A Complete Guide to Different Types of Taxes & Their Importance
November 14, 2023
The government imposes different types of taxes on all taxpayers, whether they are individuals, legal entities, U.S. citizens, or permanent residents. Taxes play a key role in regulating and developing the community.
Specifically, the government uses taxes to generate funding for its programs. These programs are designed to provide medical and educational services, implement safety measures, improve transportation, and provide financial aid to senior citizens, persons with disabilities, and unemployed individuals.
It pays to know the different types of taxes with examples of when these taxes are applicable so you can understand how each tax is withheld from your hard-earned money.
- The three main types of taxes are income taxes, property taxes, and taxes levied on goods and services.
- The government collects taxes to generate funding for a variety of programs meant to protect and serve the community. These programs include healthcare, education, public safety, disability insurance, and improving infrastructure.
- Progressive taxes adjust depending on the taxpayer’s income. Regressive taxes are assessed regardless of the taxpayer’s income. Proportional tax levies the same tax percentage for everyone.
What are Taxes?
Taxes are essential and requisite contributions imposed by the federal, state, and local governments and levied on income generated by individuals, businesses, corporations, organizations, and other non-tax-exempt entities.
The government uses taxes to fund programs thatprovide assistance and benefits to the disabled, senior citizens, and individuals who were displaced from their jobs.
Taxes are also used to fund projects meant to build infrastructure, improve healthcare and educational facilities, provide recreational activities, and boost public safety.
There are three main types of taxes:
- Taxes imposed on income
- Taxes imposed on property
- Taxes imposed on goods and services
Each tax type is levied on a percentage of taxpayer income, capital gains, interests, and dividends. It is also important to point out that not all individuals and organizations are subject to taxation.
Tax-exempt individuals and groups are those who generate revenue through receiving donations or voluntary contributions. Hence, the IRS does not consider the money they generate as subject to federal, state, or local tax.
4 Types of Taxes on Income
The following are the four different types of taxes levied on taxpayer income:
#1. Income Tax
Income tax is imposed on employee earnings and other sources of income, such as commissions, dividends, and profits earned from capital assets.
This type of tax is an example of a direct tax because taxpayers pay the said tax directly to the organization or body that imposed it. In this case, business owners and individuals pay income taxes to the IRS.
Businesses, self-employed individuals, sole proprietors, legal entities, and organizations are also subject to income taxation. Income taxes are levied by the federal, state, and local governments, but not all states and regions impose taxes on their constituent’s earnings.
Income tax rates follow a progressive tax system, which means that the tax percentage increases as the income goes up.
For employees, their income tax amounts are determined by the information on their Form W-4, as well as their tax bracket and filing status.
Tax brackets comprise different ranges of income used to determine an individual taxpayer’s taxable income. Filing status determines the filing requirements, tax amounts, and suitability for certain tax credits.
Meanwhile, the IRS assesses the taxable income of small businesses based on their structure. The different business structures are sole proprietorship, C-corporation, S-corporation, and LLC.
Sole proprietors file personal income tax returns, while income taxes on LLCs are based on the number of members and the agreed-upon design of the company.
#2. Payroll Tax
Payroll taxes are also levied on employee wages and salaries, although the tax amount is shared with their employer. The government uses payroll taxes to fund its programs designed to provide healthcare benefits, disability insurance, and unemployment assistance.
There are specific types of taxes that make up payroll tax, and these are the Federal Insurance Contributions Act (FICA), Federal Unemployment Tax Act (FUTA), and State Unemployment Tax Act (SUTA) taxes. FICA includes Medicare and Social Security taxes.
Employers and employees split the 12.4% tax rate for Social Security and the 2.9% tax for Medicare. Self-employed individuals pay the percentages for both Medicare and Social Security taxes in full.
As for FUTA and SUTA taxes, employers shoulder the burden of paying for both. For FUTA, employers pay taxes on the first $7,000 paid to their employees’ salaries or wages each year. SUTA taxes differ in each state. Keep in mind that not all states levy unemployment taxes.
