What are Taxes?

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Taxes are money that the government collects from individuals and businesses to fund the vital services and infrastructure they provide.

🤔 Understanding taxes

Federal, state, and local governments impose taxes on their residents and businesses to provide services, operate public works, and create infrastructure for the community. There are many different types of taxes, including income, property, and sales taxes. Some taxes, such as income taxes, go into the state and local government’s budget to fund a wide variety of programs and services. Other taxes, such as the Social Security tax, go toward one particular purpose. Governments at all levels collect taxes. The federal government primarily funds programs using income and payroll taxes. Local governments, on the other hand, rely more heavily on property and sales taxes (and fees). The United States has a progressive income tax system, meaning the more you earn, the higher a percentage of your income you are supposed to pay in taxes.


The most common example of a tax that most of us face is the income tax. Every month when you get your paycheck, you’ll see that your employer has withheld money to pay your federal income taxes and, in most states, your state income taxes. This type of tax makes up the largest source of revenue for the federal government and many state governments. While it might seem like you’re throwing this money away every year, it’s actually going to pay for services and infrastructure that we all use and enjoy. The roads we drive on and the public education our children receive are both paid for with our tax dollars.


Paying taxes is like paying your rent…

As long as you pay your rent every month, you get to enjoy all of the services and amenities that your apartment building has to offer. After all, your landlord uses your rent money to pay for them. Taxes are similar in that the government uses tax dollars to provide government services. You’ll likely receive an eviction notice if you don’t pay rent. Similarly, neglecting to pay taxes that you owe could result in serious legal trouble — including jail time.

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What are the different types of taxes?

Most people pay several different types of taxes. Let’s talk about some of the most common types of taxes.

Income tax

Income taxes are those we pay as a percentage of our income. The amount of money we make determines what percentage of our income we have to pay.

The Internal Revenue Service (IRS) collects income taxes on a pay-as-you-earn basis, meaning you have to pay taxes on your income throughout the year. As a result, your employer typically withholds money from your paycheck to pay the government.

Then, after the year ends, we each file a tax return with the IRS. On this tax return, we tell the government how much we made throughout the year and how much we’ve already paid in taxes. In the end, we either get a refund from the government for overpaying our taxes, or we have to send them a check for underpaying.

Income taxes represent the largest source of revenue for the federal government. About half of federal tax revenue comes from individual income taxes.

Most states also have a state income tax. Seven states have no income tax (Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming), but if you live in one of these states, you’ll still have to pay federal income taxes.

Corporate tax

Corporate taxes are like individual income taxes but for corporations. Companies pay a percentage of their profit for the year in taxes.

Unlike individuals, who pay a tax rate based on their income level, most corporations have a flat income tax of 21%, as of 2020. Corporate income taxes make up just a small share of the federal government’s annual revenue.

Property tax

If you own a home or any other type of property, you likely pay property taxes. State and local governments levy property taxes to pay for government expenditures. School districts also sometimes levy property taxes to help fund educational and infrastructure expenses in the school district.

The amount you’ll pay in property taxes will vary widely depending on where you live. You usually pay property taxes as a percentage of the value of your home. Both the cost of housing and the property tax rate in your area will impact your property tax bill.

Capital gains tax

You’ll pay capital gains taxes when you sell an asset and the sale results in a capital gain for you. Capital gains taxes could apply to the sale of a physical asset like a house or to the sale of shares of stock.

The percentage you pay in capital gains depends not on the value of the asset, but your individual income. As of 2020, the rate you’ll pay in capital gains taxes will either be 0, 15, or 20 percent, depending on your income. In some cases, usually when the asset is held for less than a year, you will be taxed at your income tax rate rather than the capital gains tax rate.

Sales tax

When you buy goods and services, you’ll often pay sales taxes on your purchase. Sales tax applies at the time you make the purchase. The seller collects the taxes and then sends those dollars to the appropriate government body. The amount you pay in sales tax is a percentage of your total purchase amount.

The federal government does not collect sales taxes. Instead, state and local governments collect these taxes. In some places, you’ll pay sales taxes to both levels of government, while individuals in other locations will pay sales taxes to just one level of government.

FICA tax

In addition to withholding income taxes from your paycheck, your employer also withholds Federal Insurance Contributions Act (FICA) taxes. FICA taxes are payroll taxes that pay for Social Security and Medicare, both of which are vital government programs to help senior citizens. Payroll taxes make up more than 25% of the federal government’s annual revenue.

As of 2020, the FICA tax is 7.65% of income. Your employer also pays 7.65% of your income in FICA taxes. Self-employed individuals pay both the employee and employer portion of the FICA tax — This is often referred to as self-employment taxes.

Why do we pay taxes?

The concept of taxation is not a new one. Taxes date back several millenia to Mesopotamia, where individuals used livestock as currency to pay taxes.

In the United States, our tax history dates back before our country existed. Great Britain imposed taxes on colonists for the purchase of items such as tea and legal documents. This taxation led to the famous Boston Tea Party, where colonists protested the taxation without representation in Great Britain’s government.

After the formation of the United States, income taxes didn’t exist until the Civil War. President Abraham Lincoln signed into law the nation’s first income tax to help fund the war. The tax was eliminated a decade later.

