Updated: Apr 18, 2021
Have you ever sat and thought something along the lines of “How do taxes work?” If so, then congratulations. You are now one of the millions of people who have been or are confused about the American Tax System. It is nothing to be ashamed of, though; taxes are tricky. There are so many different taxes from multiple different categories, and what each tax is can be confusing to comprehend. It would help if these topics were covered in school, but unfortunately, most people who graduate high school enter the real world with little to no knowledge of taxes, setting themselves up for many challenges in adulthood. Fear not, for you have come to the right place. This mini-series of blogs will help you understand the different types of taxes, the most commonly encountered taxes and how to deal with them, as well as other information and tips on how to manage taxes. (Note: This post will only be covering American Taxes)
The Three Main Tax Categories
Taxes on what you buy
Taxes on what you earn
Taxes on what you own
1. Taxes on What You Buy
Taxes on items you buy are very commonly known since they are encountered in everyday life, and sales taxes are no different. In the States, every time you make a purchase, you will have to pay a small percentage extra based on what state you are in. Each state has its own tax rate, and certain counties in each state can also have their own tax rate. The most common sales tax rate is around seven percent, though it can and will differ. For example, in Wake County, North Carolina, you would have to pay a sales tax of 7.25% when accounting for state and local taxes. If you wanted to buy a ten-dollar shirt, you would end up paying $10.73 for that shirt ($10 * 1.0725 [full price of the shirt + the tax rate] = $10.725, which rounds up to $10.73).
Excise taxes are similar to sales taxes in that they are levied on goods that are bought, but they are normally assigned to specific goods. Excise taxes are commonly known as “sin” taxes in many places because items that receive these taxes include items like alcohol, cigarettes, gambling, and gasoline, which all negatively impact one’s health, the environment, or both. These taxes are not generally seen on receipts since excise taxes are charged to the businesses who produce or sell certain goods such as alcohol or tobacco. To counter the costs of these taxes, they charge more to the consumer. Excise taxes can be either Ad Valorem, meaning the tax is a fixed percentage, or they can be Specific, meaning that the tax is a fixed amount or on a per-unit basis. Excise taxes also affect retirement accounts, which you can read more in-depth at the end of this article.
Value-Added Taxes (VATs)
These taxes are known as consumption taxes and are charged to the consumer based on how much value was added to a good or service during each stage of production. Each entity is to pay a certain VAT depending on the value of the good at that step, but the VAT can be written off each step (basically, they do not have to pay the VAT). This is true up until it reaches the final consumer, who must pay the VAT without writing it off or having it as a deductible. By doing this, the issue of tax pyramiding is avoided, which will be discussed later. VATs are common in the world and present in 140 countries, but America currently does not levy a VAT.
Gross Receipts Taxes (GRTs)
Gross Receipts Taxes can be confusing, but since they can heavily impact small businesses, they are extremely important to understand. GRTs are levied on the gross sales of a company. Similar to VATs, GRTs are charged at each stage of production of a good or service. However, unlike VATs, these taxes are not deductible at each step, meaning every party involved in the production must pay and impose higher taxes every step. This, combined with the fact that GRTs are charged regardless of if a company profited, can be extremely detrimental to small businesses which struggle to make a profit early on. Because the tax is constantly paid after each step, tax pyramiding occurs, which creates vastly different taxes for each group involved.
2. Taxes on What You Earn
Individual Income Taxes
Income taxes are taxes you pay based on how much you earn, such as from a job. Depending on how much you make, you pay a different tax rate. This rate is anywhere from 10-37% depending on how much you make, according to the 2020 tax brackets from the Internal Revenue Service (IRS). Because you pay more taxes the more you earn, income taxes in America are considered progressive taxes. There has been a heavy debate over income taxes and their ethicality, mainly in relation to the extremely rich and how much they pay in taxes. These will all be covered in part three of this mini-series.