#3. Corporate Tax
Corporate tax refers to the tax imposed on a corporation’s taxable profits or income.
The taxable income for corporations includes their administrative expenses, general expenses, costs of goods sold, expenses incurred for marketing and selling their products, and other costs associated with operating the business.
In the U.S., the federal corporate tax rate follows a flat 21%, a significant decrease from the initial 35% rate. The change was brought about by the Tax Cuts and Jobs Act (TCJA), which was signed into law by then-president Donald Trump in 2017.
The TCJA took effect in 2018 and has since made major changes in business taxes.
Most operating expenses, investments, and real estate purchases made by a corporation for the sole purpose of generating more income are considered taxable.
However, there are also ways in which a corporation can reduce its tax-deductible income. They can do this by deducting bonuses, health benefits and insurance premiums, travel costs, and taxes on sales and fuel.
#4. Capital Gains Tax
Capital gains tax is a type of tax levied on the profit generated from selling investments. Investors owe capital gains tax for the specific tax year in which they sold the investment.
Specifically, real estate, capital assets, bonds, stocks, coin collections, and even digital assets such as NFTs and cryptocurrencies are subject to capital gains tax.
There are two different types of capital gains tax that can be levied on investment profits: short-term capital gains tax and long-term capital gains tax.
Long-term capital gains tax applies when the investment has been under the investor’s ownership for at least one year.
In contrast, short-term capital gains taxes are levied on profits earned from investments owned for less than a year.
When it comes to tax rates, long-term capital gains follow either a 0%, 15%, or 20% rate, depending on which tax bracket the taxpayer’s income belongs to. Short-term capital gains tax rates are based on ordinary income tax rates.
Ordinary income tax rates are regular tax amounts typically levied on salaries and wages, bonuses, tips, and commissions.
3 Types of Taxes on Property
The three main types of property taxes are as follows:
#1. Property Tax
Property tax is paid by private individuals and legal entities or corporationson the property they own. Property taxes are estimated by assessing the value of a taxpayer’s personal property or estate.
To ensure accuracy in calculating the tax rates for different properties, the local government hires a tax assessor to evaluate the value of each property, compare it with the current fair market value, and determine the tax rates.
The current market value of the property is multiplied by the property tax rate to determine the amount of taxes that property owners must pay.
Since property taxes are derived from the appraised or determined value of a property, they are considered a regressive tax. Typically, the local government takes on the task of measuring property values and imposing the appropriate tax amounts.
The tax rates and regulations on property taxes also vary per location and jurisdiction.
#2. Real Estate Tax
The real estate tax is a type of tax similar to property taxes, but to a certain extent. The key distinction between real estate and property taxes is that real estate taxes are levied on the estimated value of a taxpayer’s home.
Property taxes, on the other hand, apply to moveable items such as vehicles, furniture, equipment, jewelry, and electronic devices.
Homeowners pay real estate taxes on their residential properties annually. Similar to a property tax, the tax rate is also measured by assessing the house’s fair market value and then multiplying the resulting value by the local tax percentage in the taxpayer’s municipality.
The real estate tax is an example of proportional taxes in the US. What this means is that the tax percentage remains the same for all, regardless of their regular income.
#3. Wealth Tax
Wealth tax, also called equity tax or capital tax, is levied on a taxpayer’s assets, such as shares, bank deposits, pension plans, fixed assets, real property, trusts, and money funds.
Wealth tax rates are based on the asset’s market value, while tax percentages are based on the taxpayer’s net worth.
France, Spain, Norway, and Switzerland all levy wealth taxes. In contrast, the U.S. does not impose a wealth tax, whether federally or individually, in each state.
The reason behind this is that the United States already levies property taxes on the same types of assets and properties every year. Taxpayers also pay annual income taxes. Not to mention, estate taxes are paid when a deceased individual owns a high-value estate.
