What Is Federal Income Tax?
It takes a lot of money to run a country. These federal expenses include defense and military spending, infrastructure and economic development, law enforcement and the justice system, social programs such as Medicare and veterans benefits, salaries of lawmakers and other federal employees, education, interest on federal debt, and a whole host of other things. Generally they are divided into three areas:
- Interest on debt held by the government.
- Mandatory spending, which accounts for spending mandated by law, such as Medicare and Social Security.
- Discretionary spending, which changes with each new budget, and accounts for the money given to various federal agencies to perform their operations.
One of the primary ways the federal government pays for their expenses is through taxation, of which a large portion comes specifically from income tax.
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Income Tax Defined
Put simply, an income tax is a tax on money that an individual or business makes. Taxable income usually includes any form of income unless it specifically considered “tax-exempt” under the law. This means that paychecks and salaries, as well as currency, property, or other forms of compensation for services provided are taxable. Gains on investments and income from a business is taxable income. A business’ profit is income, and so are royalties. Even bartering items are technically taxable income.
Benefit payments that come directly from the government, however, such as welfare, generally won’t be taxed (unless you work for the government, then your pay would still be taxed.)
Federal Income Tax
Federal income tax is the rate of tax that every person in America pays to the federal government. The rates are the same for the entire country, and are generally divided into tax “brackets” or schedules, requiring people of different levels of income to pay different amounts of tax. In theory, this is to ensure that people only pay what they can afford in tax, and that those who make more money pay more tax.
State Income Tax
In addition to federal tax, many states have a separate tax applied to the income of residents. State taxes are used much the same way as federal taxes, to fund government operation specific to that state.
Not all state taxes use a graduated schedule system like federal taxes. According to the table linked above, eight states use flat rates that do not change based on income, and seven states have no tax rate at all other than federal.
States With No State Taxes
- South Dakota.
States With Flat Tax Rates
- Colorado: 4.63 percent.
- Illinois: 9.95 percent.
- Indiana: 3.23 percent.
- Massachusetts: 5.1 percent.
- Michigan: 4.25 percent.
- North Carolina: 5.75 percent.
- Pennsylvania: 3.07 percent.
- Utah: 5.0 percent.
How Income Tax Works
The primary way that income tax works is through the federal graduated bracket system. Within a certain level of income, a certain tax rate applies. Once income rises above that level, and into a new bracket, a higher tax rate applies.
It’s important to remember that taxes only apply to the income in that bracket. Tax on income in a higher bracket is not retroactively applied across lower brackets. If you made $50,000 in a year, and the tax bracket changed at $25,000, then the first half of your income would be taxed at the lower rate, and only the second half of your income would be taxed at the higher rate.
For people who are employees of a company, taxes are automatically deducted from their paychecks. This rate is variable, and can be adjusted up or down. This can result in either under- or over-paying on taxes, meaning at the end of the year you might need to pay more money to the government, or you might be entitled to a tax refund, depending on those deductions.
What is the Purpose of Income Taxes?
A government needs money to operate: in national defense, in the maintenance and creation of infrastructure, in the regulation of the economy and negotiation of trade, and in many other functions.
Taxes are intended to pay the cost of these services that enable Americans to be successful. There is a lot of debate, however, about which services the government should be performing and taxing for, which is why taxes, budgets, and funding are often hot-button political issues.
Who Pays Income Tax?
Generally, everyone is supposed to pay income tax. Every person and entity that has an income is subject to income tax law. Who actually pays income tax is another matter, as the system has a number of intended and unintended rules that allow a large portion of the population to pay no income tax. Sometimes this is due to intended rules that allow people who are struggling breaks on their taxes. Sometimes, however, large corporations and rich individuals find ways to pay little to no tax.
Business Income Tax
Any entity that draws an income, whether a person or a business, is covered under tax law. This includes big businesses, small family-owned businesses, and even individual contractors and people who run home businesses. Any type of business entity is covered under federal tax law, unless it is a specifically tax-exempt organization such as a charity or church.
The fundamental ideas behind taxation, what they’re used for, and who pays them, are deceptively simple. The details, however, are complicated, bogged down in legislation, and often become political battlefields. Taxation is a constant political, business, and personal conversation because it touches our lives in many different ways each year.
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Ben Steele is a writer, theatre(re) professional, and nonprofit administrator. He was born in England, spent his teen and early 20s in Canada, and now lives in America. Please excuse his occasionally confused voice and the odd recalcitrant u after an o.
This post was updated June 6, 2019. It was originally published June 17, 2019.