% employer Medicare).
Payroll taxes and income taxes differ, although both are withheld from an employee's paycheck and remitted to the government. Payroll taxes are specifically to fund Social Security and Medicare programs. A self-employed individual must pay the equivalent of both the employee and employer portion of payroll taxes through self-employment taxes, which also fund Social Security and Medicare.
Corporate taxes are paid on a company's taxable income. The steps to calculate a company's taxable income are:
- Sales Revenue - 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
The corporate tax rate in the United States is currently a flat rate of 21%. Before the Tax Cuts and Jobs Act (TCJA) of 2017, the corporate tax rate was 35%.
Sales taxes are charged at the point of sale, when a customer executes the payment for a good or service. The business collects the sales tax from the customer and remits the funds to the government. Different jurisdictions charge different sales taxes, which often overlap, as when states, counties, and municipalities each levy their own sales taxes.
As of 2021, the highest average state and local sales tax rate is found in Tennessee, at 9.55%. Five states do not have a state sales tax: Alaska, Delaware, Montana, New Hampshire, and Oregon. Alaska does allow municipalities to charge local sales tax.
The most common property tax in the United States is the real estate ad valorem tax. A millage rate is used to calculate real estate taxes; it represents the amount per every $1,000 of a property's assessed value. The property's assessed value is determined by a property assessor appointed by the local government. Reassessments are typically performed every one to five years. Property tax rates vary considerably by jurisdiction. Property taxes can also be assessed on personal property, such as cars or boats.
As of 2018, the state with the highest property tax collections per capita was New Jersey at $3,378. (D.C. would rank higher if it was counted with the 50 states, at $3,740 per capita.) The lowest state ranking was $598 per capita in Alabama.
A tariff is a tax imposed by one country on the goods and services imported from another country. The purpose is to encourage domestic purchases by increasing the price of goods and services imported from other countries. There are two main types of tariffs. Fixed fee tariffs are levied as a fixed cost based on the type of item. Ad valorem tariffs are assessed as a percentage of the item's value (like the real estate tax in the last section). Tariffs are politically divisive, with debate over whether the policies work as intended.
Estate taxes are levied only on estates that exceed the exclusion limit set by law. In 2021, the federal exclusion limit is $11.7 million. Surviving spouses are exempt from estate taxes. The estate tax due is the taxable estate minus the exclusion limit. For example, a $14.7 million estate would owe estate taxes on $3 million.
The estate tax rate is a progressive marginal rate that increases drastically from 18% to 40%. The maximum estate tax rate of 40% is levied on the portion of an estate that exceeds the exclusion limit by more than $1 million.
States may have lower exclusion limits than the federal government, but no state taxes estates less than $1 million. Massachusetts and Oregon have the $1 million exemption limits. State rates are also different from the federal rate. The highest top state estate tax rates are in Hawaii and Washington at 20%.
Estate taxes are different from inheritance taxes, in that an estate tax is applied before assets are disbursed to any beneficiaries. An inheritance tax is paid by the beneficiary. There is no federal inheritance tax, and only six states have an inheritance tax. The six states are: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania.
The Bottom Line
There are many types of taxes that are applied in various ways. Understanding what triggers a tax situation can enable taxpayers to manage their finances in order to minimize the impact of taxes. Techniques that can help include annual tax-loss harvesting to offset investing gains with investing losses and estate planning that works to shelter inherited income for heirs.