Taxation is the central part of modern public finance. The importance of taxation arises from the fact that it is by far the most significant source of government revenue and is therefore the primary means of financing government expenditures. In the United States the Internal Revenue Service is the regulatory authority empowered by Congress to collect taxes.
Due to the pervasive nature of taxation, taxes can be used as an instrument of attaining certain social objectives. For example, income taxes due to their progressive nature are used to equitably derive revenue by differentiating tax rates by income strata. The income derived in this manner is then used to transfer income to lower income groups, thereby, reducing inequalities related to income and wealth.
Taxation is also used as part of fiscal policy to stabilize the economy. Increasing taxes can reduce consumption and lead to economic slowing when the economy may be growing too quickly. Alternatively, decreasing taxes can be a mechanism to promote economic growth by increasing the funds available for consumption and investment spending. It is important to note that when the government spends more than the tax revenue it collects, the government is operating at a deficit and will have to borrow funds to finance operations until taxes can be increased to return the government spending to a balanced budget.
Types of Taxes
The U.S. government imposes a number of different types of taxes in order to finance its operations. The following is a list of taxes in common use by governmental authorities:
- Excise tax: tax levied on production for sale, or sale, of a certain good.
- Sales tax: tax on business transactions, especially the sale of goods and services.
- Corporate income tax: tax on a company’s profits.
- Income tax: tax on an individual’s wages or salary.
- Capital gains tax: tax on increases in the value of owned assets.
Financing State and Local Government
Taxes are the primary source of revenue for state and local governments; income, property, and sales taxes are common examples of state and local taxes. State and local governments collect taxes from residents to support corresponding state and local government activities. Examples of these services include maintenance of public parks and provision of a police force.
- Property tax is an example of a local tax. It is imposed on the value of real estate.
- Sales tax may be imposed by both a state and local government. It is charged at the point of sale of the good or service.
- Income tax may be imposed by the federal, state, or local government. Tax rates vary by location, and often by income level.
Taxes are important to federal, state, and local governments. They are the primary source of revenue for the corresponding level of government and fund the activities of the governmental entity. For example, on a local level, taxes fund the provision of common services, such as police or fire department, and the maintenance of common areas, such as public parks. On a state level, taxes fund the school systems, including state universities. On a federal level, taxes are used to fund government activities such as the provision of welfare and transfer payments to redistribute income.
Example of a Federal, State, and Local Tax
Income taxes are taxes imposed on the net income of individuals and corporations by the federal, most state, and some local governments. State and local income tax rates vary widely by jurisdiction and many are graduated, or increase progressively as income levels increase. State taxes are generally treated as a deductible expense for federal tax computation.
Example of a State Tax
Sales taxes are imposed by most states on the retail sale price of many goods and some services. Sales tax rates also vary widely among jurisdictions, from 0 percent to 16 percent, and may vary within a jurisdiction based on the particular goods or services taxed. Sales tax is collected by the seller at the time of sale, or remitted as use tax by buyers of taxable items who did not pay sales tax.
Example of a Local Tax
Property taxes are imposed by most local governments and many special purpose authorities based on the fair market value of property. Property tax is generally imposed only on real estate, though some jurisdictions tax some forms of business property. Property tax rules and rates vary widely.
Many countries impose a corporate tax, also called corporation tax or company tax, on the income or capital of some types of legal entities. A similar tax may be imposed at state or lower levels. The taxes may also be referred to as income tax or capital tax. Most countries tax all corporations doing business in the country on income from that country. Many countries tax all income of corporations organized in the country. Company income subject to taxation is often determined much like taxable income for individuals. Generally, the tax is imposed on net profits. In some jurisdictions, rules for taxing companies may differ significantly from rules for taxing individuals.
Net taxable income for corporate tax is generally financial statement income. The rate of tax varies by jurisdiction; however, most companies provide or make public the effective tax rate on the income earned. The effective tax rate is the average corporate tax rate on the company’s income and this takes into consideration tax benefits included in a current tax year.
Corporations are also subject to a variety of other taxes including property tax, payroll tax, excise tax, customs tax and value-added tax along with other common taxes, generally in the same manner as other taxpayers. These, however, are rarely referred to as “corporate taxes”.
Payroll taxes are taxes that employers are required to pay when they pay salaries to their staff. Payroll taxes generally fall into two categories: deductions from an employee’s wages, and taxes paid by the employer based on the employee’s wages.
- Deductions from an employee’s wages are taxes that employers are required to withhold from employees’ wages, also known as withholding tax, pay-as-you-earn tax (PAYE), or pay-as-you-go tax (PAYG). These often cover advance payment of income tax, social security contributions, and various insurances, such as unemployment and disability.
- Taxes paid by an employer based on the employee’s wages are taxes that are paid from the employer’s own funds. They are directly related to employing a worker. These can consist of fixed charges, or be proportionally linked to an employee’s pay. The charges paid by the employer usually cover the employer’s funding of the social security system, and other insurance programs.
In the United States, payroll taxes are assessed by the federal government, all fifty states, the District of Columbia, and numerous cities. These taxes are imposed on employers and employees and on various compensation bases and are collected and paid to the taxing jurisdiction by the employers. Most jurisdictions imposing payroll taxes require reporting quarterly and annually in most cases, and electronic reporting is generally required for all but small employers.