Types of Taxes: the US Tax System Explained
Last Updated: January 11, 2023
“The hardest thing in the world to understand is the income tax,”
…said Albert Einstein.
So, what are the chances of understanding for the rest of us mortals then?
With the right guide, a bit better!
So, stay with us and learn all you need to know about:
- what is taxation
- how do taxes work, and what are they used for
- the types of taxes in the United States
What Are Taxes — Tax Definition and Historical Facts
Tax is a compulsory financial contribution of any individual, association, or institution that supports government projects and public expenditures. These payments are imposed and supervised by the official authorities.
And so, any failure to fulfill this legal obligation, including tax evasion and resistance, leads to strict law punishments.
Although new types of tax seem to be appearing every day, taxes are, in fact, nothing new.
The first confirmed example of taxation dates all the way back to ancient Egypt, somewhere around 3000 BC. Although, the chances are some older civilizations probably had different forms of tax collection even before that. Claims exist that Mesopotamian people paid taxes in the form of livestock starting from 4500 BC.
In the US, Abraham Lincoln was the first to introduce the income tax within the Revenue Act of 1861. The income tax collection was supposed to help the Civil War efforts. And so, as soon as the war ended in 1872, the practice became unjustified, and it got aborted.
Tax in independent America got overturned a couple of more times after that and was, in general, hard to establish. Mainly because the nation still suffered the consequences of heavy Great Britain tax demands from colonial times.
Finally, at the beginning of 1913, the idea of tax system implementation received the needed support and became a part of the Sixteenth Amendment.
Since then, the system evolved dramatically, and different types of taxes emerged. The latest Federal tax reform happened in 2020.
How Do Taxes Work?
If you’d look at the world’s tax map or chart, you’d get to see a very colorful picture.
Tax collection works differently around the world. Also, tax rates differ significantly by country, from Aruba and Chad with close to 60% individual income tax rate to the Cayman Islands and Qatar with 0%.
The US stands somewhere in between with its seven different income tax brackets. The lowest being 10% and the highest 37%.
But before you pack your bags and start looking for your passport, let’s see how taxes work in the US and why they are necessary.
First of all, how are taxes paid?
There are three ways in which one can make their tax payment. These are:
- through tax expenditures
Direct taxes — as the name suggests, these are the taxes that a person or association pays directly to the government entity that levies it. Individual income tax, corporate taxes, and property taxes are all examples of direct tax.
Indirect taxes — are all taxes we pay on goods and services, including those of importing gas, alcohol, and tobacco. They are named indirect because you’re not directly paying them to the government or any of its entities. Instead, you give a set amount of tax money to a merchant who then settles tax with the government. Indirect taxes include sales taxes, value-added taxes, tariffs, and excise taxes.
Tax expenditures — Whenever you donate to charity or buy a house, you’re, sort of, helping your government. To repay you, the government then forgoes a chunk of your tax. These are tax expenditures in simplest terms. Or in other words, tax expenditures are the activities that you can perform to benefit the community. And, the government promotes these activities by offering tax deductions and tax credits in exchange.
How you pay your tax will define the tax rate.
- And so, for taxes paid directly, you will follow your tax bracket and pay the percentage of the whole taxable amount as defined by that tax bracket.
- Indirect taxes, on the other hand, are the same for everyone.
- With tax expenditures, you get to decide on the value and type of your contribution.
Who collects taxes in the States?
The United States collects taxes on three different levels.
The biggest chunk of the total tax amount goes to the federal government that collects income tax, excise taxes, custom duty taxes, tariffs, and similar. All these add to over two-thirds of the total tax deduction in the US.
Precisely, who collects income tax for the US government?
Governments typically hire different agencies or commissions to collect their income taxes. In the US, the Internal Revenue Service (IRS) is in charge of this formal duty.
State governments collect around 20% of all tax, mainly through sales and some excise taxes.
Local governments collect the rest. Most of the time, they impose taxes on property, land value taxes, and a part of taxes from sales.
Unfortunately, very often, tax collection jurisdictions are not clear-cut. Same property, income, or service can sometimes be taxed at a few different government levels without the taxes offsetting each other.
