What Are Taxes?

What Are Taxes?

Let me explain taxes directly: they're mandatory contributions that governments—local, regional, or national—levy on individuals or corporations. These revenues go toward funding government activities, like building roads and schools, or supporting programs such as Social Security and Medicare.

From an economic standpoint, the tax burden falls on whoever ends up paying it, whether that's the business being taxed or the consumers buying its goods. In accounting terms, you'll encounter various taxes like payroll taxes, federal and state income taxes, and sales taxes.

Understanding Taxes

Governments tax their residents—individuals and corporations—to fund public works, services, and infrastructure that benefit the economy and everyone in it. You see this in the United States and many other countries, where income taxes apply to money received, like salary, capital gains, dividends, interest, or payments for goods and services.

These tax revenues support public services, government operations, Social Security, and Medicare. With the aging baby boomer generation, these programs take up more of the federal budget. Tax policy has always been a hot topic in U.S. political debates.

A tax means the government takes a percentage of your earnings or money and you must pay it—it's compulsory. Evading taxes, which is deliberately not paying what you owe, is illegal and punishable. But tax avoidance, where you legally reduce your liability to keep more after-tax income, is fine.

Most governments have an agency for collecting taxes; in the U.S., that's the IRS.

Types of Taxes

You'll encounter several common types of taxes. Income tax takes a percentage of your generated income for the state or federal government. Payroll tax is a percentage your employer withholds from your pay to fund Medicare and Social Security. Corporate tax is a percentage of company profits for federal programs. Sales tax applies to goods and services at purchase, varying by jurisdiction. Property tax is based on the value of your land and assets. Tariffs are taxes on imported goods to boost domestic businesses. Estate tax hits the value of property in someone's estate at death if it exceeds certain thresholds.

Tax systems differ by country, so if you're earning income or doing business in a new place, study the laws carefully. In the U.S., the federal government handles income, corporate, and payroll taxes; states do income and sales taxes; local governments focus on property taxes.

Income Tax

The U.S. uses a progressive income tax system, meaning higher earners pay a higher percentage. This works through marginal tax rates, influenced by your filing status—like single, married filing jointly, or head of household—which can significantly affect your tax bill. The type of income matters too; learn terms for different incomes to understand taxation.

For investors, capital gains taxes are key—these tax profits from selling appreciated assets. Short-term gains (assets held a year or less) are taxed at your ordinary rate, while long-term gains (over a year) get a lower rate to encourage investment. Keep records to prove holding periods when filing.

Payroll Taxes

Employers withhold payroll taxes from your paycheck to fund Medicare and Social Security. You pay 1.45% for Medicare on all wages and 6.2% for Social Security up to an annual wage base that adjusts for inflation. If you're a single filer earning over $200,000 (or $250,000 for joint filers), you pay an extra 0.9% for Medicare.

These taxes have employee and employer portions; employers match your contributions, totaling 15.3%. Payroll taxes differ from income taxes but both come from your paycheck. Self-employed people pay both portions via self-employment taxes but can deduct the employer share.

Corporate Taxes

Companies pay corporate taxes on taxable income, calculated by subtracting cost of goods sold from sales revenue to get gross profit, then deducting operating expenses to reach EBIT, and subtracting interest to get taxable income. The U.S. rate is a flat 21%, down from 35% before the 2017 Tax Cuts and Jobs Act.

There's also a 15% corporate minimum tax from the 2022 Inflation Reduction Act, applying to large corporations with high book values or U.S. income.

Sales Taxes

Sales taxes hit at the point of sale; businesses collect them from customers and send them to the government. Rates vary by state, and even cities or counties can add their own, as long as they follow state rules.

Property Taxes

Property taxes, like real estate ad valorem taxes, use a millage rate per $1,000 of assessed value, determined by local assessors with reassessments every one to five years. States may also tax personal property like cars and boats, with rates varying by area.

Tariffs

Tariffs tax imported goods and services to make them pricier and encourage buying domestic. They come as fixed fees or percentages of value, and they're often debated politically on whether they achieve their goals.

Estate Taxes

Estate taxes apply to estates exceeding exclusion limits, but surviving spouses are exempt. The tax is on the amount over the limit, with progressive rates from 18% to 40%. States may have their own limits and rates, sometimes adding inheritance taxes paid by beneficiaries. No federal inheritance tax exists, and only a few states have one.

Tax Delinquency

Taxes have different due dates; some are immediate like sales taxes, others recurring like property taxes. Failing to pay can lead to penalties like one-time fees, interest, liens on assets, denied access, or seizures. Each governing body sets its own schedules.

Why Do We Pay Taxes?

Taxes provide the main revenue for governments to maintain infrastructure like roads and fund services like schools and emergency programs.

How Do Income Taxes Work in the U.S.?

U.S. income taxes are progressive, with seven brackets from 10% to 37% based on income level.

Who Has to Pay Taxes?

It depends on the tax type and rules; for example, federal income tax applies to those above certain income thresholds, while corporate taxes hit businesses in specific areas.

What Are Different Types of Taxes?

Taxes include transaction-based like sales or tariffs, income-based like individual or corporate, and event-based like estate or capital gains.

The Bottom Line

Various taxes apply in different ways, and knowing what triggers them lets you manage finances to reduce their impact, such as through tax-loss harvesting or estate planning to protect heirs.