Corporate Income Taxes (CITs)
These taxes are imposed by federal and state governments on businesses. Unlike GRTs, these taxes are only charged for the profits of the business rather than the gross sales. CITs are paid differently depending on the type of business, of which there are mainly two: C corporations and pass-through businesses. C corporations are required to pay CITs as normal and are able to spread the tax price across the entire business, including the consumers and employees of the business. Meanwhile, pass-through businesses (including S corporations, LLCs, etc.) are allowed to have the taxes “pass-through” the business to the owner(s) of the business, where the taxes are then converted into individual income taxes of the owner(s). CIT rates are generally under thirty percent, as higher taxes can be detrimental to the economy in the long run. Today, the corporate tax rate issued by the federal government is at 21% as of 2017.
Payroll Taxes are often paid based on the wages of employees of businesses in order to fund federal programs such as Social Security and Medicare. These are often taken care of for employees before they receive their paychecks. Around 15.3 percent of an employee’s wage is taken in the form of payroll taxes. Around half of payroll taxes will be paid for by employers, while the other half is paid for with employee salary, essentially meaning an employee works for a lower salary than what is agreed upon.
Capital Gains Taxes
These taxes apply when something you own gains value, also known as a Capital Gain. When someone decides to act on a Capital Gain by selling it (known as “realizing” the gain), they will pay a tax based on the profit they make from selling their increased value item. Most commonly, the items that increase in value are stocks but can be anything that gains value over time, such as a car, jewelry, or art. With stocks specifically, something called double taxation can occur, which is when the same dollar is taxed twice. This occurs because corporate earnings are still liable to standard CITs. Capital Gains Tax rates vary depending on how long the items are held. If the items are held for over a year, the tax is either 0, 15, or 20 percent, depending on income. If items are held for less than a year, then the tax will correspond to the tax rate of the tax bracket that person is in (for example, if someone pays 22% in income taxes, then they will also pay 22% on capital gains taxes if the items were held for under a year).
3. Taxes on What You Own
Property taxes are levied on property that cannot be moved, such as the land of a house or a building. Property Taxes are one of the most necessary taxes for governments as the money collected is used primarily for schools, roads, and emergency services such as the police and fire departments and medical services. Standard property taxes are relatively simple, but the next property tax leads to more issues than standard property taxes.
Tangible Personal Property Taxes (TPPTs)
This form of property taxes deals with property that can be moved or transported, like vehicles, inventory, and business equipment, among other things. These taxes can be difficult because taxes for different items are all different, and the tax can affect how a business or person can invest and what they can invest in. Every state has different laws on TPPTs, and it can reduce the want for more equipment for businesses, potentially making it difficult to grow small businesses.
Both of these taxes are similar and are therefore grouped together. These taxes are levied on the value of the property of someone when they die. Estate taxes are paid for by the estate itself, and inheritance taxes are paid for by those who inherit the property of the deceased person. A third tax known as a gift tax is added in conjunction with the other taxes, which is just a tax on anything that is given to someone else as a gift. Because inheritance and estate taxes are generally very confusing and a hassle to facilitate, only six states today still require inheritance taxes, and only twelve have an estate tax. Also, the federal estate tax only kicks in when all combined assets of the deceased person exceed 11.7 million dollars, though this number fluctuates depending on the state. In general, these taxes are more confusing than important and can mostly be forgotten.
Wealth Taxes are taxes that are usually on the net worth of an individual (net worth being total assets minus total debts). This tax only applies after a certain net worth level is reached, and the tax applies only to wealth that exceeds the net worth threshold. For example, if the net worth threshold is five million dollars and the tax rate is ten percent, a person with a net worth of six million will only pay ten percent of any wealth that is above the five million dollar threshold. Because the person has a net worth of one million dollars higher than the limit, they will pay ten percent of only one million dollars, or $100,000. Wealth taxes are uncommon, as only six nations have ever imposed one, and they have generally been met with failure, having to be repealed soon after being administered.
And that, is every major American Tax, briefly described. That is it for part one of this three part tax series. Come back next week for part two, which will discuss the most important taxes to the average American and help you understand how to deal with them when the time comes to pay them.