Taxes Definition: Types, Who Pays, and Why (2024)

What Are Taxes?

Taxes are mandatory contributions levied on individuals orcorporations by a government entity—whether local, regional, or national. Tax revenues finance government activities, including public works and services such as roads and schools, or programs such as Social Security and Medicare.

In economics, taxes fall on whoever 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.

Understanding Taxes

To help fund public works and services—and to build and maintain the infrastructure 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 who are living in it.

In the United States 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, payments made for goods and services, and so on.

Tax revenues are used for public services and the operation of the government, as well as for Social Security and Medicare. As the large baby boomer generation has aged, Social Security and Medicare have claimed increasingly high proportions of the total federal expenditure of tax revenue. Throughout U.S. 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).

Types of Taxes

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 behalfto 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 with the aim of strengthening domestic businesses
• Estate tax—Rate applied to the fair market value (FMV) of property in a person’s estate at the time of death; the 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 mainly levy property taxes.

Income Tax

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 that 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 taxesare of particular relevance for investors. Levied and enforced at the federal level, these are taxes on the profit generated when you sell an asset that's increased in value.

The rate of taxation on the profit depends on the length of time for which the asset was held. 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, whereas long-term gains on assets held for more than a year are taxed at a lower capital gains rate—based 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 both the assets were sold and the tax return was filed.

Payroll Taxes

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. In 2023, employees will pay 1.45% into Medicare on all wages and 6.2% into Social Security on the first $160,200 earned, up from $147,000 in 2022.

Payroll taxes have both an employee portion and an employer portion. The employer remits both the employee portion, described above, and 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. Therefore, the total remitted is 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

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%.

In August of 2022, the United States Congress passed a new 15% corporate minimum tax into law as part of the Inflation Reduction Act of 2022. This new minimum tax only affects U.S. corporations with three-year average book values of $1 billion or more and foreign corporations with three-year average U.S. income over $100 million.

Sales Taxes

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.

Each state can implement its own sales taxes, meaning they vary depending on location. There's even room for cities and counties to use their own rates, provided that they abide by the taxing rules of their state.

In 2022, the highest average state and local sales tax rate was found in Tennessee, at 9.55%. Five states—Alaska, Delaware, Montana, New Hampshire, and Oregon—did not have a state sales tax, although Alaska did allow municipalities to charge local sales tax.

Property Taxes

A 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 and many states also taxtangible personal property, such as cars and boats.

In FY 2018, the state with the highest property tax collections per capita was New Jersey at $3,378. (The District of Columbia 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.

Tariffs

A tariff is atax imposedby 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, which are levied as a fixed cost based on the type of item, and ad valorem tariffs, which are assessed as a percentage of the item’s value (like the real estate tax in the previous section).

Tariffs are politically divisive, with debate over whether the policies work as intended.

Estate Taxes

Estate taxes are levied only on estates that exceed the exclusion limit set by law. In 2023, the federal exclusion limit is $12.92 million, up from $12.06 million in 2022. 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 $1.78 million.

The estate tax rate is a progressive marginal rate that increases 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 worth less than $1 million. Massachusetts and Oregon have the $1 million exemption limits. State rates are also different from the federal rate. In 2022, the highest state estate tax rate, implemented in Hawaii and Washington, was 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, as of 2022, only six states have an inheritance tax: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania.

Tax Delinquency

Every type of tax has a different due date or reporting requirement. Some are collected immediately at the time of a transaction or leading up to a transaction like sales taxes or tariffs. Others are on a fixed recurring schedule with a due date repeating on a specific date or specific day/month combination (i.e. property taxes being due the first day of April). The due dates for similar types of taxes will vary across governing bodies (i.e. different counties will have different property tax due dates).

Upon failure to remit the appropriate amount of a tax to the taxing authorities, various penalties may be incurred. Regarding the various taxes mentioned above, tax penalties may include:

• A penalty assessment resulting in a one-time fee or charge.
• An interest assessment resulting in an escalating penalty based on the duration of the delinquency.
• A lien placed on underlying assets in the event the delinquent party should be unable to satisfy their debts.
• A denial of access or service for transaction-related taxes (i.e. tariffs).
• A seizure of company property or placement of a lien on the company property for business-related taxes.

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 to minimize the impact of taxes. Techniques that can help include annual tax-loss harvesting to offset investment gains with investment losses, and estate planning, which works to shelter inherited income for heirs.