4 Types of Taxes on Goods and Services
Taxes on goods and services are levied on the production, sale, delivery, and transfer of goods.
There are four main types of taxes on services and goods:
#1. Sales Tax
A sales tax is levied on the sale of services and goods. It is a type of consumption tax that is commonly calculated and charged as a portion of the product’s retail cost. Consumers pay sales taxes on the goods they purchase at the point of sale.
Sales taxes typically undergo different stages in assessing who is ultimately liable for paying the said tax.
Let’s say a consumer purchases a jacket from the department store. Prior to the sale of the jacket, the end product was sourced for raw materials, manufactured, mass-produced, and distributed to different vendors and stores.
Throughout all the different stages completed to produce the jacket, key players in producing the jacket, such as the manufacturer, supplier, and distributor, may have secured a resale certificate to exempt themselves from paying sales taxes upon purchasing the goods or acquiring the materials for the product.
The sales tax rate also differs by jurisdiction.
#2. Value-Added Tax
Value-added tax (VAT), also called GST (goods and services tax) internationally, is a type of tax that is levied at each stage of manufacturing and distributing the goods. That said, VAT rates are determined and measured incrementally.
Collecting value-added tax applies to all stages, from the initial manufacturing and production of the product up to the point of sale. Compared to a sales tax, VAT prices charged to consumers do not include all the other taxes that were initially charged prior to the purchase of the product.
For instance, the taxes levied on the cost of materials have already been paid for by the vendor who purchased the materials from the supplier. VAT percentages are also charged at the same value, regardless of who purchases the product.
In other words, VAT uses a flat tax rate. While some may say that VAT charges taxes equally on the rich and the poor, several critics have pointed out that the flat tax percentage eventually leaves a heavy tax burden on low-income households.
In response, the government excluded certain products from levying value-added tax. These products comprise the basic needs of a typical household, such as food, clothing, and medicine. For some basic necessities, the VAT prices are significantly lower.
#3. Tariff Tax
Tariff tax refers to the types of taxes imposed by a country on imported goods. The goal of imposing tariffs is to protect the national interest and domestic industries of the country importing the goods.
While importing goods provides benefits such as reducing manufacturing costs and introducing new products to the importing country’s population, excessive importing can outcompete the country’s domestic market.
The importing country’s government levies a tariff tax to balance their economic gains and losses. Tariff taxes are either ad-valorem, meaning they are charged based on the goods’ assessed value or levied only on specific types of goods, such as vehicles, shoes, or computers.
#4. Excise Tax
Excise tax is a type of indirect tax imposed on alcoholic beverages, fuel, and tobacco.
Business owners and vendors selling the said products pay the excise taxes, although consumers also pay a percentage of the excise taxes once vendors include the tax rates in the product’s final price.
Similar to tariffs, excise taxes can also be charged as an ad valorem tax or adjusted based on the product.
All in all, the quality of life you are experiencing in your community is a reflection of where your tax money ends up.
Now that you know the different types of taxes in the USA, it is important to take note of the taxes you are subject to pay based on your financial and employment status.
Understanding your tax obligations is both your responsibility and your right, whether you are a business owner, self-employed, a taxpayer earning a considerable income fit for a comfortable life, or an individual whose earnings land you in the lowest tax percentage of the federal tax bracket.
Types of Taxes FAQ
#1. Why do we pay taxes?
We pay taxes to help the federal, state, and local governments generate funding for programs meant to improve healthcare, education, public roads and railways, transportation and facilities, and public safety.
#2. Who needs to pay taxes?
In general, the majority of U.S. citizens, including permanent residents working in the U.S., are required to pay federal taxes. They may also have to pay state and local taxes, depending on their municipality and place of residence or work.
#3. What is the highest type of tax?
The highest type of tax is the individual income tax. Individual income taxes provide the highest revenue for federal, state, and local governments. Also, based on the 2023 Federal Income Tax Brackets, the highest tax rate for income taxes is 37%. The said tax rate is imposed on individuals earning at least $578,125 or more annually.