What tax does every American have to pay?
As a UС citizen, you’re in legal obligations to pay all the taxes imposed by the law on federal, state, and local levels.
However, by no means does this imply that everyone pays the same amount.
If we divide all our government set financial obligations in these three basic tax categories:
- tax on what you earn
- consumption tax
- tax on what you own
Then, your total tax amount will depend on how much you earn, how much you spend, and what you own.
What Do Taxes Pay for?
So far, it seems like taxes are just a lot of expenses. But in reality, they are designed to support the society.
Various types of taxes exist to improve different segments of life. Those usually include healthcare, infrastructure, social security funds, and similar.
Also, by sparing a fragment of your salary, sales, or possession for tax purposes, you’re helping gross domestic product (GDP) rise. And this, in turn, promotes the economic growth of your country. Finally, new job opportunities appear, salaries increase, and an altogether better standard of life generates.
All in all, wisely used government taxes can create a ripple effect with numerous social and economic benefits.
All this being said, let’s now see how your tax money gets spent in the States.
What are taxes used for in the US?
You know that feeling of thrill when the salary arrives?
And then the disappointment when you realize that the government gets to spend over one-third of it…
Would it make you feel any better if you’d known that, at least, that money ends up well-spent?
Well, let’s see if that’s the case.
Leading health programs
Did you know that about 18% of your tax bill goes to funding leading national health programs?
Medicaid, Medicare, and the Children’s Health Insurance Program (CHIP) all receive support from different types of taxes and taxpayers around the country.
Not too bad, right?
Social security has been one of the principal motives for tax collection since the beginning of the practice. Retirements, survivors’ benefits, and disability support all make a return from the social security treasury.
You work and contribute to the national budget through different tax types while you are young and healthy so that you don’t have to work when you reach the greater age.
With almost 23% of federal budget investments, social security is a mandatory segment of tax expenditures.
National defense and security
National security presents one of the major concerns of the government.
Then, it doesn’t surprise that the government reserves almost 16% of the federal budget to support the Department of Defense and Homeland Security Agency.
And so you follow and respect the long list of taxes daily.
But at least you sleep peacefully at night.
Safety net programs
Why do we pay taxes if not to help those in need?
Not everyone is in a position to enjoy different health programs and social security benefits. Unemployed citizens, low-income and some mid-income families, as well as underprivileged kids, often need additional assistance.
This aid is ensured by the government, with:
- unemployment insurance
- housing assistance
- food stamps
- underprivileged children programs
Around 9% of all federal taxes reach those who need help the most, one way or another.
But this is not all.
Taxing in America ultimately serves many other purposes.
It helps take care of the interest on the national debt, benefits for federal retirees and veterans, and similar.
Furthermore, most infrastructural, educational, and scientific projects wouldn’t be possible without the government’s financial support.
So what makes the USA the way it is — it’s all of us!
Types of Taxes in the USA
For a while in US history, the only taxes that the government collected were import taxes or tariffs.
Imagine living in those times!
Instead, we have a quite complex tax structure — that even the brightest among us can’t follow at times without professional advisors or tax software.
Still, the better our understanding of that structure and our obligations as US citizens, the lesser the chances of unintended tax breaches and evasions.
So let’s now see — what are the different types of tax currently in force in the USA?
1. Income tax
Income tax statistics show that over 70% of US citizens don’t pay taxes on, at least, a portion of their income.
Some taxpayers accidentally forget to file it. Others do intentional evasions or are not fully aware of how it works.
To lessen this confusion, let’s first dig into what income taxes are and how they are categorized.
As their name suggests, income taxes are taxes that each individual or corporation needs to pay on their earnings or income. Different rules and regulations apply to each type of income tax. However, the common thing for most of these taxes is that they are marginal and progressive.
Marginal — means that there are different tax brackets or categories based on one’s taxable income amount. They are expressed in percentages.
Progressive — means that as your income increases, your taxes will increase too.
The two main types of income tax are the following:
Personal income tax
This is a tax that each citizen pays on their individual or household income that comes from wages, salaries, or investments.