Then in 1909, the Supreme Court passed the 16th Amendment, which gave the federal government the constitutional right to collect personal income taxes. States ratified the Amendment in 1913, and the government began collecting income taxes.

Taxes play an essential role in allowing the government to build infrastructure and provide critical services to individuals. As Supreme Court Justice Oliver Wendell Holmes, Jr., once said, “Taxes are what we pay for a civilized society.”

Taxes help pay for things we all have access to, such as roadways, law enforcement, and public education. Taxes also help to pay for programs to help our nation’s most vulnerable. These programs include the Social Security program, which provides income to older individuals, and Medicaid, which provides health insurance coverage to low-income families.

If the benefits that we all receive from taxation aren’t enough to incentivize someone to pay, the penalty they’ll incur for not paying might do the trick.

For some people, the penalties might be minor. If you fail to file your tax return, the Internal Revenue Service (IRS) may file a return on your behalf. But they won’t claim any deductions for you, including the standard deduction. Your tax liability will undoubtedly be higher than if you had filed your return yourself. If you owe money, they’ll send you the bill, along with interest and penalties.

The longer you fail to pay your tax bill, the more you’ll pay in penalties. The penalty is 4.5% per month for failing to file and 0.5% per month for failing to pay. Since the penalties accrue monthly and interest compounds daily, the amount will add up quickly.

In extreme cases, the punishment won’t just be a financial one. If you use illegal means (such as misrepresenting your income to the IRS) to avoid paying taxes, you might be guilty of tax fraud. The penalty for tax fraud can be as high as five years in prison and up to $250,000 in fines.

What are taxes used for?

Your tax dollars pay for vital infrastructure, programs, and services that the federal, state, and local governments provide. On the federal level, just a few programs make up the vast majority of spending. Based on 2018 budget data, those programs are:

  • Social Security: This program, which provides monthly income for seniors, costs taxpayers more than $980B annually. The program is funded by a dedicated payroll tax (aka the Social Security tax).
  • Medicare: In addition to providing income for seniors, our federal government also gives them health insurance coverage through Medicare. The program costs more than $580B annually and, like Social Security, has a dedicated payroll tax.
  • Medicaid: The Medicaid program provides health insurance coverage to low-income individuals and families. The program costs about $390B annually.
  • Defense: The final expenditure that makes up a considerable chunk of the federal government’s budget is defense. Defense spending costs more than $620B annually.

Other federal government spending includes transportation, education, health, housing, unemployment insurance, and veterans benefits. The federal government also spent $325B in 2018 on interest.

In total, federal government spending represents more than 20% of the nation’s gross domestic product (GDP), which is the total value of goods and services that a country produces.

Federal expenditures are classified as either mandatory or discretionary.

Mandatory expenditures are those that the law requires Congress to fulfill. Programs such as Social Security, Medicare, and Medicaid are mandatory expenditures, as are several smaller programs.

Discretionary spending refers to money that Congress isn’t legally required to spend. Defense spending is a form of discretionary spending.

We also pay taxes to our state governments, which are responsible for delivering many essential government programs. One of the primary jobs of state governments is providing public education. As a result, K-12 education represents about 26% of state spending.

Another significant expenditure for state governments is funding Medicaid. The program is jointly funded by the federal government and state governments and administered by the state governments. It makes up about 17% of state government spending.

Other major state expenditures include higher education, transportation, corrections, and public assistance to families in need. Ultimately the spending numbers vary widely from one state to another, as each state has different needs and priorities.

How do income taxes work?

In the United States, we have a progressive income tax system. The percent you pay in income taxes increases as your income level does. There are seven tax brackets with seven different tax rates. Individuals pay a particular rate on the portion of income that falls within a given bracket.

The 2020 tax brackets for a single individual are:

  • 10% for income $0-$9,875
  • 12% for income $9,876-$40,125
  • 22% for income $40,126-$85,525
  • 24% for income $85,5260-$163,300
  • 32% for income $163,301-$207,350
  • 35% for income $207,351-$518,400
  • 37% for income $518,401 or more

Suppose that an individual had $250,000 of taxable income in the tax year 2020. They would pay income taxes in six of the seven tax brackets. But each percentage would only apply to a portion of their income. For example, the 35% tax rate would apply only to the portion of their taxable income that was greater than $207,351.

How do state and local taxes work?

Remember that it’s not just the federal government that levies taxes — State and local governments do as well. The makeup of state and local tax revenue looks very different than that of the federal government.

States rely heavily on sales taxes, individual income taxes, and fees for their tax revenue. Fees that state governments collect include university tuition, payments to public hospitals, and tolls on highways or bridges.

States also rely on intergovernmental transfers, meaning the money they receive from other state or local governments. Most state intergovernmental transfers come from the federal government to pay for welfare programs such as Medicaid.

Like state governments, local governments get a lot of their money from other levels of government. Most of their transfers come from the state government, while a smaller portion comes from the federal government.

Local governments also collect taxes directly. They rely most heavily on property taxes, sales taxes, and fees such as water, sewer, and parking charges.

Sources: Internal Revenue Service (https://www.irs.gov/) Congressional Budget Office (https://www.cbo.gov/) Social Security Administration (https://www.ssa.gov/) Committee for Economic Development (https://www.ced.org/) Center on Budget and Policy Priorities (https://www.cbpp.org/) Tax Policy Center (https://www.taxpolicycenter.org/)

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