Currently there are seven tax brackets for personal income in the States. They are: 10%, 12%, 22%, 24%, 32%, 35%, and 37%.
Here’s an income tax example:
If your taxable annual income is between $0 and $9,950 and you are a single person filing individually, your tax bracket is the lowest one of 10%. The same goes for married couples filing individually. Married couples filing together will fall under the same bracket with a combined income of up to $19,900.
As your single earnings rise above $9,951 to up to $40,525 or combined ones exceed $19,901 but not $81,051, you will move to the next tax bracket (22%), and so on.
However, as we work on understanding tax brackets, you should remember the following:
Moving to the next tax bracket doesn’t mean that all your taxable income will undergo that bracket. Instead, for your first $9,950, you will still have to pay only 10% of tax. And then, for the remaining of your total income between $9,951 and $40,525, the tax will rise to 12%.
The trend will continue until some of your income, currently above $523,601, reaches the 37% tax bracket.
Corporate income tax
A corporate income tax is usually a federally or state-imposed tax on all corporate revenues, excluding the costs of managing and executing the business.
Currently, more and more countries around the globe are lowering their corporate income taxes to support their corporations.
In the US, the federal corporate tax rate got lowered to 21%. That is thanks to the Tax Cuts and Jobs Act of 2017.
However, in some US states, some additional corporate tax rates by state apply.
2. Payroll taxes
These are also types of taxes deducted from your salary. However, they have the specific purpose of covering your social security and medical insurance expenses.
In some cases, your employer will take care of your payroll taxation, and in others, you will have to do it yourself.
And then, we have payroll taxes under the Federal Insurance Contribution Act, or FICA taxes — shared between the employer and the employee.
In any case, the combined payroll taxes in the USA rarely exceed 15%.
3. Capital gains tax
Once your investments pay off, the earnings become taxable. These types of taxes we pay on profit from investments are known as capital gains taxes.
Capital gains taxes, therefore, apply to dividends and interests. Likewise, they’re imposed on stocks and bonds earnings but only once realized.
The rate of the tax you’ll have to pay will depend on several factors, but mostly on your tax bracket and the duration of your investment.
And so, in the US, short-term capital gains taxes match the regular income taxes. However, the long-term ones have much more favorable rates.
4. Property tax
To have a nice house in a good neighborhood is pretty much everyone’s dream.
Until they get the property taxes explained.
Basically, the more valuable your house and the better its area — the higher your taxes will be. And if you don’t have the adequate income or savings to support that, your unpaid property taxes could diminish your house value and sale chances.
Your property tax debt could turn into a tax lien and your dream into a nightmare.
But, how do you pay property taxes?
You pay property taxes to your local government. To calculate your tax rate, they multiply the fair market price of your property and the tax rate of your area. The results are the taxes that typically range from 0.50% to 4% of the property value.
As an owner, you have the right to declare the property value, which then a professional tax assessor may accept or alter.
5. Sales tax
In simplest terms, the sales tax is what you see at the bottom of your receipt every time you visit a store. It’s a tax on things you buy.
Sales tax falls under the category of consumption tax. Unlike income or capital gain tax, consumption tax is imposed on people’s spendings and not on their earnings.
It is also an indirect tax because the consumer pays for it, but the merchant is responsible for money reaching the government.
The two main types of sales taxes are:
General sales tax
Each of the US states applies the general sales taxes. To calculate them, one should multiply the purchase value with the effective tax rate in that state.
Usually, it’s the state government that imposes the official tax rates. Alaska, Delaware, Montana, New Hampshire, and Oregon are exemptions here since they entrust this responsibility to their local governments.
Sometimes the state and the city taxes both apply, leading to higher total sales tax.
Excise taxes or sin taxes
You must’ve heard of another type of compulsory taxation called sin taxes.
Sin or excise taxes are also consumption taxes which, most of the time, consumers settle indirectly.
The name itself suggests that these are the taxes that apply to specific, often harmful, goods. These include tobacco, alcohol, cigarettes, casino gains, and similar.
The taxes, usually, get levied on both federal and state levels. Besides, the rates of these taxes are among the highest, with the obvious intention of discouraging consumers. Sin taxes are either charged as:
- Ad valorem tax — expressed in percentages so they can vary.
- Fixed tax rates — flat fees added to the regular cost of an item.
6. Estate tax and inheritance tax
People often mix up and interchange these two different kinds of taxes. And although they share the settlement of taxes on assets inherited from a deceased person, this is how they differ:
Estate taxes — are covered by the estate itself before its assets even reach the heirs.
Inheritance taxes — are left for heirs to settle upon the inheritance receipt.
Both of these types of taxation could be difficult to implement and complex to administer. On top of that, they often lead to unsatisfactory economic outcomes such as poor estate planning or altogether abandonment.
As a consequence, more and more states are dropping the estate and inheritance taxes.
7. Gift tax
Yes, you read it well.
You need to pay taxes on gifts too!
Or, to be precise, if you’re the donor of the gift, you will need to report it and settle the gift tax. The recipients usually don’t pay for these types of taxes in the USA.
Gift taxes have been created on a federal level to minimize income and capital gains tax avoidance. Namely, taxpayers realized, at some point, that by transferring some of their profit to their friends or relatives, they can steer clear of paying most of their income taxes.
By introducing gift taxes, the country got a better insight into its investors’ actions.
Gifts, in this case, are only the contributions of financial value that the receiver doesn’t cover in total. Partial payments are allowed for the contribution to remain a gift.
Although these types of federal tax can turn out to be quite high, 18% to 40%, they are usually still lower than capital gains taxes. Besides, there are a few tax gift exemptions that make gifting away some of your assets worth considering.
- One can give an unlimited asset amount tax-free to their US citizen spouse (or up to $159,000 if the spouse is not a citizen of the US).
- Gifts for educational and medical purposes to a person or institutions are tax-free.
- That applies to the gifts to charitable and political organizations too.
- Gifts that don’t exceed in value the annual gift-tax exclusion rate are free of tax.
8. Tariff taxes
Also known as import duty, custom duty, or import tax, these types of taxes in the US have the following aims:
- to raise funds for local governments
- to promote locally-grown food and locally-produced goods by giving them the tariff-free advantage
- at times, tariffs may even serve for restricting certain countries from importing their products (by applying high tariff rates on those products)
In the USA, Congress determines the tariff rates.
Most often, these rates are based on:
- the imported good’s value
- and the importing country’s relationship with the USA.
Special rates for underdeveloped countries apply. The same goes for the countries that are under the international trade program.
To sum everything up:
- Whether we like it or not, taxes are present in almost every sphere of our lives.
- Different types of federal taxes can take more than one-third of all your assets each year.
- The more you learn about tax, the lesser chances for potential fines and losses.
- The crucial purpose of taxation is funding major public programs and projects and, ultimately, a GDP rise.
- Besides, paying taxes is everyone’s legal obligation. And, failure to do so can lead to a lot of problems.
Federal taxes are the money that the government collects from individuals and companies to invest in healthcare, social security, infrastructure, education, and similar. Examples of federal taxes are income taxes, property taxes, and sale taxes.
Taxes in the US are collected on federal, state, and local levels. The government hires trusted professional agencies to do the tax collection. On a federal level, that is the IRS.
We pay different types of taxes on most of our earnings, our purchases, and our property. The list goes on, but these are the main segments of our tax obligations.
Yes, paying taxes is everyone’s law obligation. Failing to do so may lead to severe financial penalties or even jail time.
The main difference is that tax evasion is an illegal practice of concealing tax obligations and information from the authorities, while tax avoidance is completely legal. Tax avoidance merely represents one’s righteous methods for taxable income reduction.
A direct tax is every tax that you pay directly to a government body. And indirect taxes are those you pay to a merchant or service provider as a mediator between you and the government.
The main types of taxes are:
- income taxes,
- capital gains taxes,
- property taxes,
- sales taxes,
- estate taxes,
- gift taxes,
- payroll taxes, and
- tariff taxes.